Have you noticed how many television programs focus on flipping houses? For the last several years, programs featured people from all sort of occupations flipping houses. The flippers go through a few setbacks but emerge from their six-week, three-month or four-month ordeals with sweaty, paint-stained hands grasping anything from $20,000 to $200,000 in profits.
Lately, some outcomes have changed with the changing housing market, and the television shows reflect that. One family-based group of flippers ignored the advice of an expert. They ended up leasing a house they couldn't sell. They hadn't taken that expert's advice to provide an extra bedroom for a house located in a family-oriented neighborhood. Several flippers saw their carrying costs rise, cutting into their profit, when they overspent on renovations, spending more than the comps for that neighborhood would support. Some found that the market had changed completely by the time they were ready to put the flipped house on the market, with prices depressed, cutting into or eliminating their profits entirely.
What does all this prove except that I watch far too many shows about flipping houses? What does flipping houses have to do with trading options, anyway? More than you might suspect. Read on a bit before options are discussed.
When the real estate market was hot, flippers could buy almost any property, spend almost any amount on repairs and dawdle away almost any amount of time due to poor planning and still count on profiting. Flippers didn't need a plan. They didn't need expertise. They didn't need much of a financial basis before starting the process. They didn't even need too much luck. They could count on a loan. They could enter the market as flippers at almost any point and exit at almost any point and be assured of their profits. They could repay those loans.
Trading long calls was like that in late 1999 and early 2000. You could enter at almost any point and count on making a profit. This isn't really an exaggeration, either. You didn't need much expertise. Traders could and did finance those calls by buying on margin and count on profiting, just as flippers in the early 2000's could count on paying back their construction loans.
However, when the housing market cooled, home equity became a dwindling asset, not an escalating one. In many regions, equity evaporates while flippers redo the houses they've bought. If they take too long, the increased equity they've built into the house with those travertine floors, granite countertops and stainless-steel appliances will be balanced against the declining existing homes sales price in their region, and the balance may be negative. The flipper may have lost money.
Flippers are in more danger if they buy the wrong house or employ a bad design plan. If they've overspent their budget, those who have bought in the wrong market will find that danger escalating. Even if flippers have got the right house in the right market with the right design, flippers who overspend their original budgets may find that lenders aren't willing to pony up any more money. Even with that right house, market and design, they could go bust.
We realize instinctively that flipping houses in a declining housing market is a risky business. We may even reason that only the most experienced and best financed of those flippers will survive with the others almost certain to get caught at some point and lose money.
Why don't we reason the same with options? If your only options strategy is going long calls or long puts, you might as well be flipping houses in a declining market, right? Your actions are analogous to those flippers the last year or so, flipping wasting assets.
Think about it. Options are, by nature, wasting assets. Part of the value of options comes from the time left before expiration. That value, commonly called "time value," always decreases as time passes. It will be at or near zero at expiration. Only the intrinsic value, the amount by which an option is in the money, will be left.
Just as today's house flippers must count on their improvements overcoming the declining house values, those who are long options must count on the intrinsic values of their options--the part that reflects how much the option is in the money--escalating faster than the time value declines. When markets are trending strongly, either up or down, going long options with a portion of your portfolio is a valid strategy, but you're going to eventually get caught when conditions change.
If logic tells you that people who flip houses in a declining market are bound to get caught at some point or another, logic should also tell you that those who only go long options are also going to get caught. A few house flippers, the most experienced and the best financed, will succeed, but the majority just won't. If you have only one strategy in your trading arsenal, you probably won't, either.
Am I telling you to stop trading options, that no one can make money trading options? No way. I am, however, telling you that you absolutely can't count on one strategy alone--going long calls and options--to make that money. You're far better off buying and shorting stocks, ETFs or the like if going long and short are going to be your only strategies. Stocks may rise or they may decline, but every time a stock hits $50, it's worth $50. It's not a wasting asset in the same sense, although it may certainly feel that way when prices are declining!
However, every time a stock hits $50, the long 50 call may not be worth the same thing. It is a wasting asset. If you bought a 50 strike call three months out when the stock was at $52.00 and it since dipped to $35.00 but has laboriously climbed all the way back to $52.00 the day of option expiration, you can bet you've lost money. Let's try it on the iVolatility.com "Options Calculator" on www.cboe.com.
Value for a 50 Strike Call, 90 Days from Expiration, with Stock Price at $52.00:
Note that the call would be worth $2.85. Using identical inputs, except for the time to expiration, we can calculate the value for the call on the day it expires, with the stock having again labored up to $52.00, the value it held the day you purchased the call three months earlier.
Value for a 50 Strike Call, 0 days to Expiration, with Stock Price at $52.00:
The call would now be worth $2.00. The so-called "time value" has wasted as time passes, just as home equity wastes in a declining housing market, and you've just lost $85.00 per contract [($2.85 - 2.00) x 100 multiplier]. You would have needed some improvement--in this case, an escalation in the underlying's price--to counter that wasting effect.
Choices do exist for trading options and making money, even if they are a wasting asset. Experienced house flippers who have reasonable plans and stick to them; who take losses when needed, not letting their asset's value waste further; and who have deep enough pockets to weather the inevitable loss will fare better than the inexperienced flipper who takes unwise choices; has no plan; refuses to sell at a loss, letting the loss accumulate while carrying costs build up; and who has spent more than is affordable.
Educating yourself about how options work, having a plan and sticking to it, being willing to take losses and keeping them small and not investing more than you can afford to lose are necessary but not the only ingredients to a winning strategy. Read everything you can find on this website. Go to www.cboe.com and www.cbot.com, both of which feature excellent free webinars on trading options on various underlying securities, and watch them. Set up one night a week, if necessary, for listening to a webinar on trading.
Even experienced house flippers will occasionally get caught, and will need to keep losses small to avoid eating into the money needed to flip another house or even feed the kids and keep the electricity turned on. Keep losses small when trading options, too.
What is a "small" loss? "Small" to a trader with a $5,000 account may be much different than "small" to a trader with a $500,000 account. How does one quantify it?
Dan Sheridan, who often conducts free "Master Session" webinars found on the CBOE, offers a specific guideline for his students. He wants them to average their gains on their winning trades over a period of months. Then he wants to see the MAXIMUM loss, not the average one, be no more than the average gain on their winning plays. For example, if you were to find that over a period of six months or so, your winning trades averaged a gain of $750.00, Sheridan wants you to set your stops on each play so that you can lose no more than $750.00 at the most, and preferably less.
Consider diversifying so that you're more like the house flippers from the early 2000's, flipping in a climbing market, than like those who are attempting to flip in a declining one. You can do that by diversifying the types of options plays you enter. Some of the time, and maybe even most of the time, employ some income-producing strategies that let you benefit from the wasting of time premium. Some of those strategies include combination plays such as credit spreads, condors, butterflies, calendars, among others. Paper trade them. Get a feel for how and when they can go wrong before you invest a penny in them, and then devise a sound plan for when and where you'll take losses and gains. Don't over-use margin and don't put more money at risk than you can afford to lose.
I am not counseling you to jump right into complicated options plays. As I write, I am myself paper trading a number of strategies that I want to try as well as paper trading some familiar ones that are set up on underlyings that I haven't traded frequently. I always do this with new strategies, and I always will. I advise you to do the same before you click on an order. The market will be waiting when you're ready, when you understand what you're risking.
Mull this information over a bit. Turn on the TV and watch a few of those house-flipping shows. Think about the flippers who got caught flipping in a declining market. Then go to your trading journal and write out a plan. Boot up your computer and watch a webinar or two on different options strategies or read about them on our site or one of the sister sites that focus on specific strategies. Set up your spreadsheet and track some plays for a few months. Trade small until you're sure of what you're risking and, most importantly, until you're trustworthy about keeping those losses small.
A place exists in your trading plan for speculative plays. That's what going
long calls and puts is: speculative. We should all include speculative plays as
a small portion of our portfolio of plays. If you don't diversify, however,
you're flipping in a declining market, and you know what that means for all but
the most experience or luckiest among you.