When buying a put or call option, the
usual objective is to earn a profit.
That may seem obvious, but investors also buy options to hedge, or
reduce the risk of owning, other positions. For example, the owner of a
large stock portfolio may buy put options as as insurance against a
market decline. The idea is the the puts will profit on that decline,
offsetting a portion of the loss that comes from owning stock. Thus the
puts are NOT bought with the intention of earning a profit. They are
used as insurance.
now, let's simply concentrate on the basic reason most traders buy
options: to make money.
Ina previous post I explained how difficult it is to earn a profit when
- You must correctly pick direction
- The timing must be accurate, or the option can become
- The size of the move must be estimated to ensure
Nevertheless, buying options is a favorite strategy, especially among
beginners. One reason is that the payoff can be substantial. It's
also true that the
chances of success are much better than buying a lottery ticket.
Here's an example of an INEXPERIENCED hypothetical call buyer's
"I've been watching my favorite stock, BVO, and
has declined to a point where I believe it's a good buy based on
value. The current
price is $44 and according to my system, this stock can move to $50 or
perhaps $51 withing the next 2 months. I don't have $4,400 to buy 100
shares, and don't believe there's enough profit potential if I buy 10
However, BVO Aug 50 calls are only $0.50 each. That's $50 per
contract. I can buy 10 of them for $500, plus commissions. If the
stock runs past $50 quickly, I should be able to earn a nice profit."
This inexperienced trader goes ahead and buys 10 BVO Aug 50 calls.
It's true that if the stock turns and moves higher and does it when
there is still plenty of time (3+ weeks) remaining in the life of the
option, then a good profit can be had. And of the stock roars towards
$55, a very large profit will be available.
The problem is that this is the wrong call option to buy. If the stock
moves higher, but at a slow pace, it's very possible for the stock to
approach 50 as the clock runs out and August expiration day arrives.
To make money, the stock MUST move quickly or it must move near $51
($50.50 is break even at expiration, but there are commissions to pay).
It would be much better to buy one Aug 40 call or perhaps two Aug 45
calls in the scenario.
It's not easy for the beginner to understand which options to buy.
Mark D Wolfinger
Expiring Monthly: The Option Traders Journal