Options Trading: Losing Before Winning

Jason Ng · February 28, 2009 · Short URL: https://vator.tv/n/720

The correct way to make a consistent profit in options trading

Most options traders were disappointed when they put on options positions expecting to see profits quickly. In fact, almost 90% of the time, your options position would make a significant loss before eventually profiting… if it profits at all. Does that sound like something you have experienced?

 

Yes, that is a fact of options trading (https://www.optiontradingpedia.com) and a phenomena that veteran options traders like myself have learnt to accept. In fact, many of my options positions, especially single directional bias ones like the long call, go into as deep as 60% loss before finally rebounding into a resounding 100% profit. Yes, most beginners would have taken that loss early and missed out on the profit.

 

What is the cause of this phenomenon? There are 3 main reasons why MOST options strategies go into a significant loss before profiting.

 

First and foremost is the bid/ask spread of all the options involved in a position. Bid ask spread is the difference between the ask price and the bid price of an options contract. Retail options traders buy on the ask price and sell on the bid price. An options contract with an ask price of $0.90 and a bid price of $0.60 has a bid ask spread of $0.30. This means that if you sell the option the very moment you bought it, you incur that $0.30 loss straight away. Options bid ask spread is significantly wide for most stocks with spreads of $0.30 as fairly tight spreads and up to $0.50 in some cases. Only in highly liquid stocks like the QQQQ do you get spreads within $0.10. Buying out of the money options costing about $0.70 with a $0.20 bid ask spread could land you in as much as 30% loss the very moment you put on the position! This is where most beginner options traders freak out especially when they commit the greatest sin of options trading… putting all their money into one trade.

 

Secondly, none of us are stock market wizards, not even George Soros or Warren Buffett. None of us could consistently put on a trade and have the stock move exactly as predicted the very moment it is put on (day trading excluded since time frames in day trading are extremely short). Like Jim Kramer said, because we are not geniuses, so we should always establish a position gradually over a number of days. Yes, most of the time, sadly, the stock seem to go the other way the very moment you put on a trade. This seems to be because most options traders enter trades emotionally when the buying get hot, which is also the point where the stock pulls back a little due to overbuying or overselling in the case of buying put options or shorting call options (https://www.mastersoequity.com/call_options.htm). Now, leverage in options trading works both ways. If it makes money quickly in one direction, it would also loss money quickly in the other even if the stock merely moves against your favor slightly.

 

Third, COMMISSIONS! Yes, most options brokers would charge in the region of $10 minimum per trade for a certain number of contracts. For beginner options traders taking extremely small positions, that $20 ($10 for buying and $10 for selling) can add a significant loss to the position especially when out of the money options are bought. Commissions also introduce significantly losses to complex options strategies with many legs such as the Condor Spread (https://www.optiontradingpedia.com/free_condor_spread.htm).

 

Now, combine the bid ask spread loss with a pull back in the stock because we are not geniuses and the merciless commission and you could end up with a 60% loss or more right the very day you put on a stock options (https://www.optiontradingpedia.com/stock_options.htm) position. Sad but true, such a deep and quick loss would spoil most stop loss policies. Which is why many beginner options traders take losses too early only to see the stock eventually recovering in the correct direction. Yes, most losses are taken way before those options expire! From a recent study, as much as 60% of all open options positions were closed before expiration!

 

So, how do professionals like I trade options? We only trade with money we can afford to lose! When utilizing options strategies with limited risk, we will limit that risk to an amount we fully expect to loss and we can afford to loss when the trade goes bad. When utilizing directional options trading, we put on a series of small “bets” over a period of time, each time making sure the amount is small enough that they result only in insignificant losses should the trade go bad. When trading this way, you would have holding power and holding power is what you need to defeat your emotions when faced with almost immediate 60% loss in directional options trading.  Holding power also allows non-geniuses like us to wait for the stock to behave as we hope it will because most stocks will not move the way we want it to right away (Neutral options strategies [https://www.optiontradingpedia.com/neutral_options_strategies.htm] are a little different as you would expect the stock not to move but most stocks go somewhere more readily than they would go nowhere…so…).

 

So, accepting the phenomenon that your next options trade is probably going to loss money significantly before they can profit means that you should use only money you expect to loss right from the start so that you have holding power which greatly increases your chance of winning.