One of the first misgivings that you must defeat, in order become a consistently successful options trader, is to realize that option traders and stock traders ONLY differ in their “execution of a trade”; the option trader uses options, while a stock trader uses stock.
Other than that there is not a lot of difference in what they see and how they see it.
Yes, obviously the option trader has more ways of making money than does the stock trader. For example, an option trader can make money due to the passage of time and the movement of volatility, while a stock trader can only play stock up and stock down.
However, both HAVE to have some idea of what the stock is most likely going to do, where it’s going to go and when! The idea that the options trader doesn’t need to know or care where the underlying (stock or other) is going… or when… is simply hogwash.
Options are a derivative product–meaning that they derive their price from the price of something else (e.g., the underlying). What’s more, the amount of extrinsic value in an option is directly correlated to the market’s opinion of where the STOCK (or other underlying) will be at a specific time in the future.
So, how can you not be well versed in the current condition and future potential of the stock both technically and fundamentally?
This is the common problem of thinking the tail can wag the dog. It can’t.
Case in point; back in the time of the credit crisis crash, there was a stock getting hit really, really hard. The stock was at $30, with just a couple of days to go before expiration. At that moment, the front month 30 strike calls were $6.00 bid! Yes, you read that right…$6.00 bid!
With only a couple days left until expiration day, there was the opportunity for a huge reward!
Suddenly, every website that deals with Covered Call Writing, every brokerage firm that gives out trading ideas, every expert who recommends trade ideas to their customers, had this opportunity rated number one on their board!
Think about it; buy the stock at $30.00 and sell the calls at $6.00. If the stock doesn’t move or goes up for the next 2 days, then you will see a $6.00 return on your $30.00 investment in just 2 days! On top of that, the stock could drop $6.00 and you would still break even. The only way to lose would be the stock dropping $6.00 in the next 2 days. What are the chances of that?!?! Not too good, huh?
You are probably wondering what the outcome was. I will give you a hint…the name of the stock was Bear Stearns!
It opened the next day at $3.00! The “guaranteed” easy $6.00 (20%) 2-day return was not to be! Instead, it was replaced by a $21.00 loss!!!
This incredible option opportunity never really existed! The problem was the stock, which the options are based on, had its own ideas!
Good, smart, technical and fundamental analysis of the UNDERLYING would have given enough warning to an option trader to know that the stock was likely to go bankrupt! And, that this great option opportunity was actually not able to wag the dog!!!
The best option traders I know are actually stock traders who are well trained in technical and fundamental analysis; they know how to find and identify opportunities in the underlying stock and then APPLY a superior and optimal option strategy to take better advantage (more profit potential and less risk) of the opportunity than just trying to use the stock!
Simply put, options are a much better tool to do the job…but you still have to FIND the job first!!!
Ron Ianieri is owner of Ion Options a company he started in 2010. He is also lead instructor at Options Monster Education and editor of the highly successful newsletter “The Income Strategist”. Ron has been trading options for more than 27 years and is also the author of the book “Options Theory and Trading” published by John Wiley and Sons. Currently Ron travels the world teaching investors the same successful Options class he developed during his years on the trading floor.