Why Options Are Bad and Dangerous
This article is directed at options trading beginners. Many new traders are unaware of the dangers involved in trading options. Options can be very confusing, and for that reason can make it very profitable for those who know how they work and very unprofitable for those who are confused. There is a reason why you have to apply specifically for options from your broker; it is very dangerous. In short, options are very gainful to the seller and at the other end, those who hold during options expirations end up being at the losing end of the trade. You can make a lot of money selling options, but buying options is a losing game, especially for beginners.
You can exponentially increase your profit trading them, but can also incur losses very quickly; that is how they are designed. Let's take the case of Apple (AAPL) stock: say Apple moves 5% in a day and you decide you want to buy options in it. The problem is that the option is priced in a 5% move, and basically, when they sell you that option, it has that 5% movement embedded in the stock. This is called volatility, meaning: if it does not continue to move at a fast pace, you will lose money buying that option. Here is the example: the day you bought it, it moved 5%; the remaining week it moved 1%. You will see a loss in the value of the option even though it went up 1% higher!
If you decide to trade options, the best strategies are: NEVER buy call options on a day where the stock moved up and NEVER buy put options when a stock moved downward. Another example: say you bought DECK puts when it moved down 6%; the next day it is green around .3%. Your put did not lose .3% of the value; instead, the option lost 10%-20%. Why? Because you paid for the 6% loss and the expectation that the next day the put will lose more. These are somewhat simplified examples, but this is what happens when trading stocks. Before deciding on trading stock options, you need to know much more than what you learn just reading material like Options for Dummies or Education 101.
Holding options and calls in earnings is a losing game. You will find that the majority of your call and put option costs are priced into the earnings report of that stock. When you purchase a stock option, the volatility (potential movement) of a price is included into the put or call. If you buy option calls or puts before earnings on Amazon ($AMZN) and plan to hold it, the options and puts expect a 10% movement in price, so therefore, your options get 10% more expensive (this example is really simplified). However when earnings come up and the stock only moves 2%, guess what happens to the cost of the options? It goes down. In order to really be a winner, you would need Amazon to jump more than 10% in this example. So just guessing if a stock goes up is not enough; it is by how much it moved up that is important! One strategy options traders do is they buy stock options a few days before an earnings report and sell them prior to earnings. They make money because the options price has increased to an amount that is closer to the earnings report. It is called Trading Earnings Volatility. Again, this example shows that those who buy the options end up being on the losing end of the trade when holding through earnings.
Another issue is some stocks, for example Kellog ($K), have a very low volume of options. This is a red flag; this means it has a liquidity problem. It will be difficult to get rid of your options when you want to sell them, and you are more than likely receiving an inferior price on them. You will see the bid and ask prices are very wide; that indicates a market-maker trying to manipulate the price. Stay away!
Always put limit orders when trying to purchase an option; the bid and ask prices are incredibly varied sometimes.
If you don't know what you're doing, options trading will be a losing game for you; it should be strongly avoided unless you fully understand how they are priced.