Option trading can deliver exceptionally high returns with very limited risk if you have a disciplined approach. Unfortunately, as many as 90% of all persons buying options lose money.
There are two very good reasons why most retail option investors lose money:
1.Traders lose money because options are a depreciating asset. This means that options lose value with the passage of time.
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Since options lose money with the passage of time, the purchasers of options are at a mathematical disadvantage; they lose money with each passing day that the security underlying their option stands still. While it is not impossible to be profitable on any trade despite this mathematical disadvantage, it is a statistical impossibility to be profitable over time. It is fairly easy however to offset the time depreciation element in options by setting up your trades properly. I will show you below how to offset the time depreciation aspect of options.
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2.Most traders are too eager to trade.
They can’t do the most important thing: weigh the risk/reward ratio of each trade before executing it. Impatient traders and “expert advisors” with very few exceptions deliver nothing but significant losses. The reason why most option services aren’t profitable is that their editors are always trading.
The truth is: The most successful traders are the ones who know when to sit on the sidelines and pick their spots. Patience is the key to making very substantial profits, and doing so on a consistent basis.
Above, I mentioned that I would show you how to offset the time depreciation element of options. To offset time depreciation, I simultaneously buy and sell options.
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This type of trade is known as a spread trade, and not only reduces the time depreciation of the options purchased, but also reduces the overall cost and risk of the trade to you.
Below is the most recent options spread trade recommendation utilized at PatientTrader.com to earn our investors profits: “BUY TO OPEN (20) XEO AUGUST 610 PUTS (XEOTB) AND SIMULTANEOUSLY SELL TO OPEN (20) AUGUST 605 PUTS (XEOTA) FOR A NET DEBIT OF 4.5.”
In essence, we recommended buying some expensive put options and recommended selling less expensive put options against them.
However, let me explain the instructions to you in more detail. “BUY TO OPEN” means we are recommending buying options and this is an opening or new transaction. “(20) XEO AUGUST 610 PUTS (XEOTB)” means we are recommending buying (20) contracts of put options on the S&P 100 Index (“XEO”), which options expire in AUGUST and have a strike price of 610.
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The symbol for the options we are recommending buying is XEOTB. “SIMULTANEOUSLY SELL TO OPEN” means at the exact same time we are recommending buying options, we are also recommending selling options, and this is also an opening or new transaction. “(20) AUGUST 605 PUTS (XEOTA)” means we are recommending selling (20) contracts of put options on the S&P 100 Index (“XEO”), which options expire in AUGUST and have a strike price of 605.
The symbol for the options we are selling is XEOTA. “FOR A NET DEBIT OF 4.5” means you will be spending $450 for every contract you are undertaking, or in this case $9,000 because the trade recommends doing a total of 20 contracts.
At the time we recommended this trade the XEO AUGUST 610 PUTS were selling for a cost of 27.5 or $2,750 per contract.
The XEO AUGUST 605 PUTS were selling for 23 or $2,300 per contract. Therefore, the total cost to buy the 610 PUTS and sell the 605 PUTS was 4.5 (27.5- 23=4.5), $450 per contract. Here are the benefits of doing the spread trade rather than simply buying the XEO AUGUST 610 PUTS on their own: First, the cost to do the spread trade is $9,000.
The cost to buy the XEO AUGUST 610 PUTS is $55,000.
This means that it costs $46,000 less to do the spread trade than to buy the XEO AUGUST 610 PUTS alone, and your risk of loss is also $46,000 less. Second, the breakeven point (that point where you will profit) on the spread trade is with the XEO trading at 605.5 or below.
You calculate the breakeven point on a trade by taking the strike price of the options purchased (610) and subtract the net cost of the trade (4.5). On the spread trade, the breakeven point is calculated as follows, 610 – 4.5 = 605.5.
The breakeven point on buying the XEO AUGUST 610 PUT options alone is with the XEO trading at 582.5, which is calculated as follows, 610 – 27.5 = 582.5 Thus means the spread trade will be profitable between 582.5- 605.5 on the XEO index, while buying the XEO AUGUST 610 PUTS options alone would be unprofitable in the same range.
The above description explains the benefits of using spread trades when investing with options.
Utilizing the spread trade allows the investor to offset the time depreciation characteristic of the options that typically works against the investor. Most investors with options employ a strategy of simply buying either call or put options.
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These investors are typically losing money with each passing day that the security underlying the option sits still, and explains why as many as 90% of all purchasers of options lose money.
Charles Sachs Editor PatientTrader.com
If you have any questions about this article, or any other issues regarding options or options trading, you may send them to me at [email protected]
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