You Have To Treat Options Differently
Options Are Not Stocks
How Options Are Priced
There are many sound investing practices that apply to stocks, but don’t necessarily apply to options trading. You can’t really take a “buy and hold” approach to options. Options have a predetermined life span and even if you are buying LEAPs that are two years from expiring, at some point you have to close out the trade.
Two of the most common questions I get from subscribers to the Cabot Options Trader are: do you use a stop loss point with the recommendations and secondly, if the price drops should I buy more and dollar-cost average.
With regard to the first question, yes I do use stop-loss points, but they might not be what many people would use if they were trading stocks. Because options are a derivative, meaning they derive their price from an underlying stock, I don’t set a stop-loss based on the price of the option. I set a stop-loss based on the price of the stock.
Let me use a recent recommendation I made in the Cabot Options Trader as an example. On February 8, we issued a recommendation to purchase the March 45 Put on Lam Research (LRCX). The stock had appeared on our bearish scan the night before and it was having trouble moving above the $45 level.
The chart will help illustrate what the stock was doing at that time. The red line at the $45 level represents resistance and the downward arrow illustrates when we made the recommendation. The blue line represents a short-term trendline. After we entered the trade, the stock dropped below the 20-day moving average, giving us two points of resistance if the stock tried to rally. These two trendlines became the stop points for the recommendation.
The two upward arrows represent our close out points. On February 21, we recommended closing the first half of the recommendation in order to lock in gains on part of the trade. The stock proceeded to rally, but never closed above either of the trendlines. After testing the resistance, the stock experienced another drop and on March 8 we recommended closing the second half of the trade.
The average gain on the first half was 72% and the average gain on the second half was 145%. Averaging the two out, the overall gain on the recommendation was 108%. By using the two trendlines as our stop points, we were able to stay in the second half of the trade for a few more weeks and boost our return by 36% compared to if we had closed the entire trade on February 21. During the rally between the two closeout recommendations, the gain on the second half declined to only 15% on February 28, but by holding to our convictions and observing the stop points, we didn’t panic sell and we were rewarded nine days later.
The fact that we closed the recommendation in two parts brings me to the second point about options. Many investors are used to legging in to a stock position in several stages. If you like a stock at $50 and it drops to $45, why not add more, right? This is called dollar-cost averaging. Instead of owning 100 shares at $50, now the investor owns 200 shares with an average cost of $47.50. Assuming the investor bought 100 shares each time.
I don’t recommend doing this all the time, but if the fundamentals haven’t changed and the stock hasn’t broken any major support levels or anything, it isn’t a bad practice. However, with options, you are dealing with an investment vehicle that has to deal with time decay.
The price of an option is made up of two parts, the intrinsic value and the time value. The intrinsic value is the amount the option is in the money. For instance, if you own an April 50 Call on XYZ Corp. and the stock is trading at $52, regardless of what price the option is trading at, the intrinsic value is $2- $52-$50. Now if the option is trading at $3, the time value is $1. This is simply the price of the option minus the intrinsic value.
Here is the problem with the time value when you are trading short-term options. If the stock doesn’t move at all, the time value will drop slightly each and every day. If the stock moves sideways for an entire week, our option will have dropped quite a bit, depending upon how close to expiration we are. Because of the time decay and the way short-term options work, I don’t recommend legging in to a position.
Rather than legging in to short-term options trades, I prefer to leg out. Due to the volatile nature of options with only a few weeks left until expiration, the price can change very abruptly. Look at the example of LRCX we showed earlier. From February 21 through February 28, the stock gained 3.8%, but the March 45 Put dropped in value approximately 33%. Fortunately we were still at a small gain on the second half and had taken a 72% gain on the first half, so it allowed us to be more patient.
Options are a different animal from stocks and you have to treat them differently. Some of the sound investing principles you apply to stock investing can’t and shouldn’t be used with options trading.
Good luck and good investing,
Editor of Cabot Options Trader
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