Contents Introduction Mistake #1: Relying Solely on Market Timing to Trade Options Why Traders Make Mistake #1 Why Mistake #1 Causes Losses In The Long Run How To Avoid Mistake #1 Mistake #2: Buying Only Out-of-The-Money Options Why Traders Make Mistake #2 Why Mistake #2 Causes Losses In The Long Run How To Avoid Mistake #2 Mistake #3: Using Strategies That Are Too Complex Why Traders Make Mistake #3 Why Mistake #3 Causes Losses In The Long Run How To Avoid Mistake #3 Mistake #4: Casting Too Wide of a Net Why Traders Make Mistake #4 2 Why Mistake #4 Causes Losses In The Long Run How To Avoid Mistake #4 Summary About the Author and Optionetics Trading Source Guide 3 4 Copyright © 1998, 2007 by Jay Kaeppel. 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Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com. Library of Congress Cataloging-in-Publication Data: 6 INTRODUCTION Options offer traders and investors a number of unique and outstanding opportunities that are not available to those who trade only the underlying stock or futures contracts. A bullish speculator can choose to buy a call option for a fraction of the cost of purchasing the underlying security. Likewise, a bearish speculator can buy a put option. In either case, the speculator enjoys the potential for unlimited profits with limited risk. Other traders may employ strategies that offer an extremely high probability of profit. Many opportunities exist for well-educated traders to craft option positions that make a profit if the underlying security stays within a particular price range, or if it remains above or below a given price. This ability to make money in neutral market situations is something that is available only to option traders. In addition, investors can use options to hedge existing stock or futures positions. Through the astute use of options, investors can mitigate or, in certain cases, virtually eliminate the risk of loss for a position that they hold in a given stock or futures contract. Investors can also use option-hedging strategies to generate additional income from an existing portfolio of stocks. Yet, despite all of these potential benefits, it is commonly estimated that 90% of option traders lose money in the long run. This staggering figure raises several extremely relevant questions: 1. What is it about option trading that causes so many people to fail? 7 2. Is there a way to avoid the apparently huge pitfalls that claim so many traders? 3. If the failure rate is so high, why does anybody bother trading options in the first place? After listening to a multitude of traders talk about their ideas on trading options over the years, it is interesting to note that there are several common themes running through many of these discussions. This raises an interesting question. If 90% of option traders lose money, and a lot of traders subscribe to the same ideas, can one gain an edge by avoiding the common approaches used by these traders? In order to attempt to answer this question, I systematically tested the option trading approaches most commonly mentioned by traders—especially novice traders—using computer simulations. As I will detail in the following sections, there are several common pitfalls that the majority of option traders fall into that cause them to lose money in the long run. As we often find to be the case in the realm of investing, whenever “the crowd” migrates to an idea or set of ideas, it usually pays off handsomely (in the long run) to go the other way and simply avoid whatever the crowd is doing. The good news is that by isolating the mistakes most commonly made by option traders, learning why they are so common, why they cause losses in the long run, and how they can be avoided in the future, you take a major step toward becoming a consistently profitable option trader. There are good trading ideas and bad trading ideas. One of the best ways to find the good ideas is to first eliminate the bad 8 ones. This is what I will attempt to accomplish in the following discussions where we will focus on the four biggest (and most common) mistakes made by the majority of option traders. So consider this the “how not to” portion of your option trading education. For each of the following four biggest mistakes in option trading, I will first discuss what the mistake is. It is important to have a clear understanding of each error in order to be able to recognize in the future when you might be about to fall into a potential problem situation. I will then explain why it is so common for traders to make this mistake and why it causes traders to lose money in the long run. The idea here is to help you understand the reasons behind why a seemingly enticing idea can lead to your downfall in the long run. But, if you can learn how to avoid making these mistakes, you will stop falling victim to the siren song of tried and failed ideas. Finally, I will detail what needs to be done in order to avoid each of the most common mistakes. The goal here is to teach you to think independently of the “the crowd” and to teach you how to achieve the success that most option traders can only dream about. One word of warning: a lot of traders may not enjoy reading these sections for the simple reason that we are about to de-bunk several ideas that many hold near and dear. Much of what you are about to read details the way that the majority of option traders trade. Yet, given the fact that most uneducated option traders lose money, it is important to read these sections with an open mind. Most often when someone attacks an idea that you believe to be true, or which “conventional wisdom” has convinced you is true, the first reaction is to become defensive and to try to defend your 9 reasons for believing the idea in the first place. It is impossible to overemphasize the importance of reading the following text with an open mind if you want to trade options profitably in the long run. This is especially true given the following paradox: in most cases, the very ideas that lure traders into the options market in the first place are the same ideas that cause them, in the long run, to lose their time and money. 10