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Why You Should Never Trade a Stock or ETF Again

Written By Trading Forex News on Saturday, January 16, 2010 | 9:23 AM

Here's some advice that I have given that has made hundreds of people millions of dollars: You probably should never trade a stock or exchange-traded fund (ETF) again.

However, if you chose the right stock option or ETF option to trade, you will be taking on a fraction of the risk that the stock/ETF trader takes on. At the same time, you will position yourself to realize the same (or a much larger) profit when your assumption about the stock/ETF's next move is correct.

I know everyone has heard that options hold more risk than stock, but the fact is, that's not always true. In fact, it's untrue in most cases. It's really all up to you and how much risk you want to take on.

Stocks, ETFs are Necessary; Their Options are Where Your Power Lies

Let's say we had a $100 stock that we thought would trade higher. What if I told you the following:

* If it trades up 30 points, you would make 29 points (multiplied by the number of shares you chose to buy). In fact, if the stock traded up 100 points or 200 points, you would make nearly that amount.

* But if the stock traded down 30 points, you would only lose 10 points (multiplied by the number of shares you chose to buy). In fact, your maximum risk is only 10 points, even if the stock traded to zero.

Isn't that a good risk/reward scenario? It's better than the scenario that any stock/ETF trader can promise you.

In fact, you don't even have to be right 50% of the time to make a fortune with that scenario. Being wrong sometimes is just part of trading/investing, so you should plan for it and factor in the possibility of a losing streak, because it will happen.

Now, if you know that the risk/reward scenario above is available (and, by the way, it really is), would you invest your entire net worth in the stock idea? Heck no! That would defeat the purpose!

You Have a Lot of Leverage at Your Fingertips …

What if you could make a list of all losses you ever took in the past, and you could reduce every single one of them -- while reducing the absolute maximum loss on all of the losses to less than 10%-15% -- and then you took the remaining money that you therefore didn't lose, and you invested that extra cash into the winners you enjoy later on in your life? What would your net worth be?

Well, this is something that is very possible and very simple!

... And the Trick is to Use it Wisely

But when people figure that out, they get greedy and immediately use that power to try to triple their net worth within six months instead of treating the process like a marathon. They turn their backs on the power they have -- almost immediately after discovering it -- and, instead, they increase their risk!

Amazing, I know. But it's human nature to do just that, and human nature is very hard to fight.

If your net worth is $10 million and I gave you this risk/reward ratio above, would you risk $1 million per point (meaning that, for every point the stock trades lower, you would lose $1 million -- with a max loss of 10 points, or the entire $10 million), for the possibility of making $1 million per point on the upside with infinite profit potential?

HECK NO!

But that's what humans do when they realize the power of stock/ETF options. It's human nature. They over-leverage themselves like crazy and, when the trade goes against them, they blame options -- saying options are extremely risky.

Anyone who studied human nature knows that it's human nature to blame everyone and everything else (not yourself), especially for financial losses.

Did my risk/reward scenario sound risky to you? NO! It was simply the human behind the wheel with the ability to veer off-course.

Options Don't Kill People's Accounts; People Kill People's Accounts

You don't have to over-leverage yourself when you trade options. Instead, just be responsible and you will have the risk/reward scenario I described above. More on overleveraging near the end of the article, but let's move forward for now ...

Here's another risk/reward scenario that's VERY real:

* If the stock trades up 10 points, you make $9 (multiplied by the number of option contracts times 100 shares in each contract that you chose to buy).

* But If the stock trades down 10 points, you lose $7.50 (multiplied by the number of contracts times 100 that you chose to buy).

Make more when right, lose less when wrong!

So, then why would you trade stocks or ETFs where you make the same amount when right that you lose when you're wrong?

That's the kind of risk/reward scenario that you are turning your back on every single time you buy an stock or ETF instead of finding the right option. You're also exposing yourself to 100% maximum downside risk. Trading specific options that I keep referring to, you can reduce the risk to about 15%.

Every time you trade a stock or ETF, remember that you are exposing yourself to more than six times as much risk as you need to expose yourself to in order to get the same exact reward (or less) when the stock moves in your favor.

The Best Options to Trade in Place of Stocks or ETFs Are ...

... In-the-money call options that expire at least three to six months after your anticipated holding period (if possible).

* In-the-money call options have a strike price that is below the stock price. The lower the strike price is, the deeper in-the-money the call option is.

* In-the-money put options have a strike price that is above the stock price. The higher the strike price is, the deeper in-the-money the put option is.

I'm sure at least 20%-30% of you are going to tell me you think I'm wrong for the same reason (and will come back and tell me I'm right, which is what 100% of the group always ends up saying): You believe the cheaper options hold less risk because, the lower the price of the option, the fewer "points" you are risking. Or, you believe the in-the-money options have a higher risk because the price is higher.

But you must consider the odds of success. The cheaper options are cheaper for a reason: They have more factors working against them, and have a lower probability of ending profitably.

There are two ways to reduce the price of your option, and both involve taking on MORE risk:

1. Buying options that are not in-the-money (which means the entire value of the option is affected by time passing, meaning the option contract can lose its entire value over time without the stock even moving).

This means you are now taking on an additional risk. Not only do you have to be right about the direction of the stock/ETF, but it has to move quickly because you have another factor working against you: time passing. If you tried to eat an ice-cream cone in a sauna, you might only get half your money's worth of the ice cream.

The other negative in that is you'll be purchasing options that have a delta of 0.50 or lower. Remember, the delta measures the amount that an option will theoretically move in either direction when the underlying stock/ETF moves 1 point.

An option with a delta of 0.50 will move about 50 cents if the underlying stock/ETF moves by 1 point. The further out-of-the-money the option is, the cheaper it will be ... and the smaller the move will be when the underlying stock/ETF moves. We want our option to realize a good portion of the stock/ETF's move.

The usual rebuttal to what you just read is, "Yeah, but can't I just buy twice as many option contracts because two contracts with a 0.50 delta = 1.00 delta?"

The answer is yes. That will work for you as long as the underlying stock/ETF moves in the right direction. So, just be sure that you're right every time and you will be OK.

(That's a joke, folks. You would still be investing in an option that has 100% of its value affected by time passing.)

2. Buying options that have closer expiration dates, which means the process called "time decay" accelerates at a much-faster pace.

When the option is in the money, only part of the option's price (the "extrinsic value," aka "time value") is affected by time decay. The deeper in-the-money the option is, (with call options, the lower the strike price is; with put options, the higher the strike price is), the smaller the part of the option's price that's affected by time decay will be.

If you need to review, be sure to read the first three parts of this series on understanding delta:

The last part might not have been very clear, so I'm going to republish the chart I showed you in Part III. Do yourself a favor and REALLY stare at it for a while.

This one simple little chart changed my life and made me much wealthier -- an effect it would have on anyone who grasped the simple concept. So, focus harder on this than anything you've ever focused on, and you will thank me!

Notice that the time value portion of the option only loses 10% (from 100% to 90%) of value in the period with nine to six months left; the period with six to three months left loses another 30 percentage points (from 90% down to 60%); and the remaining 60% of the extrinsic value portion of the price gets clobbered in the last three months.

Notice how the deterioration of the peach or red part, the extrinsic/time value part, accelerates.

All options will react differently, since all of the variables change depending on the specific option's situation. But you get a basic understanding with this chart, and how this process of the option's loss of value (aka, time decay) accelerates.

Keep in mind, you can and should chose to buy an option that has very little time value, since time decay can only affect the time value (extrinsic value) portion of the option.

Bad Trades Make Better Traders of Us All

And I'm going to share one of mine with you so that you will learn from it and hopefully save yourself some heartache (and cash).

I built this chart to illustrate an example of a bad trade I made in the late '90s.

The red and green bar on the right side represents the price of an option that started out at $4 long before I bought it (when there were nine months left before expiration).

The chart represents what happened to the extrinsic value (time value) portion of the option over time, assuming the stock didn't move in price.

This option traded down from $4 to $1.50 at expiration day due to time passing.

The call option was the IBM $100 call. Since IBM was trading at $101.50 ($1.50 higher than the strike price), the option was $1.50 in the money, which is represented by the bottom (green) portion of the vertical bar.

Stare at the chart for a minute. The bottom, in-the-money, amount of $1.50 is not affected by time decay.

The option starts out with nine months left before expiration. Let's assume for a second that IBM's price stayed exactly the same for the next nine months.

When there were six months left before expiration, the option would have been worth about $3.60, after losing 40 cents in that three-month time frame. That's a 40-cent loss from the starting point.

When there were three months left before expiration, the option would have been worth about $3, after losing 60 cents in that three-month time frame. That's a $1 loss from the starting point.

When there were TWO MINUTES left before expiration, the option would have been worth about $1.50, after losing $1.50 in that three-month time frame. That's a $2.50 loss from the starting point.

The final three months caused the option to lose nearly four times as much ($1.50 versus 40 cents) as the first three out of nine months.

So let's compare the difference (in the way time works against us) between the shorter-term $3 option to the longer-term $4 option...

When the option was trading at $3 with just three months left, it was $1 cheaper than the option was when it had nine months left (and was trading at $4). But the $3 option, which had three months left lost $1.50 due to three months passing, while the higher-priced option ($4) option only lost 40 cents due to three months passing.

I chose to use this example because the option was actually in the money, and I'm telling you to buy options that are in-the-money. But the option above wasn't deep enough in the money. Said differently, it didn't have a high enough delta. The delta was probably about 0.55. It was only one strike price in the money.

Time is Always Working Against You

Today we continue to learn the concept of trading options with a higher delta (that is deeper in the money), so I'm not talking about the calculation or what the deltas of the options actually are. Soon, I will show you how to find the EXACT option to buy, and what the deltas of those options are.

In the previous above, what happened to me, in real life, was I bought the option when there were three months left. Rookie mistake.

The option started out at $3 in my case. I knew that since it was $1.50 in-the-money (it had $1.50 intrinsic value and another $1.50 of extrinsic value (time value), at least half of the price ($1.50) wouldn't be affected by time decay.

What happened to me was the stock actually traded a bit higher (by about $1, if memory serves) and I still lost money. This happened because, although the stock gained $1, I lost the $1.50 in time value. So I lost 50 cents. Time was working against me.

Had the stock traded down by $1.50, since I waited until expiration day, I would have lost $3 (twice as much as the stockholder would have lost).

So the stock had to trade more than $1.50 higher for me to just break even, or $1.50 lower for me to lose everything. And boy did I over-leverage. My stomach hurts just thinking about it.

With odds working against me like that, I shouldn't have committed so much to the trade. In fact, with those odds, I shouldn't have even committed $1 to the trade.

Are those the kind of odds you want to work with? NO!

We want to increase our potential reward, and we want to significantly reduce our risk. Because when we are wrong, which tends to happen, we are left with a heck of a lot more money that we can use to make nice profits when we are right. We don't want to end up feeling like we should now risk a larger percentage of our investment capital just to make back what we lost on the last trade!

One last note on how to avoid over-leveraging before. Your broker will absolutely HATE this idea because they want you to invest (risk) as much money as possible, but I happen to like the idea of you trying to get yourself paid. You don't have to commit as much to the trades/investments any more.

Keep lots of cash on the sidelines and consider it as part of the trade. You can use leverage, but just a little bit. Assuming you would have felt comfortable buying 500 shares of a $20 stock (a $10,000 trade/investment), then what you should do, instead, is buy five or perhaps six call option contracts, which would represent 500 or 600 shares of the stock.

Buying that extra call option (six instead of five) is FINE and will usually amount to the same risk and same reward that a stock trader with 500 shares would have if there is a 1-point move in the stock ... as long as you buy the right option.

What Happens When You Pick The Right Option

If the stock (or ETF) moves up 10 points, the option trader will make more than the stock trader, and if the stock moves down 10 points, the option trader will lose much less than the stock trader.

If it's a call option, since it's a $20 stock, you would probably want to buy the option that has a strike price of $15. This is a bullish position, and you would use it if you thought the stock will trade higher.

If it's a put option, since it's a $20 stock, you would probably want to buy the option that has a strike price of $25. It's a bearish position, and you would use this if you think the stock will trade lower.

In either case, the option would be 5 points in the money (which means it has 5 points of intrinsic value). Your delta is probably going to be about 0.75 - 0.80.

In either case, you would chose the option that has an expiration date that is at least three months after the anticipated holding period. So, if I believe I would exit the position sometime within six months, I would chose the option that expired at least nine months out.

Remember the time decay chart above. The closer the option is to expiration day, the faster the acceleration of the process time decay is going to be.

If you bought the option for $6, the investment would be $600 per option. (A $6 option that has 5 points of intrinsic value would have $1 extrinsic/time value). If you bought five option contracts, you would pay $3,000.

Remember, we said you are a person who normally commits $10,000 to a stock position. That leaves you $7,000.

This is one of the most important parts of the strategy ...

Keep that $7,000 sitting in cash, or an interest-bearing minimal-risk security like a money-market fund. Consider it as part of the position. You now have a $10,000 position.

Familiarizing yourself with this takes minimal time. Think about how much time it took you to learn the skill that made you the money in your bank account. Think about how much time you then spent applying that skill in order to earn the money in your bank account.

Learning what I'm writing about will save you from disaster and make you thousands or millions.

by Chris Rowe

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