How to Lose Money Trading Options
Options give investors the right to exercise them at pre-set strike prices before expiration. The two types of options are calls and puts. For calls, exercising a contract means buying the underlying shares; for puts, it means selling the underlying shares. The option premium or market price fluctuates along with the underlying share price. Depending on the option strategy, your profit and loss could both be theoretically unlimited. You could minimize your losses by avoiding certain option strategies.
- Difficulty:
- Moderate
Instructions
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Invest in only calls or only puts, which means you are betting on only one price direction. If you buy calls, you will profit if the share price goes up. However, markets are not always logical. Even if a company reports strong profits, the stock price could suffer because the company fails to meet expectations. If you buy puts, you are betting that the share price will fall. If you are wrong, the option could expire worthless and you could lose your entire investment.
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Buy and hold an option position. Patience is usually not a virtue when it comes to options investing. Greed is good, but fear is even better when you are investing in options. If the share price is not moving or starting to move in the wrong direction, cut your losses and sell the options. Unlike stocks, you do not have the luxury of waiting weeks or months for the market to change direction. Option contracts often have three months or less to expiration.
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Use dollar-cost averaging, which means accumulating an option contract while its price is falling. This strategy works for stocks because markets usually stabilize after a period of volatility and quality stocks see their prices stabilize. However, if the market does not recover before the options expire, you could lose your entire investment.
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Bet against a trend. This may work for stocks, but fighting the trend is usually a losing strategy for options because of the short-term nature of option contracts.
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Buy options that are about to expire. For example, if an option is expiring on Friday and the company plans to announce its quarterly profits on Tuesday, you could buy call options on Monday if you expect that strong earnings will mean increases in the share price and the option premium. If the company announces a loss instead of profits or if the profits fail to meet market expectations, there will not be enough time for the options to recover and you could lose your entire investment.
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Lose money because of implied volatility, which is the expected volatility of shares over the life of an option. In addition to the underlying share price, supply and demand forces affect option premiums. These forces vary with market expectations of price movements. The more volatile a stock, the more in demand are its options. Implied volatility usually increases before earnings reports and falls after the announcements. When demand falls, the premium falls. This means you could lose even if the underlying share price rises following an earnings report because the supply-demand forces no longer apply.
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