Take Note of What It Says on the Packet

Take a stroll around your local supermarket or chemist, and you will see thousands of products staring right back at you.

All neatly packaged — boxes and packets of different sizes, colours and designs. The graphic designers working their craft, trying to make their product stand out from all the rest.

Some of these products will feature in an ad on TV. Or in one of those pop ups you see on your screen. However, that is a very small group. For all the other products, they have to fight it out on the shelves or the web.

That is why some companies pay for the best real estate in the shop. That is, a shelf where the punters can easily read and access their product. Not for them, will there be any bending down.

But if you don’t know what is available, how do you choose? Perhaps you like a particular colour. Or maybe it’s the shape and font style on the box.

However, that is only the start. You then need to read exactly what is on the packet to decide if that product is for you.

More to it than theory

One of the reasons people trade options also stems from something they read on the ‘packet’, so to speak. No doubt, you have read it many times yourself.

That is, ‘limited risk, unlimited reward’. It is a slick phrase — one that encapsulates one of the benefits of buying options. Who wouldn’t want a shopping cart filled with that?

However, there is a bit more to options than that. Note that the phrase applies to buying options, not writing them.

The idea is that when you buy an option, the most you can lose is the premium you pay. And yes, that is mostly true. Though technically, not fully true.

If you exercise a call option — that is, take up your right to buy the underlying shares at the option’s strike price — you don’t own the shares until the trade settles. In the meantime, a piece of bad news could send the share price tumbling.

That aside, when you buy an option, the most you risk is the premium you pay. And this is why you pay a premium in the first place.

As the option buyer, you are buying yourself time. Time to decide whether you want to buy (call option) the shares, or sell (put option) them.

Probability versus possibility

While the premium you risk is limited, it does not take probability into account. That is, the likelihood that the option will have any intrinsic (real) value, as it runs into expiry.

If, say, a utilities stock is trading at $10, there is little chance it will be trading at $15 or $20, within a few months. Because a regulator might set the amount the utility stock can charge for a five-year period, there is almost a negligible chance that the share price could jump that much.

In that case, while buying a $15 or $20 call option will likely be cheap, it comes with, in my opinion, almost a zero chance of success.

Yes, limited risk…but reward? Highly unlikely. Do this enough times and you will soon fritter away your trading account.

Both calls and puts

It is a similar story with put options. Shares typically fall faster than they rise. That is because the fear of losing money is often stronger than the fear of missing out (FOMO) in a rally.

Remember also that you can only trade options on the largest 60–70 stocks. What is the chance that any of them will go to zero?

Well there is always some chance…any company has the potential to fail. Again, though, it comes back to probabilities.

Could a market heavyweight like Commonwealth Bank of Australia [ASX:CBA] fall 3–4%? In my opinion, absolutely. But, say 15–20% within a few months? Well, yes, it is a possibility, but it has a lower probability, in my opinion, than a 3-4% fall.

If you buy put options a long way below the current price, they also might be cheap. But they too come with a lower probability of success.

Do too many low probability trades and you might soon be scratching your head. That is, why your trading account is shrinking, although you are only taking ‘limited risk’ trades.

The other thing to consider is the so-called ‘unlimited’ reward. Because a share price can (in theory at least) go to infinity, buying a call option could generate unlimited profits.

For a start, though, no share price in history has ever gone to infinity. Nor will one ever do so in the future.

It comes back to probabilities. Yes, BHP Group Ltd [ASX:BHP] could reach $40 again. But $80 or $100?

Maybe, but, in my view, very unlikely anytime soon — especially in the lifetime of a typical option (2–3 months).

As the packet says, buying an option sounds like a good deal. Who doesn’t want unlimited reward for a limited amount of risk?

However, that is the theory part. When it comes to the crunch, the likelihood of success — that is, probabilities — play a much bigger part in a trade.

Matt Hibbard

Editor, Options Trader

While many investors chase quick fire gains, Matt takes a different view. He is focused on two very clear goals. First: How to generate reliable and consistent income in a low-interest rate world. And second, how you can invest today to build wealth over the next 10–15 years. Matt researches income investments. You can find more of Matt’s work over at Total Income, where he is hunting down the next generation of dividend-paying companies for the future. He is also the editor of Options Trader, where he uses basic options strategies to generate additional streams of income beyond the regular dividend payments. Having worked for himself and with global firms for almost three decades, Matt has traded nearly every asset in existence. But now he is on a very different mission — to help investors generate income irrespective of what the market is doing. It’s about getting companies to pay you a steady, stable income, with minimal stress and the least risk possible. Matt doesn’t believe you have the luxury of being a bull or a bear in the market right now. You have to earn an income from it, regardless of whether stocks are going up or down. By getting the financial markets to pay you an income, you can get to focus on more important things than just money.

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