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Are Options For Losers?

To be fair, options have two very basic uses for 99% of the people who buy them. I realize there are more but let's (for now) stick to these two.

The #1 reason, to buy an option and most popular, is simply to speculate on the future price of an underlying security

The #2 reason is to buy an option for protection against losses which may occur in an underlying security that one already owns.

Because of the weightiness of the subject of options and its high confusion factor let's go a step further and stick to

#1 - Buying options as a speculative trade on the underlying security. Or in other words, a bet on the future price of security XYZ.

Let's say we are going to buy a 60 day call. To optimize the time premium we will be paying, we buy a slightly out of the money call option with a $100 strike price.

One 60 day Call Option to buy XYZ Stock at $100/share

We hope the price will rise, but the reality is the only sure bet is that one of the following scenarios is going to happen:

1. The price of XYZ will rise a lot

2. The price of XYZ will rise a little

3. The price of XYZ will remain unchanged

4. The price of XYZ will fall a little

5. The price of XYZ will fall a lot

Your view of a what constitute a value for "a little" or "a lot" may vary from mine but it doesn't change the validity of the premise that one of the five scenarios above will come to pass and there are no other possibilities. Furthermore, they will all 5 affect the price of the option we just purchased.

Now let's take a look at how each scenario and how it will affect the value of our "investment". Remember also that we will be right 50% of the time about the next 20% move (up or down) of a security if we simply flip a coin.

1. The price of XYZ will rise a lot

The trade is profitable

2. The price of XYZ will rise a little

The trade breaks even or loses money

3. The price of XYZ will remain unchanged

We lose all of our money

4. The price of XYZ will fall a little

We lose all of our money

5. The price of XYZ will fall a lot

We lose all of our money

Again, remember that one of these scenarios will come to pass and there are no other scenarios possible. This part of our trade is not left to chance.

Let's summarize the possible results. Definitely in scenarios #3, #4 and #5, we see that we lose all our money. Scenario #2 provides us with a chance to break even or lose money and only in scenario #1 do we make money.

My point is this. If I told you that you were going to play a casino game that would take your money on 3 out of 5 rolls, would you play? I doubt it. On the other two rolls you would only make money on 1 and the other one would at times return your original bet to you and at times take your money. All of it.

So why play? Simple, just look at human nature and you see that most people will focus on the fact that scenario #1 has the ability to pay out an unlimited profit. There's the hook. It's the same hook used to get people to play impossible odds in the local state lottery, only worse because of the betting size. For you to get to profits of scenario #1, you have to navigate an impossible mine field of risk where you are all but guaranteed to exit the other side with fewer limbs than you started with.

It is as if I were to tell you I will give you a million dollars if you can swim across the Atlantic Ocean. And oh yeah, you have to pay me on a whole slew of other bets so I can line my pockets with your money just in case you can swim the Atlantic. It's a good business. Well…for the guy's business who happens to be on the other side of your trade.

Admittedly there are other option strategies other than a straight out purchase for the purpose of speculating on the future value of an underlying security. Just remember as well, that the option market offers no free lunches and the devil is in overpaying for risk which is often masked by the profit potential. Don't let yourself be drawn into making bad odds bets because of their "potential" profits.

Brazil5mil@yahoo.com

William Murphy is a former floor trader on the New York Futures Exchange, New York, NY and today is retired and lives with his family and writes from Medellin Colombia

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.