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5 Points to Remember About the Long Option Position
12/04/2014 8:00 am EST
Option trader Michael Thomsett of ThomsettOptions.com thinks there might be serious reasons to speculate in long or short calls and outlines five key points for options traders to consider before disregarding them.
You have probably heard that about 75% of all long calls and puts expire worthless. So why bother with them if the odds are against you? Actually, this is not entirely accurate. About 75% of all options held until last trading day expire worthless. A majority are closed or exercised before that day arrives.
I think this statistic deserves another look. There might be serious reasons to speculate in long or short calls. Consider the following:
- If you are swing trading and using reliable and confirmed reversal signals, your odds of good timing go up. Buying calls at a short-term low or puts at a short-term high swing increases that 3-to-1 against you to something better, maybe even more than a 50-50.
- Also with swing trading, using very short-term long options is sensible. Swing traders expect a three- to five-session turnaround. So options expiring in three or four weeks, opened at-the-money, are going to be most responsive to price movement in the underlying. Long puts are bearish plays at the top of the swing, but vastly less risky and cheaper than shorting stock. This alone makes the long option swing trade a worthwhile endeavor; and because options are so much cheaper than shares of the underlying, options open up the way to better diversification as well. But you should open a long position only after seeing strong reversal signals and confirmation in the underlying chart.
- If you use other reliable reversal signals, like some candlesticks for example, you can really beat the odds. Strong candlestick reversals like the engulfing pattern are extremely reliable and, when confirmed, give you a much better chance for short-term profits.
- Long positions can serve a purpose beyond mere speculation. For example, if you are long stock and you experience a sudden decline, buy calls not only to ride the wave back up, but to make a little extra profit at the same time. If the price has soared and you expect some retracement, a long put can be profitable and also provides you with insurance of those paper profits.
- Buying calls or puts as the entire strategy is only one of many ways you can use them. In practice, long positions end up as one side of more involved spread or straddle positions. For example, if you are short an option and the underlying moves against you, the added risk is efficiently and affordably offset by a long option. This sets up a spread or straddle against the original short position without the complexity of closing down or rolling the risk and replacing it.
If you take a new look at long options, you are likely to conclude that the 75% rule is inaccurate. In addition, long options are very effective when used to manage your portfolio, create short-term profits, or swing trade. For swing trading, long options are better leverage than shares of stock and lower risk as well.
A wise rule of thumb when it comes to options is this: Don’t rely on the common ‘knowledge’ about risk levels. The more you study options, the more twists and turns you discover. Risk is not a fixed and unchanging feature to all options. What matters is how and when you use them.
By Michael Thomsett of ThomsettOptions.com
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