Learning the Options Market the Hard Way
Many people like to talk about how risky the options market is. While there is risk in all forms of investments the options market offers some excellent was to make exceptional returns. However, having said that there are things that you must understand about options.
In stock trading it is pretty simple to understand that if you buy a stock and the market goes up you make money and if the market goes down you loose money. It's not so easy in the options market. I remember once purchasing some put options. After having done some research and looking at the charts of some particular stocks I felt that one particular stock was poised to drop substantially so I purchased several Put Options.
When buying Put Options you are expecting the price of the stock to go down. After purchasing the Put Options the stock rose slight and then dropped hard. I WAS RIGHT!!!! The stock dropped somewhere around 18% within a couple of days and I LOST MONEY!
What was the problem? I made two basic errors. First of all I purchased puts that were FAR out of the money. The Delta on these Puts was 4. Yup! No typo here it was only 4. What does this mean. First of all it means that with every $1.00 move in the stock price my option would change in value of .04 cents. Another way to look at this is that I had a 4% chance of my Options moving in the money. But the main point of this HUB is not the poor trade construction, but is about volatility.
My error with volatility is the fact that when I purchased these Puts I was about three weeks from the release of their earnings numbers. Volatility was high and was increasing. I held the Options through earnings and as is typical about 95% of the time, volatility dropped substantially. The drop in volatility crushed the value of my options. So while the drop in price of the stock would cause my option to increase in value the drop in volatility priced into the Option dropped much more.
There's value in learning The Greeks and what they mean. In addition, it is advisable to learn how volatility effects a trade. As described above volatility hurt my trade. But had I known what I know now I could have easily structured the trade where I could take advantage of the volatility crush.