4 ways to lose, only 1 way to win

The most popular way to trade options, is to buy them.  The
 reason for doing so is always the same...your risk is
 limited.  But, a closer look into buying options may not
 hold as much promise as many think.  

Options hold one of the few guarantees in trading.  The
 passage of time.  One key ingredient to option pricing is
 time.  And I guarantee (oops, there is that word again),
 that time, no matter what anyone says, will pass.  Because
 of this one constant, there is also another guarantee that
 is associated with options.  All extrinsic value contained
 in the price of options will decay to exactly 0.  

Most of the time, option buyers are not buying intrinsic
 value, they are buying time.  And because this is a major
 ingredient to option pricing, this creates a huge hurdle
 to overcome...most don't.  Buying time creates a situation
 where there are four ways to lose from buying options, and
 only one way to win.  

1.   If the underlying market remains the same at
 expiration, all time value decays to zero and you lose.
2.  If the underlying market goes against the option,
 intrinsic value (if any) will decrease AND all time value
 will go to exactly zero. 
3.  If the underlying market goes in your direction, but
 not enough to cover the amount of time value associated
 with the price when you bought the option, you will lose.
4.  If the underlying market moves in favor of the option,
 and more then the amount of time value paid, but only
 after the option already expired, you lose.  

In other words, you have to be right with the direction,
 within a certain period of time and the degree that the
 market moves in the right direction.  You have to be right
 on a lot of things in order for you to make money. 

Of course, the draw to this is that your profit potential
 is "unlimted".  Having talked to thousands of traders, I
 have yet to find one that has actually held onto an option
 for that "unlimited profit"!  

The winning way?  The underlying market has to move in the
 right direction, in the right amount of time, more than
 the time value associated with the option for the option
 buyer to make money.  And, let me tell you, if you are
 that good, you don't need options to make money.

This, of course, is based on holding the option until
 expiration.  You can get rid of an option early, during a
 spike in volatility that will actually increase the time
 value of an option dramatically, but if you want any
 chance of profiting, you better have a plan to do just
 that.  

Bottom line, you must look at two factors.  Winning % and
 win/loss ratio.  If you have a situation where you have
 50% winners and a 1:1 win/loss ratio (your wins are the
 same size as your losses), you will only break even. 
 Since between 70% and 90% of all options expire worthless
 (depending on what statistics you are looking at and the
 type of options...i.e. in the money, at the money, out of
 the money), it is a difficult thing to win 50% of the time
 buying options.  But, if you can pull it off, this means
 that you have to see your option MORE THAN DOUBLE in price
 in order for you to just breakeven.  

Options are much like Algebra.  What is done with one side,
 must be offset on the other.  This means that if there are
 4 ways to lose buying options, then there are 4 ways to
 WIN selling options.  This means that if there is only 1
 way to win buying options, there is only one way to lose
 selling options.  (Again, based on holding through
 expiration for purposes of this article).  

But, that doesn't mean I recommend everyone going out and
 starting to sell options.  Remember that one major draw to
 buying as opposed to selling.  Your risk is limited and
 your profit potential is "unlimited".  Well, what exists
 on one side is offset on the other.  If you sell an
 option, your profit potential is limited and your risk is
 theoretically "unlimited".  Those risks MUST be properly
 dealt with, otherwise you will see one loss wipe out 70% -
 90% winners.  

Many traders who come to realize that buying options is a
 very, very difficult trading task, do not properly address
 the risk when the begin to sell options.  The most common
 risk strategy used when selling options is the use of
 stops.  In other words, traders will sell an option for
 say, $1.00 and then put a stop to get out if the option
 reaches $2.00.  This is one of the worst ways to address
 risk in option selling.  

Obviously, since the one constant in options is the passage
 of time, the best options to sell are ones that are
 COMPLETELY TIME.  In other words, out of the money
 options.  Let's say that $1.00 you brought in on the
 option was based on a 50.00 strike call when the market is
 trading at 47.00.  You sold a call option that is $3.00
 out of the money.  The very next day, the market spikes
 quickly to 48.50 and the price of the option trades at
 $2.20.  You got stopped out (probably with slippage) for a
 loss.  But how much intrinsic value was associated with
 that option?  0.  It was still ALL extrinsic value.  At
 expiration, the price of the market remains at 48.50 and
 the value of that option is 0.  You got out at the worst
 possible time using a stop, and based on panic.  

There are several strategies that can be used to better
 address the risk associated with selling options.  A few
 suggestions will be posted sometime next week.  This
 article cannot possibly address everything that needs to
 be addressed when considering options.  But, for now, I
 hope this gives you some food for thought. 

In closing, if you thought any of this information was
 valuable, please, by no means contact me...there are
 certain people on this newsgroup that might think I
 am "spamming" the group...and we wouldn't want to ruffle
 their feathers, now would we.

[EMAIL PROTECTED]