1) They read some elaborate post about how some piece of garbage stock is the next MEME explosion. To their newbie eyes the extensive DD looked convincing, and the stock is only $10 a share right now, so they they buy 1,000 shares. And then they average down another 1,000. Two months later they are being told by the same people that were wrong about their DD to begin with, to hold on to the now, $8 stock. Even worse, they now believe that selling that stock is “exactly what the evil hedge funds want you to do!”. A few months after that they are questioning their life choices and stuck with a useless $4 stock.
2) Most YouTube videos are geared towards trying to sell you a method of Day Trading that is based on Gap n Go strategies. These methods, while real, are far more difficult than they are made to appear, but yet they are very marketable (i.e. “how to turn $5,000 into $50,000!”). Instead what happens is new traders become singularly focused on finding low float, highly shorted stocks that jump up after the open, convinced they are moments away from the next big score. Once again, months later they are questioning their life choices and stuck with an account that has dropped far below the PDT requirements
And finally that brings us to OTM options:
3) Slightly more sophisticated than the first two methods of losing your money, this one requires actual thought and analysis.
The appeal is obvious – they are cheap. And if the stock explodes those options can double, triple, etc in value.
Here’s why they don’t work – The options themselves have no real value other than the pure premium you are paying. When buying options, your goal should always be to pay as little premium as possible. Ideally you would have options at total parity (i.e. Stock is at $100 and the $99 Call Option is worth – $1).
Simple formula here for ITM Options – (Strike Price + Option Price) – Stock Price = Premium you are paying.
Simpler formula for OTM Options – Option Price = Premium you are paying.
So let’s take an example –
You like CSCO, it is smart pick, the daily chart looks good, it is past earnings (and seriously, please stop holding options over earnings) and looks like clear skies ahead. Two choices:
56 Strike Call, Expires Aug 27th for $2.35
59 Strike Call, Expires Aug 27th for .30 cents
Let’s say you are going to spend $500 – so you can get 2 of the 56 Calls or 16 of the 59 Calls.
If next week CSCO hardly moves at all (current at $58.22), your 56 calls will be worth $2.22 – a loss of only 13 cents per call or $26.
However, in that same scenario, your 59 calls will expire worthless, a loss of $480.
OK, let’s say CSCO goes up $1 next week, it is now at $59.22 –
Your 56 Calls are now worth $3.22 (at expiration), a profit of .87 per call or $174.
Your 59 calls are now worth .22 a loss of .08 per Call or -$128.
OTM Options place heavy lifting on the stock to get you to profitability. You are betting on a huge move in the stock that pull your options ITM faster than Theta strips away their value.
You are almost always better off going with ITM options, that have a Delta of .6 or higher and are at least a week out, if not more.
In fact, if you just stuck to these three rules it would increase you likelihood of success a great deal:
1) Do not trade Options over earnings, trade them before, trade them after, but do not hold them over the earnings announcement.
2) Do not go for the cheaper OTM options, instead choose Calls or Puts that have a higher Delta and are farther out in time.
3) Do not trade Option Spreads unless you know how to leg out of them if they do not go your way.
(the 3rd one may seem like a small issue, but the number of people that get stuck in spreads they do not know how to exit is alarmingly high).
This advice may seem basic to some traders here, but if you look at the posts on this forum you will quickly see that the foundational rules you may have been following as a trader aren’t as obvious as you think. New traders clearly do not know these basic principles and we should stop assuming they do.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.