Traders love options because of their versatility, and for the leverage, a small amount of money can pay off big, and the limited risk.
If you buy an option, you may pay only a few dollars a share.
If you buy a call and the stock takes off, you can double your money in a few days.
That is great for your brokerage account.
If you buy options, the risk is limited to the price of the option.
So it looks like the ratio of risk to reward is low.
That is, there is a high reward and low risk, the best of all possible worlds.
If you have a system for predicting the movement of stocks or commodities you can do very well, it seems.
If there is a high probability that a stock will go up, you buy a call and wait for it to double.
If there is a high probability of a stock to fall, you buy the put and wait for the stock to fall, your put climbs in value.
It's not quite that easy.
Even if you get the direction right, you can still lose money.
There are other elements to options.
One is time decay.
Let's say that you believe that UPS is going to fall in price, we know that US consumers are saving money, not spending, shipping volumes are way down, there are lots of good arguments.
So you buy a put that expires in a month.
UPS is trading at 43 and the March 40 put costs 2.
March expiration is 47 days away.
What would it take for the put to go to $4? We can compare it to another put that is deeper in the money to see how much UPS has to move.
The March 45 put is at 4.
20 / 4.
40 and is a little over $2 in the money.
That tells us that for our put to go to $4, we need it to be about $2 in the money, or UPS would have to trade at $38.
This doesn't take into account that we lose time value of the option each day.
After all, if UPS is at $38 and we are a few days from expiration, our option will only trade at $2.
There is no time value left.
So we need UPS to move soon.
How large a move do we need? From 43 to 38 is 5 or about a 12% move.
To estimate how likely this is, we can ask, when did UPS trade 12% higher? It traded around 50 on January 13.
That was twenty days ago.
So if it is still falling, it might fall another 12% in another twenty days or so.
This is cutting things too close for me.
I would not do this trade.
We haven't even discussed how the implied volatility might affect things.