When you have a winning option that has turned profitable, you are going to be VERY tempted to keep hanging on to it to see if it will go up even more before you sell it.
But don’t do it. Because options can lose value just as quickly as they can go up in value and make you money.
Let’s take the example where you bought an option from me on SprintFast Stock. You paid me $100 for the option. The option gave you the right to buy 100 shares of my SprintFast stock for $5 a share any time in the next thirty days.
And amazingly, SprintFast stock went up to $20 in the first three days. The value of your option went up from $100 to $1500 – in just three days. I think that’s incredible, don’t you? And other people thought so too. They absolutely coveted your option.
So everyone wanted to buy your option for $1500 because they thought it might go up even more in the remaining 27 days before it expired.
You would probably be smart to sell the option right now because you just made $1400 on your option you paid $100 for. That’s an awesome profit.
But I smell greed in the air. You are thinking, just like the people who want to buy it, hey, there are 27 days left; this thing could go up to $2000, maybe even $3000. So you hang on to it.
But a few days later there’s a news report about the SprintFast Company. It turns out that top executives have been cooking the books and reporting profits that didn’t exist. The price of SprintFast stock plummets from $5 a share to $.50 a share. No one wants to own SprintFast stock, much less options on it. Your option is instantly worthless. Oops.
How do you feel now? I bet you are wishing you had sold it the day before for $1500 when everyone wanted to buy it. I’m thinking you are kicking yourself for being so greedy.
Or let’s take another situation – less dramatic. But this one happens ALL the time. Let’s say there is no bad news report, but after the stock has gone up to $20 a share, it doesn’t go any higher. It starts creeping slowly back down toward $5 a share. As the days of the month keep going by, your option keeps getting worth less.
You keep hanging on, thinking it will go back up. But it doesn’t. Every day it gets worth less and less. It’s melting before your eyes like an ice cube in the hot sun. And finally, your 30 days have passed and it expires worthless.
You could have made $1500 on it. But you didn’t. You let your profits slide right through your fingers.
When I was trading commodity options with my trading partner Charlie in the 90’s, we came up with a name for this phenomenon. We called it the Hoping, Wishing, Praying phenomenon. You just keep hoping, wishing and praying that things will turn around instead of taking profits or cutting your losses. Later on, Julia Roberts stole our phrase and made a movie about it (kidding – her movie was Eat, Pray, Love).
Charlie and I were all too familiar with the phenomena in the early days. Because all beginning traders will do this until they get smart. And we had done a few trades like this early on.
Here are two instructive examples. Years ago, back in the early 1980’s, I had a trade on silver, and it was very profitable. Silver had gone up a great deal, to $14.97 per ounce. For some strange stubborn reason, I was holding out for $15 an ounce. Do you smell greed in the air about now?
An older work associate even kept telling me, John, sell it – take your profits and run. But I didn’t. And the next morning I read in the newspaper that the Soviet Union had dumped tons of gold on the international market to raise money to buy wheat, because their crop was doing badly that year.
Gold and silver prices tend to follow each other. So when the world market was instantly flooded with gold, the gold price plummeted – and so did silver. Overnight I went from a very profitable option to losing money. Fortunately, not too much money, but I was glad to get out of that trade alive.
Here’s one last example – one that we called the Infamous Bean Trade. My Father, who also traded commodity options, bought $10,000 worth of options on soybeans. Trading beans can be very profitable, by the way. If the price of beans goes up one penny per bushel, you make $50 for each option you own.
Very quickly, the bean price went up, and his $10,000 option was worth $30,000. I kept telling him, Dad, sell it, take the money and run. But he hung on to it. And it went back down to $10,000. Oops.
But here’s where it gets interesting. He still had time on the option. And miracle of miracles, it went back up to $30,000 again. So he sold this time, right?
Nope. He hung on, hoping for bigger profits, and it went back down to $10,000 again. Fortunately he sold at that point and didn’t lose money, his original $10,000 invested, but he could have sold for $30,000 and had a much happier outcome.
Lest you think I’m picking on my Father, I’ll mention a worse one on me. In those early trading days, Charlie and I did one we still refer to as the Infamous Hog Trade. By the way, you can make a lot of money trading options on hogs, i.e. if the market price goes up $1 a pound, you make $400.
Outside of telling you we did the whole Hoping, Wishing, Praying thing on that option trade, let’s just say I won’t tell any more details in public on how we (mostly me, really) botched the end of that trade (chuckle). Hmmm … another movie title is coming to mind – that would be Inglorious Bastards.
We went on to make profitable options trades, but my point here is that early on you may make a mistake or two. I’m just giving you a heads up about it.
So these two examples may seem very obvious to you, and you may be wondering why they happened.
Because, if you’re not careful, if you don’t constantly remind yourself that options will eventually expire, you will ride them into the dirt and they will expire worthless on you.
So how often does this happen in the real world? You won’t believe my answer. Here it is.
80% of the options people buy expire worthless. Amazing isn’t it.
So about now, you’re probably thinking, why would I ever trade options? That seems like pretty bad odds.
And you are right – that’s pretty bad odds.
But let’s turn that around. If 80% of the time people that buy options lose their money because their options expire worthless, then 80% of the time, the people who sold them their options win and get to keep their money.
Hmmm … I have a thought just trying to creep up in my mind about now. Maybe if we can’t beat them, join them. Now there’s a thought, and the subject of a future post.
To your health and prosperity – John
Note: This post is part of a continuing series on trading stock options. My book Stock Options For Beginners will be coming out in April of this year.