Don’t Let This Common Options Trading Mistake Trip You Up!
When properly used, the option market can be a sea of valuable information. But it’s easy to misinterpret this activity. I’ve heard some fellow traders compare option trading to a game of chess. This is a great analogy. With so many option strategies, the complexity can get particularly confusing for retail traders.
Here’s the problem that arises with retail traders…
There’s clearly some confusion when trying to interpret what some of the big institutions are thinking and what their trades actually mean.
Sometimes it even becomes difficult for professionals to decipher exactly what’s going on.
For instance…
Just the other night I was out socializing with some friends. Needless to say, it didn’t take very long for the chatter to start up about trading!
One of my friends started asking me a few questions about a trade I wrote about.
One question in particular stuck out. In this trade, he asked how I could be bullish on a stock, even though I pointed out a large amount of call selling activity was going on.
It didn’t seem to make any sense to him.
You see, most retailer investors believe the only time you sell call options is when you think a stock is going to move lower.
But that’s simply not true!
So friends, allow me to explain…
A few months ago I wrote an article on Ariad Pharmaceuticals (ARIA).
At the time, it was trading for $15.05. I told my readers that a large block of the May 2012 $15 strike calls were sold for a price of $1.35 a share.
Now, usually a retail trader would assume that this trade was an indication the stock was going to move lower. And as a result, the trader would profit from the premium he collected.
However, call selling isn’t automatically a bearish bet.
If anything, short calls could be neutral or possibly even moderately bullish.
That’s right, even in a naked call sale, the position can still profit if ARIA stock rises by as much as $1.00. If this occurred, the trader would still benefit by $0.30 a share ($16.35-$15.05). Not a huge winner, but nevertheless, still a 2% gain.
Here’s another possibility…
Given the price of the stock at the time, it could be that the call seller owned the shares. And he is simply selling call options as part of a covered call strategy.
Remember, covered call writing is the popular strategy of long stock and short calls.
In this example, at May expiration the trader would have his calls exercised. His stock would be sold at $15 a share plus the $1.35 in premium, or $16.35. With the stock originally trading at $15.05, that’s an 8.6% gain.
The bottom line…
Understanding how to interpret the options market can certainly give you a competitive edge.
But misunderstanding how this market works can lead to undue frustration, incorrect trading, and worst of all, losses.
Safe Trading,
Marcus Haber
Category: Options Trading Strategy
