Trading Strategy: How to Avoid This Mug’s Game

Sometimes, buying into a former high-flying stock that is wallowing at a fraction of an earlier price, can be too tempting to pass up.

You do the usual mug’s mental gymnastics: Yep, it’s fallen a lot…it looks cheap…surely it can’t go much lower than this.

But alas, the next day it does get cheaper. And the day after that…and the day after that too.

What at first looked cheap can start to become an expensive headache. Do you hold on, or take your loss, promising yourself you will never do it again?

One of the goals of investing is to buy shares in companies trading below their true value…in other words, ‘cheap’. And, to avoid companies that are trading too high above that same true value, meaning ‘expensive’.

While you might use common tools to value stocks — such as price earnings (P/E) ratios and earnings per share (EPS) — there is always a level of subjectivity. Such as judging its management, or if the sector it operates in has already peaked.

Of course, ultimately the market decides a stock’s true value. All you have to do is look at the last trade.

Hopefully, having fallen for the ‘it looks cheap’ trap one too many times, you eliminate this capital-killing strategy from your toolbox.

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Avoiding the ‘cheap’ trap

With options, it’s easy to fall into a similar trap. It’s a trap that often stems from one of the reasons traders are attracted to options in the first place: To get more bang for their buck.

Rather than buy shares outright, a trader might instead decide to buy a wad of call options. All the share price has to do is jump — or so goes their thinking — for them to make an absolute killing. From there on, it will be a life of palm beaches, swimming pools and travel.

Because options only cost a fraction of the underlying shares, a trader can gain exposure to a much larger position. And because they are buying the option, it can limit their potential losses to the cost of the option’s premium.

But sometimes, trying to leverage too high a return can bring a trade down. 

Let’s look at an example using BHP Billiton Ltd. [ASX:BHP], with BHP trading at $32.85. And please note, this is NOT a recommendation.

BHP call options — December expiry

BHP Call Options

Source: CommSec

[Click to open in a new window]

In the above quote table, I have put a red box around three different call options. The last column on the right is the strike price. The top red box is a $33 call, the middle a $34 call, and the bottom a $35 call option.

If you are new to options, a $33 call option enables you to buy shares in BHP at $33, up until the option expires. The $34 call enables you to buy BHP shares at $34, up until the option expires, and so on.

If you now look at the blue circles, they show the bid and offer prices for each option. The bid/offer for the $33 call is $1.19/$1.265. Meaning, if you wanted to buy this option, you would need to pay somewhere around the middle. That is, around $1.22–1.23.

If you go down to the $35 call option, the bid/offer prices are much smaller: 41 cents/48.5 cents. To buy this option would be much cheaper than the $33 option, at around 44–45 cents. In other words, the $33 call option is around three times more expensive than the $35 call option.

This is where option traders can fall into the same trap as share investors. That is, buying something that looks ‘cheap’, versus looking for the best value.

Because the $35 call options are much cheaper, an options trader might decide to buy them instead of the $33.

After all, if the share price gets above $35 before the option expires, they have three times as many contracts. And that means much bigger profits.

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A game of probabilities

These higher price options ($35), though, are cheaper for a reason. The share price has to rise much further before they have any true (intrinsic) value. If BHP’s share price is below $35 at expiry, the $35 call options will expire worthless.

With BHP trading at $32.85 in this example, for BHP’s shares to reach $33 is not a big move. However, for the share price to reach $35, it will require a much bigger (and less likely) move.

In addition to that, the clock is ticking. These share options above only have around two-and-a-half months until they expire.

It therefore becomes a game of probabilities. The more time ticks away without the required share move, the less probable the trade will be successful — irrespective of how cheap the trade was to place.

As you can see, there is a sweet spot. That is, picking a strike price where your trade has a high chance of success, but not paying too much for your option.

In your article next week, I’ll show you one easy-to-understand tool, that will help you choose the right option. So please keep an eye out for that.

All the best,

Matt Hibbard
Editor, Options Trader

Money Morning Australia