Option Trading Tip #2

Avoid Chasing Option Premium

This article on Not Chasing Option Premium is Part 2 of a 4 part series on my top option trading tips.

Option Trading Tip #2 - Avoid Chasing Option Premium

In Option Trading Tip #1, I recommended that you consider selling (or being a net seller of) options.

When you're a seller or net seller of options, you receive a premium payment upfront in the form of cash for your willingness to, in effect, temporarily give up some form of your rights. You're basically selling the opportunity for someone else to force you to do something (e.g. sell your shares, buy theirs, etc.) if it becomes in their best interest to do so.

But there are significant structural advantages to certain credit strategies, and as I pointed out in Part 1 of this series, I also make a distinction between volatility and risk.

The Lure of Option Premium

But if you are going to be a seller of options, one of the greatest temptations you're going to have to overcome is that of chasing option premium.

When there's great uncertainty about a company's prospects or what its fair and accurate valuation ought to be, then there's going to be lots of premium on its options - and plenty of opportunity to get hurt.

Yes, there needs to be a certain amount of "time value" and implied volatility priced into the option for it to be a plausible candidate for selling in the first place. But, in a way, the premium levels should be the LAST thing you consider when initiating a credit or net credit strategy.

The Stability of Quality

I would argue that the quality of the underlying business should always be your first priority whether you're a long term stock investor or a short term option trader (or anywhere between).

If you've spent much time on this site, then you know how often I talk about the importance of quality investing. But my one-track mind doesn't make the message any less true.

The structural advantages of those certain credit strategies won't do you much good if you employ them on the stock of companies with questionable futures.

I've been "wrong" on option trades (in terms of directionality) many times (and fully expect to be "wrong" many more times in the future), but the secret to my success is that I choose trades that I can keep alive and adjust or repair over time even as I keep generating at least some kind of positive returns.

But this simply wouldn't be possible (or advisable) unless I have complete confidence in the long term viability and profitability of the underlying business in question.

You never know when something bad is going to happen - and you need to have the confidence that whatever company you're investing in or trading on can weather it.

In the Great Recession, American Express and Washington Mutual were two financial stocks that were both hit hard.

But it's no accident that a structurally sound company like American Express eventually came back to new all time highs and a questionable operation like Washington Mutual, widely known for extensive portfolio of subprime U.S. housing loans, ended up having to be absorbed by another institution (but not before permanently destroying a lot of capital first).

To reiterate then - Don't chase option premium! You can still make great returns without lowering your quality standards.

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