TALES OF A TECHNICIAN: THE SEDUCTION OF BUYING OPTIONS

If you’re not visiting the Tackle Trading clubhouse on a regular basis, then you are undoubtedly missing out on one of the best tools we offer. It’s there for demystification, education, and motivation. And best of all, it’s free. Adam recently asked a great question in the clubhouse, and I wanted to expand my answer to blog length to do it justice.

The first part of our discussion involved the merit of buying calls and puts. Adam’s point was that you make money so much quicker with profitable call/put trades than with strategies like naked puts, covered calls, and credit spreads.

This was my reply:

There’s no doubt buying calls and puts delivers the quickest profit. The issue is that they’re hard to consistently make money with. You have to be a really good chart reader with impeccable timing. When you buy a call, you’re betting that the stock isn’t just going to rise, but that it’s going to rise far enough, fast enough. And that’s challenging to do consistently.

I’m all for buying calls and puts, but the reality is most people won’t generate consistent profits with the strategy (myself included). That’s typically the reason they move on to look for lower hanging fruit.

And that brings us to Adam’s next question that prompted today’s post:

I’d like to make a nice living off trading. It’s the only thing I want to do. Having said that, I have to find methods to make the best return on my money. Is this why some people day trade? To make the most money in the most efficient time as possible?

Let’s first talk about “finding methods to make the best return on my money.” This is usually a question posed by traders wielding smaller accounts which, quite frankly, is almost everyone when they start out. When you’re only trading $5K or $10K, generating a 3% return over 60 days can feel unsatisfying and too slow. (Nevermind that that translates into a mouth-watering 18% annual return which most investors would kill for!) An 18% return on $5K means you made $900 over the year ($1,800 on $10K). And for someone like Adam who wants to “make a nice living off trading” the numbers simply don’t add up.

So you look into generating higher returns, which I can only assume is what Adam means when he says “make the best return on my money.”

But here’s the first problem. Comparing the potential return of a covered call to that of buying a call option is incomplete. That’s like me comparing the 1.5% I can make risk-free in a CD at the bank (in a year) to the 10% I could make through buying call options (in a day!). Obviously, buying calls offers a much, much higher return. But they also entail a ton more risk than the CD, not to mention the skill required to trade them successfully.

Risk and skill are the two biggest hurdles. If I’m willing to take the risk but lack the skill necessary to generate the higher profits with calls, then I can’t. And if I possess the skill but am unwilling to take the risk, then I can’t. Though, the latter case is easy to fix. You merely use less money.

So, Adam, you have those two things to consider — risk and skill. If you use your entire account for long calls and puts, you will see much larger fluctuations in your account value than those using more conservative strategies. Is that something you can stomach without giving up after a significant drawdown?

If so, the next question is, have you proven you have the skill to generate consistent profits through buying calls and puts? It’s not impossible, but it is difficult and not very many traders can do it.

Now to the next part of the question on day trading and making the most money in the most efficient time as possible. There is merit to the idea that trading more often can increase your overall profits. If you think about it, you can either increase the quality of your trades (place better trades that make more money) or increase the quantity. It’s far easier to increase quantity. If we both have systems with a positive expectancy, but I only place one trade a month and you place one trade a day, then you’ll probably generate higher profits over the year.

But that doesn’t mean day trading is automatically better than other types because it involves a different time commitment and skillset. Day traders don’t trade options and spreads. They don’t play time decay or implied volatility. Instead, they’re directional betters, pure and simple. It requires you to be a reliable chart reader and market timer. Some love and excel at that type of trading but others don’t. In the end, you have to find what works for you.

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