Another topic that is brought up often in my Group Coaching class is buying call options and put options outright. When option traders first get their feet wet trading options, they often just buy call options for a bullish outlook and put options for a bearish outlook. In their defense, they are new so they probably do not know many if not any advanced strategies which means they are limited in the option strategies they can trade. Buying call options and put options are the most basic but many times they may not be the best choice.
If an option trader only buys and for that matter sells options outright, he or she often ignores some of the real benefits of using options to create more flexible positions and offset risk.
Here is a recent example using Twitter Inc. (TWTR). If an option trader believed TWTR stock will continue to rise like it has been doing, he could buy a July 39 call for 1.80 when the stock was trading at $38.50. However the long call?s premium would suffer if TWTR stock fell or implied volatility (measured by vega) decreased. Long options can lose value and short options can gain value when implied volatility decreases keeping other variables constant.
Instead of buying a call on TWTR stock, an option trader can implement an option spread (in this case a bull call spread) by also selling a July 42 call for 0.75. This reduces the option trade?s maximum loss to 1.05 (1.80 ? 0.75) and also lowers the option trade?s exposure to implied volatility changes because of being long and short options as part of the option spread. This option spread lowers the potential risk however it limits potential gains because of the short option.
In addition, simply buying call options and put options without comparing and contrasting implied volatility (vega), time decay (theta) and how changes in the stock price will affect the option?s premium (delta) can lead to common mistakes. Option traders will sometimes buy options when option premiums are inflated or choose expirations with too little time left. Understanding the pros and cons of an option spread can significantly improve your option trading.