Objectivity is critical when trading options.
Since greed is an intense, selfish desire for something, especially for accumulating wealth… it can distort your perception of reality.
With option trading the tendency to sell the option contract with the highest premium regardless of the probability that the underlying security will reach the strike price associated with that inflated premium.
That is not the wisest choice.
Since trading options is based on probabilities, it’s much better to put the odds in your favor.
We have discussed in previous posts that selling options has a higher probability for success than buying options.
That’s because there are two drawbacks to option buying.
- Getting the directional movement of the underlying security correct… which no one can do consistently, and
- Doing that in the allocated time before the expiration of the option contract… which just compounds the difficulty of the task even more.
Thus, the only way option buyers can make money is if the market value of the underlying security is trading higher than the strike price plus its premium cost at time of expiration.
The reasons why most options that buyer’s purchase expire worthless are:
- Options are bought too far out-of-the-money (OTM)¹
- Buyers didn’t give themselves a long enough option expiration period, or
- They picked the wrong direction
The odds are not in the option buyer’s favor.
Smart option sellers will take the other side of these low probability trades.
Plus, option sellers can make money three separate ways.
- If the market moves lower… as long as it doesn’t go below the seller’s strike price,
- If the market stays at the same level, or
- If the market goes higher… as long as it doesn’t go above the call seller’s strike price.
So, the odds are 3 to 1 in favor of the options seller.
There is always the desire to go for the maximum profit possible on each option contract.
For option sellers the maximum profit you can earn is the initial cash premium the option buyer pays you. And the only way you can accomplish that is for the option contract to expire worthless.
In other words, the market value of the underlying security is trading at a higher value than the option seller’s strike price at expiration… thus expiring worthless.
There are times when the difference between the strike price and the market value of the underlying security is very narrow approaching expiration. It could go either way.
That’s when greed kicks in…
And emotions overrule logic.
Greed is motivating the trader to wait until the time of expiration to see if the option contract expires worthless.
This can backfire and the market value of the underlying security drops below the strike price… resulting in an option assignment requiring the option seller to purchase the underlying security.
Certainly not the end of the world, but a more expensive result.
The more prudent action…
Is to buy back the option contract… since at this point being so close to expiration the cost to do that is usually minimal.
Granted you are giving back some of the premium dollars you originally earned on the contract… but it’s better than having to pay full price for the underlying security upon assignment.
Plus, even with the benefit of margin, when you buy back your option position it immediately “frees up” additional capital to pursue other lucrative option sales.
So don’t let greed blind your view of other profitable option trades.
To get a full picture of how to eliminate greed from your option trading… click here.
¹ Puts are out-of-the-money (OTM) if the price of the underlying security is higher than the strike price. The reverse is true with calls.