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Options: The importance of market timing
Say you like the prospects of a company called ABC Engineering but it hasn't been performing well over the last few years with the share price has taken a battering.

However you feel the company's foundations are solid and it's odds-on for a management restructure or even a takeover.

The date is January and you buy some shares thinking that they should rise significantly within the next 6 months. The shares don't move that much heading into the summer but in October another company makes a bid, the shares double in price and you sell out for a tidy profit.

What went wrong? Nothing really.

Your analysis was spot on but your timing could have been a lot better, ie you bought too soon. But did your timing lose you any money? No, it just meant that you had to wait a few more months for your original analysis to bear fruit.

Now trade the above example using options

It's January and instead of buying the shares you elect to use options. The quoted months for ABC Engineering's call options are March, June, September and December.

March is too near, June is only the beginning of the summer but September covers all the summer and by then your fundamental analysis of the company should mean the shares are considerably higher.

But the takeover didn't come till October and therefore the September call options you bought expired worthless.

You were 100% correct in forecasting the future direction of the shares but lost 100% of your money because your timing was out, in this example by only a few weeks.

In my experience there's nothing that wrong with losing money in the markets when we're just plain wrong - we forecast higher prices but they went lower. But there's nothing more soul destroying than being right and also losing, and that's exactly what happened in the example above.

The point of this is to highlight the fact that if you buy options you have to be right, or nearly right, in two aspects

  1. Direction, and
  2. Timing

And most traders, even the best ones, will tell you that it's the element of timing that's incredibly hard to get right when dealing in the markets (using options or not).

How to handle the timing problem with options

Always assume that your timing will be out. So if you think an event will happen within the next month, assume it won't happen until 2 or 3 months later.

This would mean that if the month is presently January, and you believe that something will happen to a stock in the next 2-4 weeks don't buy the February options. Instead, buy the March or April ones.

People new to options they often don't like this advice because it means they'll cut down on their potential profits. This is because the February options might be priced at just £0.10 whereas the April ones cost £0.45.

The return on investment by paying £0.45 against £0.10 (assuming the trade works) is massively reduced. True, but the odds of the event happening before the expiry of the February options are also massively longer than by the April date.

Personally I always like the analogy that short dated options (less than 4 weeks to expiry) are similar to long shots at the racecourse. Yes, if you bet the 100-1 horse rather than the 20-1 horse, that's where the maximum return on investment occurs. But how many times do 100-1 horses win versus 20-1 shots?

In summary you should always assume your timing will be off when you buy options and so buy the next month or even the month after that. Your profits will be lower (as a return on investment) but the odds of the trade working are dramatically higher.

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  • For my personal trading I like to use Core Spread
  • Got to love their ultra low bid-offer spreads

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