Option trading why you should never compound profits

Perhaps the most direct way of investing long term in stock options is through buying LEAPs call options. LEAPs call options are stock options that expires 6 months to a year in the future. This kind of long expiration stock options allows anyone to benefit from the same move in the underlying stock in a leveraged manner, using lesser money than stock traders do.

However, the one mistake that most option traders make when investing long term in call stock options is that one magic word that all investors love : Compounding. Compounding one’s profits means to keep reinvesting one’s profits so that the profits also make profits of its own. This is a concept that has made multi millionaires out of stock traders, but this is a concept that kills option traders. When an option trader compounds profits when option trading, he also end up compounding the eventual, inevitable loss and end up with nothing due to the leveraged nature of stock options.

Here is an illustration :

Assuming XYZ Company’s stock is trading at $10 on 1 Jan 2007 and it’s $10 strike price LEAPs call option (Jan10call) expiring on Jan 2008 costs $2.

John invests his entire saving of $1000 into the Jan 2008 call options and bought 5 contracts.

On Jan 2008, XYZ Company’s stock did well and was trading at $20 during expiration of the Jan10call and those LEAPs call options worth $18.

John sells those LEAPs call options and ended up with $18 x 500 = $9000! A Profit of 800%! (The stock trader who bought XYZ at $10 would have made only 100% profit)

John continues to think XYZ will do well and did the unforgivable mistake. John invests the entire $9000 into XYZ Company’s $20 strike price LEAPs call options (Jan20call) expiring on Jan 2009 for $2, betting on another good year.

On Jan 2009, XYZ Company had a bad year and its stocks remained almost stagnant and were trading at $19 during expiration of the Jan20Calls. The Jan20Calls that John bought expired out of the money and John loses ALL his money. (The stock trader would have lost only $1)

See why compounding is dangerous for option traders? Make sure you, as an option trader, do not compound your profits unless you are willing to undertake the risk.

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