Page 420 - How to Make Money in Stocks Trilogy

290 BE SMART FROM THE START

option fluctuates three times as rapidly as the underlying stock, then per-
haps 20% or 25% might be a possible absolute limit. On the profit side, you
might consider adopting a rule that you’ll take many of your gains when they
hit 50% to 75%.
Some aspects of options present challenges. Buying options whose price
can be significantly influenced by supply and demand changes as a result of
a thin or illiquid market for that particular option is problematic. Also prob-
lematic is the fact that options can be artificially and temporarily overpriced
simply because of a short-lived increase in price volatility in the underlying
stock or the general market.

Buy Only the Best
When I buy options, which is rarely, I prefer to buy them for the most
aggressive and outstanding stocks with the biggest earnings estimates, those
where the premium you have to pay for the option is higher. Once again,
you want options on the best stocks, not the cheapest. The secret to making
money in options doesn’t have much to do with options. You have to analyze
and be right on the selection and timing of the underlying stock. Therefore,
you should apply your CAN SLIM system and select the best possible stock
at the best possible time.
If you do this and you are right, the option will go up along with the stock,
except that the option should move up much faster because of the leverage.
By buying only options on the best stocks, you also minimize slippage
caused by illiquidity. (Slippage is the difference between the price you
wanted to pay and the price you actually paid at the time the order was exe-
cuted. The more liquid the stock, the less slippage you should experience.)
With illiquid (small-capitalization) stocks, the slippage can be more severe,
and this ultimately could cost you money. Buying options on lower-priced,
illiquid stocks is similar to the carnival game where you’re trying to knock
down all the milk bottles. The game may be rigged. Selling your options can
be equally tricky in a thin (small-capitalization) stock.
In a major bear market, you might consider buying put options on certain
individual stocks or on a major stock index like the S&P, along with selling
shares of common stock short. The inability of your broker to borrow a stock
may make selling short more difficult than buying a put. It is generally not
wise to buy puts during a bull market. Why be a fish trying to swim
upstream?
If you think a stock is going up and it’s the right time to buy, then buy it,
or purchase a long-term option and place your order at the market. If it’s
time to sell, sell at the market. Option markets are usually thinner and not
as liquid as the markets for the underlying stock itself.