Experience is Over-Rated

There's one in every office and every organization. We're talking about the guy who has 20 years experience and says he knows everything. But sometimes, he doesn't! The fact is, he has one year's experience repeated 20 years in a row. We must not fall into the same trap of making the same mistakes over and over again while at the same time failing to innovate and change when necessary. It is better instead to take note of errors and missed opportunities and learn from them immediately.

In our options-trading infancy, we made mistakes that everyone does, but we learned from them. The following advice could be worth $1000's to novice options traders, and "experienced" guys who just don't get it.

#1 Stay Away From Most Small Cap Stocks

We've all seen the Ibbotson charts that show that small cap stocks have historically outperformed large caps in the long hall. So that means we should invest in small-cap options right? Wrong! The fact is that most small caps either are not optionable (not enough public demand) or they the bid/ask spread is wider than a Humvee. Look at the option chain below for Bucyrus International (BUCY).

The spread on the January 40 put is 10.2%. That means that if a trader bought the put now, and sold it immediately, he would lose 10.2% instantly! Las Vegas slot machines don't even take that much from you!

Now, lets look at  Abbott Laboratories' put options.

Look at the January 45 put. It's about the same price as the last put we mentioned. The spread is 3.8% of $2.60. Isn't it better to pay 3.8% rather than 10.2%? Of course it is! That's lesson #1. It's easier to make money when odds are not heavily in favor of the house (market makers). Now many investors, might say that small cap stocks are more volatile than large caps. Most of the time, that's true, but not always. All other things equal, buy the higher-beta stocks and buy options that have 1000 or more open interest. Remember this- just because there is a market for something, doesn't mean anyone should buy it! Buy the right options with narrow spreads.

Cheap Stocks Fall Apart

That's right! $5 dollar stocks are fun to gamble with, but should the intelligent trader buy options on  them? No, he shouldn't. Here's an example. Lucent Technologies' Nov $3 calls are selling for $0.25. They are currently in the money. The stock is trading at $3.11. These calls are $.11 in the money and have only 4 weeks to expiration. In order for the option to double in value (assuming implied volatility remains the same) Lucent stock will have to go up $.25. That's 8%.

Now let's look at Norfolk Southern Corporation (NSC). It's currently trading at $40.28. The Nov 40 call costs $1.40. The call is 28 cents in the money. In order for the option to double in value, NSC has to go up 3.4%. It's much easier to go up 3.4% than 8%!

There are many other factors that go into option pricing. This exercise assumes an instant move. But, the lesson is very clear here. Traders should not buy options on cheap stocks. We recommend options on stocks with a minimum price of $20.

The Moral of the Story

Follow these rules:

• Avoid options on most small cap stocks
• Avoid options on most stocks under $20

Again, just because there is a market for something doesn't mean anyone should buy it. You can get a pretty good deal on illegal drugs if you find the right seller, but would you really want to? Remember, this trading business is a probability game. Traders should buy when the odds are in their favor. Be disciplined, and trade well!

Price Headley is the founder and chief analyst of BigTrends.com.