Option traders are drawn to volatility like moths are to flames.
Shares which move around readily thus fetch very high premiums. Option buyers "pay up" to own calls or puts on those stocks. Option sellers, also called option writers, love high premiums as they’re getting paid well for selling volatility.
Big premiums can be seductive, though. Traders are often tempted to play high beta names simply because the option prices move around so freely.
The key to any good equity option trade is knowing what you believe to be that stock’s true value.
Unfortunately, many of today’s hottest stocks include companies which have never even gotten close to turning a profit. Two examples would be Carvana (CVNA) - Get Report and Plug Power (PLUG) - Get Report. Other similar situations apply to ride share companies Uber Technologies (UBER) - Get Report and Lyft (LYFT) - Get Report.
People like Carvana's idea of selling vehicles totally online and having them delivered directly to buyers’ homes. Revenues have gone up dramatically since its 2017 IPO but heavy losses led to huge secondary share offerings. Outstanding shares expanded from about 18 million at year end 2017 to around 172 million as of Dec. 31, 2020.
What is a company worth which has never made a penny? I challenge readers to give me an answer to that question based on logic.
The same valuation riddle applies to shares of PLUG, UBER and LYFT.
There is no correct true price for these kind of stocks. The only smart choice, then, is to avoid investing in them completely.
That brings me to what I feel is the worst possible option trade, the long straddle.
Buying both calls and puts on the same stock, at the same price implies you know nothing about its future share price direction. Traders/gamblers often play it around earnings report dates hoping for a big move in either direction.
The technique is equivalent to a sports bet that refuses to pick a winner but wagers instead on a blowout by one team over the other.
Carvana is scheduled to release quarterly results during the first week in May. Here were the recent actual prices of its May 21, 2021 $260, near-the-money, calls and puts with CVNA @ $264.98.
Those option premiums were very pricey. Buying 1 contract of each cost $7,102 or $71.02 per share. The graphic below details the break-even prices needed to recoup your entire initial cash outlay if held through expiration day.
In the stock market anything is possible. That said, from Nov. 15, 2020 right through Mar. 8, 2021, there was not a single day that CVNA shares were high enough or low enough to have reached break-even on the long straddle trade.
Why would anyone care to make a bet with such an unlikely chance of success?
Setting up long straddles on most other stocks appears equally unappealing.
The first rule of “Fight Club” was, “Never talk about Fight Club.” My first rule about long straddles is, “Never think about buying Long Straddles.”
There are few option trades with lower expected winning percentages. The odds become even more negatively skewed when you combine a bad technique with stocks that have unfathomable values to begin with.
Don’t say you weren’t warned.
Paul Price provides trading ideas, analysis and investing lessons each day on Real Money Pro, TheStreet’s premium service for active traders. Click here to learn more and get great columns, market commentary and actionable trade ideas from Paul Price, Doug Kass, Tim Collins and many others.
Disclosure: At the time of publication, Price had no positions in any stock mentioned.