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Finance , Investing

Don’t Enter If You Can’t Exit

August 9, 2016

I’ll admit it… this is really boring and dry. So, I would recommend that you skip reading this all together…

BUT… if you are interested in minimizing your risk in investing, at increasing your odds of doing well on making a trade, and are truly intent on increasing your wealth, then you should read this.

I’m going to talk about option liquidity.

Bear with me, I’ll make it simple and fun. I hope.

Option liquidity is basically what it sounds like. When we are trading options we want liquidity. We want to be able to buy and more importantly, sell options that we are trading.

If you are trading options and do not have enough liquidity, you can make a lot of money on paper, but not in reality.Let me explain…

An option is just the right to buy shares of a company at a certain price. You have the ‘option’ (hence the term) to buy the shares for the price that is in the contract you bought.

If you buy an option contract that ends up making you a lot of money, then you may want to sell that option before it expires. This is how many option traders do business. They want to get out of the trade while they are up, before the option contract expires, because there is the chance that the value of that option could crash back down to zero.

It’s the idea of walking out of the casino when you are up instead of hanging on until wee hours of the morning trying to further your winnings.

So… if you own an option contract that has increased in value, then you’d probably want to sell while you are up. But, what happens if no one wants to buy? What happens when you own a contract that says you have the right to thousands of dollars, but no body will buy your contract?

I’ll tell you what happens… you don’t get your money.

Let’s say that someone gives you a brand new Ferrari as a gift. It has a value of $300,000. The person that gave you the Ferrari says, “Hey, you have to sell this Ferrari in two weeks. You can keep all the money you make from the sale, but you have to sell it by two weeks. At the end of two weeks, if you haven’t already sold the car, I am going to take the car to the crusher and you won’t be able to sell anything.”
(Ok, ridiculous scenario, but it illustrates the point well.) 

At the last Ferrari meetup in West Palm Beach a couple months ago. A liquidity nightmare!

So, you frantically try to sell this Ferrari. You think immediately… who are my rich friends? Who wants to buy a Ferrari?

Your mind goes blank. You don’t have any buyers! YOU DON’T HAVE ANY LIQUIDITY!

Ok… you get the point.

I am bringing this topic up for a specific reason. I believe that there will be many extremely profitable trades within the next year or two that will provide tremendous gains for savvy investors.

There are so many tumultuous events occurring in our world, so there will be massive volatility in a variety of markets. THAT MEANS OPPORTUNITY FOR YOU AND I.

We can leverage our gains by trading options (which I will be talking a lot more about in the future), so we can make lots of dough. But, we can also get caught in trades if we become too greedy. We need to watch out for this.

We need to look at trading volume, open interest and overall trends for the specific stocks we will be trading.

That’s it for now. Just don’t get stuck in a trade!