Option Sellers Beware

In day seven Mark Wolfinger penned a warning for option buyers. I thought it appropriate to provide the yang to Mark’s ying.

I don’t recall where I read that options sellers eat like chickens and shit like elephants, but I sure laughed hard and the phrase still brings a smile to my dial. I’m predominately an option seller and can testify to having been covered by a few large steaming piles in my time.

Experienced traders will extol the virtues of buying protection for written options. That is insuring you’re not naked. Unfortunately those new to the trading options seldom listen to that advice for a number of reasons.

1. Buying protection reduces the attractiveness of a position.
2. Buying protection forces an acknowledgement and assessment of the risk and requires more involved calculations.
3. It won’t happen to me.
4. I’m happy to buy or sell at that strike price.
5. I’ll close the position if it moves against me.

Two words sum up the danger, surprise volatility. In Bleed or Blowup, Nasim Taleb has the following to say

In some strategies and life situations, it is  said, one gambles dollars to win a succession of pennies. In others one risks a succession of pennies to win dollars. While one would think that the second category would be more appealing to investors and economic agents, we have an overwhelming evidence of the popularity of the first. A popular illustration of such asymmetry in returns is evident in the story of the Long  Term Capital Management hedge fund. The fund derived steady returns over a dozen quarters then lost all of them in addition to almost all its capital in a single observation (see Lowenstein, 2000) –only for the main principals to restart a new, albeit milder, version of the strategy. Is there a systematic bias in favor of such return profiles?

That’s right LTCM were options sellers. So if the most intelligent (note I didn’t say smartest) collection of people to ever form a hedge fund blew up selling options, why do newbie option traders think they can better?

How to Overcome the Dangers of Selling Options

Slip, slop, slap. Slip on some protection, slop on some protection, slap on some protection. Buy a lower priced put or higher priced call to protect yourself from surprise volatility.

Invert your thinking. In day five, believing writing covered calls is conservative, I highlighted how covered calls are not as risk free as many investors think. The easiest way to overcome the danger of writing covered calls is to invert your thinking by considering whether you would write a put on the stock at the same strike price. As a put is equivalent a covered call that simple mental gymnastics helps me decide whether I should be writing the covered call or simply selling the stock.

While that takes care of downside risk, which to me is the real risk, many experienced investors have argue that missing out on the upside is an even greater risk. While I disagree, I certainly concede that forfeiting upside is a risk that many investors ignore. Is it worth selling that $50 call for $1 when the at expiration the share could be $60?

When you sell options you are in general forfeiting upside while taking on the downside risk. You’re behaving like an insurance company and as such it pays to re-insure against catastrophic risk.

More:

• Day Eight in this series of options trading mistakes.
• The series so far, ten biggest mistakes in option trading.

This, the eight post in my ten biggest mistakes in option trading series, features my first ever guest writer. Options educator and author Mark D Wolfinger from Options for Rookies kindly agreed to help me complete this series. Mark’s recent book is The Rookie’s Guide to Options.
Now it’s over to Mark.

Option Buyers Beware

Most option rookies begin their careers by buying an out of the money put or call, hoping – more likely expecting – that the stock will magically soar or dive, earning that rookie trader a good-sized reward.

When a few weeks pass and the option expires worthless, the rookie is not only disappointed, but often perplexed.  The stock underwent a very nice rally in just 4 weeks – moving from 40 to 48.  He/she owned call options.  How could the trade not make money?

The bottom line is that it’s difficult, at best, to prosper when buying options.  Many beginner books suggest buying options as the ideal learning strategy, but I find that to be very poor advice.  We all know that the majority of professional money managers cannot beat the stock market, yet they are handed hundreds of billions of dollars to try to do just that.  And, they charge their customers a fee for under-performance.  The fallibility of money managers is well known, yet the majority of individual investors are confident that they are different, and can beat the market.  There’s plenty of evidence to show that individuals perform no better than the market averages, and many accept that as true and buy index funds.  But not all investors accept the facts.

Bucking those odds is bad enough.  But to make matters even worse, investors with market-beating stars is their eyes love the idea of buying options.  After all, the prospect of spending a few hundred dollars to control several hundred shares of stock (that’s leverage) allows them to the chance to make as much money as investors with larger bankrolls.

To win the option-buying game, they must not only pick the correct direction for the stock – and as already mentioned, that’s already too difficult for most – but the timing must be right.  That makes the probability of earning a profit even lower.  Options have a limited lifetime and if the trader is not sufficiently accurate in timing the market move, there’s no payoff.  Just more losses.

If that combination is not bad enough, there’s also the requirement to make a good guess as to the size of the market move.  I’ll agree that if the trader buys in-the-money options, this becomes less of a factor.  However, option-buying, leverage-seeking traders – especially newcomers to the options world – prefer those low-delta out-of-the-money calls and puts.  And that makes guessing the size of the move imperative.  True, options should not be held until expiration day, but if the underlying stock doesn’t move far enough, fast enough, then the option’s value can quickly fade away.

Looking at the example I used earlier, the trader sees the stock zoom 20% in one month and all the investor has to show for making a good stock prediction is the equivalent of a torn-up pari-mutuel ticket.  The ‘horse’ just did not have enough to finish the race.  Out of the money options are useless once expiration arrives.  The trader bought calls with a strike of 50 when the stock was 40.  The price was low, but it was still too high.

It’s a difficult task to make money buying options.  The incentive to try is the chance for big score.  It’s possible to turn $1,000 into $10,000 in only a few weeks.  And that possibility is what keeps hope alive.  I’m not telling you it cannot be done.  Traders who have proven they have a good track record when it comes to picking direction or timing the market may be able to earn a very good living when buying options.  Those with exceptional technical analysis skills may also prosper.  But for the average individual trader, buying options as a primary strategy is a big mistake.

I am not suggesting these traders should be selling options.  Especially not naked options.  But there’s a world of option strategies between buying and selling naked options.

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More:

• Day Seven in this series of options trading mistakes. Under and over valued options.
• The series so far, ten biggest mistakes in option trading.

I invited Mark to contribute to this series and was delighted that he accepted, especially when he has his own very busy publishing schedule. Mark along with four other excellent bloggers are about to launch Expiring Monthly a journal for option traders. There is currently a a charter member offer for $79 (regular price $99) and you could even win a free subscription. I plan on subscribing.

The number one mistake in option trading is losing all your money. You’d think that was blinking obvious. You would wouldn’t you? Yet, this mistake trips a lot of new options investors.

That’s right, no introduction! I’m trying to get rapidly to the point these days, trying, I’m on the path. If I complete the ten days then I’ll write an intro and summary.

Don’t loose all your money is manifest, yet too many new options traders find themselves walking home from the track rather than sipping champagne in that limo they dreamed of.

Don’t loose money. Rule number one and two! Before you start to trade options you must be confident you’re not the patsy at table. You must know you’re going to keep your shirt on your back.You need to know yourself, you need a trading plan or investment strategy. You need to take small steps as there is no rush.

How to ensure you don’t loose all your money
A starter for ten.

You have to maximise your winners and minimise your losers. Cut your losses short and let your winners run. Peter Lynch felt “pulling the flowers and watering the weeds” was the number one mistake of most investors.

The two main methods for maximising your winners and minimising your losses.

1. By Dollar. A few big winners make up for a lot of small losses. You’re the high stakes gambler. Who cares about the losses, you only talk about the winners. This is the most popular form of options trading for inexperienced options traders and the reason why the number one mistake in options trading is losing all your money. Still for the calculating, experienced trader and the lucky a lot of money can be made.
Buying derivatives (options, futures, CFDs) of any kind is the closest you can come to gambling without stepping from the financial world into the gambling world. Yet it is the style the options industry is setup to cajole you in to. If you buy options then it is vital you pull up your weeds and water your flowers. There are less risky strategies for buying options, but that’s a topic for another day.
zeeco spreadsheet to come illustrating how a few big winners offsets a lot of contained losses.

2. By volume. You maximise the number of winners and minimise the number of losers. Lots of small winners with a few big losses. My preferred method. That doesn’t imply it is the better method, it simply is the right options trading method for me. You’re the insurance person. Selling speculation to the greedy and insurance to the fearful. The returns aren’t as sensational and you’ll occasionally be on the losing side of the options buyer’s cocktail party story, but this is an easier game to win. You mainly sell options.
zeeco spreadsheet to come.

For further reading check out Why do so many people lose money in commodity options? from T & K Futures and Options Inc.

Whole Series: Ten of the Biggest Mistakes in Option Trading
Next Post: Day Two You Need Speed and Direction

You Need Speed and Direction

Not understanding that option trades require both speed and direction to be profitable is often quoted as the number one reason why option traders loose money, it make it in to my list at number two.

Option trading is not stock trading. You can’t buy and wait, you can’t wait for the weighing machine to deliver your profits. You absolutely need the early exit poles to show the vote is in your favour. To consistently make money buying options you need to determine the direction, speed and likely distance of your chosen vehicle.

On average stocks are range bound 70% of the time. If you’re buying options the deck is loaded against you. You start with a 30% chance of movement and that’s in either direction, so you might have as low as 15% chance the stock will move in your direction. Factor in how far it has to move for your position to be profitable and you can see why so many option buyers consistently loose money. Short term option trading is difficult as you must correctly call the direction, target and speed of the underlying stock. On top of which time decay and volatility premiums are working against you.

you must correctly call the direction, target and speed of the underlying stock.

It’s difficult to win a game when you’re losing most of the time. Worse yet is many new option traders attempt to limit their loses by buying cheap options. Buying cheap out of the money (OTM) options doesn’t limit your loses, it guarantees them.

How to Overcome for Not Knowing the Need for Speed, Direction and Distance

The easiest fix is to become an option writer. Selling options lets you reap the rewards from market participants who don’t understand the need for speed and direction. When you sell options time decay and volatility premiums become you allies.

If you know yourself and buying options is the right path for you then ensure you consider the following:

1. Figure out your breakeven point before entering a trade. The breakeven point for calls is the option price + strike and for puts it’s strike – option. Determine if, in the time to expiration, the underlying stock or index is likely to move beyond your breakeven point.
2. Stop buying cheap options. Pony up for worthwhile options. Try buying either in the money (ITM) options or long dated options or LEAPS. While they may seem more expensive when you look at them from a breakeven or time value perspective you’ll see they are a lot better value than short term OTM options. If you’re not comfortable investing more, then adjust the number of contracts you buy while investing the same dollar amount as you would on those cheap options.

The following spreadsheet uses June Fedex Puts and Calls to illustrate how buying ITM options is normally the better choice. Despite being more expensive the ITM options are profitable sooner and require much smaller moves to become profitable. Comparing strikes like this is a quick way of determining the best strike to buy. This spreadsheet shows how it would require an 8% move up before the OTM Call became more profitable an a -7% move for the OTM Put to become more profitable.
You can enter your own figures in the white cells.

Whole Series: Ten of the Biggest Mistakes in Option Trading
Next Post: Day Three: Not Buying Enough Time
Previous Post: Day One Don’t Loose Your Shirt

Not Buying Enough Time

There’s never enough time to do all the nothing you want.
Bill Watterson, Calvin and Hobbes

How many times have you heard people lament about not having enough time? There is never enough time, except in those long summer days of youth.

Options allow traders to buy enough time and to be successful you must take advantage of this and buy more time. If you buy options, not paying for enough time is a critical mistake you must overcome. Before short term option buyers start flaming me, let me say there are instances when short term option are the right strategy; however, those instances are the exception to the rule.

There are four benefits to paying for more time when trading options.

1. You are actually paying less not more. You are paying less per time unit (day, week, month). The longer the time to expiration, the cheaper options become per time unit. Let’s look at $40 Calls on Akamai (AKAM) to illustrate this. AKAM closed at $38.58. June options set to expire in 24 days have a bid/ask mean of $1.30, July $2.20, Aug $3.05, Nov $4.70, Jan 2010 $8.45. How much are you paying per day?

Expiration	Cost	Days	Per day
June	1.30	24	0.054
July	2.20	52	0.042
August	3.05	80	0.038
November	4.70	178	0.026
Jan 2010	8.45	598	0.014

As this table shows the June Option is really two times more expensive than the November and almost four times more expensive than the LEAP. You are buying time and should want to buy it as cheaply as possible. Don’t be fooled by the lower price.

2. I touched on the reason why you should be paying more for time in Day Two: The Need for Speed and Direction. On average stocks are range bound 70% of the time. By paying for more time you give your trade the opportunity to work. You’re paying time to be your ally, rather than paying a smaller amount and having time as your foe.
3. Options are a wasting asset. The value of these financial instruments decays with time. This decay is fastest in the four to six weeks prior to expiration. By buying more time you are slowing the decay of your asset. All going well you’ll get to take your profit before decay can eat up your profit.
4. By buying more time you increase the responsiveness of out of the money options. Geeks and Greeks call this delta Delta measures the sensitivity of an option’s theoretical value to a change in the price of the underlying asset. Put simply if the underlying goes up and a longer dated option will go up more. To illustrate this and point three let’s look at those Akamai $40 Calls again. First a little more Greek. Time decay is called Theta, the dollar amount that an option will lose each day due to the passage of time.

Expiration	Delta	Theta
June	0.4115	-0.0390
July	0.4630	-0.0274
August	0.4940	-0.0234
November	0.5391	-0.0155
Jan 2010	0.6178	-0.0080

This table shows how the shorter dated options will move less in response to changes to the price of Akamai and will have faster time decay. You don’t want either of those characteristics. You want your options to move more in response to the underlying and decay less. So buy more time.

Conclusion

It may feel like you are putting more money at risk, but in reality you are increasing your odds of success rather than throwing your money away. If you want to be successful buying options then you must buy more time.

Whole Series: Ten of the Biggest Mistakes in Option Trading
Next Post: Day Four: Only Buying Out of the Money (OTM) Options
Previous Post: Day Two: You Need Speed and Direction

Only Buying Out of The Money (OTM) Options

Time for a quick recap. Don’t loose all your money. Maximise your winners and minimise your losers. If buying options you need speed, direction and distance. Make sure you buy enough time; always buying short term options is a sure way to loose your money.

Conceptually only buying OTM options is the same as mistake three, not buying enough time. Beginning options traders think that by paying less for their options they are protecting themselves from losing all their money. However, the complete opposite is true. Most things in life that are cheap are pretty worthless and the same goes for options. You simply must pay for quality. (Now you may be thinking, that as you’re not paying for this information it too must be worthless. The reality is you are paying! You are trading your valuable time for this information. I do hope it has some value to you.)

If you always buy OTM options then before you place your next trade consider selling an In The Money (ITM) option instead. If you analyse the options you’ll quickly see you are increasing your odds of success and you are paying less for the extrinsic or time value. In general if you sell options you should be looking to do the reverse and maximise the extrinsic value you receive, but as with all rules that is one I often break.

Let’s look at an example of using Intuitive Surgical (ISRG). A fine Fool analyst and option trader just alerted me that ISRG has broken it 200 day moving average for the first time since January 2007. As Jim said this sometimes signifies a change in trend and is worth investigating.

Checking the chart I see ISRG has broken the 200d MA, though the 50d MA is still above the 200 day. In conjunction with fundamental input I do find technical analysis assists in my option trading, but that is a story for another day. A quick look at the fundamental stats in conjunction with the chart, without detailed analysis and just to get a starting point I’ll say there is a possibility ISRG could fall to the 150-200 region where it put in the big white candle back in July 2007.

Now let’s look at some quotes. I’d want to give my thesis time to play out and as always ensure I didn’t bet the house on this one trade. Checking earnings.com I see earnings were on 19 July last year and are expected around 21-31 July this year. I’ve got no opinion on ISRG’s earnings, but before placing any trade I’d try to get some idea. Anyway (stick to the point Dean) I wouldn’t even consider June options with nine days to go as that is a complete lottery ticket. July may be worth a look at, but October is probably what I’d go for.

ISRG Closed $269.66, let’s call it $270 and use a target of $200.

Looking at the two extremes here I’d wager most options beginners would be more inclined to look at the $220 Puts rather than the $320. After all the $220 is only $14.50 instead of $66.50. They convince themselves they can buy more, risk less and make a bigger profit if a large move occurs. However, as the above table shows they are paying about the same in extrinsic value and require a considerably larger move to breakeven and at the initial target actually make less on the all important $ basis and less important % basis. For the lower strike to be more profitable on a percentage basis the stock would have to drop 29% to $192.

If you picture a bell curve you’ll soon realise that buying the lower strikes dramatically reduces your odds of success and paying for ITM options has a higher probability of success.

I’ve used Puts in this example, but exactly the same principles apply with buying calls. If you want to play around with the spreadsheet, fell free to grab a copy of the option spreadsheet.

Next time you are going to buy an OTM option stop and think if an ITM option would be the better trade.

Whole Series: Ten of the Biggest Mistakes in Option Trading
Next Post: Day Five: Believing Writing Covered Calls is Conservative
Previous Post: Day Three: Not Buying Enough Time

Believing Writing Covered Calls is Conservative

The entire options industry is setup to convince you selling covered calls is a conservative strategy. If you look at the option trading levels below you’ll see covered call writing only requires the lowest level of option trading approval, level 1. Most brokers and option advisors will recommend you start option trading by writing covered calls. Despite what your broker wants you to believe, I’m here to tell you that writing covered calls is NOT a conservative strategy. Come on say this 21 times with me, Writing Covered Calls is not a Conservative Strategy.

I’m guessing you’re not simply going to believe me without a persuasive argument. Yet you probably believed your broker with no evidence

For my evidence I offer:

1. Look up at the table again. Can you see what trading level uncovered put writing is?
   The second highest level of approval, level 4. Only uncovered writing of index puts and calls requires higher authorisation. Do you find that a wee bit strange? Writing covered calls and uncovered puts are identical option strategies from a risk reward perspective. If they are identical from a risk and reward perspective then why don’t they require the same level of approval? Covered calls is the first strategy most people are “sold” while writing puts is considered an advanced strategy that requires years of option trading experience. Odd, don’t you think?
2. Look at the following profit and loss (risk graph). Is this graph for a covered call or an uncovered put?
   Trick question. There is no way of knowing as the profit and loss, the risk profile, is the same for both. Limited upside and almost unlimited downside. When you sell a covered call you are selling the right to the upside while taking on all the downside risk.
   
   
3. Most people think selling a covered call is giving them some downside protection. The reality is covered calls do not protect the downside. The small downside hedge you receive in selling a covered call is in most cases outweighed by the psychological impact of having sold the covered call. If business conditions change and you should sell the stock, you are more likely to hold the stock rather than sell as your judgement is clouded and confused by the call you sold.

In summary covered calls are not a conservative strategy. They are amongst the riskiest of options strategies and should only be employed under specific circumstances. Covered calls do not protect your downside. They cap your profit leaving you holding all the downside risk and they leave you at the mercy of the market.

Here are my rules for writing covered calls.

1. Only write calls on stocks you own and are comfortable to continue to own.
2. Only write calls at a price you are happy to sell at. This should be your calculation of fair value or some margin above fair value.
3. As stocks generally move in spurts it is preferable to write a covered call after a run up in the price.

My rules when not to sell a covered call.

1. Never sell a call as an exit strategy. Absolutely never ever sell a call as an exit strategy. If a stock has risen to fair value or above and you do not want to own the company for the long term then sell the stock or enter a collar (sell a call and buy a put).
2. Never sell a call to simply to collect a high premium. If a premium looks high there is a reason for it and the downside will bite hard.

Covered calls are a good income producing strategy for long term stock holders. They are not a conservative option trading strategy.

Happy trading.

Whole Series: Ten of the Biggest Mistakes in Option Trading
Next Post: Day Six: Failing to Make the LEAP to Long Term Thinking
Previous Post: Day Four: Only Buying Out of The Money (OTM) Options