Entries Tagged 'Options Mistakes' ↓

Failing to Make the LEAP to Long Term Thinking Part Two

A LEAPS debit spread has two forms a calendar spread and a vertical debit spread. It is the vertical spreads which I consider a fantastic tool to add to your options toolbox. For calls you are buying a call option and simultaneously selling a higher strike call option with the same expiration to offset some of the cost, this is also called a bull spread. As the lower strike call will always be more expensive than the higher strike, the net result is a debit. You pay the difference between the two strikes and that amount is your maximum known risk. Debit spreads reduce the volatility compared to buying options. The decrease in volatility works both ways. The spread value will not decline as fast if the stock price falters, but also will not rise as fast in the event of a rally. The objective is for the stock to be above the top leg of the spread, or if puts are used below the bottom leg, as expiration approaches. Be aware that you will also have two different bid/ask prices and two transaction costs.

The three simple rules to help you design winning LEAPS debit spreads.

1. Look for a spread of ten to twenty points between the strike prices, I find 15 works well for most stocks.
2. Aim for a maximum profit of at least 400%
3. Using an options simulator find a spread that has over an 80% probability of success.

A simple rule of thumb for the first two rules is the debit should be 20% of the spread. So if the spread is 10 you want to pay $2, for $15 you’d pay $3. Below is a profit and loss diagram of the trade you’re looking for.

If 80% sounds high to you then consider this. I’m not talking 80% chance of the price being above the higher leg at expiration. It incredibly unlikely you’ll ever find a trade with those odds. You’re looking for a trade which has an 80% probability of the spread doubling some time during the option’s life.

If you find these trades then you need to guard against another danger. Due to the high probability of your spread doubling some time during the trade you may grow overconfident. The danger is you’ll be so confident that you’ll let profits slip right through your fingers. The easiest way to improve your results is to sell half your position if the spread doubles and let the rest ride with a trailing stop. In stock investing I am not a fan of trailing stops or selling my winners, the key difference with options is time. With time working against you trailing stops and locking in profits are sensible tools to ensure your confidence doesn’t cost you. The easiest way to keep this in mind is that you entering a trade with 80% probability of success at some time during the trade, but which may well have less than 50% probability of success at expiration.

More on Using Leaps Options for Long term profits.

Both these guys are trying to get you to subscribe to their newsletters, I don’t recommend them but they have some examples and their free information is worth checking out.

• By Jeff Carter
• By Ken Trester
• Numa.com has the following to say on Bull Spreads

Strategy View Investor thinks that the market will not fall, but wants to cap the risk. Conservative strategy for one who thinks that the market is more likely to rise than fall. Strategy Implementation Call option is bought with a strike price of a and another call option sold with a strike of b, producing a net initial debit, OR Put option is bought with a stike of a and another put sold with a strike of b, producing a net initial credit. Upside Potential Limited in both cases - Calls: difference between strikes minus initial debit Puts: net initial credit Maximum profit if market at expiry is above the higher strike. Downside Risk Limited in both cases - Calls: net initial debit Puts: difference between strikes minus initial credit Maximum loss if at expiry market is below the lower strike. Margin Possibility for margin requirements to be off-set. Read Part One…

Failing to Make the LEAP to Long Term Thinking

Is it possible to find an option strategy that delivers a swing at a home run, an 80% chance of 100% and a known limited risk? You bet it is.

While the old lore that 90% of options expire worthless does not give a true picture of the options market, it is true that buyers generally loose more than they win. Option buyers are speculators. There’s nothing wrong with being a speculator, the important point is to recognise that you are engaged in speculation and to make sure that fits with your personality and risk profile. As a general rule I need to win more than I loose so I don’t often buy options. If you buy options you can loose a lot of the time, but still make money. A few home runs can makeup for a lot of losses.

As predominately an option seller I didn’t get the opportunity for home runs. In fact my losses were sometimes other people’s home runs and those big losses sure ate up a lot of my winners. Just like an insurance company, I collected a lot of premium, but occasionally suffered a big loss. The small speculator in me, never got the reward of those cocktail party stories of option trading glory. It soon became ludicrous to have tor refer back to my SAP home run story of ‘95.

I was always searching for a strategy that could give me a shot at a home run and a high probability of profit.

Then one day I found it, the perfect strategy to add to my options armoury, a strategy that delivered a swing at a home run, an 80% chance of 100% profit and a known limited risk.

Are you mentally screaming tell me, tell me what that amazing strategy is? Maybe you’re screaming it OUT LOUD. Or maybe not, I know I wouldn’t have been. I’m sceptical of most things and the hyperbole surrounding options trading made me wary of such claims years ago. The thing is if you’re an experienced option trader or have any read a few books or followed online discussions then you probably know what this strategy is already. You probably knew it when you read the heading.

Read Part Two….

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
Dean

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.

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.

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.

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.