Day Four: Ten of the Biggest Mistakes in Option Trading

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.

ISRG ChartChecking 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.

Strike

Price

Extrinsic Cost

Breakeven

Move Required

If Target Profit $

If Target Profit %

220

14.50

14.50

205.50

-24%

6

38%

240

21.50

21.50

218.50

-19%

19

86%

260

30.30

30.30

229.70

-15%

30

98%

270

35.35

35.35

234.65

-13%

35

98%

280

40.80

30.80

239.20

-11%

39

96%

300

52.80

22.80

247.20

-8%

47

89%

320

66.50

16.50

253.50

-6%

54

80%

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.

Standard DeviationIf 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

Day Five: Ten of the Biggest Mistakes in Option Trading

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.


Options Trading Level

Strategy Lvl 1 Lvl 2 Lvl 3 Lvl 4 Lvl 5
Covered call writing

X

X

X

X

X

Protective Puts

X

X

X

X

X

Buying stock or index puts and calls

X

X

X

X

Covered put writing

X

X

X

Spreads

X

X

X

Uncovered put and call writing

X

X

Uncovered writing of straddles and strangles

X

X

Uncovered writing of index puts and calls

X

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.
    profit-loss
  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

Day Six: Ten of the Biggest Mistakes in Option Trading

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.

Making A LEAP 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.


Whole Series: Ten of the Biggest Mistakes in Option Trading
Next Post: Day Six Part Two: LEAP into Debit Spreads
Previous Post: Day Five: Believing Covered Calls are Conservative

Day Six Part 2: Ten of the Biggest Mistakes in Option Trading

Spread Failing to Make the LEAP to Long Term Thinking Part Two

A LEAP 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 LEAP 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.

LEAPS Debit Spread

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.

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.


Whole Series: Ten of the Biggest Mistakes in Option Trading
Next Post: Believing You Can Profit by Trading Overvalued and Undervalued Options
Previous Post: Day Six: Failing to Make the LEAP to Long Term Thinking

Day Seven: Ten of the Biggest Mistakes in Option Trading

Believing You Can Profit by Trading Overvalued and Undervalued Options

lost-it-allI’ve heard this mistake proffered as advice more times than I can remember. Believing you can profit by buying undervalued options and selling overvalued is a common mistake. At it’s heart is arrogance; a belief that you are smarter than all the other options traders out there.

Statements like this are ludicrous “In most cases, historical volatility and implied volatility will be different, and that’s where the trading opportunities can occur.” 

If you are selling overvalued or buying undervalued options  you are saying your opinion on future volatility is better than the collective wisdom of the market.   

The key to correct for this mistake is to understand that historical volatility is merely a number which represents past volatility. Historical volatility tells you nothing about the future. Conversely implied volatility represents the collective wisdom of all the options traders and market markers. Implied volatility is what they believe is a fair price for future volatility.

As a general rule there are no easy trades in options. There are no free lunches. There are no available option pricing models which will help you become wealthy.

Is it possible to profit to option mispricing? Yes, it is. Market makers and other large professional options tading firms do this by comparing one option to another. They find relatively undervalued and overvalued options by comparing options to each other, not IV to HV.

More: Days one to six in this series of options trading mistakes.

Whole Series: Ten of the Biggest Mistakes in Option Trading
Next Post: Any Suggestions?
Previous Post: Day Six: LEAP into Debit Spreads

Marty Whitman’s Guidelines

In his most recent letter, Whitman offered investors some guidelines going forward. He said:

Indeed, today the opportunity of a lifetime seems to be present for passive investors who follow a few simple caveats:

1) Be a buy-and-hold investor;

2) Don’t use borrowed funds to invest;

3) Don’t own the common stocks of companies which need relatively continual access to capital markets if they are to remain going concerns.

from TMF

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