Options for Rookies

The Cost of Not Knowing Enough

I read a very interesting post (hat tip to JD) by Carl at behaviorgap.com

It's  entitled 'The Simplicity Premium.'  This post is based on Carl's.

Background:  When someone doesn't know any better, he/she often pays an 'ignorance premium.'  That phrase refers to an extra cost associated with overpaying because the buyer lacked significant information.

Is it worth the effort to save that premium?  There's no correct reply because it takes research.  If you spend too much time learning what you need to know, saving the ignorance premium may not be worth the effort.  Or, it may be worth far more.  It's not so easy to know, in advance, if the deal you are being offered is reasonable or overpriced. This situation occurs frequently - when you buy a car, home, or furniture.  When you shop at a flea market or farmer's market.  When you shop online, there's an increased risk of  paying for a counterfeit. 

The ignorance premium is used by salesmen to convince consumers to overpay for almost anything.  I'm thinking of those over-priced, over-hyped, multi-thousand dollar option seminars.

The Simplicity Premium

Carl has coined the phrase 'simplicity premium' to represent the added cost of valuing simplicity.  The idea is that people are willing to pay a premium to make their lives easier.  We hire people to do tasks we can easily do ourselves.  But sometimes, the premium is really inexpensive - and you get good value and an easier life. 

Carl's prime example:

"Investing is simple. But... not easy.

There really are only a few things that you have to get right (simple), but because there are so many ways to get it wrong, it seems complex.

It’s simple, but not easy...

There are so many ways to invest. So many people willing to sell you crap. So many entertainers pretending to provide advice."

It's true.  That's one reason why investors buy front-end load funds instead of no-load or index funds.  They take advice from a broker who makes a living by selling funds with loads (up-front sales commissions).

The financial industry is loaded with people (some aim to harm you deliberately) who look out for themselves first.  That means they want their fees and/or commissions, and if the customer doesn't buy something appropriate, too bad.  Just look at those mortgage brokers who convinced the ignorant to buy homes they could not afford and/or trade fixed rate mortgages for variable-rate mortgages, with incredible interest rate leaps.  True, many home buyers did it to themselves, but not all.

It's the same in my world.  There are those who love taking large sums to impart knowledge that's available for little or no cost.  They sell pricey lessons and materials at very high prices to those who don't know where to get good information for next to nothing.

I live by the simplicity premium, when it's affordable.  I just never gave it a name.  And that's how I operate when helping others learn to trade conservative option strategies.  There's plenty of free material in this blog, or on my website

Thank you Carl.

287

Backspreads. Standard and Diagonal. III

Part III: The risk graphs.

Part I and Part II.

I discussed three different RUT diagonal back spreads last time.  Reminder:  These positions were selected randomly.  Thus, please do not try this at home.  If you are comfortable with this idea, carefully choose your own strike prices and underlying.  But these positions, or your own, are appropriate for a paper trading account.
 

RUT 429; (Closing price 3/27/2009) 

The y-axis shows Profit/Loss (multiply by 1,000).

P/L = 0 at current price (429).

The x-axis represents RUT price (multiply by 100).

Position A:

Sell 10  May 460C @ 16.70; Buy 16 Jun 500C @ 11.70

 

a) The position has positive theta.  That's true as long as there is significant time value remaining in the short option.  If RUT undergoes a significant move in either direction, the May options move towards 0 or 100 delta, and the time premium quickly disappears.  As that happens, theta for this spread becomes negative.

b) The position has positive vega. Thus, the final profit or loss can only be estimated.  So much depends on the price of your June options when it's time to sell.  Obviously, if you are satisfied with the profit (or unhappy about risk) at any time, simply exit the trade.

c) Note: This spread usually does not make a large profit, but it does provide the possibility of collecting when the market rallies.  If you are lucky and  RUT moves another 25% and if IV increases, there's money to be made.

d) There's another way to profit - and that's when the traditional diagonal spread would also be a big winner.  That occurs when the near-term option is inexpensive to cover, but RUT is still high enough for the Jun calls to retain substantial value.

Position B:

Sell 10  May 460C @ 16.70; Buy 19 Jun  510C @ 9.50

Buying 19 Jun 510 calls instead of 16 Jun 500 calls allows for the possibility of a larger gain.  But beware - if a move does not come quickly, the 19 Jun 510 calls will lose value more quickly than the Jun 500 calls.  

The position is + theta and vega (see Table below).  When vega is 408, the position makes or loses $408 when the implied volatility changes by one point; higher or lower.

Position C:

Sell10  May 460C @ 16.70;  Buy 25 Jun 520C @ 7.70

 

Potential profit is much higher, but theta is less (See Table).  Vega is much higher.  Thus, this position is far riskier then the others.  It's difficult to see from the current graph, but as time passes, the upside becomes ever more dangerous.  Right now this position works well on a continued rally, but if a few weeks pass, ans especially when IV declines, this can turn into a disaster.  [Sadly I lack the software to see these positions at a later date, but plan to post an update to these hypothetical positions.]

Table

3 Positions and the Greeks

 

DEBIT: Dollar cost to open position

286

Backspreads. Standard and Diagonal. II

In Part I, I gave a brief description of a standard call back spread in which an investor buys more options than he/she sells.  The idea is to profit in a bull market when the underlying stock makes a big upside move - while minimizing (usually, eliminating) risk if the underlying moves in the opposite direction. 

Similarly, you may be able to profit in a bear market by owning put back spreads.

Back spreads allow the investor to own extra options and positive gamma.  Instead of paying for those options, the cost is reduced (or eliminated) by converting the position into a spread by selling fewer options that are closer to being in the money.  Typical back spreads allow the investor to profit when the underlying stock or index moves significantly in either direction. 

Because the focus of this series of posts is on diagonal back spreads, which are uni-directional, there is no need to dwell on that aspect. [But, if you want to understand how it works, consider yesterday's example.  Instead of selling May 90 calls, sell May 50 calls or stock.  Time decay becomes much worse, but gamma increases and if XYZ undergoes a serious decline, the back spread is very profitable - because the stock declines by far more than the May 90 calls would have declined.]

Diagonal back spread

The purpose of a diagonal back spread is to create an opportunity to earn a profit when the underlying makes a large move in one (specified) direction.  But, as with 'regular' diagonal or double diagonal spreads, there is the possibility of profiting when the option you sold is not far out of the money as expiration nears.  But keep in  mind that being short an ATM (at the money) near-term-option is a high-risk situation because of negative gamma.

Much of the profit/loss that results from owning a diagonal spread is dependent on IV (implied volatility) at the time you exit the position.  Diagonal back spreads are even more dependent on future IV  because you own extra options.  Thus, these spreads are especially rich in vega. [If that aspect of the trade bothers you, you can add some negative vega positions to your portfolio as an offset: sell credit spreads, for example.] 

I proposed the idea of diagonal call back spreads in Part I and suggested it's one method to profit from a major upside move  (use puts to play for the downside).  But there's one caveat:  Most of the time when the market rallies,  IV decreases.  That hurts a vega rich spread.  In very recent times, IV has not be declining on rallies, and for the moment, that specific risk may be minimal.

There are two ways to win with diagonal back spreads:

• A large favorable move - The sooner, the better.
  

• If time passes and your short options expire or are repurchased at a low price - as long as the market has not moved to a point where your long options have little value.
  

The Set Up

a) Choose an option to sell.  The idea is to sell a near-term (or 2nd month) option. 

You can choose an out of the money call - but not too far out.  This option must be trading at a significant price because you want to collect enough from selling these calls to pay (or almost pay) for the calls you buy.  The bakspread is not as effective when your cash outlay is large.  In that scenario, you'd be better off by simply investing the money in naked long calls - when looking for a big rally.

It's appropriate to sell an ATM option, if your comfort zone allows it.  Mine does not and I sell options that are a few strikes OTM.

b) Choose an option to buy.  This is a crucial decision.  If the market rallies and if IV declines, the best call options to own are those that with the lowest strike price (or highest delta).  But, if IV holds steady or increases, then the best options to own are those with higher strike prices.  Why?  Because you must own more of the lower delta options to achieve delta neutrality - and that translates into more vega.  If IV rises, it pays to own vega; if IV collapses, owning vega is costly. 

In addition, your potential upside win is larger when you own more options.  But be careful - time can destroy the position.  We'll look at risk graphs next time, but it's a good idea to use your broker's software to see how various positions make or lose money under various conditions.

Be careful here.  If you are considering the purchase of calls with a strike price of 700, it's reasonable to choose 710 or maybe 720 instead.  Don't consider buying 780s or 800s just so you can own a fistful of options.  That's a huge gamble that will cost dearly, unless IV explodes.

When trading an index, there are many choices.  That does not mean you can't adopt this strategy for individual stocks.  With stock, there are fewer choices - and that's okay (as long as you can build a position you want to own).

Each option has a different delta.  That allows you to build a ratio that appeals to you.  Because this idea is probably new to you, this is the perfect time to set up a paper trading account, open a variety of positions, and see how you feel about owning each of them - as time passes, and as the market moves.

EXAMPLE (Chosen almost randomly. Please do not make this trade.  The strike prices of the options you buy and those you sell should be as near to each other as possible.  But, the nearer they are, the more cash it costs to open the trade.  The only problem with a significant cash debit is that the spread can become a loser - if the market tumbles.) 

RUT is currently (Fri close) 429.

Sell 10 May 460 call @ 16.70; delta: -363

Buy 16 Jun 500 call @ 11.70; delta: +369

or   Buy 19 Jun 510 call @  9.50; delta: +352

or   Buy 25 Jun 520 call @  7.70; delta: +363

These are just three possibilities out of many.  You can sell Apr or May options and then buy May or Jun calls to hedge.

You can trade options with higher or lower strike prices - but it's important that the difference between the options you buy and those you sell are not 'too far' (a relative term) apart.

Next time: Choosing a spread

to be continued... 

285

Back Spreads. Standard and Diagonal

The market has been surging recently.  One way to participate is to be long.  Buy calls or call spreads, sell puts or put spreads etc.  But for those of us who (stubbornly) are not willing to do that, is there an alternative investment that provides an opportunity to make some money if the market continues to rise - but which is protected from loss if the market turns around and declines as rapidly as it rose?

Yes, there is.  A back spread is a position in which you begin by selling a call (or put) spread, and buy extra options.  In this example, we're looking to win on a continued rally, so we use calls.  It's those extras that give you an upside profit potential.  For example, instead of selling an XYZ May 90/100 call spread, you might decide to make this position delta neutral.

Back Spread Example:

Sell 10 XYZ May 90 calls
Buy 15 XYZ May 100 calls

Depending on the price of these options, which in turn depends on the implied volatility (IV), you can probably collect a cash credit when opening the position. [And you may want to buy more than 15, depending on the option's delta].

The good news about this spread is that it has an unlimited upside gain.  If the stock rallies far enough those 5 extra calls will pay off.

Unfortunately, this spread carries significant risk due to its negative theta.  If too much time passes, your long options will not increase in value fast enough to offset time decay, and you lose money.  If expiration approaches, and XYZ is trading near 100, there's the possibility that your long calls become worthless and the short calls can be worth about $1,000 apiece.  Not a pretty result.

That's the problem with a back spread.  If the market tumbles, you will be glad you didn't own calls because they would lose their value in a hurry.  If you have the back spread, and if you collect cash when opening the position, they you can earn a small profit (the credit) on the decline.  Back spreads are difficult for individual investors to manage, but are excellent insurance against a huge upside move for market makers and other traders with large positions.

So if it's not so good for you, the individual, why am I discussing this trade?  The answer is that this is similar to a spread can work out better - especially when you intend to own the position for more than a few days.  It's the diagonal back spread.  It has its own set of risks, and we'll look into those.

I've written about the diagonal spread before, but those positions consist of buying one call for every call sold.  The diagonal back spread involves owning extra calls.

I'll go into further detail next time and provide some risk graphs to illustrate how this position can work.

to be continued..

284

 

VIX; The CBOE Volatility Index. What Does it Measure?

The CBOE volatility Index, VIX, was created and began tracking market data in June, 1988.  For most of its 20-year history, VIX was considered by many traders and investors to be a measure of the current fear or complacency of market participants.  VIX is an up-to-the-minute index.  According to the CBOE, "VIX is calculated directly from the price quotations of nearby and second nearby S&P 500 Index options spanning a wide range of strike prices. The VIX calculation is independent of any theoretical pricing model"

VIX tends to increase as markets fall, and decrease when markets rise.  There is a very good reason why this is true (more on this below).

As every trader remembers, 2008 was a very volatile year for stock markets around the world, and the levels of implied volatility - as measured by VIX - increased dramatically as the market tumbled.  A record closing high (81) was established during the worst of the market slide.

Why VIX rises as markets fall

Markets decline much more rapidly than they rise.  One popular phrase that describes this situation is that 'markets are much more likely to melt-down than they are to melt-up.'  Thus, when markets begin to decline, market participants buy options.  Some buy as speculators, hoping the downward move will continue.  Others buy options to protect the value of their investments.  The more the market falls, the more option buyers appear in the marketplace - searching for insurance.  They need to buy options urgently.  As you are aware, as more buyers appear and as sellers disappear, there is upward pressure on option prices.  That shouldn't be surprising as stock prices also fall rapidly as sellers predominate and buyers back off.  Add to that, the urgency displayed by some put buyers and it's no wonder that option prices can surge.

Why are all options affected, and not only puts?  It's clear that most option buyers want puts under these circumstances.  But don't forget that a trader can buy calls and sell stock to create a synthetic put. Efficient markets do not allow those synthetic puts to trade at a bargain price.  There's an arbitrage strategy (reverse conversion) that would provide free money to those who bought synthetic puts at a cheap price and sold 'real' puts at a high price.  When the market is working, as it is virtually all the time, free money is not available.  Thus, as put prices move higher due to increased demand, an increase in implied volatility, and a falling stock market, call prices fall more slowly than you might expect from the option's delta.  In extreme cases, calls increase in price (an amazing occurrence to unsophisticated option traders) when the implied volatility moves high enough. [That's exactly what happened during the crash of October 1987.  All options increased in value as VIX surged to an incredible 150.  Note: That value was calculated after the fact because VIX had not yet been created.]  People were scrambling to buy any option they could get - at any price - to enable them to hedge, or reduce the risk of owning investments.]

When the market is moving higher, there is no such urgency to hedge.  Sure, some people buy calls to play the rally, but the panic is absent.  Thus, option buying tends to decrease during rallies as market makers and other traders become more willing to sell options - because steady or rising markets an instill confidence that the future will not turn into a nightmare of uncertainty.

That's the reason VIX has been referred to as 'the fear index.'

What's New?

Recently, we have seen divergence from the standard pattern.  We had bullish periods during which VIX increased, as well as periods of a declining market, during which VIX moved lower.  I'm not making any predictions, but I am wondering if the traditional method for using VIX as a fear index is waning.

VIX represents the implied volatility of options that, on average, expire in 30 days.  Recently, VIX closed @ 43.  That's another way of saying that the collective estimate of future market volatility over the next 30 days is 0.43.

Keeping math to a minimum, that translates into an estimate that there is a 68% (one standard deviation) chance that the realized market volatility (how much the market actually moved, when we look back 30 days from now) will be less than 43 and that there is a 32% chance it will be higher than 43.

And that's what VIX is supposed to represent - an estimate of future volatility.  Most of the time when the market declines, the urgency to buy options translates into a higher VIX, and that, in turn, translates into an expectation that market volatility is going to increase.  But if options are being bought out of a need to avoid catastrophic losses, is it really an estimate that the future will be more volatile?  Or is it recognition that risk is too high and that insurance is needed for investor portfolios?

Currently, with SPX @ 814, many believe the market has bottomed and that if the market declines, it cannot decline by too much.  If that's the majority belief, then downturns will not be greeted with fear - and as a result, VIX will not increase significantly.

That's what I anticipate - at least for the foreseeable future.  My guess is that VIX will cease being a measure of fear and become a true estimate of future volatility.

283

Getting Back in The Saddle

To my fellow iron condor traders:

Depending on how skillfully you chose your strikes for March expiration, you either had a very bumpy ride, or came out with a very profitable month.  My ride was bumpy.  I don't usually second-guess myself, but this time I lost as a result of a whipsaw, and although a loss is a loss, I hate losing because of a whipsaw.  Earlier, I had closed almost all my short call spreads.  Imagine how that position would have worked out with the huge market rise.  Unfortunately, I decided to sell new call spreads after buying in the others.

It's always a dilemma [do I re-sell call spreads after covering] for me because it's psychologically so upsetting to make the good decision of buying in spreads when they become cheap, and then turning around and converting that good buy into a loss by selling new spreads.

But expiration is over and it's time to get back on that horse for another ride.  The biggest decision is whether to continue to trade iron condors, or if there is another more suitable strategy.  For me, it's iron condors with some extra long Apr options as insurance.  And that was an easy decision because I already own a bunch of RUT May and Jun iron condors.

If you trade with a market bias, as most investors do, then you may be afraid to sell puts for fear that the recent gains are nothing but a bear market rally.  On the other hand, you may fear selling call spreads and that the ultimate bottom has been reached and the markets are going to move significantly higher - and quickly.

That bias may lead you away from iron condors and into the idea of selling only put credit spreads or call credit spreads.  There's some merit to that idea because the risk of incurring a large loss has been cut in half [assuming the chance of a melt-up equals the chance of a melt-down].  Profit potential would also be halved.  Lacking a true market bias [I am a bear, but unwilling to wager on being correct], I cannot choose that route.

The point of mentioning the half-iron condor idea is to remind you that you are not locked into trading iron condors.  There are alternatives and you don't have to be market neutral, you are allowed to trade with a bias - especialy when you have a proven track record of making good stock market calls.

Agreeing with Jared, here's a piece of advice I've discussed previously, and which worked especially well last week.

"we usually close out any positions that are short gamma at least a few days - and often up to a week - before they expire, since the exponential increase in gamma near expiration makes those positions more difficult to manage...For most traders, giving up a smidgen of raw performance in exchange for less psychological stress is a good bargain."

282

Geithner Is Volatile

The first time Treasury secretary Tim Geithner spoke, the markets were very disappointed by the lack of detail in his presentation and while he was speaking, the market tumbled several hundred points.

Today, he announced the latest details about the bailout package,which could rid U.S. bank balance sheets of up to $1 trillion of bad assets. The highlight of the program is the generous financing offered by the government to persuade private investors to participate. This time Wall Street liked what it heard and the the Dow Jones Industrial Average was higher by almost 500 points.

Here's my conclusion (based on only two data points):  Iron condor traders do not like Timothy Geithner.  With two speeches, the market has given him one thumbs up and one thumbs down.  Iron condor traders offer two thumbs down.  Way down.

This was not a fun day for me.  I did get to cover two different $RUT May put spreads when they reached prices low enough to cover.  But my call positions were in trouble.

I was short the May 430/440 call spread and I bought all of them (using the 3 stage process described earlier), beginning when RUT traded above 420 and ending when RUT reached 430.  In their place, I sold May 480/490 spreads - but sold no extra spreads.  I paid cash to roll down the position.

Adjusting risk is a necessary part of the game when trading iron condor positions, but that doesn't mean it's fun.

281

Can You Make Money With Options?

In a forum I frequent, I recently came across this innocent sounding question: "Can anyone make money consistently when trading options?"

I don't know if the poster was thinking about learning to trade options and wanted an opinion as to his prospects, or whether he's been unsuccessful and wants to know if he is in the minority.

What I dislike about this type of question is that it serves no purpose.  That's equivalent to asking: "Is eating food good for you?"

The answer is yes, most of the time.  You need it to survive.  If someone eats only at McDonald's, that's certainly bad.  But, if the alternative is to eat nothing at all, then McDonald's becomes  healthy in comparison.

It's not the 'trading of options' that turns an investor into an investing wizard.  Options are a tool.  Tools are instruments that provide help in the completion of a task.

Options provide investors with investing alternatives not otherwise available.  The investor can write covered calls in an attempt to collect extra dividends.  An investor can buy puts or collars to protect the value of his/her holdings.  And investor can adopt conservative strategies with limited gains and/or limited losses and there's always the opportunity for gambling - something I believe is best avoided.

It's not necessary to trade stocks, because options allow all stock market investing methods without ever trading a single share. 

Don't forget, an option's primary purpose (at least in my opinion) - is to allow hedging, or risk reduction.

It's not an option that makes money, it's the investor and his/her decisions, strategy selection, stock selection, and risk management technique.

Yes you can make money with options.  But no one is going to hand it to you.  As with anything else in life, it takes some effort to learn to invest wisely with options.  If you are diligent and careful with risk, you can make money with options.

280

Q and A. Is Hiring a Mentor a Good Idea?

Mark,

As an active options trader I would like to bring up an issue: 

Even after you've got a solid self education (books, internet sites and webinars, paper trading and even live trading) - the nature of the options world is that there is always a lot to catch up, in this risk/reward sophisticated area. The issue is: after "graduating" yourself... does it make sense to practice with real money on your own (starting with modest amounts, of course), or to get a mentor to walk you through complicated stages like: making the right entry to the right strategy, set up exit points, adjustments, repairs and more. There are companies out there which charge a couple of grand, usually accompanied by risk free guarantee (if you don't make money, you get refund). As for myself, I do try to get around on my own, unless I find some mentoring program in which I pay gradually reasonable amounts, and see results as I move forward. What do you think?

Gil

Good questions. And it brings up important points.

There is a huge difference between being a very short term trader and an investor.  They develop different skills when learning their craft.  You must know which skills you need.

For example, timing is far more important for a very short-term trader than it is for an investor.  I consider myself to be a short-term investor.  The strategies I teach are not for day trading. They are meant to be held for a period ranging from a couple of weeks to two years (if you use LEAPS options).  Thus, timing is not at the top of my list of things I believe someone must master.  But, more than that, I don't believe it's a transferable skill.  It takes a big effort and years of experience to become a successful market timer.  I know those who love technical analysis disagree, but this is an argument that may never end.

"Setting up exit points" is also a method associated with day-trading.  An investor modifies such decisions as conditions change.

If you find a mentor who can transfer his/her knowledge of technical analysis and years of experience so that you become able to pick the 'right' entry point for a trade, more power to you.  I don't think it can be done.

1) When ready to trade with real money, I prefer to see an investor/trader begin on his/her own, trading a small number of option contracts.

2) It's far too soon to hire a mentor.  The new trader must gain real world experience because for some, virtual trading is of minimal help.  That's true for those who didn't take it seriously because it was 'only' play money. 

You don't want to hire a mentor and say "Teach me."  It's better to discover the areas in which you want additional help, and find someone who has a proven record of being able to teach those specific skills.

3) Can a mentor help?  Part of the answer depends on how you define 'mentor.'  It can be a teacher or a trainer.  Some may confuse the mentor with a trading coach.

a) For example you say you'd like help with 'making the right entry.'  I believe very few people can time the market and make the 'right' entry.  And if you find someone who can do that, as I mentioned, it's not something that can be easily taught.

b) Yes, there is a great deal to more to learn once you begin trading.  In my Rookie's Guide, I explain 'what to look for' when entering a position and how to manage risk.  That includes exit strategies.  But for an investor, it's not necessary to make the 'right' decision all the time.  I believe the goal is to make a good decision - I call that process 'making the best decision you can make at the time you must make it.'  If you understand a given strategy, if you understand the risk of adjusting a trade compared with not adjusting, if you can take a loss and move on - then your chances of being successful are excellent.  Those are not the sort of items you said you are seeking in a mentor.

c) I don't believe a mentor can do those things.  If you want to be a very short-term trader, then the strategies I discuss are not for you.  As an active options trader, you already know the difference between opening hedged positions vs. naked longs or shorts.

The day trader probably wants to buy calls or puts with high delta, and profit by predicting market direction.  I suppose some short-term traders use option spreads, but that's a very difficult thing to do (too many trades, too much slippage).  It's much easier to day-trade stocks or single options.  But, if you want to be a day trader, then a trading coach may be helpful.  To me, that's not the same as a mentor.

d) I consider myself to be a mentor - but not under any of the conditions discussed so far.  I believe a mentor is a teacher.  Someone who can explain - so the student can understand well enough to go out and make decisions for him/herself. I wrote the book with that in mind.  And I reply to follow-up questions from readers. 

I also take on a few as clients - when they want to get more detailed information on specific strategies or want to discuss various aspects of using options.  But I am not into technical analysis, and never know the best time to enter or exit a trade.  I think you are discussing a mentor who is more into helping you learn about active (vs. passive) trading skills.

e) I consider adjustments and repairs to be part of the education process and not something that an option trader learns to think about after positions are owned.  I recognize that many trades require no adjustment and thus, the newbie gets less practice in a crucial area.  That's one good reason for trading with smaller sums when beginning.  It's not just that the trader is a rookie, but it's also because he/she has no experience with the (sometimes frightening) idea of making an adjustment and locking in a loss.  It all takes time to become comfortable with the entire process.

4) Regarding firms that charge thousands, promise refunds, and spend a great deal of time (that you paid for) telling you that you need more seminars: Don't do it.  They always (randomly) have successful students who provide testimonials, but they will not tell you about the losers.  I have no idea how easy it is to receive a refund.  There is no need to pay that much money.  You have good books.  You have the OIC and CBOE web sites.  You have blogs such as this one where you can learn and also ask questions.  Use the money you would have paid for those seminars to trade, or buy other educational material.

A mentor may be appropriate for you - but please understand just what it is that you want help learning - and most importantly whether someone can teach you those skills.  I'm sure someone may be able to help you better understand specific trading techniques: how to enter an order, should you enter a position as a spread or as individual legs (spread is my answer), why one strategy may be better for you (as you discuss your ideas, the mentor may offer good guidance).  But teaching you to time the market.  No way, IMHO.

279

Options Education; Spend Your Time Efficiently

I've been reading a variety of blogs and have come across some interesting ideas that are applicable to my world - that of an options investor/trader.

One such post (a guest post, written by Ramit) warns readers that most people waste too much time by focusing on items that may seem to be beneficial, but which contribute essentially nothing to the overall goal. 

"One of the problems with starting a new business is that you have an infinite number of choices for ways to start earning money...She picked a crisp goal, eliminated all the possible things she could do, and decided to focus on tactics that would take her directly to her goal. That's the importance of reducing choices and focusing on the things that matter."

Focusing on things that matter.  That's the key.  There are  people who will tell you what you should do, or must do.  It's very likely they have no idea what it takes for you to succeed.

As a trader, one goal is to make money.  Another goal could be (I'm avoiding telling you what you should do) understanding how adding too much risk can destroy your chance for success.  Perhaps you have additional goals.  Your job is to find a good path towards meeting those goals.

For the vast majority, trading options is not a business.  But treating your plan to use options as if it were a business makes it more efficient to take the necessary steps towards achieving your goals.

You could rent an office, get state-of-the-art computers, buy packages of trading software, read every trading book you can find, etc.  But that's overkill for any beginner.  Whether it's an appropriate way to spend your time and money - after you have proven you have a a business - i.e., you earn money when trading - is a personal decision.  I never did any of those things. 

But it's not a good way to get started.  None of those steps give you the necessary skills or education.  [Too many books will provide conflicts.  Reading more books is a good idea to expand knowledge - after you understand the basics.]

If you are at the stage of deciding whether to learn about options, it's important to understand how options work and what they can do for your investment portfolio.  If you think options provide the path to instant riches, you are mistaken.  I use options to hedge - reduce the risk of owning - investment positions, and I hope to encourage you to use options conservatively.  Doing so allows plenty of room for profits, with limited losses. 

I recommend you spend your 'options education time' doing things that help you meet your objectives: protect your assets and earn money with less risk than the investor who buys and sells stock.  To begin, pay attention to the most basic concepts of options and how they work.

Ask your broker for the paperwork necessary to begin using options and open a practice account.  The broker may call it paper-trading or virtual trading.  Take advantage of such an account.  It allows you to become familiar with your broker's trading platform, and also allows you to make trades - all with no risk (yes, there's no reward either.)

Then study some basic option strategies.  I recommend my book, The Rookie's Guide to Options, but here are two sites that offer decent information at no cost: The Options Industry Council and CBOE.  

None of this is a waste of time.  Each step provides a benefit that moves you closer to your objectives.  When trading you'll get practice choosing specific options to trade.  You'll learn how option prices move up and down as market conditions change.  You'll learn what can go wrong, and how money can be lost.  That, in turn, helps you appreciate risk.  You will also learn what it takes for trades to become profitable.  All of that occurs as you gain experience with various aspects of buying and selling options. 

You can pretend you signed a contract to become a starter in the major league of options - but first you get to play and learn in the minor leagues - where your pay may be zero, but so is the tuition.

Ask questions of people you trust. Join an online forum, but be aware that not all of the information can be trusted.  Don't spend big bucks for costly seminars.  Have patience, and when ready, begin trading with small sums of real money.

278

 

A Simplified Risk Management Method For Iron Condors

There are many ways to manage risk, and I'm always on the lookout for new ideas, and want to share something so simple, that I considered not blogging about it.  But, if it's new for me, it may also be new for others.

I believe that risk management is the most important aspect of being a successful trader or investor.  When the decision to adjust a position is made, market conditions and the attractiveness of available choices play a large role in determining which specific strategy is chosen.  That part of my overall game plan requires no change.

But what about taking profits?  I'm so busy managing my 'whole portfolio' of iron condors that I've been missing opportunities to exit trades and lock in good profits - and at the same time, eliminate risk.   The cost to exit: sacrifice decent profit potential.

The idea of meeting my monthly profit target and being able to watch from the sidelines (no risk) until expiration arrives - and it becomes time to open new positions - is attractive.  When you own positions with negative gamma, as I do as an iron condor trader, being out of the market translates into zero risk.

My goal:  To make good money with minimum risk. Thus, closing early has its advantages.

The Simple Plan for Exiting an Iron Condor Position

Assumption:  Iron Condor opened for a $3.00 credit

1) Exit the winning side of an iron condor when the price is relatively small.  To me, that means $0.15 to 0.$35, depending on how much time remains before the options expire.

2) Do not sell a new spread to replace the spread that was closed. 

3) Manage the remaining portion of the iron condor as usual, and if its too risky to hold, make an adjustment.

4) This is the new (to me) part.  Close the other side of the iron condor much sooner than my usual methods dictate.  It's unnecessary to hold long enough for the position to decline to my $0.15 to $0.35 target buy price, and it pays to 'pay up' to exit.  Why?  Because the entire iron condor position is closed, margin money is released (for those who want to use it), and there is no residual risk.

5) The monthly profit has been earned.  No risk remains.  That goes along with my general conservative philosophy.

Big Deal! That's It?

The driving force behind my desire to adopt this method for exiting positions is that I get whipsawed too frequently.  When I recently bought in all my Mar, Apr and Jun call spreads (plus a few May), that gave me no upside risk.  Imagine that.  I had a chance to make a substantial sum on any rally,  But, I decided to sell new call spreads to complete my iron condor positions - and RUT quickly soared by 20%.  Instead of a nice gain, I am facing trouble. 

I'm not second guessing my decision to sell.  That was a reasonable thing to do.  And the options I sold were about 25% out of the money.

The suggested approach is: "You've made good money on the calls, there's no need to try for more.  Let's see if we can close the put spread at a favorable price before it's necessary to adjust."   

I'm not playing results.  I'm just saying I've whipsawed myself too often to continue using my current methodology.  It's time to make a change - and one that's more conservative.  How can that be wrong?  

And if the market reverses quickly, as it did this time (I know it usually does not), I buy in the put spreads and gain an unmeasurable added benefit of sitting safely on the sidelines.  And if it does not reverse, all I've lost the opportunity for extra gains.  I like extra profits as well as anyone, but my primary risk management goal is to prevent large losses.  The more time I spend out of the market, the chance of such a loss is cut.

Conservative traders should like the idea of earning a good profit and then being able to wait, before getting back into the game.

How This Started

When privately replying to a question sent by S. (yesterday's blog post), I made a casual suggestion about adopting the idea discussed above.   I thought no more about it, until he wrote back to tell me that is exactly how he (sometimes) chooses to close his positions.

I now believe this is a reasonable alternative for managing overall portfolio risk, and is worth sharing.

I want to mention (again) that there is nothing earth-shattering about this idea.

277

Q and A. Trouble With Iron Condors

Mark,

I have been trading IC for some time now and have become accustomed to different types of adjustments, some with great success and others not so much. The point is, the timing on the adjustments are proving difficult to master. 

My IC tend to be opened approximately 3 months out - I like to give myself some time to let them work.  However as a few weeks pass and the underlying has moved within a few % of my short strikes I find myself deliberating whether to hold a little longer before adjusting. Ordinarily, my comfort level would be to wait longer, but no later than a month before expiry to adjust. That being said, I am now considering adjusting earlier. I would be interested to hear your thoughts on this situation?  

Thanks,  
S.

***

I believe very few people can successfully time the market.  That's true for new investments as well as for adjustments.  So don't beat yourself over the fact that timing is difficult to master.  It's difficult, period.  Forget about the 'master' part.

As to adjusting earlier - there's nothing either good or bad about that in itself.  It's simply a more conservative approach.  You will probably have fewer wins and more losses, but the losses will be smaller.  And if you adjust early enough, you may convert what would have been small losses into small wins instead.  [See the idea about adjusting in stages below.]  Does that work for your trading style?  It's a personal decision.


Trading philosophy

My philosophy (it may not suit you) is that you make the best decision you can at the time a decision must be made, and then you live with what you have done - until it becomes time to adjust once again.  Closing the position because you are happy with the profits does count as an 'adjustment.'

You may not be able to master the timing, but you can master knowing when risk has increased beyond your desire to carry that risk any longer.  Right now you are using "within a few percent of the short strike."  To me, that is a very reasonable adjustment point. 

Apparently you are not always pleased with the results.  Be fair when judging your performance.  Are you dissatisfied because the adjustment proved to be unnecessary (market reversed direction), or are you unhappy that a different type of trade would have worked out better?  If you made a good decision - a decision that was appropriate for your comfort zone at the time it was made - that's a good decision in my opinion.  It's not fair to call it a bad decision if result in a monetary loss and a good decision if it's a winner. 

 

Keeping score by 'the results of the adjustment' is fine for a very short-term trader whose goal is to time the markets.  But you hold iron condors for a month or two, and market timing is not your primary concern when adjusting.  Making sure you don't get blown away is your primary consideration. [My #1 rule for option traders:  Don't go broke.]


Stages      

 

Have you considered adjusting in stages?  You may decide to adopt different strategies, depending on the stage.  When you adjust a portion of the position at a time, you can encompass your idea of 'adjusting earlier' by making a Stage 1 adjustment earlier than your current methods.

The following is merely one idea for establishing stages. Please consider it as a possibility, not as a specific recommendation.  I assume you trade more than 2-3 lots of those iron condors.  Small positions are difficult to adjust in stages.  In fact, they are difficult to adjust.

Stage 1.  Adjusting 20% of the offending position.  How do you do that?  Several choices:

a) Close 20% of the position.  You have the option of rolling to a new spread, but you already have a risky position and there's no good reason to open another position when your portfolio is in a bit of jeopardy.

b) Buy extra options - enough to cover more than 20% of those deltas.  Also enough so that the risk graph is less scary than it was before you adjusted.  Again a choice:  Buy options that expire at the same time as your risky position, but spend the necessary cash to get options that are closer to the money.  For example, if you have a 750/760 put spread in trouble, buy the 770 put.  You may only be able to buy one or two because of the high price.  It's tempting to buy 740 or 730 puts, but thsoe only work when the market takes a big dive.  They make the risk graph look great, but there's a decent chance you could lose the maximum on your original position and also lose the cost of the OTM puts.

I prefer (but many traders cannot bring themselves to do this) to buy front-month options as temporary protection.  There are two excellent reasons [more details in Chapter 20 of The Rookies Guide to Options] for doing this:

i) They are less expensive (in dollars, not necessarily in implied volatility (IV).  But, we trade using dollars, not IV chips.)

ii) You can get an option with a more useful strike price at a decent dollar price.  In the example, you may be able to buy front-month 780, 790, or even 800 puts.  Those pack a powerful punch and provide excellent protection.  Even if it's a one-lot.

c) Roll part of the position to a same month, further  OTM strike.  This will cost you cash out of your pocket, but it's still a good idea if two conditions are met: 

i) You an get a decent premium for the spread you sell.  Don't pay $3.00 to close the dangerous spread and then sell a new spread for $0.50.  There is no point in opening the new trade with new risk for a mere 50 cents.

ii) If, and only if, your position is smaller than usual, you may choose to sell a small number of extra spreads - to pick up some of the cash you are paying to cover.  But, DO NOT believe that all you have to do is sell enough extras so that the adjustment trade is free (no out of pocket cost).  That would increase your size - and risk - by far too much.  That's a common trap.  Be careful not to fall into it.


Stage 2.  If the position continues to move against you and you are still not ready to exit the entire position, adjust an additional 30% of the original trade.  That cuts the position to half it's original size.

You can choose any of the adjustment ideas used in Stage 1, including the possibility of rolling (but please - roll only when you believe the new position is attractive to own.)


Stage 3.  Comfort zone breached.  End of story.  Exit the remaining 50% and decide whether to open a new position at this time.

276

Buy, Hold, and Sell. Is That All There Is?

Jared at Condor Options eloquently expressed an opinion that I share.  Because he makes it sound so obvious, I want readers of this blog to benefit from the comment:

"Although the investing public seem to have little tolerance these days for anything that smacks of financial complexity, the simple fact is that some financial propositions cannot be uttered in the language of buy, sell, or hold.  For more elegant elocution, derivative language is needed."

"...option spreads allow us to express our core view [of the markets] with more precision.'

Exactly right.  In my efforts to get the mainstream media to pay some attention to options, I constantly run into the argument that options are simply too complex for most investors and that it's an investment tool that the individual investor cannot understand and does not need.

I have been unable to find the right words to convince the financial journalists otherwise.  But Jared's words may be precisely what's needed.

I've argued that stockbrokers, financial planners, financial advisors all lack the proper knowledge to help their clients when help is really needed, and that's during market declines - especially when volatility has increased.  Because individuals tend to be 100% bullish, almost any advice works well during bull markets.  But when it's necessary to reduce risk (which is 'all the time' in my opinion), those who are paid fees or commissions for their advice have nothing worthwhile to offer.

Options are the perfect hedging tool.  They can be used to reduce risk and still allow room for ample profits.  Many will believe it's just too late, now that the markets have fallen by 50%.  That may be true, or this bear market may not be over - and even if it is, there will be other bear markets in the future.  Investors must know how to use all the important tools to preserve their assets - and the stock option should be near the top of the list.

Options can be used to buy insurance (partial or complete) or to generate extra 'dividends.'  They are versatile investment tools and when spread positions (buy one option and sell another) are used, there is 'elegance' that's simply not available to the investor who is limited to buy, hold, or sell.

One major advantage to using options is the ability to generate impressive profits when an investor doesn't believe the market is going to move by a significant amount in either direction.  Why should that investor's only choice be to 'hold' and earn nothing?  Option writers can take advantage of the passage of  time and generate income during stagnant markets.  Some strategies used under these conditions are: iron condors, credit spreads or writing covered calls.

Why should the individual investor be denied the ability to earn profits this way?  Why should the unwillingness of a stockbroker to recommend the use of options limit the choices of his/her clients?  Why should the under-educated financial planner prevent a client from adopting conservative, risk-reducing option strategies just because the planner never learned to use options?

None of those situations should occur, yet they are the norm. 

Options reduce risk.  I want to shout it from the mountaintops - but who will hear me?

If you agree, and if you ever discuss investing with friends or family, ask if they ever considered using options.  Then send them to this blog as a place to begin learning about the basic concepts of options.

275

Q & A. Theta. An Option's Daily Time Decay

Hi Mark,   

Just a simple question on theta. Is the theta figured into the options pricing at the end of the day overnight or on an hourly basis?

Often with options that have 1-2 weeks time remaining it sometimes appears that the theta is actually taken into account through the trading day . Even on an hourly basis . I noticed this in a position I am holding in SPY today as the market was non-trending, option values seemed to fall on a 1-2 hour time frame .

Thanks 
dave

Good question
 
There is no simple, one-size-fits-all answer.  When I began trading as a market maker (1977), there were no on-floor computers, and we each used theta as an 'overnight' change.  In other words, the theoretical value of an option changed from the time the markets closed one day until it opened the next.  Today, it's much more sophisticated.

Because each market maker individually controls the computer that establishes his/her bids and offers, each has the ability to establish the parameters that go into determining what those markets are.

With competing market makers making competing markets, the value of the highest bid and/or the lowest offer can change for many reasons.  One of those reasons is how the trader decides to program 'time.' 

One choice is to use real time.  i doubt many use that method today.

Another choice is to assume a 'day' is six and one-half hours long.  If using that idea, then times moves along 4x faster than real time.

A third option is to assume one week (7 days) only has five days (trading days) and to set the clock to tick at 7/5 it's normal rate.  Or this can be modified further by moving the clock more rapidly at the end of the week and slower at the beginning.

The bottom line is that you cannot know which algorithm becomes the primary one for a specific class of options.  But you can be sure it's not 'regular' time.  Ingenuity, personal preference, and who knows what else goes into programming the 'clock' used to set option values.

NOTE:  Implied volatility is much  more important than theta when it comes to establishing the value of an option.  Thus, you may have seen IV decline in a dull market, rather than a faster clock.  We may be able to see the price changes, but we cannot know which specific factor(s) the MMs tweaked to cause those changes.

274

Q and A. More on Iron Condor Adjustments

Mark,

Just found your site and am enjoying it so far. I am new to trading condors and am currently learning a number of expensive lessons in how all of this works. I am most interested in adjustments given the current market conditions and found your response to Erin informative. My follow on question has to do with what are you personally trying to do when you make adjustments.

Are you merely trying to extend break even points?

Are you attempting to bring your delta to zero (or cut it by 50% or some other measure)?

Do you focus on any other greeks?

I understand your point about how much of trading is personal comfort zones but I am curious as to what things you are looking at when you are deciding your comfort level. Thanks.

ATB

Hi ATB,

I tried to squeeze a lot into this response, so it may feel that I am 'rambling' at times.

Sorry the lessons have been expensive, but at least you recognize that adjustments are often necessary.  Obviously we love it when iron condors go quietly into the night, but that does not happen often enough to make this a mindless strategy.

Expect to take losses.  It's impossible for iron condor traders to make money every month.  I once had a 14-month streak, but I know that will never happen again.

In replying to your questions, please understand that I am telling you how I think about making adjustment decisions.  That means I'm sharing what suits my comfort zone.

Also understand that there are so many different personalities that not everyone can agree on what works.  Clearly I believe my suggestions are good methods to follow, but I do not recommend them as gospel.  What I do recommend is that you consider my ideas and then decide if those methods are suitable for you.  If not, they may give you ideas that allow you to find alternatives that suit your personality, trading style, comfort zone etc.

1) I do NOT try to extend break-even points. In fact, I strongly believe you will be far better off if you ignore break-even points.  Once I own a position, I no longer worry about whether it's making or losing money.  I manage risk, not profits.  I do what I believe is necessary to make the most money - or lose the least money - from the current time.  It does not matter how much I have gained or lost up to this point.  My position is what it is, and I must decide whether to add to it, hold it longer, or adjust (and that includes exiting).  What matters (to me) is how much I have to gain or lose going forward.  If risk is too high, I modify the position.  If potential gain is too small (because the remaining premium is small), I exit the position (to lock in the profit.  But, I don't think of it as taking profits; I think of it as 'there's too little reward for holding longer').  That works for me.  If I do a good job managing risk, the profits will be there (in my account).

2) I don't specifically manage risk by delta, but being aware of the total delta of your position is important.  I consider 'what happens' if the index moves another 1 or 2%.  How bad can this get?  I look at the risk graphs and think how far must the index move before I lose $X (X = 'too much').  If I think there's a high probability of losing 'X' then it's time to do something.

I'll say this about delta:  If you establish a maximum position delta, that will work as a boundary for your comfort zone.  Just remember that if you eventually trade more contracts, that delta number will have to be increased.  

But, my primary indicator is that I hate when my short option moves into the money.  At that point I must do something - even if I have already made previous adjustments.  One other iron condor strategist whom I respect, suggests that having your short options move to within 3-5% of being in the money requires  a full  adjustment (exit or roll). 

I also note that Erin adjusts when the delta of the short option reaches 20.  He adjusts very aggressively.  I've communicated with people who firmly believe that no adjustment should ever be made to an iron condor.  To me, those are extreme ideas and you will probably be more comfortable somewhere in the middle.

3) Gamma is the most important of those greeks.  Gamma tells you the rate at which delta is changing.  If delta is becoming too large for your comfort zone, you must be aware of how fast that delta is moving against you - and that's gamma.  The higher the gamma, the more quickly you will want to make an adjustment. 

When I own extra gamma, as I do when I buy extra options as insurance, I have staying power because that gamma soon turns the deltas in the right direction.  But staying power is not 'stubborn power.'

I don't manage each iron condor position as a standalone position.  I manage the risk of my entire portfolio simultaneously.  If I have a bunch of iron condors (I do), of course I adjust the riskiest one first.  But, if I own enough extra puts (I do right now), I am a bit less concerned with the downside.  I still adjust as needed, but there is less of an emergency.  When I no longer need my extra long options, I sell them.

I am aware of the other greeks, but don't dwell on them.  Iron condors traders are short vega.  If you feel you have too much negative vega (the volatility component in the value of an option), there are ways to pick up vega: buy a few extra options or perhaps open double diagonal spreads, instead of iron condors.

4) Opinion about adjusting methods covers a very wide range.  I don't believe anyone is exactly right because we all have our own needs - financial and psychological to satisfy.  In other words, if you would personally find it devastating to make an adjustment, only to see the market reverse - and the result is that a position that would have been a winner has been closed at a loss, then adjusting is probably not a good idea for you.  You want to avoid those feelings.  If you can keep your emotions in check, that's wonderful (essential).  But, if you cannot, at least try to avoid putting yourself into a position in which you may be emotionally clobbered.

I don't believe in 'playing results.'  I believe you make the best decision you can at the time a decision must be made, and that's the path to success. In fact, I don't check back to see how I much I would have made had I done something different.  I keep emotions out of the trading game.

Here's my bottom line suggestions for you.

a) Assume you define your comfort zone boundary as: when the short option gets within 1% of being in the money - although you can choose any point. 

Before that happens (choose your own preliminary adjusting point), adjust 10 or 20% of your position.  You can do that by closing some of your position.  You can buy in 10-20% of the deltas as protection.  If you are short a 500/510 put spread, I'd suggest buying 520 puts, rather than further OTM puts.  Yes, these are costly. [Cheaper insurance can be had by owning pre-insurance.]  There are other choices, but the point is: do something small.

If the underlying moves even nearer to the boundaries of your comfort zone, do more, leaving only 50-60% of your original position unhedged.

At some point, exit the whole position.  If you do that, it's usually best to also unload the extra options you bought as a partial hedge.

Please understand, if you don't like the prospects of your position, then get out.  Don't exit piecemeal and don't hedge in stages. If you don't like the position there is no point in holding longer.

I cannot tell you exactly what to do, because I just don't know the right answer for you.

5) Rolling.  At any time you want to make an adjustment, rolling all or part of the original position into a newer one is an acceptable thing to do.  One requirement:  Do not roll just to do something; you must like the new position and want to own it.  If there is no suitable roll, then just take your loss and wait for a better time to make a new trade.

I hope this helps.  Your own experience is going to help guide you, but I know you need some ideas to get started.  You may want to reconsider how you choose iron condors - if you find you are adjusting 'all the time.'

Two Methods For Correctly Calling a Market Bottom

I've often stated that closing your eyes and hoping for a good outcome (the equivalent of doing nothing) from an investment is not a good idea and that 'hope' is not a strategy. 

Agreeing with that idea, Jack writes: "Having a plan and waiting for more information, however, is indeed a legitimate strategy in this turbulent world... He wants to wait for the odds of success to become easier to asses, which, unlike doing nothing, IS an investment strategy."

The above quote refers to Bill's (unfortunately, there's an annual fee for Bill's commentary) refusal to jump in now, during the current rally (Market up strongly two out of the last three days).  Everyone likes to pick market bottoms, but Bill's thought is: "I personally would rather pay up down the road — having a little better understanding of how so many of our problems are going to work themselves out. And, there’s always the possibility that one might not even have to pay up. To sum up, perhaps this will be a decent rally or perhaps the start of something bigger. However, for my money I still don’t like the risk/reward landscape in the aggregate.”

The market has fallen a long way, and if you don't catch the exact bottom, as a long-term investor that should not be a problem.  Bill believes that's better than jumping in too early.

Adam has decided he's not going to miss the next bottom and offers this humorous idea:

"I make fun of all these "bottom" and "bottoming process" calls, but then it occurred to me. My book comes out in 6 month's or so and I'm going to have to plug my expertise like crazy. And what better way than to call a bottom accurately.

And what better way to call it accurately than to call it every day. Starting today.

Now remember, it's a process. So by "bottom" I mean "process". I may be exactly correct or I may be 20% and 6 month's early. Doesn't matter, I called it right in my mind."

As for me, I have no idea whether we have seen the lows.

272

Q and A. Iron Condor Adjustments. Calls vs. Puts

Hi Mark,

I've been trading ICs for a while now and typically adjust when my short put (or call) reaches 20 delta. If the short put is hit then the likely spike in IV means there is often a suitable spread I can roll down to. However, if the market has a huge rally (as it has done this week) and my short calls need adjusting, the likely IV implosion makes it very difficult to find a spread to roll up to that is within my comfort zone. I ended up closing the entire IC for a small profit but was wondering what sort of adjustments you would make in this situation (i.e. call spread is in danger and IV has imploded)?

Many thanks.

Erin

***

Hello Erin,

First, rolling is not necessary.  Sometimes you can simply take the loss (or profit in your case) and wait for a better time to open a new trade.  But I know that almost everyone feels better when the position is rolled.

Next, adjusting is a personal thing - something to be done when a position moves out of your comfort zone.  I find closing a position when the delta moves to 20 to be too aggressive for me, and I wait longer.  That's not a criticism, merely a personal preference.  The good news about your methodology is that you will never take a huge hit and you don't have to worry about your position moving into the money.  On the other hand, you make more adjustments.  Bottom line:  If this works for you, that's all that counts.

If 20 delta is the stop point, you must use low delta options as a starting point.  How much premium do you collect for those iron condors?  I hope you collect enough to make the risk worthwhile.  I am not a fan of low premium.  $0.50 for a 10-point iron condor in a high priced index is unsuitable, IMHO.


As to your question:  The good news about getting squeezed on the call side is that IV has decreased and that means you can use alternative adjustment ideas - rather than one which requires closing the current position.

Because you adjust at 20 delta, I'm assuming that you trade only front month options, but just on case you don't:

You may be able to buy a few front-month, OTM calls at a reasonable price.  Although not free, if you can get decent strike prices you gain a lot of upside profit potential.  This method works best when the options you are short are not front-month options - because you can buy options with lower strike prices.  Protection is short-lived, but it's also relatively inexpensive.

Another choice is to buy a bit of protection.  One way to do that is to close only a portion of your position, intending to do more on a continued rally.

Another choice is to buy some calls (as few as you believe you need) at a lower strike, with the same expiration date as your spread.  There's nothing like naked long options to make you feel safer.  Of course, they are not inexpensive.

A third choice I don't use any longer is to buy calls that are further OTM than your spread.  That only helps if there's a huge upward move, and time decay will be unfavorable.  It also allows for a big loss when expiration arrives, so this method is not intended for traders who hold positions into expiration.

But, if I must cover because I've run out of alternatives, or don't like the alternatives, then I close and take my loss.  Of course, I'd prefer to roll the position if something is attractive, so I look at further OTM call spreads with a more distant expiration month. I can usually find one that is far enough OTM to meet my needs.  But because you probably originate iron condors with options that have a delta of less than 10, your choices may be limited.  Especially if you (as do most people who roll) feel you must collect a credit for the roll. 

There's nothing magical about collecting a credit.  Sometimes you are going to lose money on a trade.  And if you roll for a debit, that's not so bad.  Please resist the temptation to sell extra spreads to 'make up' for that cash difference.  Sure, if your trade size was small to begin, you may feel ok selling a small number of extra speads, but don't get tempted to double your size.  It's okay to take losses.  It's also impossible to win every month when trading iron condors.

271

Choosing An Appropriate Strategy, Continued

An introduction to the idea of selecting an investment method when using options was recently posted, and I suggested a few of the options strategies that I trade.  The first one mentioned is covered call writing.

When you write (sell) a call option, you accept the obligation to sell 100 shares at the option's strike price.  You may never be required to sell those shares, but as long as that option is outstanding (you haven't repurchased it and it has not expired) that obligation remains intact.

When you are 'covered' it simply means that you already own the shares that you are under obligation to sell. [If you do not own the shares, your option position is 'naked' and if you must sell the shares, it would be a short sale.]

Only the option owner has the right to decide if he/she wants to exercise the option to buy your shares.  You, as the option writer, have no rights.


Warning

When investors first hear about the idea of covered calls, they are often surprised at how much 'free' money there is to be made and thus, are eager to adopt this investing method.  And the sooner the better. 

It's not that easy to make money, and it certainly is not 'free.'  But, this method can be considerably less risky than owning stock outright - as in 'buy and hold.'  There is still risk of loss when the share price declines - and profits are limited (you cannot sell stock above the strike price), and if the market surges at any time, you may be dissatisfied with the profits.


Benefits of writing covered calls

This is not the safest of option strategies available to the option trader.  But it has two very special benefits that, in my opinion, make this the ideal strategy for the rookie option trader to study.

1) It's the option strategy that's easiest to understand for the investor with experience trading stocks.  That's true because it involves the stock ownership.   You buy shares, or use stock you already own.  Then the final step is to sell a call option.  That option gives someone else the right (it's their choice, not yours) to buy your stock by paying an agreed upon price (the strike price).  You are paid cash (premium) for selling the call option, and that cash is yours to keep, no matter what else happens.  The option has a limited lifetime and expires on a known date.

That's pretty straightforward.

Of course, there's lots more to the strategy, such as deciding which stock to buy and which call to write, from among the many choices. 

As with owning stock, the primary factor that determines your long-term profitability when you adopt this strategy, is stock selection.  It's also important to understand how to manage risk when owning stock and/or covered call positions.

2)  Profits.  When using this method, you have a higher percentage of winning trades when compared with the buy and hold investor.  When you do incur a loss, that loss is smaller than that of the buy and hold investor.  Thus, you make money when the stock rises, holds steady, or even when it declines by a small amount (less than the premium you collected when selling the call).

Most authors suggest that rookies begin their trading careers by buying, rather than selling, options.  That idea 'feels' right to the rookies who are not in any position to know if the suggestion has merit.  The good news is that losses are limited to the cost of the options.  The (unmentioned) bad news is that it's very difficult to know which option to buy, when to buy it, and how much to pay.  As a result, the beginning investor often loses the maximum.  To me that's the wrong way to go. 

Why learn about a new investment tool by adopting a method that's unlikely to return a profit?  Why not modify your existing investing method (buying stocks) by reducing risk, and increasing your chances of earning a profit?  That's what covered call writing offers to the options rookie

This topic was discussed earlier.

270

Options Section at Minyanville

Minyanville has added a new section devoted to options.

As of .....right now, Adam will  be editing the brand spanking new Minyanville Options Section

Look for Options and ETF content from me,  Adam Warner, Steve Smith, Bill Luby, and Jared Woodard, as well as assorted Minyanville "Professors".

269

Emotional Diversification

I can always count on Dr. Brett Steenbarger, trading coach, trader, blogger and psychologist to come up with interesting commentary.

"Emotional diversification: the degree to which the happiness and contentment in your life are coming from multiple sources. When we are emotionally diversified, no one area of setback in life can turn our stress into overwhelming distress. That is absolutely crucial in a field such as trading, where occasional setbacks are the norm even for the most profitable professionals."


A very simple, yet important concept.  If you are facing stress as a result of difficulties in other aspects of your life: marital problems, or the loss of a job etc, then it becomes much more difficult to perform at your best as a trader/investor.  And if those difficulties are financial, it's even worse because you may urgently need money to pay your bills.  That is about as bad as it gets for a trader.  If you 'must' make money and make it now, then you are going to want to expand the boundaries of (or completely ignore) your comfort zone and be trading with increased risk - in an attempt to earn that cash.  Being able to stay within your comfort zone is important.

Be alert to this situation.  If you are stressed, try to cut back on your trading.  At least be certain your decisions are sound and fall within your standard comfort zone.

On the other hand, if you are emotionally satisfied with the important parts of your life, then there's a likelihood of trading better.  Your mind will be clear, and you won't feel the pressure resulting from outside stress.

Brett discusses this further in his new book, The Daily Trading Coach.

268

Financial Professionsals. Do They Serve Any Purpose? Part II

Since my recent rant about financial planners, I learned a few things.

1) A former industry professional, with more than 20 years experience writes that: "There is an unbelievable lack of understanding of options amongst all levels and all participants within financial institutions...The regulatory requirements for brokers, managers etc is antiquated and insufficient. For that reason many professionals do not understand today's options markets." 

He goes on to say that too many not only don't understand options, but also are more concerned with not being sued if a client loses money, than they are in providing clients with the ability to reduce risk.

2) Preet writes an excellent financial blog from Canada.  He was primarily a financial advisor until recently, and offers this: "I’ll try not to bite the hand that feeds me too much (I’m still in the industry), but many of the criticisms of the industry stem from the fact that advisors are paid as salespeople and not advisors, and training is focused on sales techniques not portfolio management."

3) Gail, A well-respected financial journalist writes: "The calls for help are frantic.  Please send me an investment advisor who will stop losing my money." 

The fact that such advisors are unable to provide worthwhile advice on how to avoid huge losses, is a disgrace. 

Conservative option strategies, anyone?

 

Gail describes how a 77-year old woman was told to invest 60% in stocks and 40% in bonds by an advisor who never bothered to get in touch with her over the past five years.  When the client finally called the advisor, the advice was to keep only 25% in stocks. 

That's it?  Go to 25% now?  He never called.  He left her stranded.  Why?   Financial advisors charge fees for this non-service?  How do they sleep at night? 

My opinion: This is just more 'business as usual' in the investment universe; earn commissions and ignore the client.

4) Ron Leiber, financial columnist for the NT Times "turned to financial planners and investment advisers who got their start as psychologists...I asked them this: At this troubling moment, what’s the best way to reorient how we think about money, before we make any rash decisions."

One advisor offered this nonsense:  "His answer to clients who articulate that nightmare is this: the markets will eventually recover."

I cannot imagine how anyone who gets paid for advice can offer that garbage to clients.  It's true that the US markets have always recovered in the past (sometimes slowly).  We're currently trading at 12-years lows and yesterday, the Japanese markets established a new 26-year low.  Does anyone truly believe that can't happen here?

 

Bottom line is that too many planners/advisors may have passed exams that allow them to be licensed to offer advice, but they are failing clients just the same.  No one expects them to pick individual stocks or recommend only winning mutual funds, but they lack the skills to protect their clients.  They, like almost all investors, make money during bull markets, and it's likely that their clients are unaware of how much (or how little) the planner's advice affected the bottom line.   But when the bear markets arrive, as they always do, the licenses aren't worth very much because the advisors simply do not understand how to reduce risk by hedging with options.  Who loses from that: the planner or the client?  Someone must protect those clients.  I'm trying.

267

Mark To The Market

Hi Mark,

I would love to hear your take on the mark to market debate. I have been saying for awhile now that mark to market is responsible for the steepness of this banking crisis, but obviously not the root cause itself. Do you agree that the financials and the market in general would benefit from abolition of these rules? Do you agree that this is an issue that should have been addressed months ago?

Mark to market helped the financials skyrocket in boom periods and has sunk them in this crisis.

Income Trader

Hello IT,

I'm no expert on this situation, but I do have strong opinions.

1) Yes.  I agree that this issue should have been resolved months ago.  And must be resolved now.

2) Here's a question for you:  Assume you have a large  position that is short a substantial number of long-term strangles and that you have a downside bias - i.e., you are delta short.  Further assume that market conditions become uncertain and implied volatility soars to record levels. 

You love your position.  The market declined and starting with acceptable risk, believe you are in great shape.  After the market decline, you are now delta neutral and anticipate that the strangles will begin to shrink in value.

There's one little problem.  The strangles you sold @ $30 when VIX (CBOE Voltaility Index) was 50, are now trading @ $180 and VIX is 120.  Your account cannot take the loss of $12,000 per strangle because you sold too many.  Your account is in deficit.

When your broker threatens to liquidate your account unless you wire a huge influx of cash, do you believe you can tell the broker that: "It's just marks.  If we ignore mark to the market, my account is in great shape.  See how neutral I am."

You know you cannot.  You are over-leveraged and lost far more money than you thought possible.

How can your broker evaluate your account by any method other than mark to the market?  And if you cannot repay your debt, it's their money on the line.  They are going to liquidate - and probably at very unfavorable prices.

3) Thus, I'm a big believer in MTM.  If the financial institutions were forced to MTM daily, it would have been obvious that they owned assets in trouble (worth less than the value carried on the bank's books), and would have been forced to begin unloading them far sooner.  I don't know who would have bought these positions, but being allowed to continue to hide losses, become more and more over-leveraged, and essentially gamble with (what turned out to be) taxpayer money, is not right. 

I believe MTM is essential and levels the playing field for everyone.  The problem is, that it should have been enforced far sooner.  We would not be in this mess (It would be a different mess) if MTM had been enforced from the beginning.  Enforcing it now is going to make things more difficult.  But the fact that MTM was not enforced earlier is not an adequate reason for not enforcing it now.

4) I believe several of these big banks are insolvent, will remain insolvent forever, and have zero chance of recovering.  I admit that I do not fully understand the consequences, but I'm for nationalization right now. 

I believe the government should take all the garbage assets (we are paying for them anyway) and create new, clean banks.  Imagine Citibank with all of their assets: branches, customers, deposits, etc - and no bad loans on the books.  That would be worth many, many billions of dollars - and the taxpayers would benefit as the government sold 80% of that bank (gotta retain some ownership in the new, thriving business) to new, qualified investors.  Current officers, not eligible.  These healthy banks would have no reason to be afraid to lend to each other, or to the public.  Thus, the economy would have an increased chance of recovering quickly.  Continued stalling is not going to help these banks become solvent.

One more point.  I know there would be a market for all those currently toxic assets.  The government could sell those positions to anyone who wanted to bid.  That way, the taxpayer would no longer own them, would no longer have to throw good money after bad, and would have temporary, partial ownership in the recovering banking system.

Naive?  Perhaps.  But it sounds right to me.

266

This 'n That

It's the weekend again and who knows what news awaits us on Monday.  Bank closings?  Bank nationalizations?  Bankruptcies - GM for example?

It makes me nervous to hold positions with negative gamma when market-moving event can so easily be announced.  Just another reason for owning portfolio protection.

I'm waiting for Treasury Secretary Tim Geithner to say something useful, but at the same time I'm concerned that his next speech will be no better than his last.

Because I no longer trade individual stocks (or their options), I seldom pay attention to where stocks are trading.  But, when I look at prices, it's so difficult to believe I'm living in the same United States of America that I know:

GM     1.46
EK   2.24
F     1.70
C     1.03
BAC    3.14
GE   7.06

The VIX (CBOE volatility index) is elevated, but far below the highs reached last autumn.  And that's reasonable because the market is less volatile now that it was then.  But many investors believe that a falling market is always paired with sky-high VIX values.  This time (so far), VIX is lower than many would have guessed - and thus believe that the bottom cannot be reached without a large spike in the VIX.  I disagree.  A bottom is possible without that spike.

There's plenty of fodder for political argument.  The right blames it all on Obama and his 7 week presidency.  The left blames it all on dubya.  Where's the bipartisanship we voted for?

265

Trading Options: What Are You Trying to Accomplish?

When some investors hear about 'options' they get very excited and can't wait to begin trading.  That's usually the result of hearing some ultra-hyped commercial that promises fantastic profits.  Unfortunately those profits are seldom realized.

On the other hand, I recently heard from someone who has always been steered away from options because he had been taught that options were 'too risky.'  After reading some of my writings, including my recent book, he now believes he can use options profitably.  But he wants to take his time and be certain that he understands what to expect from any option investment that he makes.  He wants to be certain he grasps just how much he must risk to earn specific rewards.  I applaud this cautious approach.

Most option rookies fall between these extremes.  I know it's important to understand how options work before getting started and that's something I stress in my writings and coaching.  If you are reading this post, then you either have some interest in trading options or have already been trading, and are looking to further your options education.

To The New Trader/Investor (option rookie)

The remainder of this post is directed to the option-trader-to-be.  Let's discuss these questions:

• What can options do for you? 
  
• Why bother to use options? 
  
• Are the stockbrokers who tell you options are too risky telling the truth?
• Why don't financial planners use options?

After the stock market crash of October 1987, one of the common ideas [oversimplified in IMHO] was to blame 'options' for the stock market massacre.  The thought was that the huge number of outstanding naked puts resulted in a put buying panic by people who were forced to cover their positions.  Many of those put sellers went bust.  But consider the market makers (and others) who were selling puts to the panicky put buyers.  They had to sell stocks to hedge their own put sales.  Thus, the put panic resulted in a stock selling panic.  At least that's one of the unproven theories.

As a result, many brokers became cautious and chose not to encourage their clients to adopt any option strategy.  Why would they do that?  To prevent someone who lost money from suing.  Never mind that their customers were denied access to the risk-reducing properties that only options can bring to a stock market portfolio; these brokers were out to protect themselves.  No surprise, as this practice continues to this day.  But the bottom line is that some brokers still discourage options from being used, telling customers that they are 'too risky.'  The truth is that too many brokers have no idea how options work, and rather than appear ignorant, they avoid the topic.

Financial planners are not required to learn about options, and that makes it easy for them to simply ignore options and tell any client who expresses an interest in options whatever is necessary to make the client lose interest.

So, if you choose to enter the options universe, what can you expect?  How can options help you?

1) If you are a speculator, and if you believe you have a proven track record of knowing which stocks are moving higher and which lower, and if your ability includes the ability to time those moves, then buying puts and calls can work for you.  When you buy options the more volatile the market, the more you  must pay for your options.  But that volatility provides the chance for huge profits. I believe that most option buyers have little chance of succeeding, but if you have the skills, options provide leverage.  That means you can control many dollars worth of stock with an investment of a much smaller sum.  It's also possible to hit the jackpot on occasion and turn a small investment into a very good-sized profit.  But that doesn't happen often.  To me, option buyers are gamblers - but let's face reality. Put buying has been very profitable lately ( after all, the Industrial Average has declined from more than 14,000 to 6600, as I write this).  Any strategy works at least part of the time.

2) If you want to protect the value of your investment portfolio, options offer the ability to 'insure' that portfolio, just as you insure the value of your home or car.

3) If you want to make bullish or bearish investments, options offers a much better method for doing that than the traditional method of buying stock, or selling stock short.  Options provide limited risk strategies with the ability to earn substantial returns on your investment.  You can adopt any of several methods that provide limited risk.  You can find a strategy that feels comfortable to use.

4) If you want the possibility of earning profits when you have no idea whether the market is heading higher or lower, you can adopt suitable strategies.  You can play for a large move (in either direction) by buying puts and calls, or you can profit, with limited risk, from a more neutral market when specific stocks or indexes trade within a pe-deterined range over a period of time. 

5) Options truly are versatile investment tools and if you take the time to learn about options, you can find strategies that suit any type of investment philosophy - from wildly speculative to extremely conservative.  From bullish to bearish to market neutral.

One final word: You can find a way to use options that suits your comfort zone and your pocketbook.  But more than anything else - more important than choosing a good strategy - more important than your ability (or lack thereof) to correctly predict market direction, is risk management.  If you take care of risk and if you never allow large losses to occur and overwhelm profits, your chances of long-term success as an option trader are significantly higher than if you gamble and ignore risk.

264

Working With Positions That Have Become Ugly

When the markets are non-directional, those are the high-profit, glory days for iron condor (or other premium-selling) traders.  Enjoy it while you can because it's not always going to be that easy.

In fact, until yesterday's rally, the market has been moving steadily lower this year - at a pace that suggests 2009 can be much worse than 2008, even when the decline occurs with reduced volatility.

I don't know which strike prices were chosen by other iron condor traders, but until this week I have been very fortunate.  But now some put spreads I sold as part of an iron condor position have moved close enough to being at the money, that I am concerned.  Not concerned enough to make any major adjustments, but I have taken some defensive action.

On Tuesday, RUT traded below 360 and I am short a bunch of RUT March 340/350 put spreads.  I have no intention of holding this position through expiration, but right now I am unwilling to pay the required price to exit the position.  Instead I am making small changes that improve my risk/reward situation.

Before describing the new trades, I want to mention that the purpose of disclosing my trades is not for anyone to keep score of how I am doing (that cannot be done because I do not report all trades on Twitter), nor am I recommending these trades as standalone investment suggestions, but because some of you may find these ideas useful and adopt them for you own troublesome situations.  I must mention that these trades are suitable when trading high priced index options, but are inappropriate for the vast majority of individual stocks.

1) Buy Mar 360P and sell more 340/350P spreads.

On a ratio: Buy one, sell 3,4, or 5 spreads.  I prefer the higher ratio when my position is not already too large for comfort.  The net cost depends on the ratio, but I collected cash by doing 1 x 5.

ADDENDUM: Nov 18, 2009.  The kite spread calls for a ratio of only 1 x 2 (the 360 and 340 puts are 20 points apart; hence 1 x 2)

At first glance the ratio feels wrong, but because you pick up an extra put, losses are limited ($3,000 if the expiration settlement price is 340), and those losses are reduced by $100 per point as RUT moves lower.  A lower ratio costs some cash, but it's well worth it for the ability to pick up extra long puts - and those puts have a very useful strike price.

This is not a good idea for individual stocks because of the increased risk that the underlying can settle near your point of maximum pain.  With the high priced index, this trade provides protection if the market takes a steep dive - perhaps 10%  - a large enough move that owning an extra few options makes a difference.  If your trade a $50 stock and it drops 10%, the final price of $45 will hurt and not help.

2) As an alternative, consider covering some Mar 350P and selling the Mar 330/340 put spreads on a similar ratio.  This is not as 'clean' and the resulting position may 'feel' uncomfortable.

3) Buy a few OTM Apr calls and puts.  No details necessary because you want options that provide help at an RUT price that suits your risk profile.  Your broker should provide the necessary risk graphs. 

Methods 1 and 2 above represent an idea about which I have not previous written.  I'll be discussing other choices as time goes by.  But, I have previously posted some of my ideas about iron condor adjustments.

263

Financial Professionsals. Do They Serve Any Purpose?

I recently read a column by a financial journalist whom I respect.  Not all such writers deserve respect. 

The discussion was about how difficult times have become for those who are saving for retirement and that many may not have a net worth that's sufficient to get them comfortably though their 'golden' years.

For that column, our writer interviewed several people who earned the title of financial advisor or financial planner.  Readers were told that advisors are currently worried that too many people aren't thinking clearly, and are not focused on making their next eggs last through retirement.  It's not so easy to think clearly when your life savings may have been cut in half.

One such planner, who works for a large firm said that she (the advisor) decided that she "could not let people continue to spend money as usual" because today's conditions were too extraordinary. Why would anyone take advice from her now, after being hung out to dry?

From the interviews, the journalist said that "most advisors 'can't allow' people to hope the stock market eventually will fix everything."  They certainly allowed that before - why would anyone follow their advice to abandon stocks now?  Isn't it too late?

What I find most disturbing about this column is that these financial professionals were supposed to protect their clients from losing such large portions of their nest eggs.  Their job was to help clients prepare for the future and that includes an understanding of the risks associated with investing.  As far as I'm concerned, they do not do enough.  Telling people to diversify, allocate assets, own some gold, buy and hold etc. worked just fine when the markets were soaring.  In fact, the advisors didn't have to do anything during those bullish times.  Oh yes, they did have one thing to do: charge fees.

But when the markets headed south, when good advice was needed, when investors needed protection, I ask: where were the advisors?  What did they do besides charge more fees?  I don't have evidence to prove anything improper was occurring.   In my opinion, it's just a case of the almost blind leading the blind.  But I intend to do some research on professional planners and advisors to see what I can uncover.

There ought be be a requirement that advisors learn, understand, and instruct their clients on how to reduce risk and protect themselves from a catastrophe by adopting hedging strategies.

The best way to do that is to use options to protect the value of a portfolio.  Does the education of planners include any study of derivatives, including options?  I'd like to know.

I recognize that too many individual investors don't have the time or willingness to learn how options work.  That's the job of those who are in charge of protecting their investments.    But do advisors understand how options work?

It's not my favorite approach, but put options could have been purchased as an insurance policy.  That insurance is costly and perhaps collar strategies could have been used.  Either would have prevented a disaster.

The point is that these advisors failed their clients, and now some of them are expressing the thoughts quoted above.  The advisor has the gall to state that she would NOT ALLOW people to spend.  Allow?  As if it's her decision.  As if she is coming to the rescue.  It's far too late for that. 

Now?  Why not earlier?  I know why.  They are being defensive.  Feeling badly that they hurt their clients, too many advisors are probably trying to earn additional fees by providing the same old, traditional advice now.  But to me, it appears as if they are issuing commands:  Thou shalt not spend.  Thou shalt save more money.

And this is my favorite:  After years of telling clients that buy and hold was the best strategy and that it was right not to panic during the markets decline of more than 50% - now - now these people are not ALLOWING clients to depend on the stock market.  What nonsense. Don't panic when the DJIA falls to 13,000 or 10,000 or 9,000.  Now, at sub-7000, now is when clients are advised to no longer hope the market can eventually fix everything.  I'm not saying that such hope will be rewarded, but it's certainly a bit late to be offering that advice.

I don't know that much about financial advisors and planners, including where they get their education and why they are allowed to peddle their advice, but I intend to look into this topic further.  If any of you hire planners or have information you believe is useful, please post a comment or send email to blog (at) mdwoptions (dot) com.

262

No Good Deed Goes Unpunished

I found this post to be so appalling that I had to bring it to the attention of readers of this blog.

Barry provides a great description of how a couple of honest  brokers hurt themselves by taking great care of their customers.  The motto for them is: No good deed goes unpunished.

Another blemish for an industry that doesn't have room for additional blemishes.

Addendum: 2/3/2009 7:40 PM

GMG comments: That's pathetic and very short-sighted. I'm pretty young, so can you tell me, has it always been like this in finance?

There was a time in America (and I assume elsewhere) when people had pride in their work. A time when guarantees and promises meant something. A time when people understood the meaning of having a fiduciary responsibility to the client. I don't understand how or when that disappeared, but it's a rarity these days. And Barry's post illustrates a fine example of people with integrity doing a good job. And they are the ones who were punished. It's very sad.

Over the past few years, risk takers were given greater and greater incentives to seek huge rewards.  Among those with huge incentives where company CEOs.  To earn those gigantic rewards, it's necessary to take huge risk. It's not so easy to have the integrity to keep risk under control, when the personal gains are so large (enough money to last a lifetime). Who can blame them for taking that risk - especially when they had nothing personally to lose (except perhaps a job)?  Not everyone has the integrity to resist.  And last year, those risk takers lost vast sums.

Consider the mortgage brokers who made high commissions by selling loans to people they knew would default. They knew their clients would never be able to make payments - yet they sold the mortgages anyway.

There are plenty of people who make a sale just to get their commissions, knowing that the customer is often shafted. Apparently this is common in today's brokerage world.

Integrity used to mean something to people. I don't know how we became a nation of people who care only for themselves and their cronies. Perhaps integrity can return to this land. I hope so.

***

Here' the post to which  referred in te opening line.  It's despicable.

By Barry Ritholtz - March 3rd, 2009, 7:09AM

Its fairly well known in the traditional retail investment world that the client and the advisor often have opposing, and sometimes contradictory, interests.

I sometimes forget just how much so in my little world of boutique asset management (We charge about ~1%). A conversation with a couple of brokers from a large firm that I can’t name (hint: Rhymes with Schmerrill) reminded my just how misaligned the incentive system is, and how screwed up it must be to work at a huge, publicly traded, mega asset management firm.

To wit: These two gents run a few $100 million dollars in managed accounts. They are mostly stock jockeys, but they have a smattering of bonds as well. Their assets are spread out amongst stocks they selected, in house managers, and other mangers on their firm’s platform. Typically, the clients are charged 1.0-1.25% on their assets. Various products (I hate that word) will pay the broker more or less depending upon the fund manager’s arrangements with the house.

As is typical of brokers with this size asset base and seniority, their payout was about ~43%.

Let’s do some quick math before we get to the heart of the conflict: On $300 million in assets, let’s call it $3.3 million dollars in gross revenue to the firm. That’s about $1.4 million to them, from which they pay a few sales assistants, T&E, etc. Thus, they each should be making about half million dollars annually before Uncle Sam takes his.

Here’s where things get interesting: Early in 2008, they moved aggressively into cash. (Obviously they are TBP readers). For most of the year, they run about 20% bonds, plus 5% percent stocks (some client would not sell). All told, about 75% of their asset base is in money market funds, which pays out essentially nothing to the broker — but preserves the clients investments. Late in the year, they put a toe back in the water.

Overall, the clients do very well. In a year where the markets are practically cut in half, their clients lose about 10%. The investors are ecstatic, and while the two brokers annual compensation was schmeissed — they went from over $3 million gross to under $1 million — they have happy, referral making clients to rebuild their business upon. Its a short term income hit that should generate gains over the long term. And, they got there by doing the right thing.

Now, that drop in income alone raises conflict issues. I tell clients who ask why they are paying 1% to sit in Cash that they are not — they are paying 1% to not be losing 45% in equities, and to have us tell them when to go back into stocks. We think that’s worth 1%, and if you disagree, well talk to your friends who have seen their investments destroyed.

Here’s where things get completely misaligned. When 2009 rolls around, their manager calls them into his office, and says: “Bad news, boys. Your revenues dropped so much last year you are in the Penalty Box. As per your contract, your payout for this year is 30%.”

Let me make sure I understand this: We did the right thing by our clients, and although we took a big short term revenue hit, we hope it pays off over the long run. And the firm response is to drop our payout even further? So the entire system is set up to discourage doing the right thing by the client?

(Hence, why they are talking with us).

We’ve previously discussed the misaligned compensation system of bankers and the short term incentives that led to the entire credit crisis. But did you have any idea that the entire industry was so utterly conflicted?

I find this utterly ridiculous. No wonder we get so many inquiries from (soon-to-be-former) clients of the big houses:They have been cut in half, but at least the firm got its 1% and the broker’s payout remains at 43%.

And that’s all that matters in the end, right?

261

Popular Misconceptions About Options

Newcomers to the options world are usually eager to learn all about options, but arrive on the scene hindered by misconceptions gathered in chat rooms or online forums.  It's difficult for novices to ignore what they believe they have already learned.

This post represents an effort to eliminate some of those misconceptions - and prevent you from making a newbie error.  As you read the writings of the excellent group of bloggers who are participating in the options section of Minyanville, I believe you will gain confidence that we are providing good, accurate and useful information.  Our purpose is to help you travel safely through the options universe.

Some of the terminology that follows may be unfamiliar to you.  In this case, that's a good thing.  It means you don't have any of those misconceptions.

Misconceptions clarified.

1)  Exercise. 

a) The owner of an option - either a call or put - has the right to exercise that option.  When you own of an option, you will seldom, if ever, want to exercise.  But you have the right to do so.  When you no longer want to own an option, sell it. 

b) The option seller has no rights.That means you cannot request or demand that the owner exercise the option.  You can do nothing but wait.

c) If an option is out of the money by one or two cents when the market closes on the 3rd Friday of the month, there is still a (very) small chance that the owner of the option will exercise.  Some believe there is zero chance the option owner will exercise.

d) If an option is in the money by one or two cents when the market closes on the 3rd Friday of the month, there is still a (very) small chance that the owner of the option will choose not to exercise.  Some believe this is not possible.

e) If you are assigned an exercise notice ('assigned' for short), your broker will let you know before the market opens for trading.  Here's something else that confuses many rookies:  most of the time, there is nothing to fear when you are assigned an exercise notice.  In fact sometimes it's exactly what you want to happen.

f) If you buy an option sold earlier, then you are 'off the hook.'  If the option owner exercises the option, it has no affect on you.

2)  Pinning. 

Some people believe that option traders with large positions can 'force' specific stocks to close at, or very near, the strike price on expiration Friday.  It's not true. 

What is true is that it's possible for a stock to move closer to a strike price as buyers and sellers with opposing option positions (one group owns calls and the other owns puts)  make normal trades to reduce their expiration risk.  But the ability to drive a stock to a strike price does not exist.

3)  Stock movement and option prices

True or False:

a) Calls always increase in value when the stock moves higher.

b) Puts always increase in price when the stock moves lower.

c) Buying puts AND calls guarantees you make money if the stock price changes

False, False, False.

Calls usually gain value when the stock moves higher, but it's important to understand when an exception is likely.  We'll discuss this topic in detail.

I trust any misconceptions on these topics have been clarified.

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The Importance of Being Under Control When Trading

From Dr Brett: 

"To the extent...that shifts in markets lead to shifts in profitability, and emotional shifts that range from overconfidence to underconfidence, traders would tend to run maximum risk just as their methods were degrading and minimum risk as their results were improving. This would ensure losing results over time, making the market seem rigged against human nature. It is not just the trading method, but the trader's management of this method, that might be crucial to long-term success."

Trading is an emotional game for most participants, yet the most successful traders/investors learn to keep their emotions in check.  That can be a very difficult task when dealing with real money and market conditions that can be frightening.  That's one reason why it's important to recognize the risk of any investment at the time the trade is initiated - and to also have a plan that describes how long you can afford to hold the position before exiting or otherwise making an adjustment.  For many, it's difficult to exercise good judgment in the heat of the battle.

The current bear market has been strong, lengthy, and heart-breaking for investors who only understand investing from the long side.  And that's the majority of investors.  They have been under-served by the professionals in the industry.  That includes stockbrokers, financial planners and advisors, and financial journalists.  Very few investors are aware that they can hedge their investments with options.  The only 'hedge' any of them understand is to sell all or part of their holdings.  Don't misunderstand - selling a portion is a very reasonable hedging strategy. But it's far better to understand how to use options to control risk.

As losses mount, it's human nature to become frightened.  And for good reason.  For every investor there is a point at which the pain is intolerable and it becomes far more important to preserve what remains of your net worth than to make any attempt to recover, or partially recover.  That's when panic sets in and decisions are made.  As you are all aware, it's important to be in control of your emotions when making important financial decisions.  And that's more important for long-term investors than traders because the latter can quickly change their minds and get right back to 'work' by making new trades. The investors would probably be so upset by what happened that it would be a long time before he/she would  consider re-entering the market.

If you have not yet learned to make wise decisions under stress, then do yourself a favor at at least have a good idea of how to minimize losses if the market does not behave as you anticipated.

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Before You Make Your First Options Trade

It's understandable that you are anxious about using options.  Maybe a friend told you how much money he/she has made with options, making you anxious to get started.  Or perhaps, the term 'options' makes you nervous because of some horror stories you may have heard.

The truth is that options are not the path to instant riches.  Nor are they something to fear.  Options are designed as risk-reducing investment tools.  If used conservatively (and that does not mean seeking small profits), options increase your chances of making a profitable trade (when compared with simply buying or selling stock).

Too many rookies have no idea how options work, and dive right in, by making some trades and then hoping for the best.  Let's get one thing straight right now: Hope is not a strategy.

If you have a bit of patience, these Minyanville posts will provide some good information to help you get started trading options with a good understanding of how they work.  If you are in more of a hurry, I recommend my recent book, The Rookie's Guide to Options.  Sample vesion here.

If you are reading this at Minyanville, then you will find posts by several others bloggers, covering an interesting variety of option topics.


Before You Get Started

It's important to state that options are not stocks and must be handled differently. In simple terms, the price of a stock is driven by supply and demand, and that in turn, is often driven by news events or rumors.

Options are derivatives.  That means the value of an option is derived from the value of something else.  That something else is a specific stock or stock index.  The pricing of options is much more complex - and that means there are other factors at play, in addition to the price of the underlying stock. We'll talk about those factors later on.

Many option rookies are dismayed when they purchase an option only to discover that the price of an option shrinks overnight - even when the price of the stock moves in the direction the rookie had predicted.  While that 'surprising to a rookie' event occurs, the seasoned option trader knows that the price collapse was a reasonable expectation. I'll make sure you understand why that happens so that you are not on the wrong end of one of those 'surprising' events.

If you don't yet understand how options are priced in the marketplace, then you should not be willing to make trades using real money.  It won't take a huge effort on your part to get up to speed, but too many novices are in a rush to get started and soon learn that buying calls when bullish and puts when bearish is not good enough.  There's much more to understand about using options.

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