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Opinion: Options Trading and the Prudent Investor

Since 1830, laws in The United States have relied on the principle that a prudent investor must act like other prudent investors managing similar portfolios with similar investment objectives.  In other words professional money managers cannot do whatever they want when taking care of other people's money.

The definition of a prudent investor has undergone major changes during the past century. In simple language, the prudent investor rule describes the standards to which managers must adhere when investing money for their clients.

One hundred years ago, no manager would have considered investing other people's money in the stock market. Before 1945, prudent investment professionals, and the law governing their liabilities, condemned stock investing as imprudent speculation. Later, as inflation became part of our everyday lives and the legal view of stock investing changed, stocks became the core holding of most investment portfolios.

In modern times, as it became apparent that few investment professionals could outperform the stock market (as measured by comparing their performance with that of broad based indexes such as the S&P 500 index), the law came to
accept passive investing, or indexing, as a prudent strategy.   Advisors were no
longer required to diligently search for outstanding investment opportunities.

This simplified road to investing became the norm. Money managers were now pleased when they matched the returns of their peers.

As the market soared during the 80's and 90's those 'average' returns were more than acceptable as the value of the average investor’s portfolio grew. When the bubble burst, and the markets declined, average returns became negative and once more became undesirable. That’s when people noticed that hedge funds were outperforming the market. Although these funds keep their trading strategies secret, it's known that they take advantage of options to find investment opportunities that are not available to traditional money managers.

Some of these superior returns by the hedge funds are due to their ability to use leverage. That means they can borrow money (use margin) to increase the size of their investment portfolios. But a significant part of their profitability comes from their use of derivative products, including options.  Now that there is fear of recession and the potential for markets to fall yet again, the appeal of hedge funds and their ability to adopt conservative option strategies, such as those described in the Rookies Guide to Options are attracting a greater number of prudent investors.

As today's hedging strategies become more
and more accepted, will they become the new standard for the prudent investor? Is that a possibility – that the versatile stock option can become the investment tool of choice for risk adverse investors? Only time will tell, but I believe that’s the direction in which we are headed. It’s reasonable to anticipate that using options will eventually be widely accepted as an acceptable investment tool for the prudent investor. 

Isn’t it time you learned to use options to reduce risk and enhance returns? 

Original version first appeared in the February 2004 edition SFO Magazine.

 

Download my eBook – an abbreviated version of The Rookies Guide to Options.

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Exercising an Option: Who’s in charge?

Important note: There
is one major misconception that is fairly common among option rookies. It leads to a great deal of confusion and I
want to be certain that it never happens to you. This discussion is important enough to
justify its own blog entry.

· The
owner of an option has certain rights.

· The
seller of an option has NO rights.

 

· Only the owner of an option can exercise that option.

· The owner of an option is NOT obligated to exercise, but has the right
to do so.

 

· The owner of an option has
three choices:

o Sell the option.

o Exercise the option.

o Allow the option to expire
worthless.

 

· The seller of an option has
only two choices:

o Repurchase the option sold
earlier – but it must be repurchased before the seller is assigned an exercise
notice. That removes the option from
your portfolio and cancels all obligations.

o Wait for expiration to learn
whether you have been assigned an exercise notice.

§ That notification arrives
before the market opens for trading on the business day following expiration.

§ Most brokers provide that
information on Sunday, following expiration. But only for online accounts.

 

· The decision to exercise rests entirely with the option owner.

· The option seller may not request that the option be exercised.

· The option seller may not ask the option owner ‘please do not exercise’.

· Once the option is exercised and the option seller is assigned an exercise
notice, the transaction is final. It cannot be undone.

 

· Automatic exercise:

o If an option is in the money
by one penny or more, it is automatically exercised.

§ The ‘closing price’ of the
underlying stock that determines whether an option qualifies for automatic exercise
is the last tick on the primary exchange on which the stock trades (usually the
NYSE or NASDAQ) on the last day that the option trades (almost always the 3rd
Friday of the month).

§ If the stock moves above or
below the strike price AFTER the market closes on expiration Friday, that price
change is ignored for the purposes of the automatic exercise rule.

 

o Option owners:

§ May submit instructions to their
brokers, telling them “do not exercise.” This is a reasonable action when the option is only in the money by a
penny or two.

§ Each broker has its own
rules and cutoff time for submitting such a notice. Be certain you are aware of your broker’s requirements.

§ May submit instructions to their
brokers telling them DO exercise, even when the option is out of the
money. This does not happen often, but
it does happen.

 

o Option sellers:

§ May not request that an
option be exercised.

§ May not request than an
option not be exercised.

§ Have no rights. None.

Bottom
line: If you sell options, such as in
covered call writing, you have no say in the decision to exercise that option.

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Does Options Trading Volume Tell You Anything Important?

Suppose you are following a specific stock (XYZ) whose average daily option volume is 2,000 contracts. Then one morning you notice that the volume in the XYZ Jul 40 puts is more than 3,000 and that a single trade consisted of 2,500 contracts. Should that mean anything to you? Should you immediately take a position in XYZ because some valuable information has become available to you – based on the fact that all those puts traded? Can you assume that ‘someone knows something’ and this stock is about to undergo a severe price decline?

Opinions are mixed on this topic. Some will tell you that the high put volume is bearish and that it’s a good idea to buy some puts yourself, or perhaps sell the stock short. I disagree.

Bullish or bearish indicator?

First, you have no way of knowing whether the person who made the 2,500-lot trade was a buyer or seller, you don’t know whether that option trade was made by someone with a bullish or bearish bias.

But, suppose you knew whether the puts were sold by the market makers and thus, bought by some unknown investor. (Part of the time you can determine whether the market makers who trade with the customer bought or sold these puts by examining time and sales data.) But, does that really tell you anything? Again, some argue that if an investor (or hedge fund or institutional investor) buys a large number of puts (or calls), it cannot be an innocent trade. Surely someone must have some inside information about the company. I hope the discussion below convinces you that this is not a valid argument.

Option Versatility

Because
options are versatile investment tools and can be used in many different strategies,
you don’t know whether the put buyer is buying these options
as a bearish bet, or if the investor bought the puts to hedge an already
existing position. For example, a
stockholder may own 250,000 shares and have a very bullish outlook for the
stock. But, that investor may be willing
to buy puts as an insurance policy, just in case that the company issues less
than stellar news when it reports its quarterly earnings in a few weeks.  This is an example in which the purchase of
puts was really a bullish play and not bearish. Thus, if you ‘follow’ that investor and buy puts yourself, you probably
have a bad investment because no one had any special information before buying those
puts.

It
may peak your interest when a large block of options trades, but unless you
know what the customer is doing, the information has little value for you.

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Warning about the exercise process

Over
the past few years, I have been asked the following questions:

· I own an option
that is out of the money. Must I
exercise it?

· I don’t have the
necessary cash in my account to pay for stock. Do I have to exercise my call option?

· My broker tells
me that I have no choice and must exercise my call option. I don’t want to do it. Was I given bad advice by my broker?

 

For
some reason that I don’t understand, many rookies find themselves asking a
similar question. Let’s be sure each of
you understands this basic point:

*The
owner of a call option has the right, but not the obligation, to take action specified in the option contract. That means the call owner may, if he decides
to do so, exercise the option and buy 100 shares of stock at the strike
price. But, there is no obligation to do
so. The option owner may sell the option
at any time before it stops trading on Expiration Friday. The owner of an option may allow the option
to expire worthless.

*The
owner of a put option has the right, but not the obligation, to take action specified in the option contract. That means the put owner may, if she decides
to do so, exercise the option and sell 100 shares of stock at the strike
price. But, there is no obligation to do
so. The option owner may sell the option
at any time before it stops trading on Expiration Friday. The owner of an option may allow the option
to expire worthless.

To
repeat – you are never obligated to exercise your option. It’s your choice. That’s why it’s called an
option.

NEW RULE
CHANGE

However,
please be aware of a new rule that was adopted by the option exchanges and the
Options Clearing Corporation: Effective
with expiration in June 2008, any option that is in the money when expiration
arrives – even if it’s in the money by only one penny – will be automatically
exercised
for you. In other words,
your rights – the rights you were guaranteed when you bought the option – have been
revoked. I find this to be outrageous and totally unacceptable. But sadly, my opinion doesn’t count.

To
protect yourself from this problem, if you are unable to sell your option and
you don’t want to exercise, it’s now necessary to notify your
broker – shortly after the market closes on expiration Friday – that you DO NOT
want to exercise. If you fail to notify
them, the option will be exercised. Take
the precaution of being certain you know how to deliver that ‘do not exercise’
instruction in case you ever need it. Ask your broker now  how to notify them.

Why
is this such a problem? If the stock is
trading at $50.01, shouldn’t you want to buy it at $50.00? No, you shouldn’t. For one thing your broker probably charges a
fat fee to exercise. If you pay $15 to exercise
an option that’s in the money by one cent, you are already $14 worse off than
before you exercised. And now you own
the stock (if it’s a call option) and probably want to sell it. That costs another commission.

This
rule change is definitely a money-maker for the brokers, but a money loser for
their customers – and that’s you, the individual investor. If I were you, I’d complain bitterly to your
individual brokers that this rule is totally unfair. But, it’s probably tilting at windmills and
nothing will change.

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Comfort Zone

Here’s part of my investment philosophy

When initiating a new position most investors recognize the importance of placing a trade that they believe will produce a profit. Those who understand the importance of managing risk also understand the risk required to earn that profit. When you are satisfied with both the reward potential and possible loss for a given position, then you are within your comfort zone.

It's also important to remain within your comfort one as the trade progresses and time passes. This is the point that many traders miss. They mistakenly believe that if the position is acceptable when opened, that they don’t have to do anything until the options expire. That is a dangerous way of thinking.

 If market conditions change or if the price of the underlying stock (the stock tied to your options) changes, it’s possible that the position (let’s assume it’s a spread) leaves your comfort zone. This can happen when:

  • The spread becomes very profitable and there is little potential profit remaining. It’s great to have done well,
    but when holding the position until expiration can only earn a small additional profit, the risk of holding becomes too great because the reward potential is too small. If the stock makes an unexpected move, the profit you earned can easily disappear. Take your profits.
  • The underlying stock makes an unfavorable move and another such move would result in a substantial loss. If that potential loss is more than you can afford to lose, then  the risk of holding and hoping that the stock reverses direction is too great – and closing (or otherwise adjusting) the position is probably the wisest step you can take.

Comfort zones should be flexible as you gain more experience trading options. That does not mean taking on more risk, but it does mean that it’s appropriate to change your basic methods as market conditions change. For example, bullish strategies such as writing covered calls may make you uncomfortable (for good reason) when
the market is bearish and you may prefer to trade iron condors instead. That’s why it’s a good idea to be aware of alternative strategies, even when you have no immediate intention of adopting any of them. They become part of your arsenal of useful trading tools.

  • Dr. Brett Steenbargen, whose expertise is trading psychology, makes this point very well in his trading blog (dated May 17, 2008) “It’s difficult to succeed at trading, but–given rapidly changing market conditions – even more difficult to sustain success. It’s not good enough to find winning trading techniques; one has to continually adapt these techniques to an ever-changing environment.”
  • Jeff White, in his blog espouses a similar philosophy for day traders.

 

New Optionspeak
terms:

Spread
– A position consisting of two or more options on the same underlying stock. One option hedges (reduces the risk of holding) the other option in the spread. Example: buy one call option and sell another call. This strategy limits gains, but more importantly, limits losses.

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What can you do with an option?

If you own an option, you
have three choices. And that’s true
whether you own a call or a put.

1) You can sell it.

  •  If you collect
    more than you paid, you have a profit.
  • If you collect
    less than you paid, you have a loss.
  • You bought this
    option by entering a buy order with
    your broker. This time you enter a sell order to close (eliminate) your
    position.


2) You can exercise it by notifying your broker that you want to do what the contract allows.  Thus:

  • If you own a call
    option, you may buy 100 shares of the underlying stock. You pay the strike price per share.
     
  • If you own a put
    option, you may sell 100 shares of the underlying stock. You collect the strike price per share.


3) You can
allow it to expire worthless
.

  • This is not your
    ideal solution because it means you lost every penny that you paid to buy the
    option.
  • When you hold an
    option, hoping for a favorable movement in the price of the underlying stock,
    many times that move never occurs and your option is out of the money.
  • When an option is
    out of the money when expiration arrives, it has no value and is
    worthless. Because it expires, your
    right to buy the underlying stock expires.
  • You may try to
    sell your option before it expires, but if there is little time before
    expiration, or if the option is out of the money by a significant amount, you
    may discover that no one is willing to buy the option. If that happens, you still own the option and
    will have to allow it to expire and become worthless.

New Optionspeak terms:

Out of the money:

    a) A call option
whose strike price is higher than the stock price

    b) A put option
whose strike price is lower than the stock price

In
the money:


    a) A call option
whose strike price is lower than the stock price

    b) A put option
whose strike price is above the stock price

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Question & Answer #2. How long does it take to be profitable?

On
June 17,
2008
George posted this question: “How long is the learning curve to using
options, and when can I expect to become profitable?

Hello George,

It’s important to understand that not
everyone who uses options does so to make money. Sometimes options are used as insurance to
protect the value of a stock market portfolio. As with other types of
insurance, that protection costs money and there are no profits.

 

But let’s assume you want to learn to adopt option
strategies to make some money.

1) The learning
curve. It doesn’t take very long (less
than one hour) to get a good understanding of what an option is and how an
option works. Thus, an investor can easily grasp the fundamental concepts of
options. But, it does take longer to fully understand one or more of the
possible strategies you can use.

There is no single best strategy for
everyone, but I recommend that you begin with covered call writing because it’s
the option strategy that is most similar to what you already  know: how to buy and sell stocks.  More importantly, this strategy is less risky
than simply buying and holding stocks. There are various places where you can
learn how to adopt  this
strategy. Of course, I recommend my
book, The Rookie’s Guide to Options, but if you search the internet, you will
find alternatives.

Once you have some practice using this
method – either with real money or in a paper trading (practice) account, you
will be ready to consider alternative methods –  strategies that involve reducing risk even further.

As to how long will it take to be
profitable using covered call writing, the answer is: how good are you are
picking stocks? Covered call writing is
a bullish strategy that increases  your
chances of earning a profit from every trade. But if you are a poor stock
picker, or if the market tumbles, you will not do well.  But fear not – there are other strategies that  cater to poor stock pickers and bear
markets. You may prefer to learn one of those instead.

2) When
profitable? Adopting the option
strategies that I recommend (and that does NOT include buying options) is
nothing like day-trading stocks. You don’t have to read charts (although it can
be helpful) or time the markets. These strategies involve holding positions for
anywhere from two weeks to a few months. If you choose strategies in which you are predicting market direction,
then your profitability depends on how skillful you are at knowing when markets
will rise and fall. If you choose strategies (recommended) that are market
neutral, you will do well most of the time, running into trouble only when the
market makes a big move. If you learn to
manage risk – an essential part of your education – you will be able to handle
problems when they arise.

Bottom line: You can be profitable from the
start of your option trading career. In
fact, if you adopt my recommended methods you will
profit most of the time. To be a
successful trader, you must be certain that you also learn how to manage risk
and keep all losses small enough to not overwhelm profits. Risk management is an important topic and
requires more time to learn than it takes to master a few option strategies.

Remember, you have your entire lifetime to
trade options. Have a little bit of
patience and begin by trading with fake money in a paper-trading account. When you feel confident that you understand
what you are doing, it’s time to trade with real money. Best of luck to you.

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Question & Answer #1. Rolling a losing credit spread

Don posed this question: ‘Regarding
credit spreads, if one is in the money on a current position, and no light is
at the end of the tunnel, is there a rolling technique for credit spreads or is
it best to close it and open a new spread with enough credit to cover the loss?’

This question is for more
advanced option traders, but to clarify for readers who are new to
options:

 A credit spread
occurs when you sell a call option and buy a less expensive call option (that is, a call option with a higher
strike price.). Both options have the
same expiration date and are on the same underlying asset. Example of a call credit spread:

Buy 1 IBM Oct 110 call

Sell 1 IBM Oct 105 call

A put credit spread is formed when you sell
a put option and buy a less expensive
put option (that is, a put option with a lower strike price.). Both options have the same expiration date
and are on the same underlying asset. Example of a put credit spread:

Buy one SPX Jan 1400 put

Sell one SPX Jan 1410 put

Note that an
option is described by four items:

o The symbol of the
underlying asset (IBM or SPX above)

o The 3-letter
abbreviation for the expiration month

o The strike price

o The option
type; call or put

 

Back to the question:

When
you sell a credit spread, it’s a losing situation when one, or both options
move into the money (that means the stock price is above the strike price of
the call option sold, or below the strike price of the put option sold). In these situations you have two choices:

  • Do nothing and hope the stock or index (underlying
    asset) changes direction.
  • Adjust the position (that means changing it to reduce
    risk), accepting the fact that you currently have a loss.

The
winning strategy over the longer-term is to take action. That means to close all or part of the position
before the loss becomes so large that it wipes out months of gains. Some traders would not wait as long as you,
Don, and would close the position before it moved into the money. The decision of when to close the position is
not easy to make because no one likes to lock in a loss. And there is no ‘best’ time to make it. Each trader should have a comfort zone – and when
any trade moves out of your comfort zone, that’s the time
(probably past the time) to adjust the position.  If you are worried about a position, it is out of your comfort zone.

However,
closing the position must be done to
prevent taking a much larger loss
. One secret to making money with options is to avoid taking large losses. It’s acceptable to take small losses when necessary,
because you will make money most of the time when you follow the strategies
recommended in The Rookie’s Guide to Options. Lots of gains and some small losses lead to success. Lots of gains and some huge losses lead to
failure.

As
far as rolling goes (rolling means closing one position and moving into another
position, with options that are further out of the money and with a later expiration date), do that ONLY if you still feel comfortable establishing a new credit spread in the same underlying. If
you do want the new position, then roll. If you want nothing more to do with
this specific stock at this time, then take your loss, do not roll, and move
on.

One
further point: It is not essential to collect ‘enough credit to cover the loss.’ Open a new spread that allows you to be
solidly within your comfort zone. Do not
roll the position to place yourself in jeopardy again.  Rolling is really two separate
decisions: Do I close my current
position, and if the answer is ‘yes’ – ask: do I want to open a new position. If ‘yes’ again, then roll. If ‘no’ then simply close and move on to your next trade.

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