Educating an options trader

Gaining a sufficient education

The setup: A newbie to the options world is learning about options. He/she picks up certain pieces of information (only those specified) in one sitting or one lesson.

Information packet #1

Let’s assume that you understood this much:

  • If bullish, buying a call is appropriate
  • If bearish, buying a put is appropriate

Education status: Let’s hope that no one believes this information is of much use. Trades made on the basis of this information are likely to result in a loss.


Information packet #2

  • Options are not always reasonably priced
  • Sometimes the trader gets a bargain – increasing the odds of winning
  • Sometimes the trader pays too much – decreasing any chance to earn a profit
  • A reasonable estimate of the fair value of an option can be made



Education status: The intelligent trader knows not to buy calls or puts based on a market bias, but is snot yet ready to begin trading.


information packet #3
Our trader finds a source that explains the basic idea of volatility. Not all the details, but enough to recognize how volatility affects option prices. Enough to recognize that implied volatility (IV) moves from high to low (significantly affecting option prices) in what appears to be a random path. Historical volatility (HV) for a stock is readily available.

Education status:

  • Pay a reasonable price when buying options
  • Understanding the concept of HV and IV allows the trader to trade at more appropriate times and to avoid overpaying for options



Education status: This is enough knowledge to get started – preferably with a paper-trading account. This is nowhere near sufficient, but the trader has a chance to make an intelligent, rather than a random, trade.

The first ‘packet’ was more dangerous than helpful.
The second offers a warning which alerts the trader to proceed with caution.
The third gives the trader a fair chance to pay a reasonable price.
This is enough to enter the game with virtual money.

It is not sufficient. It offers no warning about risk or risk management. The trader stands a chance, albeit a small chance, to earn money.



Information packet #4
Prognostication: It is not easy to predict market direction. Most highly-paid, professional traders cannot do it consistently.

    Personal note: I do not understand why so many people suggest that a trader can learn technical analysis quickly, and with minor effort, and then use charts to predict market direction. Experts tell us that technical analysis is difficult to master, while the hype artists tell us it is a cinch.

    I do not understand why new traders are not immediately taught that being bullish does not mean a stock will move higher. Or that it’s crucial to buy the right options. Or that ‘technical analysis’ is neither easy to learn nor universally accepted.

This information packet is seldom available. Students ‘learn’ that chart reading is easy to master. They believe that being bullish leads to easy profits. This harms most students by providing false confidence.

The truth: Trading is difficult. Making money is not guaranteed. There is no reason to pay high prices for an education.

Education status: Teaching beginners to rely on graphs is harmful. Learning that market prediction is often a waste of time makes a big difference by helping the trader face reality.


Information packet #5

  • It is a bad idea to buy OTM options
  • Buying options requires good timing, as well as picking direction
  • Earning money when buying options is a difficult task. Not impossible, but difficult

Education status: This is more than enough for most people to get started. Unfortunately, it is not the curriculum of many options educators.

The trader who has been exposed to these five packets of information recognizes that the price paid for an option is important and has some idea of how to decide whether the price is reasonable. The newbie learns that there are many factors that go into the decision on buying options. This is more than many beginners get out of their courses.

It is sufficient information. With an idea of when to buy, how much to pay, the importance of timing, the chances of success, the trader’s skill in using charts – a new trader can decide whether to go ahead and spend some time practicing this strategy, or whether to seek another.

Personal note: Far too may ‘educators’ teach so little of what is sufficient and teach only enough to get the novice excited about using options. That works for the educator. That sells more courses and more lessons. The student soon learns that he/she does not know enough to trade effectively, neatly falling into the ‘more lessons’ trap of the instructor.

Students should get sufficient information the first time. Each person learns at his/her own pace, and the time required varies with each person. It is unfair to offer the student too little and then send him/her out to trade.

I’m doing what I can to combat that nonsense, but my efforts are apparently a well-kept secret.

To learn more about my idea of teaching beginners to trade, visit Options for Rookies Premium.

Information packet #6

  • It is mandatory to manage risk with care
  • Appropriate position size is step one in risk management
  • Hedging reduces risk

Does packet #6 add anything of value?

Yes. It completes the ‘sufficiency’ requirement. Enough to make a solid beginning. Lots of practice is required. Skills must be developed and honed, but the student has the background needed for success. Risk management is an essential ingredient of any trading course.

An options education

There are a bunch of well-qualified options instructors. However, some deliberately offer too little – hoping to sell more lessons. Others offer too little because they are not qualified to help traders find success.

When it comes to decision making and the ability to choose trades wisely, too many novices are left to their own devices, instead of being taught the ropes by their teachers.

How is the new trader to judge whom to trust? No beginner knows what it is that must be learned, and is forced to trust the teacher. The truth is that many cannot be trusted.

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7 Responses to Educating an options trader

  1. Dmitry 05/31/2011 at 6:31 AM #

    Hi Mark, sorry but i feel i have to take a defensive stance on TA, as i see it it`s not about predicting and it`s not about being right most of the time. It`s just low risk/high reward entry points, where being “right” 30% of the time is more than enough while keeping those 70% of losses small.

    I also dont find TA hard to learn by itself, it`s the psychology of those method that are hard to master. imho.

    I know i`m picking a topic out of the context. Just wanted to add my 2c on a part of it.

    • Mark D Wolfinger 05/31/2011 at 8:29 AM #

      Dmitry,

      You raise a very good point. If TA is used as another tool, if it used as a guide to help pick entry/adjustment/exit points – it is not a bad thing.

      My problem is with people (I don’t want to get sued, so cannot mention any names) who encourage newbies to look at charts, and come away with the believe that they can quickly learn to use them. I don’t know much about charts, so perhaps it is a topic best avoided. However, I was interviewing someone who learned to trade options via costly lessons, flew cross country to attend those lessons, and tells me :”I love charts.”

      It’s that attitude of having so much confidence in charts that I don’t want to see spread. Remember these are beginners – often with zero trading experience of any kind.

      It’s great to have a useful tool to help with the items you mentioned My fear is that beginners – not really understanding how to benefit from using charts – will place to much confidence n their own ability to interpret the charts.

      I also interviewed a very successful long-time trader show believes that it takes many years to master charts and technical analysis. Between these two extremes, I have no idea which is correct, nor do I know how the average new trader can benefit from technical analysis.

      I’ve been anti TA for a long time. Perhaps I have been harsh. But I believe in the ;do no harm’ approach to education. Expose newbies to as much as possible, but keep it realistic and explanation – in depth he things they are learning.TA is not something to be learned in a one hour lesson. At least that’s what my expert trader/analysts tells me.

      Thanks for sharing your thoughts. I do appreciate the opinion of anyone who has a comment – especially when it disagrees with something I said or wrote.

  2. Tiger 05/31/2011 at 11:12 AM #

    I agree with some points and disagree with many others. As for Historical volatility and Implied volatility, the most common event is an earnings announcement for an individual stock. Historical might narrow before the event and implied will often jump just before the event. This doesn’t mean the options are mispriced. The worst beatings I’ve taken tend to be when selling high option premiums, when implied was higher than historical.

    I would also tend to disagree packet #5. What some successful traders do is sell premium on some options and then put that money into buying OTM premium in specific instances. That goes hand in hand with packet #6. I might be tempted to start with packet #6 for novices, because risk management and right sizing of positions is probably more linked to the long term survival of novice option traders than predicting market direction, or seeking undervalued or overvalued options.

    Risk and reward are often near a straight line with options. If an option position has a 80% chance of winning, there is often a 5-to-1 pay off for the opposite side that only wins 20% of the time. Not always true, but the options market is much more efficient now, than many years ago.

    I’m not going to rehash the bit about technical analysis, but would suggest that all novices would do well to learn at least the basics of reading a bar and/or candlestick chart, so they can follow the commentary that typically dominates short term trading discussions. They won’t master the art any time soon. However, the basic basics can be taught in a hour or less and that is plenty for most novices to chew on. A few may take to it like ducks to water.

    • Mark D Wolfinger 05/31/2011 at 11:37 AM #

      Hi Tiger

      Too few people read the comments section. I’m going to run this Q/A as a regular blog post. I know this is an important discussion.

      1) “The worst beatings I’ve taken tend to be when selling high option premiums, when implied was higher than historical.”
      I’ve been there and done that also. But this post talks only about buying options – and never talks about selling. Why? Because that’s the methods used by the hype artists whom I so despise. They ‘energize’ the students, they get them excited about leverage and how much can be made.

      And they do that because these energized students go home and tell their friends about an exhilarating learning experience that they recently experienced. Fantastic publicity. The student who does not yet realize that he/she learned far too little to make any money – is touting the course for the hype artist teacher.

      When it works that way, there is no incentive – other than integrity – to present options in a true light. I hate that. I loathe it. But what can I do? I’m a small voice that is not heard. I am not a talking head on TV.
      But the hype artists service and prosper. They hold classes, webinars, sell newsletters with market ‘picks.’

      Can you imagine the dishonesty in suggesting a specific option trade to someone with no knowledge of the person – or his ability to tolerate risk, his financial condition, or any other of a dozen factor that must be considered? This is the options industry.

      2) ” I might be tempted to start with packet #6 for novices”
      Agree. Just one minor point. I cannot teach risk management to someone before I show them what an option is and how it works. Risk management comes at the start of the education process – agreed. But it is not step one on day one.

      3) “… buying OTM premium in specific instances”
      I was referring to buying OTM options as a speculative play, not as insurance. Beginners love to buy options that cost very little cash – and they anticipate hitting a 10-bagger. That’s what these hype artists allow their novices to believe.

      If beginners buy OTM options and expect a miracle, they cannot refrain from blowing up the account (gradually).

      4) “Risk and reward are often near a straight line with options.”
      But the novice has no clue which to buy, how much to pay, how long to hold (all the way to expiration is the typical play), etc. That novice does not know what he/she is getting fair value for the wager. Some education is required before the rookie goes out to trade – especially if that rookies is making a long shot play.

      5) Regarding TA. Read a book or two? Sure. Practice making/reading basic charts, sure. Go for it.
      However, that is very different from being encouraged tos eek charts as the method of knowing what’s going to happen in the market.

      You are right on every topic you mentioned. However, from my perspective they were removed from the context of: “Rookies buy options. Rookies are encouraged to depend on charts. This is a bad practice. This is not the correct or reasonable method for educating a beginner.”

      Thanks for your input.

  3. Sally J. 05/31/2011 at 5:34 PM #

    I have question about option trading. Can you explain how to calculate intrinsic value? How do you calculate time value and can time value be used in at the money and out of the money? Thank you.

    • Mark D Wolfinger 05/31/2011 at 8:09 PM #

      Sally,

      The intrinsic value is a simple subtraction. If that results in zero, or a negative nnumber, then the option has NO intrinsic value.

      Call option: Stock price minus strike price = intrinsic value
      Example: Stock is 34. The 30 call has an intrinsic value of 4 points, or $400/
      The 25 call has an intrinsic value pf $900.
      The expiration date is not involved in the number. All 30 calls (on same underlying asset) have the same $400 intrinsic value, regardless of expiration date.

      Put option: Strike price minus stock price = intrinsic value.
      Example. Stock is 87. The 90 put has an intrinsic value of 3 points or $300.

      Time value = option price (the premium) minus intrinsic value

      I have no idea what ‘used’ means. However, in the money options, at the money options and out of the money options can all have time value. In fact, out of the money and at the money options are 100% time value. They have zero intrinsic value.

      Most in the money options have time value. However, if expiration is near and if the option is deep in the money, the option may be 100% intrinsic value with zero time value

  4. Sally J. 06/01/2011 at 10:17 PM #

    Thanx, Mr. Mark.

Please share your thoughts.