Philosophy of Options Trading. Part II

Welcome to visitors from the 209th Carnival of Personal Finance.

Part I

Part II. It’s Your Money. Protect It

This topic is one I take very seriously and I admit that I have difficulty convincing people of the truth of the following statement:

When you own a position, unless there is something very unusual about the current option prices (that will be resolved shortly), the current value of the position represents your current stake. In other words, the price at which you can exit the trade right now (even when you don’t want to exit), represents your money.

If you have a profit, that profit is yours. It does not belong to the house. If the investment turns against you, and your $1,000 profit becomes a $600 profit, you lost $400.

I can hear the disbelief now. “How can I have lost $400 when I earned a $600 profit?” Here’s how I look at this situation, and hope to convince you to do the same: You have a position, or a bunch of positions. Every time you sit in front of your computer (or telephone or blackberry etc.) and look at the position, if the market is open, you have the choice: you can hold the position; you can add to the trade; or you can exit and accept the current price – regardless of whether it represents a profit or loss. If the market is closed, you can submit an order (when the market next opens), in an attempt to take any of those actions (holding requires no such order).

Holding is a decision. It’s a decision not to act. Because you can exit the trade at the current price, that price represents the value of your trade. This is marking to the market. No other accounting method makes sense [and that’s why I believe so many banks are insolvent – a few accountants excused them from being forced to mark to the market]. That’s the way your broker values your account when it provides the current net liquidation value. It’s also the value they use when determining whether to issue a margin call. Telling the broker that the position is worth more and asking that a margin call be postponed is a plea that is ignored.

When you make the investment decision not to close the trade – as will happen almost every time you look at your portfolio – that’s equivalent to closing the old position and re-opening it at the same prices – commission free. It’s a decision to own the position at the current price. Thus, if your position declines in value from this point, you lose money. Your money.

If you earn profits from this point, you make money. And that is true even when a larger loss becomes a smaller loss.

Why is this important? Why should you care?

It’s important for traders to have the correct mindset. Too many feel they can afford to hold a profitable position that’s become risky, just because they have a profit and feel they are playing with someone else’s money. If the position is too risky for the potential reward, why own it? When you respect money and protect it, it will remain yours.

Many investors refuse to take a loss. That makes no sense. If the current mark to the market tells you that the position is worth less than it was when you initiated the trade, you have lost (past tense) money. Don’t pretend that holding and giving yourself a chance to get even is always the right choice. Sure you can hold, but only when you want to own the position at its current price. You may even want to add to the trade, but in general, it’s a poor idea to add to a losing trade.

If the trade is unsatisfying from either an intellectual or comfort zone point of view, why own it? Close and open a better position. Open a position you believe has a better chance to earn money going forward. You are trading to make money, and to do that you want to invest in positions you believe have profit potential. If you recover $500 by holding a losing position, it may give you a feeling of satisfaction, but if you could have invested those same dollars in a new position and earned $1,000 over the same time, how can recovering $500 be considered a good result?

Unless you have a good reason to believe that an open position is more likely to make money than a fresh position, there is no reason not to move your trading dollars into the better trade. And that’s true whether the position is a winner or loser. It’s either good to own or it isn’t. Investors everywhere cling to those losing trades – hoping to avoid a loss, or they gamble with winners, believing it’s not their own money.

If you have a bad position, don't hold it.  Ignore whether it's a profit or loss – and open that better position. 

No specific trade owes you a profit.  When you earn your target profit each month, it doesn't matter which positions provided that profit.  Unload bad positions and manage risk carefully.   That's the path to winning.

to be continued

Two years ago I wrote a magazine article on this topic.

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6 Responses to Philosophy of Options Trading. Part II

  1. dj 06/22/2009 at 11:26 PM #

    complete newbie here so I apologize in advance. But i’m keen and have started virtual trading at CBOE.
    I tried a collar of MFC (a stock I own that has appreciated greatly YTD)
    I look at my account now and see that the stock has decreased in value from 19.88 to 17.67, the sept 22.5 call has increased in value by $120 and the put by $55. Am ok holding the stock but wonder about the september options. Up a combined $175 or 8.8% of 19.88*100 in 30 days.
    If this is accurate, I think I should close the collar now and not wait till sept.
    Is this what you mean by protecting your money?

  2. Mark Wolfinger 06/23/2009 at 12:13 AM #

    dj,
    Don’t apologize. Asking questions is the best way to learn.
    Opening the collar position is one way to protect your assets. And I’m a big believer is using that strategy.
    In this specific post, I was referring to remembering that a profit that has been earned represents your own money and it should be protected and not ignored with the belief that ‘it’s not my money.’ It is your money.
    You have an unusual situation. The stock has declined and the call is trading higher. The fact that the put is higher is reasonable, but not the call. I don’t want to say anything that may confuse you – an acknowledged ‘complete newbie’ – but I assume you understand that call options usually decline in price when the stock falls.
    OK I see the problem. The call has deceased in value, hasn’t it? That’s why you are ahead by $175. But is that correct, the call you sold went down in value?
    I consider it completely wrong to claim a profit of $175 on this option trade because you made this trade ONLY because you owned stock. And the stock has declined by $221. Thus, you lost money over this period of time. You did not make any money. But, what you did accomplish is protect your assets, and that’s what a collar is supposed to do. But the ‘collar’ is the stock plus the put plus the call, and not just the put plus call.
    You did not mention the strike price of the put. I must assume you bought the put. But, if it is the Sep 22.5 put, then there are some important things for you to know:
    a) You don’t have a collar – if the put is the Sep 22.5 put and if you BOUGHT that put that position has another name. But it’s really: synthetic short stock. BUT THAT’S TRUE ONLY WHEN THE PUT AND CALL HAVE THE SAME EXPIRATION AND STRIKE PRICE. If the strike price is different, then it is a collar. Forget what it’s called. All that means is that you have NO risk in this position because your stock was essentially ‘sold’ when you traded the options. I’m sure this is confusing.
    You can ignore everything in the above paragraph except for this: You have no collar and you effectively sold your stock when you bought the put and sold he call WITH THE SAME STRIKE AND EXPIRATION.
    2) If you close your option position now, you will take off the collar and you will have successfully protected the value of your stock. But, once the collar is gone, you are once again unprotected.
    I cannot find any options for MFC. But here is a general warning that may not be necessary for you: if your options don’t trade a lot of volume, then the price you found may be very inaccurate. So I ask where you found it. I must also warn you that ‘last’ is not the right way to get option prices. That ‘last’ may represent a trade from hours, days, or weeks ago. To get the current price, you must find the current bid and ask prices for the option, and then use the midpoint as a rough estimate of current prices. Check that out and see if it makes a difference.
    3) If you do close he option portion of your position now, that is NOT what I meant by protecting your money. That would leave you naked long the stock – with all of the downside risk.
    I want to be certain there is no misunderstanding due to my using words that you don’t know, or you using words that tell the wrong story. So fell free to continue this conversation.
    what I meant by protecting your

  3. dj 06/23/2009 at 12:19 PM #

    Thanks Mark,
    The value of the call is in fact down.
    The put has a lower strike (17.5)
    I am using the CBOE virtual trader ( which looks like it’s optionsexpress) and the value they quote on positions is the bid or the ask, not last. MFC comes up for me when entered there. Quite right about the volumes, none for either these options today.
    I now clearly understand that the position is the collar AND the stock and this makes sense to me. Would you ever consider closing the option portion and open another collar around the new stock price? (considering I remain happy owning the stock)
    And finally, I have opened another “paper money” account with thinkorswim and have started “trading” covered calls and naked puts. Seems a little more straight forward for now.
    DJ
    ps. it worries me a bit that you couldnt find any options for MFC :(

  4. Mark Wolfinger 06/23/2009 at 12:39 PM #

    dj,
    They it truly is a collar. I wanted to be certain.
    Glads to hear that you are getting accurate prices.
    Yes, you can close one collar and open another. You should do that when the current position doesn’t give you the protection you want to own.
    Trading is not free because of commissions and slippage (the amount lost when trading due to the difference between the bid and ask prices. Unless you transact all trades at the mid-point between the bid and ask prices, you incur slippage. It’s just part of the cost of doing business.
    With those costs in mind, don’t move the collar just to make a TINY change. When your position feels wrong and a change is needed – then do it. Don’t let trading expenses get in your way. But if it costs to much, then there may be nothing to gain from changing from one collar to another. This is especially when the broker charges a fee ‘per trade’ and you are only trading a few option contracts at one time.
    TOS software requires a learning curve and you are moving along that curve. Good news.
    Regarding MFC. I see option quotes now. Have no idea what the problem was yesterday.

  5. dj 06/24/2009 at 11:23 AM #

    Thanks Mark,
    I understand the role of commissions and slippage.
    When considering buying/selling stocks or ETFs I use a rule of thumb that the commission must not be more than 1% of the transaction.
    Do you suggest a rule of thumb for newbies who would tend to trade small contracts and not necessarily have access to super low commissions?
    DJ

  6. Mark Wolfinger 06/24/2009 at 12:11 PM #

    No rule of thumb. But I believe an investor ought to be able to trade one- or two-lots, if he/she so desires.
    If your broker charges a minimum of $15 per trade, or if there is a $15 ‘per ticket’ charge, call the new accounts department (call the ‘retention’ department if they have one) and tell them that you are new to options trading, want to remain a customer, but need a break on commissions because it’s impossible to make any money when trading small size. Ask if they can give you a commission break so that you can afford to learn to trade options with real trades. Tell them that paper trading doesn’t work for you, or that you have done enough and want to use real money now.
    They may offer a temporary discount, or you may get lucky and get a permanent discount (not likely).
    If they refuse, and if commissions are important to you, then consider TradeKing, or Interactive Brokers (there are others).

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