Repeat: Options are not Stocks.

Hello Mark,

I have a question that is not related exclusively to options, but, given the time decay element built into them, it may be particularly relevant to them.

The question is this: are there any general rules that you use for exiting trades that start to go against you, especially if they are not based on an anticipation of a specific catalyst? For instance, do you tend to liquidate your positions in the event of a general market correction that sends a particular stock lower than the general indexes, in the event of your position losing a given amount of value (say, 50% or 33%), in the event of a clear-cut technical trend being broken, in the event of a combination of these and/or other elements, or with the use of some other methods altogether?
Jakub

Jakub,

1) The problem is that your questions are those of a trader who plays the market and they are not specific to options. That may seem to be a trivial point, but it far from trivial. It is also one reason that so many newer option traders get into trouble.

When using options, you must (my opinion) trade as if you own options and not stock. That requires a different mindset. Bullish stock owners can ignore timing, they do not have to be concerned with volatility, and there is no concern over whether the options are priced fairly (or are too expensive to purchase). None of that matters — unless you own an option position.

Bull Market Symbol

Bull Market Symbol

When trading options, you want to think as an option trader thinks to gain the benefits that come with option ownership.

2) Yes, I have such rules. They are not written in stone, but are general guidelines.

If If you have a “long” position, it must be based on your expectation that the stock price will move higher – even if you do not know what the catalyst will be. I would liquidate that position at ANY TIME that you no longer expect the stock to move higher. Sure it can be when the stock price declines by a certain percentage (perhaps 6 – 10%). Yes, it can be when a technical indicator tells you that the buy signal for the stock market or the individual stock is no longer valid.

However, if you own an option, then there is an additional consideration: Can the stock price change occur quickly enough to generate a gain when you own an option position? You would not look at the percentage decline in the price of your call option because that is not the crucial factor. If you still believe that owning that specific option (and that means you must evaluate the time to expiration and whether the option is ITM or OTM), then you can hold. The only important factor is your outlook for the stock in the time period from now to expiration — and whether that expectation makes it a good idea (or not) to own the option that you own. If it is a bad idea, then get rid of the option. Do not believe that owning “any call option” will generate a profit when the stock price rises. When IV gets crushed, you option may lose value, even in the face of a rally. When time passes, the ATM or OTM option can lose all of its value if the rally comes too late.

Any time you are playing the market, you should have a stop loss. And it can be based on anything that you want. However, in my opinion, it is foolish to buy a wasting asset (call option) when you do not know when the stock price will move higher. It would be better to sell an OTM put spread or by an ITM call spread so that if the stock does not move higher right away, you still earn a profit from your position (the put spread goes to zero when both options remain OTM, or the call spread goes to its maximum value when both option stay ITM).

,

2 Responses to Repeat: Options are not Stocks.

  1. Haans 03/15/2015 at 10:36 PM #

    Do you buy a faction of put options to “cushion” the loss in the event one is caught unexpectedly with a downfall or misses to see a down turn (usually a newbie like myself)? It’s painful to cut loss with a loosing 30-40% call option position. You are right one should not look at the percentage of option loss rather the outlook of stock. What about rolling out of the call option so that we can ‘buy’ more time for an OTM call position?

    Hello Haans,

    You cannot buy a fraction of any option because each option represents 100 shares of stock. However, you can buy options on some broad-based indexes that are 1/10 the size of the regular options. In other words, you can buy approximately 0.10 options on SPX (buy SPY options); RUT (buy IWM options); or NDX (buy QQQ options).

    Do not believe that newbies have a more difficult time predicting a downturn that other traders. It is very difficult for everyone.

    Yes, it is painful to take a loss on a call option. However, you should NEVER EVER own an option that you do not want to own. Once you buy the call option, you should be anxious to sell. And that means you can sell it when any of the following happen:

    • You earned your target profit
    • The stock price is not behaving as expected and you no longer expect the stock price to rise quickly
    • Due to a change in the stock price, you no longer own an option with an appropriate strike price. Get rid of it before your loss becomes 100%.

    I do not like hard and fast rules, but this is my philosophy: NEVER own an option that you do not want to own. Never own any position that you do not want to own. NEVER EVER roll a position to “gain more time” unless you WANT to own that longer-dated option. NEVER EVER roll an option because you refuse to accept that you made a losing trade. The ONLY time to roll the option occurs when you still honestly believe that the stock price will go as predicted, but that you also believe that it will take longer than expected. Please, please recognize that stocks do not move higher just because you want them to do so. Please recognize that buying options is a high-risk strategy, especially if you buy out-of-the money options.

  2. Haans 03/16/2015 at 9:38 PM #

    In addition I have these further queries.

    1. What’s your strategy on buying LEAPs options? In order to avoid time decay, when do you roll out if you have a long term view and would like to hold on the securities as long term investment? I guest the pros probably do it within at least 6 months of remaining time value?

    2. When you sell put/call options, do you sell for a 1-month expiry options or longer so that the premium is higher but takes longer for the option value to decay due to longer time frame?

    3. As my portfolio is small ard $10k, like most rookie traders, I am comfortable with selling 1 or at most 2 covered contracts of puts/calls options. But the premiums is very little for a forward 1 month expiry options. This prompted lots of newbies, to take unusual large risky position on selling naked puts like 10 contracts which can be disastrous when volatility increased. What’s your take on this?

    Reply here: http://blog.mdwoptions.com/options_for_rookies/three-questions-from-a-reader/