Tag Archives | buying options

How Should a Beginner Approach Option Trading?

The following question seems rather tame, but it addresses a very important issue:

Is there a correct syllabus for new option traders?

Hello Mark,

I’ve just starting to read your Rookie’s Guide book, bought from Amazon. I also read several other options books, while doing my paper trading with OptionXpress with thinkorswim platform.

I also have joined an options course and what they teach are very basic, which is just Buy To Open (Call / Put) and Sell To Close (Call / Put) and pay attention to the candlestick chart for entry point. So making profit from that simple strategy. What do you think of that strategy? They didn’t teach any strategies mentioned on many options books.

Candlestick Charting

Candlestick Charting

But after reading couple of books on options, they all teach the Covered Calls as basic strategy, which from my understanding that one investor has to have real stocks in order to make the options trading. Do I need to buy real stocks? Is that true?

How about if we only open an options account, and didn’t have a real stocks to trade in that Covered Calls strategy? And why I can’t trade the Covered Calls in optionsXpress? Please help me.

Thanks in advance,
Aldo Omar

Paper trading is an excellent idea. It teaches you how to handle your broker’s platform and it gives you experience learning to make critical decisions — entering and exiting positions.

However, this course is a disgrace, in opinion. I do not care how respectable the course giver is, but these lessons are almost guaranteed to see their students go broke when using options. Unless they explain that the course is designed only to teach you something about options and that “buying to open and then selling to close” is NOT a strategy that you ever want to adopt, they are doing you a great disservice. I hope this course is free because it is not worth even that much.

  • First; A trader, and especially a new trader, cannot be expected to know how to use Candlestick charts. It is extremely difficult to “pay attention to” charts and come away with useful information. Think of this way: Candlestick charting is well-known and used my millions of traders around the world. Despite that, the data is clear: The average individual investor does worse than the S&P 500 index. The average mutual fund manager — someone who ears big bucks to pick winning stocks and beat the market averages — cannot beat the averages. Do not get trapped into believing that you can read one or two books on charting and know how to sue the charts. My conclusion is that it is far more difficult to pick entry points than your course teachers suggest.
  • Second; You are learning the simplest of all strategies, and that is a good thing because one should begin with the most basic concepts of options. However, it should have been mentioned as often as possible that buying to open and then selling to close is a death wish. Unless you (A. O.) have a proven track record of predicting which stocks will rise and fall, then you must not — for your financial well being — believe that you can suddenly start trading options and become a successful stock picker. Life does not work that way and using Candlesticks will not turn you into a successful stock picker. The professionals cannot predict stock direction on any consistent basis, and neither can you
  • Third; Even if you work diligently and learn to read the charts successfully, there is more to “buy to open” than simply picking a stock and correctly forecasting the direction of the stock price. Did they teach you that buying out-of-the-money options is not a viable strategy? Did they teach you to pay attention to the implied volatility of the options? In fact, did you learn anything at all about volatility and how crucial it is to an option trader? I assure you of this: If you but out-of-the money options and if you buy them when their prices are relatively high, you will ruin your trading account, even when you get the stock direction right. My advice: If you are going to play the “buy to open” game, at least stick with options that are already several points in the money when you buy them.
  • Fourth; I know that advanced strategies cannot be dumped into the lap of a beginner. Building a sound foundation in option basics comes first. But that is no reason to teach a strategy where the vast majority are guaranteed to fail.
  • Fifth; Yes, covered call writing is a sound basic strategy and yes, it does involve the purchase of stock (in multiples of 100 shares). However, it is still a bullish strategy and the covered call writer can still lose a lot of money if the market takes a dive. Obviously you lack the cash to buy stock. That is okay because there are other ways to use options to generate exactly the same profit/loss profile as writing covered calls. You will get to that in Chapters 13 and 14 in the book that you are reading (The Rookie’s Guide to Options; 2nd edition).
  • Last; The whole idea about using options is to hedge (reduce) risk and still give yourself a good probability of earning a profit on any given trade. Buying options based on Candlestick chart reading is not one of the paths to success. Sure some people can do it, but you don’t want to count on being one of them. Covered call writing is “better” for the new trader – but only when he can afford the downside risk. However, there are other strategies that I would recommend for you. At the top of the list is “credit spreads.” But please have patience. Don’t jump to the chapters on this and related strategies. Go through the lessons at your own pace and if possible, resist the temptation to trade until you feel comfortable.

Aldo,
I hate that course and the sad fact is that this is popular stuff taught by many people.

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Option Trading with Too Little Cash

Mark,

I have a very small amount of money invested with TDAmeritrade. I have some stocks, about 10, with varying amounts of each, but all under 100 shares.

In reading your book about options, I do not want to write covered calls or puts, but do want to use options to earn small profits from 1-5 contracts. Is the best conservative way to invest with options to buy a small number of contracts for an interesting stock or to start with collared positions to protect my money? Thanks for your response.

Teresa

***

Hello Teresa,

Very sound questions.

A good and conservative method for protecting assets is to use collars. They offer a limited opportunity to earn cash, and that is one reason why I don’t believe they are currently a good choice for you. However, the point is moot.

To use the collar strategy effectively, you must own at least 100 shares of stock.

The collar is made up of three parts. Buy stock, buy put, sell call

You already own stock, but it is less than 100 shares

You are allowed to buy a put option because stock ownership is not required to buy puts.

However, you cannot sell the call option unless you own 100 shares (your broker will not allow it, and it is far too risky for you. If the stock rises too far, you can lose a lot of money. When selling one call option, you accept the obligation to deliver (sell) 100 shares at the agreed upon (strike) price. You don’t own those 100 shares. If the stock rises, you can easily lose money.

Part of the collar?

If you try to do part of the collar and only buy one put to go with your stock, that is ill-advised. First, it will cost more than you would be willing to pay. Next, you would own too much put protection. Remember that each put option allows you to sell 100 shares at the strike price – and you don’t own that many shares. Thus, unless the stock takes a very big move higher (to compensate for the cost of the put) or lower (allowing you to profit by owning more put protection than needed – this trade is going to lose money. And that’s going to be most of the time.

Buying options

As far as buying 1-5 contracts in an ‘interesting stock’ is concerned, you certainly can do that.

However, you are asking my opinion and I strongly believe that the chances of finding the right stock, at the right time, and buying the right option at the right price – are so tiny, that it is truly a very bad idea. But it’s a common idea. Vast numbers of individual traders do buy options, hoping for a miracle.

In addition, some brokers make it impossible to succeed. The commissions are so high that the small trader has no chance. Do you want to pay $15 to buy the options and another $15 to sell? If you make a profit of $50, all you get is $20. And if you lose $50, the loss becomes $80. The numbers are stacked against you.

Theresa – please think of what must happen: Your interesting stock must make a move in the right direction. It must move quickly because your option loses value every day. It must move far enough to compensate for the cost of the option and the time decay. Do you recognize how the odds are stacked against you? This is more gambling than investing. I don’t recommend it, but it is your money and if you want to gamble you can do so. But for someone who is concerned with using collars to protect assets, gambling should be the last thing on your mind.

My best advice

Avoid options until you have more money. Assuming you have an income, add to your savings every week or every month). When you have more cash available, and if you want to own 100 shares of a single company that is the time to re-think your choices. The collar is very conservative and not for investors seeking growth. If you seek protection of your assets, I’d suggest avoiding the stock market altogether.

Although age is not a determining factor, if you are young with your whole investing future ahead of you, I urge you to wait until you are better funded before using options. If you are nearing retirement, then I believe the idea of buying options is a bad choice. This is when you can ill-afford to be taking chances.

Repeating for emphasis: Buying options is speculative, no matter how interesting the stock may look. It is a way to make some big money – but the odds against success are very long.

I hope you make a satisfactory (for you) decision.

926
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Can you believe this?

What some brokers do

I recently read a trader’s lament in an online form. It turns out that his broker forbids him from buying options on an unspecified day during of expiration week. Why? Because if he still owns the calls at the close of trading on Friday, he would not have enough cash in his account to meet his margin requirements if the options were exercised.

I’ve heard that at least one other broker enforces the same rule, but at least they allow their customers to buy options from Monday through Thursday of expiration week.

This practice is nothing short of stupidity in action. There is no rational reason why customers should be prohibited from trading.

This firm willingly granted him clearance at the appropriate permission level to buy and sell calls and puts. It now seems that the permission is strictly limited and only available to certain customers on certain dates. If their customers do not have enough cash to exercise the options, this firm does not trust the customer to exit the trade in a timely manner.

It now seems that ‘permission to buy options’ now depends on how much time remains before the options expire and how much borrowing power is available to the customer.

Isn’t this why many investors trade options? They don’t have the cash required to trade the shares, so they own options instead. It’s called leverage and reduced risk. This firm does not allow a customer who had $50,000 in his account to buy a 10-lot of calls for a quick trade. That’s all this customer wanted to do: Hold the position for a very short time. However, because buying 1,000 shares would cost more than this customer can borrow on margin, the call purchase was forbidden.

It is beyond belief that any customer would accept this. To his credit, this trader accepted the denial of trade and the lament was his way of asking whether anyone else had seen that happen.

As a disinterested reader of the forum post, I was horrified. I recognize that the brokerage firm must protect itself against customer losses that cannot be recovered, but this specific ruling startled me.

Weeklys

Weeklys options have become a star attraction, as many traders love the idea of playing with short-term options. I don’t know if this firm blocks everyone who lacks sufficient buying power from trading Weeklys, or whether this individual was singled out for a specific reason. It would not be a wise business decision to forbid a significant portion of your customers from trading in Weeklys.

Protecting the broker

The brokerage firm has other methods to protect itself from the possibility that this, or any, trader would incur a margin call that he cannot meet. For example:

  • If trader the calls one hour prior to the market close on Friday, liquidated the position
  • Trader must submit ‘Do Not Exercise’ form no later than (pick a time) on Friday, or else options are sold
  • If trader fails to sell calls, firm locates broker-dealer and sells short 100 shares per call.
    • If the fill is not at a good price, I’m certain that the firm could not care less

To me, these are three viable alternatives to prevent the firm from incurring risk. At this point it seems fair to ask, just what is that risk? How bad can it be for the firm would to take such drastic measures to protect itself?

For the firm to suffer a substantial loss, these items must occur:

  • The trader must forget to to close the ITM option position
  • The stock must undergo a large price gap (in the wrong direction) on Monday morning
  • The gap must be large enough to place the customer account into deficit
  • The customer must be unable to re-pay that debt
  • The customer must have so little remaining assets that the firm cannot recover via lawsuit

I don’t believe there is a person on this planet who deems this to be an event with any reasonable chance of occurring. I agree that the firm wants to avoid even this much risk, but it has better ways to accomplish that task than by preventing a customer from making a trade.

Brokers have dissed their customers for decades. I never thought it would reach this level.

905
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Buying fair valued options

I have a question, another options book I just read talked heavily about the theory of options pricing in the context of Black Scholes. If options are priced “fairly” based upon expected value (log normal distribution of expected price range based on volatility, etc), why do most call buyers lose money and the option writers are generally more successful?

Thanks,

Terry

***

You make the reasonable qualification: “if options are priced fairly”…But, that is not reality.

Options tend to be overpriced

When we calculate a ‘fair value’- it is based on the prediction that the stock will be as volatile as the estimate used in the calculation. We are forced to make an estimate or else we cannot use the formula to crank out option values.

Looking back, history tells us that index options have been priced higher than actual realized volatility, and options traded above ‘fair value.’ This is true for indexes – I am not as certain about individual stocks. Nevertheless, when buyers pay too much, they are not likely to win.

When buying options it is so difficult to earn money on a consistent basis. Besides worrying about overpaying for the options, the buyer must get the timing correct. With options being a wasting asset, if it takes too long for the move to occur, there may be no profits to be earned.

The direction must be correctly predicted. Obviously buying calls is not going to be a winning strategy if the stock moves to the downside.

The move must be large enough to overcome time decay and the premium paid. Many times the stock moves in the correct direction – and moves quickly. However, if the move is not large enough, the option price may barely budge.

Buying options with the expectation of making money is a game that must be left to those traders who have a strong track record that proves they can predict both direction and timing. They must win often enough to overcome the many times when one or both of those predictions fails to come true. It’s my opinion, not a proven fact, that the vast majority of traders would be making a smart move by not buying individual options.

Option sellers have so much less that can go wrong, so they WIN far more often. The problem is that losses can be enormous and it’s up to the trader to prevent big losses. The best method for managing risk and limiting losses is to sell an appropriate quantity – and not look for a huge win on a single trade.

The 2nd best method is to avoid naked selling. Sell spreads instead.

In other words: manage risk and don’t get cocky as a premium seller. Premium sellers win often, but not often enough for many to walk away as winners. Failure to manage risk properly dooms them to failure. Why? It’s the size of the losses that determines their overall success/failure. And I can assure you that no matter how long your winning streak, it will come to an end when something unexpected happens.

Coming April 1, 2011

896
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Establishing Trading Rules: How Much Experience is Needed?

Mark,

Based on what I learned and thought about over the past few days due to my
trades:

  • I would now only buy calls/puts in the front month. The
    odds are more with us [MDW: Us? How did I get involved?]  because of gamma. Is this thinking correct?
  • The
    loss is limited to premium paid, but the upside is huge

     
  • I would
    never buy otherwise because theta is the enemy

  • I am not sure what I
    would buy though, ATM or 2 levels OTM.

 

Slightly off-topic: Based on looking at my trades, time decay is not
linear. The more the underlying is at a particular strike, the more the
time decay at that strike.

Is the time decay calculated per day or week
to week?

The time decay graphs given in most literature gloss
over the fact that those decay graphs are concerned with an option which stays
exactly ATM all the time. Why?  The real spot price gyrates?

Thanks

Amit

***

I get it.  You are an eager student.  You want to trade options right now and make money today.  Every time you see a piece of evidence about a specific strategy, you believe you found the Holy Grail.  I can only tell you that you are making a huge mistake.

You are FAR TOO INEXPERIENCED to make these decisions.

This is learning time.  This is experiment time. 

You cannot make a few trades and reach a permanent-sounding decision such as: 'I would only buy front-month options.'  If you reached this decision, on what is the thought process based?  How many times have you traded 2nd or 3rd month options?  How did the results compare?  Did you make good money by correctly predicting direction, or did something else happen that made the trades profitable.

It is wrong to assume that a profitable trade means you are a genius. 


It is wrong to assume that a losing trade is the result of a mistake.

You must compare the trade with others and discover why the trade was profitable (or not).  The 'why' is how you learn.

NOW is your chance to trade a variety of ideas, analyze the results, keep detailed records, think about the results and make an attempt to get a feel for what works and where to establish risk limits you can handle.

1) No the odds are not with you because of gamma.  The odds are not with you, period.  You have much less time to be right in your prediction.  If it does not happen soon, time decay will eat away at the value of your options.

How can the odds ever be with you when you must predict the direction of the move, the timing of the move, the size of the move?  You must be a very skilled market timer with a PROVEN track record before you can have any expectation of making money when buying options.

I'd hate to see your enthusiasm disappear down a sink hole.  Didn't you try this 'buying options' strategy once before?

2) Yes the Reward to risk ratio is excellent.  But the probability of success is not.

3) I don't understand the 3rd point.  When you buy front-month options, theta is the big enemy.

4) This is your problem in a nutshell.  You want to buy. You think buying and owning positive gamma puts the odds of success on your side.  But you give no consideration to how far the stock must move.  You don't know which options to buy.

It doesn't work that way.  The whole strategy requires knowing which options to buy, or having a method for deciding.  It's not a random selection.  It you cannot estimate the size of the move you should not be buying options.

Buying out of the money options is very much a gamble.  Some players succeed. I have no idea where your talents lie, but if you are excellent (proven track record), you can win this game.  Otherwise, not a chance.  Especially when you buy OTM options.

Off topic:  Time decay is NOT linear.  ATM options have the most time premium and thus, the most rapid time decay.  Time decay of American style options is based on the amount of time remaining until the market closes for trading on expiration Friday. 

The decay can be determined for one week, one day, one second, or any other time period you care to mention.  However, the Greek theta measures the time decay for one day.  Theta tells you how much value the options loses overnight.

Most option analytical tools that measure something specific, such as theta, assume all else is constant.  It MUST be this way.  If you want to know about theta, then if anything is not constant, that item will also affect the option price, and you will NOT be able to tell what part of the option price change is due to theta.  Please tell me that you understand this is true.

One of my basic tenets is that it is very foolish to trade when you don't understand the rules.  Some rules (automatic exercise) can come as quite a surprise to the novice. Other properties of options (how quickly they decay as expiration nears; or the sale of options is not free money) may not be immediately obvious.  But it makes no sense to use tools  when you don't know how to use them.

What's your hurry?  You have the rest of your life to trade. 

Practice in a paper-trading account or trade small size in your real account.  But don't go jumping to conclusions based on one or two trades.

746

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Buying Options

Mark,

I see a lot of chatter on boards for the most part concerning short
sided (premium selling) neutral plays but don't come across nearly as much on directional
type trading. In theory, I understand because this is often considered a
"riskier" play.


I have found I have the best success trading on 4 -5 stocks (and 2
indexes) over and over again, as I seem to learn their movements and
ranges pretty well.
The stocks specifically have medium to low IV and trade pretty decently
within a range for the most part.   That helps me identify
when they are outside their top and bottom levels and probably due for a
reversal of some sort at some time.

Based on this I have been paper trading some long plays thru slightly
OTM calls or puts when stocks hit a high or low level.  This has turned out
quite well over the last few months. Much better return than my short
sided plays.

I'm going to take 10% of my capital and start placing real
funds in the game.


My question is this. I'm sure you've had much experience on the buying
side
. Any particular recommendations you may have on this strategy?
Better to be ATM, OTM, etc? (I'm using slightly OTM as in 1 strike away)


How many months out have you found best? (I'm going 2 months out
currently).

Any particular technical indicators or other analysis tools
you find to be helpful? (I currently am just basing when price swings
outside the normal range).

Not really sure exactly what questions I'm wanting to ask but more or
less get your "been there done that" feedback as to what has worked for
you in the past. Thanks.

Jason

***

Hello Jason,

You see most comments about premium selling because most traders understand that is the more profitable side over the longer term – IF, AND ONLY IF, ONE EXERCISES PRUDENT RISK MANAGEMENT.

Your 'style' is unusual.  Most traders who use technical analysis believe that when a stock is trading at a new high, it's right to buy, not get short.  Similarly, a new low is a signal
to sell. 


To your questions:

I have almost never bought options as a directional play, and I've been trading options since 1975.

I do buy options to add positive gamma to a position, but the purpose is to adjust another position – not to make a directional play.

However, I do have opinions:

1) Unless you are playing for either a very quick move or a substantial move, buying OTM options is a losing strategy

2) Is your total trading history for directional plays that 'few months' of paper trading?  I ask because when buying options you must have a proven ability to get the direction and timing right.  I note you are not so sure about timing.  'At some time' is not quite good enough for trading options.  Especially OTM options.

A few months experience is not nearly enough.  Maybe you had several good years picking stocks before you moved on to options?  But I do encourage you to go ahead with your 10% plan and see if you can make money on your idea.

Please go in with the understanding that the odds of success are very much against you – track record or no track record.  Just look at the mutual funds as one example.  They hire expensive professional traders, and those guys/gals cannot outperform the market averages.

Why do you believe you can do it?  If it were me, I'd want solid proof that I had the elusive talent to consistently get it right when picking stocks – before attempting to make money by buying OTM options.   

2) If cash is not an issue, I'd prefer to buy (one-strike) ITM options.  These don't lose much to time decay and immediately gain the major portion of the move (due to high delta).

If your plan is to use leverage and buy a 'bunch' of options, looking for a big win, then that requires you to buy options with a lower delta.  But I loathe that idea for myself.  It may work for you – if you have the talent mentioned previously.

3) I like the idea of two-month options, but to be honest, when making a forecast – and especially when buying options – being accurate on timing is essential.  That's why you should KNOW, and not ask, which option to buy based on timing of the move.

Lacking that timing instinct, you are just taking a chance, no matter which option expiration is chosen.

4) Going one step farther and being even more helpful (smile), I use zero technical indicators.  I know FOR A FACT that my stock market prognostications are not good, and I do not make directional plays.

5) I have never been 'there' and I have never done 'that.'  But I hope this reply is helpful

736

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