Teaching Options

Options education. That’s my business. It has also been my passion.

One basic question in preparing a course of study for individuals or groups is deciding which ideas can be taught vs. which can come only with experience.

Students can be helped to understand the greeks, what they represent, and how to make them correspond with the trader’s outlook for the market. In simple terms, all students come to understand that being long delta is likely to bring positive results when the market moves higher. However, there are enough exceptions that the student must be taught when delta (or any other greek) can be overwhelmed by other factors and fail to produce the anticipated profits.

One example occurs whenever news is pending. Option prices tend to be bid higher, so that the after-the-news-is-released collapse of implied volatility can result in the call (or put) owner suffering a loss, despite having correctly predicted in which direction the stock price would move. This is an important aspect of the learning process. However, it is reasonable to expect students to grasp the principle that predicting market direction is not sufficient to generate profits when using options.

Mindset: Moving from stock trading to options

Because getting market direction correct is not good enough, experienced traders often adopt ‘market neutral strategies.’ Instead of predicting the market will move higher or lower, the prediction (or wager) becomes: the market will not move too far in either direction. That is foreign to short-term traders

This represents a big change in mindset for the person who has experience trading stocks. Stock trading is all about direction – bullish or bearish; holding for the long term or short term, betting on daily price swings or 20-second price changes, etc.

Risk/reward ratio is another big change for the trader who is moving from stocks to options. Stock traders always want the trade to have more to gain than to lose. Option traders do not have to accept that limitation. For example, many traders make a living by selling a $5 call or put spread and collecting a $1 premium. The maximum loss is four times the maximum gain, yet this is viable for option traders.

Having the ability to get the options student to recognize that he/she has entered into a new realm is an important qualification for the options educator. It’s truly important to be certain that the student understands that options are different. As trite as that sounds, when that difference is not emphasized early in the education process, some students will be troubled with the idea of ‘risking so much’ to ‘earn so little.’

Risk Management

To help ease the transition of new options traders into our universe, the concept that managing risk (other than by using the stop-loss tool that is so valuable to stock traders) is the essential talent required for success. Timing may add to profits, but it is not as important as it is when trading non-option vehicles. Something as basic as this is mandatory in the training process.

But it involves more than that. I doubt there is an options educator on the planet who does not mention ‘risk management’ in one form or another. However, options are different. Options and option positions have risk that can be quantified (the greeks). When that’s possible, a whole world of risk management becomes available to the trader. We measure those risks and use ‘the greeks’ to describe them.

What’s the big deal? When trading options, knowing how much money is at risk if something specific (price change, IV change, time passes etc) happens – represents the opportunity to reduce and control any specific risk. If the stock trader fears that markets will become deadly dull and trade in a very narrow range, there is not much that can be done. However, the option trader can seek positions with positive theta and/or negative vega. Or, if the trader is a strict believer in owning positive gamma, then sitting on the sidelines becomes the appropriate strategy.

There is such a large advantage to knowing that the greeks can help plan strategies and measure risk, that failure to emphasize their importance makes the whole learning process far less valuable.

Philosophy

Taking a class when the course consists of:

  • Explanation of some strategies
  • Being told appropriate conditions for using each
  • The promise that you can read charts and predict market moves

is just not good enough. The mechanics of using options are important, but not sufficient. Learning the basics, understanding how to apply them, achieving proper (profitable) mindsets – those are important. Those are the ideas that the teacher must pass along to the beginning student. I wonder how many mentors who charge big bucks for an education understand these truths.

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4 Responses to Teaching Options

  1. John 06/27/2011 at 6:47 PM #

    Mark,

    You have taught me so much about option trading in the last year plus and I for one am very greatful for all that you have done and continue to do for rookie traders such as myself. I have certainly made some foolish mistakes, but I have learned from all of them. I still am struggling with the “greeks.” For some reason I just can’t quite get them to make sense yet, but I am working on that. I have definitely learned your favorite principle though, Risk Management!

    Your passion and desire to help are very apparent to me and again I just want to say “THANK YOU.” I look forward to becoming a premium member very soon.

    • Mark D Wolfinger 06/28/2011 at 7:49 AM #

      John,

      Thank you.

      Keep in mind that the math behind the greeks may be complex, but each greek is a ‘number’ that shows a trader the potential gain or loss – if something changes.

      It shows the risk. If that risk is too much, the trader can take action.

      I’m sure you will understand better soon. If you do become a member at Options for Rookies Premium, there is a video that does a good job of explaining the greeks.

  2. marty 06/27/2011 at 8:22 PM #

    mark,

    enjoy your site. now for a question.

    when the markets close on the 3rd friday how do brokerage houses handle itm options. my broker will exercise any option itm. this sounds like they do this after the market has closed. is this being done after hours? and who are they trading with after hours? can the price of the option change from the closing price? since the option is good until noon saturday is there a clearing house that is open /late that 3rd friday/all night/saturday morning? thanks in advance.

    • Mark D Wolfinger 06/28/2011 at 8:04 AM #

      Marty,

      1) Brokerage houses do not handle ITM options. The OCC does all of the exercises and assignments.

      2) Once the OCC tells your broker how many exercise notices they received for each option, the broker assigns those notices to their customer accounts on a ‘fair’ (usually random) basis.

      3) ITM options are automatically exercised, but not by your broker. A customer who owns an ITM option has the right (too few people know about this) to submit a DO NOT EXERCISE notice to prevent unwanted exercises. NOTE: People who are short options have no rights and may not enter this request. Deadline is one hour or so after the market closes on 3rd Friday. Ask your broker for their procedure.

      4) Someone who owns an OTM option can do the same by entering a DO EXERCISE notice. This is how those options get exercised when the stock changes price after the market closes for trading

      5) Options are NOT traded after hours. The closing price of the option cannot change after the NYSE closes. But who cares? It’s the price of the stock (or index – and that price will change as the final calculations are made) that determines whether an option is ITM and thus, whether it will be exercised. The option price does not matter.

      6) The options is not ‘good’ until Saturday. That’s when the official exercise/assignments occur, but the option owner must decide MUCH earlier (ask your broker for their cutoff time) whether to enter a DO NOT EXERCISE notice.

      7) The OCC is ‘open’ – probably 24/7. If it ‘closes’ it would only be after all option exercises are complete, and all assignment notices have been sent to the appropriate broker.

      Regards

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