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Learning to Trade Options when Employed Full Time

on 06/15/2011

Conversation with a Gold Member

Mark, If I may ask, how do you select your trades? The selection of the trade is so critical.

That statement is true. It is also a problem area for me as a teacher. I prefer not not use technical analysis. That means I seldom try to time a trade entry. I admit it – I do not know where the market is headed. Sure, I may lean a bit bullish or bearish on a trade, but I want to earn my profits by skillful management of an option position, rather than by correctly guessing in which direction a stock or the market will move.

If you believe you can predict direction well enough to prosper by doing that (I know you have been a long-term stockholder, and may have an excellent track record for stock picking. But timing is different), then continue. Use what you learn about options to trade positions that are better than owning stock: Better because they are more likely to produce profits, require less cash, allow you to limit losses, etc.

I don’t try to time the markets. I enter trades in a vacuum, trying to be market neutral. Right now, my general plan is to earn cash bu owning positions with positive time decay. That’s working very well now but will not always do so. There are no guaranteed profits. But the bottom line is that I leave the timing of trades to those who have expertise. However, what we can in the realm of timing is to adopt a strategy that feels right for today’s market. Covered calls are okay – but it is a quite bullish strategy (even though most people think it is a neutral strategy).

I am also trying to teach myself the basics of fundamental analysis and technical analysis. This can make you a much better trader. But do not believe it’s a quick study.

FA is generally used for longer term investing, and my stance is that you cannot expect to do better than the pros who do it for a living. And the evidence is there: these people cannot outperform the market averages. Thus, I believe it takes a special talent to earn money as a fundamentals trader. On the other hand, the Cramer idea (I am not a fan of his) of doing research every week on every stock you own cannot be a bad idea. I just don’t know how helpful it will be.

TA is better for the shorter-term trader (one week to couple of months), so it is likely to be of significant value in your options trading – if you have a talent for using it.
Some decades ago, there were the ‘nifty fifty stocks. Owning those worked until it didn’t. That idea crashed badly

I have been reading about this also. I bought 2 books for “dummies” on the subject, and will start these.

The one other site I am looking at is Investors Business Daily- they do fundamental analysis and technical analysis and keep track of the entire market with special attention to the top 50 stocks in the market. But they are not involved much with options (or that is my impression so far-but I do not subscribe to them)

General information is a good thing. Knowing about markets in general is helpful. If you have the time and patience, I love that you are learning as much as you can about all aspects of making this work for you. It’s a lot better than your old buy and hope strategy.

All of this would be easier if I had more time to spend but I have a busy job and a family, so my time is limited.
When we had the crash in 2008 we had our money in a Schwab “private client ” account where we were being advised. I don’t think the advice we were given was very good. Subsequently my husband and I took all our money out of that service, but managing it ourselves is a bit daunting-we are diversified in mutual funds, bonds, ETFs etc.

What I like about options, is that you can actually lower risk. Thanks again for your help!

.

Comments { 0 }

Options and Risk Reduction

on 06/14/2011

A note from a Gold Member at Options for Rookies Premium reminds us that investing is serious business.

I am a beginner.

We lost a ton in 2008 (as did many others) and now we are paying college tuition for one of my children and will be paying soon for a second. Also both may be interested in grad school and I hate the idea of their needing to borrow a lot and be deep in debt.

We had saved up enough for college, and actually lost a big fraction of it in 2008. Very frustrating as you can imagine, and thus my interest in options and risk reduction.

J

I’m very sorry to hear of your situation. Knowing that you are not alone is not much of a consolation.

In my school days, or at least in chemistry, no one paid for grad school. We all had assistantships or fellowships. I suppose times have changed. This is none of my business, but some advisors would tell you NOT to sacrifice your financial security, but to have your kids pay their own way – at least after college. However, I admire that you want to prevent them from incurring the large debt and are willing to assume that burden yourselves. It is a big burden.

I understand where you are. I believe one warning is in order:

When ‘investing’ or ‘trading’ and you NEED the money – it is far too easy to press and take extra risk. That does not lead to good results. So keep that point in mind when making trade decisions.

The fact that you will be using options is not going to solve your problems all by itself. However, with reduced risk as your objective, you can still earn good money with that reduced risk. I’m here to help you achieve that result.

In moving forward, there’s an important point you may not have considered. You spent your entire investing career being bullish and looking for stocks that are moving higher. That is unnecessary with options. You can take short positions and bet on the downside. You can adopt market-neutral trades and not care where the market moves, so long as it doesn’t move very far. Or you can take a different tack and wager that the big move will occur. You do that by owning puts and calls. But that is a long shot and I do not recommend it. The point is: Being bullish is not necessary.

MINDSET changes required

Rising markets are not your only friend.
Investment portfolios can be insured.
There is no need to put everything into owning stocks.
Many strategies come with limited risk. I urge that you consider only those.

A an options beginner, you have some exciting times ahead. But you are tackling a serious problem and I know that both of you are not in it the for the excitement. I wish you the best, and if you have questions, please feel free to ask.

987
Comments { 4 }

Less Common Adjustments for Covered Call Writers

on 06/13/2011

Mark, One question: How about covered calls or naked puts; is there any other usable adjustment method besides rolling down or closing position?

Robert

As you know, these are equivalent positions, so I’ll answer as if you were asking only about covered call writing (CCW). Reason: It’s a far more popular strategy, although I urge covered call writers to consider writing cash-secured puts instead.

Each of these trades is equivalent to being short a put.

As an adjustment, consider these alternatives:

    a) buy a further OTM put to limit losses
    b) buy a longer term put to move into a calendar spread
    c) buy a closer to the money put to own a bearish position – changing your outlook
    d) Target bigger profits with added risk (I hope you don’t choose this) by selling a call, and going short a naked strangle or straddle
    e) Short some stock to own a delta neutral position

No single one is better than another. It all depends on how you want to ‘play.’ If you want positive theta, that limits your choices. If you are very conservative, that very much limits your choices and adopting this strategy was not the best initial trade for you. If very aggressive, you have different choices, with added risk.

But it is easier to just quit a winning (enough profit) or losing (enough pain) trade and open another. If you open that new trade in the same stock then you would be rolling. If a different stock, well then, it’s obviously just a new trade.

Don’t look for complications where there are none. If you don’t like a position, it is often best to exit.

Personally, I prefer the roll for the CC or NP position. Unless I am no longer bullish on this stock. I bring in more cash by moving the option to a lower strike and more distant month. Let me rephrase that. It’s what I used to do. I no longer sell naked options.

986
Comments { 2 }

Taking Risk

on 06/10/2011

The following quote about risk taking is not as trivial as it seems. It’s an important concept. By Eric Falkenstein from his falkenblog.

Don’t expect to make more money for taking risk, just know you have to take risk to make more money. If you don’t understand the difference, you shouldn’t be taking risk.

I frequently discuss the fact that to earn higher rewards it’s necessary to either be a very skilled trader, or to take more risk. And I let it go with no further discussion. However, Eric points out the extra ingredient that was missing from any of my earlier discussions. The fact that extra risk is taken does not guarantee any extra reward. In fact there may be no reward.

It’s very possible for the given trader to be in over his/her head with more risk than the trader can handle. And the sad part about that is that it is not immediately obvious. A trader can adopt a new strategy or trading style successfully, without recognizing the extra risk. Until that day when the risk makes itself obvious and it is too late for the trader to recognize that he/she should have been prepared for the possibility that just occurred in the real world.

If you are going to take added risk, that risk must be understood. In many cases, a look at the greeks or a glimpse of the risk graph does not paint the whole picture.

As Eric says – you may want to make more money – and that usually requires taking additional risk But do not believe that simply trading riskier positions (such as trading bigger size) is the path to those profits. Often, that extra size creates situations that frighten the trader into panic mode because the amount of money at risk suddenly overwhelms the trader, if and when the unexpected occurs. Please don’t add risk to your trading before being certain that you are prepared to handle that risk. It’s acceptable to make a bit less money when you can do it without facing a situation that is psychologically too difficult.

The Risk Premium

Definition: The reward for holding a risky investment rather than one that is risk-free. Alternatively, it is the minimum anticipated return required to entice the investor to own the more risky position.

We all recognize that options trading involves some risk (the super-risk adverse, computer-assisted, traders can neutralize their positions efficiently). One problem is that it is difficult to describe the specific risk for a specific strategy. We can all calculate the maximum dollar risk, but because each of us makes risk-management decisions differently, the true risk is not something easy to measure.

Yet we must have some handle on risk to know whether it’s justifiable – considering the reward we want to earn. Options trading does offer substantial rewards. That’s the attractive part. It is well known that options are not risk free, and it is an individual decision on just how much risk to take. The problem is that many are unable to quantify risk.

985

Comments { 9 }

Bad Things do Happen

on 06/09/2011

Have you ever felt that the market was out to get you? You had a winning position. The stock was acting just as you had predicted. Then suddenly the position turned to crap when the stock price experienced a large gap at the opening. The good profit disappeared and you were the proud owner of a losing trade.

Did you take that personally? I suspect you already know better than to blame the market. We are involved in a big probability game.

Tyler offers a simple explanation of why you should not blame the market (Tyler’s Trading).

The financial market is no respecter of persons. Each trader rises or falls based on merit and merit alone…

After getting hosed a few times or treated unfairly by Mr. Market I too am tempted to bellow, “Hey! Do you know who I am?” But, alas, such an exclamation falls on deaf ears. No, the market doesn’t know, nor does it care who I am. It doesn’t care about the size of my bank account, my voluminous library of trading books, the time and effort I’ve put forth or years of experience. My shins will get kicked in just as swiftly as the next guy. The market doesn’t care about my family name, my background, my connections, or my social status. It simply provides a playing field which rewards or punishes based on skill.

I’m just one of millions of nameless, faceless traders.

It’s our job to manage risk. Sometimes we are going to be unprepared for the unlikely event. However, as a risk manager, if we take care of our trader persona and monitor position size carefully, then out trader persona will be spared the agony of blowing up a trading account.

984
Comments { 2 }

Iron Condor Spread Strategies: Book Review

on 06/08/2011

Jared Woodard, my partner at Expiring Monthly, has produced an outstanding essay published in book format.

Iron Condor Spread Strategies: Timing, Structuring, and Managing Profitable Options Trades $8.99

It cuts to the heart of iron condor trading. With no wasted words, Woodard makes a significant contribution.

Iron Condor Spread Strategies by Jared Woodard

  • Don’t have a lot of time? – this book is short
  • Already know the basics? This book builds on what you already know
  • Want your trades to perform better? This information is valuable

From the introduction:

Iron condors have become popular, but there is little detailed or quantitative information about the best way to employ them. As participants in 2008’s crash and 2010’s bull market can attest, “set it and forget it” is not ideal. I’ll discuss when to enter a condor spread, introduce key structuring techniques and considerations, and present back-tested returns for selected strategy variations

Direct quotes

Instead of taking the approach (as I admit that I often do) that the iron condor is your trustworthy friend, Woodard lets you know that the trade is speculative in nature and that there must be a reason for initiating the trade:

Objective, statistically-significant indications that some asset is likely to be range-bound in the future, provide an excellent justification for a speculative condor trade.

Woodard issues an alert:

The characterization of iron condors or any other option spreads as “income-oriented” is misleading. A given iron condor trade will conclude with a net profit for the trader only if the thesis of the trade proves correct… In this respect, option spreads are no different from any other form of speculation.

I highly recommend this e-book.

982
Comments { 7 }

Options Education: Feeling Pumped and Ready to Trade

on 06/07/2011

Today’s post continues the discussion of what is necessary for an options education to be useful for the student. I’m imagining myself speaking with someone who operates a weekend seminar business or who offers $10,000 option classes:

Is it better to pump the student with energy? To set high expectations? To describe leverage in a manner that students immediately think about living the life of luxury? I prefer to tone down the rhetoric and explain the true risk of using leverage. The rookie must understand that trading skills are not developed overnight.

Is it better to explain that most people who attempt to become full time traders or earn a living by trading – fail to make it? Is it better to explain that learning to trade requires work and that certain personality types are far better suited to the profession than others? Yes to both.

The beginner must understand the task being undertaken. Why would you suggest that making money is a cinch and that everyone who takes your very expensive class will mint money? I get it, treating newbies as if they will be experts in a week may make them look up to you with awe, and it certainly lines your pockets with cash as that energy gets them to tell their friends – but when reality sets in, you will have taken their money and their dreams. How do you sleep at night?

Do we tell students that it’s not all fun and games. Sure, I enjoy making trades and working with positions, but the trader cannot ignore risk. Risk management is the name of the game. Forget that aspect of trading, and no matter how talented you are, there’s a significant chance of destroying the trading account. Do you do more than mention the words ‘risk management? Do you stress that topic and show examples, or do you only concentrate on the winning trades?

Position size is critical to risk management. One must never believe that a short string of successful trades means that the trader is ready to double size – because it has been so easy to make money. Do you warn students of the danger of allowing early success to breed overconfidence? Have they been taught that it is easy to get into trouble quickly when they leave the classroom filled with energy and high expectations?

Yes it it easy to make money with options. I have no doubt that you mention this as often as possible. The problem is that it is far easier to lose more than one earns. Does that even get a mention? Do you discuss the risk of ruin? The truth must not be hidden from the new trader.

So what do we tell the options rookie? The truth or the hype? You know where I stand.

983
Comments { 0 }

Legging into Spreads

on 06/06/2011

I like trading RUT spreads but I’m not sure if its better to place a spread order or just leg in. Does a spread order make more sense with a smaller order? I can see trades occurring at the spread price I want but I fail to get filled.

Dan

Dan,
It is far more practical to enter a spread order. In the vast majority of cases, it is also less risky. The primary reason for that extra safety is that you cannot get trapped by a sudden market move after buying or selling the first leg of the trade.

Very Actively Traded Options

There are exceptions to my recommendation for entering spread orders. If you trade front-month options, especially options that are nearly at the money (CTM or close to the money), then there is a lot of trading volume and a continuous flow of orders. What that means to you is that there is a much improved chance to get a good fill – and quickly.

    Example:
    The bid/ask spread for a CTM option is $10 bid $10.80 ask.
    When there is a constant order flow, this option will be trading – at least every second, and probably far more often than that – at prices ranging from $10 through $10.80, and probably every 10 cents in between those prices. And this ignores all those trades that occur at penny increments.

    If you enter a sell order @ $10.50 or even $10.60, there is a very good chance that you will get filled when another customer is trying to buy that option and is willing to pay a price near the ask end of the range. Notice that you do not have to depend on a market maker to get filled. You are going to be trading with customers just like you – people who enter orders.

    Once filled, it’s time to enter the order for the other side of your spread. The expectation of getting filled is as before. If it’s a very actively traded option, you have a reasonable chance to get a good price.

    However, there is the huge risk of a sudden change in the air. If you buy a call, RUT may decline a few points in a heartbeat – far too soon to get your other order filled. That’s the risk and it is real.

Less Liquid Options

If you prefer to trade out of the money (OTM) spreads, then you must recognize that there is less order flow, less volume, and less chance of making a successful leg. If you trade options (as I do) that are not only reasonably far out of the money, but are not even front-month options, then the chances for a good leg are dismal. These are low delta options, and even if you get a good leg as far as market direction is concerned (buying a call just before the market moves higher, for example), there will still be difficulty getting a fill on the sell part of the spread. Low delta options don’t move much- and they move even less when implied volatility shrinks – even if by a minute amount.

You do not see trades at your price

To be filled on a spread, your broker’s computer must be able to execute both (or all) legs of the trade simultaneously.When you think that trades are occurring at your price, please understand that they may be off my a few milliseconds – and that’s more than enough to prevent the computer from grabbing both ends of the trade for you. And when you see trades you think should be yours, consider that when one leg is offered at one exchange and the other leg is offered elsewhere, it is more risky for the broker to go after the legs. You must ask your broker what conditions must apply before their trading algorithm allows your order to get filled.

But more than that – what about all the ‘market’ orders? They just get filled. There is no opportunity for that market order to find your spread order, or to be found by that spread order. The system has too many participants and a market order hits the highest published bid (or takes the lowest published offer) and it does it immediately. Those trades are never available to your spread order.

Trade Size

I see one advantage and one disadvantage trading small order size. To get a fill, you must attract a market maker’s interest. Small orders do not accomplish that.

However, when trading with other customers, there is an increased chance to fill the whole order, rather than just part of it when trading two lots instead of 10.

Bottom line: Legging adds extra risk, so if you do make the attempt, be absolutely certain that you will not get stubborn about finishing the spread, even when the price is not as good as you prefer. If you are trying to earn an extra 10 cents per spread, there has to be a correspondingly small ‘loss’ from getting a poor fill. I’ve seen traders lose dollars trying for dimes. It’s not a good practice to take the leg, unless you are a VERY skilled market timer.

981
Comments { 4 }
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