I published a new blog post about volatility at options.about.com

Although the article is short, it contains links to a bunch of other (brand-new) articles on various aspects of volatility, with most of the information geared to newer option traders.

What is Volatility?

Volatility Products for Trading.

Option Volatility and Black Monday.

Volatility and Option Premium.

An Options Pricing Model.

Volatility: A Topic for New Traders?


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The Versatile Stock Option

As the market approaches new all-time highs (S&P 500 Index), it’s natural to want to ride the gravy train. Of course we never know whether the bull market will continue, fade slowly, or disappear. The beautiful thing about trading options is that we can adopt any type of strategy and limit our losses at the same time. No one expects the stock market to open lower by 20% one not-so-fine day, however instead of getting hurt in such a black-swan scenario, even bullish traders should be able to walk away without too much pain.

For that reason, it is important for option traders to recognize what they are trying to accomplish and to own positions for which both potential reward and risk are acceptable. Options are the most versatile investment tools around, and can be used to micromanage any investor’s portfolio. Be sure to manage risk.

    –Aggressive bulls probably own naked long calls, while others own call spreads. Either strategy may be working well — if those traders held on, or re-loaded during the end-of-January market decline. Success also depends on how skilled these traders are in selecting good options to own. Many times the traders buy options that are too far out of the money and never earn a dime.

    –There is not much we can say about aggressive bears. Unless they took a quick profit a few weeks ago, the market has not behaved well for them and the only good news is that bearish strategies come with limited loss. Any bearish trader who was mindful of the importance of risk management should be unhappy, but not financially hurt.

    –Market-neutral traders made or lost money, depending on the strategy chosen. This market may be quite non-volatile from a day-to-day perspective, yet the moves have been devastatingly large for owners of iron condor or ATM butterfly positions. However, straddle buyers and back spreaders probably performed very nicely. Once again, the choice of which specific options to trade played a big role.

Some people in the options world like to repeat the phrase: “You can use options to make money in any market; bull, bear, or neutral.” This is a true statement. However, the most important part of the truth has been omitted. The sentence should also include “as long as you position yourself correctly for the next market move.”

Regardless of your market outlook and the strategy you choose to play, please limit risk to affordable levels. The best way to do that is to be very careful when deciding the size of each position.

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Outcome or Process

One of my basic trading tenets is:

Make the best possible decision at the time that a decision must be made.

The stock market is a statistical world and both good and bad luck affect our results. However, if you constantly make good decisions and manage risk effectively, the probability of success is high.

If you are lazy about managing risk and make quick decisions, giving little consideration to which decision is likely to give the best bang for the buck, then luck — both good and bad — will play a large role in your overall performance.

We know that 90% chances do fail to come true one time in 10. Therefore even “good” or “the best possible” decisions lead to occasional losses.

This same line of reasoning appeared in a recent Barry Ritholtz article in the Washington Post..

Outcome is simply the final score: Who won the game; what numbers came up in a roll of the dice; how high did a stock go. Outcome is the result, regardless of the method used to achieve it. It is not controllable. You can blow on the dice all you want, but whether they come up “seven” is still a function of random luck.

Process, on the other hand, is a specific methodology. It is a repeatable approach to any challenge or endeavor, be it construction or medicine or investing. And you can control a process.

What kind of people are outcome-oriented? Gamblers, many (but not all) sports fans and, of course, speculators.

What about the process-oriented people? They include airline pilots, professional sports coaches and, of course, long-term investors.

Luck is ever present, but If your process is solid, if your decisions are intelligent, you are less likely to depend on a strict rolling of the dice.


2nd edition cover

2nd edition cover

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Comfort Zone

I often stress the importance for newer traders to define their comfort zones when trading. The idea is that there is so much to learn and so many lessons to think about that distractions must be kept to a minimum. Believe me when I tell you that the fear of losing money is a serious distraction.

    NOTE: Traders know that they are going to lose money on some of their positions. It is inevitable. However, being afraid that a specific position is likely to lose or that too much may be lost is a serious distraction. If you cannot sleep at night, get out of the position that is troubling you.

The best method for avoiding as many distractions as possible is to own positions that are comfortable to own. This is not as difficult as it may sound. To be comfortable with any given trade (and with the portfolio as a whole), several things are necessary:

  1. Understand the option strategy. Simply stated you understand what has to happen for the trade to earn or lose money.
  2. Know the maximum possible loss for the trade if the worst-possible scenario occurs. Yes, losing that sum would be discouraging and make you unhappy, but you must be certain that you can afford a loss of that size. NOTE: This is the loss that occurs when something unexpected happens, such as a gap opening in the market or when the company issues unexpected news and the stock price makes an unfavorable move. Good risk management technique does not allow for holding positions until the worst possible result is achieved. Good risk management requires exiting earlier.
    • —When the maximum possible loss is too large, the solution is to trade smaller position size (fewer options) or otherwise modify the original trade.

      —Make this calculation before you make the trade.

  3. Have a plan (a). Set a target profit and when that target is achieved plan to exit. Yes. You can re-evaluate at that time, but having a profit target is important because inexperienced traders who have no plan seldom know when to exit the trade.
  4. Have a plan (b). Set a maximum loss you are willing to accept for the position if and when the trade goes awry. This number is VERY different from the worst-case scenario. Good risk managers know when ‘enough is enough’ and that the original expectations for the position are unlikely to come to pass.

When you, the trader, own positions that you believe have a good chance to earn a profit and when you are sure that you do not have too much money at risk, it is far easier to concentrate on learning to trade. By remaining within your comfort zone, you can spend your time learning important lessons. For example:

    –Which option strategy is appropriate for today’s market conditions. This takes judgment that comes with experience.

    –Choosing the strike prices and expiration date for the options.

    –Making a trade plan that describes your target profit as well as the maximum loss that you will accept before closing the trade (this is not the worst-case scenario loss).

    –Watching the days pass and examining how the position makes and loses money on a daily (or weekly) basis.

    –etc. There are many aspects of trading that only come with experience. Those are the things that should occupy your thoughts. You do not want to trade any position without a sufficient understanding about how the trade is supposed to play out or else you will find it difficult to know when to hold longer or exit.

There is a lot to learn without worrying about having too much cash at risk. Nor do you want to find yourself owning a position without a good idea about ‘what do I do now’ if something unexpected happens.

Trading Outside the Zone

There reaches a point when a trader wants to grow. We all want to move beyond the beginner stage. For that to become reality, one thing must be true:

You must survive. You must still be in the business of trading. That means you did not blow up your trading account. It means that you learned how to handle and manage risk for at least one strategy. In short, you survived and are ready to continue growing as a trader.

Here are some recent ideas on expanding the borders of your comfort Zone by Dr. Brett Steenbarger

Some of the best traders I know make pushing the comfort zone a lifestyle. They will find the offbeat restaurant, the challenging vacation voyage, the stimulating theater or dance performance…

The above statement refers to very experienced, probably professional, traders. But the idea is sound. To improve, you want to expand your comfort zone. But the key point to remember is that the new trader must first survive the education process and to take things one step at a time.


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Personal Note

Every time I sit at my desk to write something, the uppermost thought is always “what can I write about that will help you, the reader.” The primary goal is options education and I have a big stack of blog posts at Options for Rookies — if you can find a way to meander among them.

I read blogs, looking for material to reproduce here. Articles on topics that are interesting to read.

I occasionally take the time to promote my written materials — but not the for the obvious reason. It is because I know that they contain information that may help others achieve a better financial future. For new option traders, The Rookies Guide to Options; 2nd edition represents my thoughts on how someone can learn to use options by understanding how they work.

That’s the rationale behind my request for questions and for suggested topics to discuss. If there is some point that you do not quite understand, just ask and I’ll do my best to clarify the situation.

The common perception is that anyone promotes his/her books is that there is money in it. And sure, I’d love to earn a living from that source. However, selling books is not the road to prosperity, unless a title goes viral. Yet, I still write, and put everything I have into them because the purpose is to serve the readers.

2nd edition cover

2nd edition cover

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I’m pleased to announce that I am writing for about.com. The material is primarily, but not exclusively, targeted to newer option traders.

Pay a visit and look around. As always, I’m available to answer your options-related questions. Suggestions are welcome.



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Trading and Logical Thinking

The truth is: we do not always reach logical conclusions.

The problem is: we always believe our conclusions are based on sound logic.

The result is: we have no incentive to look for a way of improving how we conduct our business or live our lives.

This is costly for traders. Consistently profitable traders don’t have to be concerned with this situation because they are probably making good decisions. It is very much against the odds for a trader to be ‘lucky’ over an extended period of time.

The problem is more serious for traders who earn very little, or who lose, money. The need something better. The very real problem is that it is difficult to convince people that their thinking is flawed and that their decisions are less than logical. It is human nature to believe that we think logically and reach good decisions based on that logic.

We all understand when we require lessons to learn something new. Sports are a perfect example. Individuals take lessons from professionals. Could it be true that people are so willing to accept help in improving their golf (tennis, bowling, baseball etc) skills because there is no logic involved. By that I mean they are willing to accept help in performing better in a physical endeavor than in an intellectual one.

If we cannot play golf well (and I cannot), we can take lessons that teach us to hold and swing the clubs more efficiently. We understand that holding the club correctly involves a decision. We have a bunch of possibilities and we must choose one that works. However, we cannot be expected to know how to hold the club without being shown. When it comes to trading, once we understand the concepts of a strategy, we tend to believe that we manage that strategy effectively. In other words, we believe that we are making good decisions as the trade progresses. If we are not making consistently, then we tend to assume the problem lies anywhere, but never in our personal inability to make good, logical choices.

I can also learn which club to choose for a given shot. Consider how similar this is to choosing an option strategy based on given market conditions. This is a situation in which we are willing to learn form someone else.

I can be taught the importance of follow through. And taking lessons is in no way demeaning. We accept the fact that the professional knows more than we do and willing pay for instruction. The follow through in golf is very similar to knowing when to exit a (winning or losing) trade. yet most traders prefer to go their own way and believe they are always making decent decisions.

However, when logic is concerned, people seldom admit that others are superior. This is not a matter of intelligence. It is merely the ability to sort through alternatives and make a good choice. It is personal. It feels bad when others tell us that we made a poor choice. Yet, we feel no disgrace when we are told me made a poor golf shot.

The Point

If we are not achieving good results as a trader, it may be that our thought processes are flawed. Once we believe we learned how to trade (from experience, reading, seminars, personal lessons, etc.) we believe that we are capable of executing what we are taught. We believe we reach logical conclusions, based on the available facts.

The fact that traders (just as anyone else) can have blind spots and fail to recognize the flaws in their thinking means that there is not going to be an improvement in the results until the the decision-making process is improved. That takes being aware that there may be something wrong with what we are doing, even when we cannot see it for ourselves.

We must be open to the idea that each of us is completely unaware that we believe some things that are just not true.


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Managing a Losing Trade

There is more than one way to look at every situation. My individual perception may be different from yours. Part of the time there may be room for interpretation because the ‘facts’ are soft and may be considered from different points of view. At other times, the facts are undisputed, but people have different interpretations. Here is one example.

Do you have a loss?

Let’s look at a simple situation. You invested $10,000 in the stock market. Today you can sell those positions and collect $7,000.

Question: Did you lose $3,000?

I find it quite surprising that many people believe that they did lose money while a segment of the population believes there is no loss yet.

Yes, there has been a loss

Here’s how I look at it:

    –The market values this item at $7,000.

    –If the account is with a broker, you may only borrow money based on that $7,000 valuation. Your belief that the stock in your account is worth $10,000 is imaginary.

    –If you receive a margin call (based on a loss on a different investment), your broker will show no tolerance for your argument that the account is really worth $10,000 and that it’s not fair to value it at $7,000.

    –If you want to withdraw cash from your account, your broker will not allow you to take more than $7,000 (assuming 50% margin), even though you believe they should let you take $10,000.

    –If this were a house and not stock, your bank would not give you a $10,000 mortgage based on your estimated valuation. They would base the loan on a $7,000 valuation.

Pretty much the whole world recognizes that an investment may have been worth $10,000 at one time but that $3,000 has been lost and the current value is only $7,000.

No, there is no loss (yet)

The argument in support of believing there is no loss is this:

    –If I don’t sell my asset, I cannot have a loss.

    –A loss only occurs after I exit the trade and have no chance to recover

The large group of people who accept those arguments do not recognize reality. This is important to us because it affects how we think — and thus, how we act.

Almost all traders accept the truth that managing risk is an essential part of being a successful trader. Those traders also share the opinion that it is unacceptable to incur a large loss and that it is necessary to take some defensive action when a position is losing money and has become too risky to hold. That defensive action is (more often than not) to exit the trade, take the loss, and move on to another trade when the time is right.

However, people who believe that they have no loss currently (even though they may admit to being at risk of losing money) may stubbornly refuse to take defensive action. If they believe that closing the position is the act that creates the loss then they will hold onto risky positions, hoping that the loss will disappear. The reason this is a very poor way of thinking is that they tend to hold bad positions when successful traders understand the importance of getting put of losing trades (accepting the fact that the money has already been lost) and reinvest (at the proper time) the money into a better (less risky, more chance to earn a profit) trade.

The innocent-sounding mindset that has people believing that a loss is not a loss until it becomes realized (i.e., position closed) keeps them locked into less than satisfactory positions. And that cannot be good for long-term results. Then there is this point: If the position does recover and the $3,000 loss disappears, they feel vindicated and ignore the fact that other positions would have earned double or triple that $3,000 over the same time period.

Rethink your position if you believe that a losing trade has not yet ‘lost’ money.


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