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Question & Answer #2. How long does it take to be profitable?

On
June 17,
2008
George posted this question: “How long is the learning curve to using
options, and when can I expect to become profitable?

Hello George,

It’s important to understand that not
everyone who uses options does so to make money. Sometimes options are used as insurance to
protect the value of a stock market portfolio. As with other types of
insurance, that protection costs money and there are no profits.

 

But let’s assume you want to learn to adopt option
strategies to make some money.

1) The learning
curve. It doesn’t take very long (less
than one hour) to get a good understanding of what an option is and how an
option works. Thus, an investor can easily grasp the fundamental concepts of
options. But, it does take longer to fully understand one or more of the
possible strategies you can use.

There is no single best strategy for
everyone, but I recommend that you begin with covered call writing because it’s
the option strategy that is most similar to what you already  know: how to buy and sell stocks.  More importantly, this strategy is less risky
than simply buying and holding stocks. There are various places where you can
learn how to adopt  this
strategy. Of course, I recommend my
book, The Rookie’s Guide to Options, but if you search the internet, you will
find alternatives.

Once you have some practice using this
method – either with real money or in a paper trading (practice) account, you
will be ready to consider alternative methods –  strategies that involve reducing risk even further.

As to how long will it take to be
profitable using covered call writing, the answer is: how good are you are
picking stocks? Covered call writing is
a bullish strategy that increases  your
chances of earning a profit from every trade. But if you are a poor stock
picker, or if the market tumbles, you will not do well.  But fear not – there are other strategies that  cater to poor stock pickers and bear
markets. You may prefer to learn one of those instead.

2) When
profitable? Adopting the option
strategies that I recommend (and that does NOT include buying options) is
nothing like day-trading stocks. You don’t have to read charts (although it can
be helpful) or time the markets. These strategies involve holding positions for
anywhere from two weeks to a few months. If you choose strategies in which you are predicting market direction,
then your profitability depends on how skillful you are at knowing when markets
will rise and fall. If you choose strategies (recommended) that are market
neutral, you will do well most of the time, running into trouble only when the
market makes a big move. If you learn to
manage risk – an essential part of your education – you will be able to handle
problems when they arise.

Bottom line: You can be profitable from the
start of your option trading career. In
fact, if you adopt my recommended methods you will
profit most of the time. To be a
successful trader, you must be certain that you also learn how to manage risk
and keep all losses small enough to not overwhelm profits. Risk management is an important topic and
requires more time to learn than it takes to master a few option strategies.

Remember, you have your entire lifetime to
trade options. Have a little bit of
patience and begin by trading with fake money in a paper-trading account. When you feel confident that you understand
what you are doing, it’s time to trade with real money. Best of luck to you.

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Question & Answer #1. Rolling a losing credit spread

Don posed this question: ‘Regarding
credit spreads, if one is in the money on a current position, and no light is
at the end of the tunnel, is there a rolling technique for credit spreads or is
it best to close it and open a new spread with enough credit to cover the loss?’

This question is for more
advanced option traders, but to clarify for readers who are new to
options:

 A credit spread
occurs when you sell a call option and buy a less expensive call option (that is, a call option with a higher
strike price.). Both options have the
same expiration date and are on the same underlying asset. Example of a call credit spread:

Buy 1 IBM Oct 110 call

Sell 1 IBM Oct 105 call

A put credit spread is formed when you sell
a put option and buy a less expensive
put option (that is, a put option with a lower strike price.). Both options have the same expiration date
and are on the same underlying asset. Example of a put credit spread:

Buy one SPX Jan 1400 put

Sell one SPX Jan 1410 put

Note that an
option is described by four items:

o The symbol of the
underlying asset (IBM or SPX above)

o The 3-letter
abbreviation for the expiration month

o The strike price

o The option
type; call or put

 

Back to the question:

When
you sell a credit spread, it’s a losing situation when one, or both options
move into the money (that means the stock price is above the strike price of
the call option sold, or below the strike price of the put option sold). In these situations you have two choices:

  • Do nothing and hope the stock or index (underlying
    asset) changes direction.
  • Adjust the position (that means changing it to reduce
    risk), accepting the fact that you currently have a loss.

The
winning strategy over the longer-term is to take action. That means to close all or part of the position
before the loss becomes so large that it wipes out months of gains. Some traders would not wait as long as you,
Don, and would close the position before it moved into the money. The decision of when to close the position is
not easy to make because no one likes to lock in a loss. And there is no ‘best’ time to make it. Each trader should have a comfort zone – and when
any trade moves out of your comfort zone, that’s the time
(probably past the time) to adjust the position.  If you are worried about a position, it is out of your comfort zone.

However,
closing the position must be done to
prevent taking a much larger loss
. One secret to making money with options is to avoid taking large losses. It’s acceptable to take small losses when necessary,
because you will make money most of the time when you follow the strategies
recommended in The Rookie’s Guide to Options. Lots of gains and some small losses lead to success. Lots of gains and some huge losses lead to
failure.

As
far as rolling goes (rolling means closing one position and moving into another
position, with options that are further out of the money and with a later expiration date), do that ONLY if you still feel comfortable establishing a new credit spread in the same underlying. If
you do want the new position, then roll. If you want nothing more to do with
this specific stock at this time, then take your loss, do not roll, and move
on.

One
further point: It is not essential to collect ‘enough credit to cover the loss.’ Open a new spread that allows you to be
solidly within your comfort zone. Do not
roll the position to place yourself in jeopardy again.  Rolling is really two separate
decisions: Do I close my current
position, and if the answer is ‘yes’ – ask: do I want to open a new position. If ‘yes’ again, then roll. If ‘no’ then simply close and move on to your next trade.

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What Is an Option?

I love trading options. My goal is to interest you in using options to make your investing more enjoyable, more profitable, and less risky.

I’m not trying to sell newsletter subscriptions or encourage you to buy costly software. This blog is for options education and discussion. If want to know more about me, look here.

Please participate by posting questions and comments or send e-mail, and together we’ll build a blog where option rookies gain enough information to trade confidently and profitably. Remember, I offer no get-rich-quick schemes. I believe in education – and that means I want to encourage visitors to understand how options work before investing their money. Rookies can open a paper-trading account with a broker and temporarily trade options without using real money.

Let’s get started.

The options world has its own vocabulary – something I refer to as Optionspeak. When I mention a word or phrase whose definition may not be clear to you, I’ll highlight the word and include a definition below. Here’s a more complete
glossary.

An option is a contract between two people:  a buyer and a seller. The price the buyer pays to the seller is called the premium.
 
When an investor buys an option, he pays the premium, and in return, accumulates some rights. Those rights are temporary and expire on a date specified in the contract.

 

When an investor sells an option, she collects the premium, and in return, accepts some temporary obligations.

There are two types of options: Calls and Puts

A call option gives its owner the right to buy 100 shares of a specific stock (called the underlying
asset
) at a specific price (called the strike price) for a limited time (until the expiration date).

A put option gives its owner the right to sell 100 shares of a specific stock at a specific price for a limited time.

If an option owner elects to buy (sell) those shares, the option owner is said to exercise the option. More on this topic soon.

That's all there is to it.  Options are easy to understand – and you have been using them for years.  Did you ever go to a store to buy a sale item, only to discover that the item was out of stock?  Did you get a rain check from the customer service department?  If yes, then you are familiar with options, because the rain check is a call option.

That rain check gives you the right to come back to the store to buy that sale item (underlying asset) at the sale price (strike price). The rain check has an expiration date, after which it is no longer valid.  The supermarket gave you that rain check at no cost. Thus, you “bought” the option by paying a premium of zero.

Consider an automobile insurance policy.  When you pay the premium to buy collision insurance, you are buying the right to sell your car (underlying asset) to the insurance company for the strike price (the amount for which the car is insured) if it's “totaled” in an accident – as long as the accident occurs before the expiration date. Thus, the insurance policy is similar to a put option (there are subtle differences).

When we use options in the stock market, the underlying asset is 100 shares of stock. 

Today’s optionspeak terms:

  • Expiration Date – the date, after which the option is no longer valid
  • Underlying asset – the item that the option owner can buy or sell
  • Strike price – the price at which the underlying asset can be bought or sold
  • Premium – the price paid for the put or call option
  • Call Option – a contract that gives its owner the right to buy the underlying
    at the strike price
  • Put option – a contract that gives its owner the right to sell the underlying
    at the strike price
  • Exercise – The act by which an option owner does what the contract
    allows. The call owner exercises the
    call and buys 100 shares of stock, paying the strike rice for each share. By exercising a put option, the investor
    sells 100 shares at the strike price.
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Free eBook: The Rookie’s Guide to Options

I’ve made a free e-book available for download – and you don’t
have to register to receive a copy.

It’s an abbreviated version
of The Rookie’s Guide to Options and contains

  • Table of Contents

  • A brief excerpt
    from each chapter

  • An afterword

You may freely use this e-book. You can post it to your blog or website or
send a copy to anyone via e-mail.

Take this opportunity to get a glimpse into the world of options.

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Recommended Option Strategies

When I discuss option strategies on
this blog, the emphasis will be on making money and managing risk.

The following are the methods I
recommend for investors who already understand how options work.  For
rookies, I recommend the same strategies, but it's important not to begin
trading any of them without first gaining a good understanding of how each of
these strategies works and what you are trying to accomplish when you adopt
them.

  • Covered call writing
  • Cash-secured naked put selling
  • Collars
  • Credit and debit spreads
  • Iron condors
  • Diagonal, and double diagonal, spreads

As I continue to write this blog, I'll
offer tips on each strategy and reply to your questions.

For readers anxious to learn much more
about these methods more quickly, my newest book The Rookie's Guide to Options teaches you (in
detail) how to use each of these methods.

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Why You Should You Care About Options

If you want to learn about options and the advantages of using them
as part of your investment program, then this is your blog: Ask questions,
suggest topics for discussions, post comments.

Let me introduce myself. My name is Mark Wolfinger and I was a market
maker at the Chicago Board Options Exchange (CBOE) for 24 years, beginning in
1977. Over the past eight years, I’ve
been teaching individual investors how to use options conservatively to make
money and to reduce the risks
associated with investing in the stock market. I’ve also written
three books and numerous magazine
articles
.  You can
learn more about me
here.

I’ve learned a great deal of practical information about options
over the past 30 years, and the goal of this blog is to share some of that
information. I strongly believe that:

  • Investors who own stocks or
    mutual funds – people like you – can benefit by adopting conservative option
    strategies
  • Options were invented as
    risk-reducing investment tools, and not as toys for gamblers
  • It's easy to begin using options

p  Option strategies can be used
successfully by people who have little time to devote to their investments (but
those who have more time can achieve even better results)

Many of you may have heard that options are strictly for gamblers,
but that’s not true. If your stockbroker
feels that way, it’s time to change brokers. Sure, you can gamble with options, but I’ll try to convince you not to
do so.

I will not be offering any get-rich-quick gimmicks. I don’t guarantee profits, but if you adopt
one or more of the strategies I recommend on this blog, your chances of making
money are going to be better than if you simply buy and hold a stock (or mutual fund)
portfolio. 


If you are interested in
learning how options work, I’m here to help.

One rule: I won’t be making any stock market predictions or recommending
specific investments. Instead, I’ll help you understand options and how to use them effectively.  I’ll discuss different strategies and answer
your questions. 

Today, many professional traders, mutual funds, hedge funds, and individual
investors use stock options and trading
volume establishes new records year after year. Yet, there are vast numbers of
investors who remain unfamiliar with these versatile investment tools. If you are one of them, or even if you already understand a little about
options, this blog will provide useful information.

In future posts, I’ll write about stock volatility and why it’s so
important when trading options. If there
are other topics you want to see discussed in this blog, please post a comment
or question.

Returning to the title of today’s post, you should care about
options because they are useful investment tools that can help you achieve a
successful financial future.  As you
learn more about them, you can decide if options are appropriate for you.

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