Author Archive | Mark D Wolfinger

Risk and Position Size

My latest blog post at options.about.com is all about risk, including a definition and recommendations for choosing an appropriate position size for each trade.

2nd edition cover

The Rookie’s Guide to Options: Intrdoduction

This is an excerpt from the Introduction to The Rookie’s Guide to Options.

You are about to enter the exciting world of stock options. These versatile investment tools possess properties not found elsewhere in the investment universe: limited lifetimes with explicit expiration dates. Options were invented as hedging, or risk-reducing tools, allowing specific risks (described by the Greeks) associated with owning any position to be identified. Thus, each risk factor can be controlled to suit your needs.

Options allow investors to use leverage to take control of far more valuable stock positions with less cash at risk.

Options are versatile and can be used in a variety of strategies, ranging from ultra conservative to outright gambles. I encourage readers to adopt strategies between the extremes.

It is possible to use advanced mathematics when discussing options, but in keeping with the goal of making this an enjoyable learning experience, this book uses nothing more complicated than elementary algebra. Let’s leave the advanced math to the academics.

Equity options are related to stocks. The term used to describe that relationship is derivative. The value of an option is derived from the value of an individual stock or group of stocks (an index). If this sounds complicated, it is not. Computers and calculators do the math for us, and our job is to understand how to use the numbers — just as we learn to use any tool.

This book delivers the background information needed to understand why options do what they do. Note that key word: ‘understand.’ I’m not going to define a term without explaining how it relates to trading options. I’m not going to tell you how to open a trade and then leave you stranded. You will learn to open, manage and exit positions. I do not provide rules to follow. Instead, you get detailed explanations and suggestions that enable you to make your own decisions.

The book contains a great deal of background information (Part I), lessons on three basic strategies (Part II), as well as explanations of how to adopt more advanced strategies (Part III).

These lessons are designed to help you use options effectively. That means trading with less risk, increasing the frequency of winning trades, and earning more money (when compared with trading without options). There is one important point: both the basic concepts and basic strategies are easy to understand. As with any other endeavor, the more sophisticated you become, the more you can do. Consider this book to be your college level course—perhaps even an elective course. However, it is not graduate school. Option trading can get very sophisticated and today’s top experts are quants with a PhD in math or physics. The good news is that you do not have to compete directly with them. Option trading is so widespread that there is ample opportunity for everyone.

If you want to become an expert trader, this book will not get you there. However, it is an excellent starting point. And if your objective is to enhance your income by generating earnings with less chance of suffering large losses, then you have come to the right place. You do not have to compete with the professionals. Most of us can succeed by adopting the most basic strategies —if we have the discipline to manage risk. While I appreciate advanced strategies, I use only the methods discussed in this book when trading my personal money.

This guide takes you from the novice stage through the intermediate trader stage. Although intended for option rookies, there is enough meat in The Rookie’s Guide to Options for the investor who already trades options. Re-reading these pages as you gain experience will provide insights you may have missed the first time.

My objective is for you, the reader, to gain a solid understanding of options and learn to use them to improve your investment results. You will not learn everything there is to know about options, but, you will be prepared to trade profitably. If we each do our jobs well, you will come away with a clear understanding of options—how they work and how you can make money by incorporating option strategies into your investing methods.

Be prepared for discussions on risk, including definitions (how much money can be lost vs. the probability of losing), setting risk limits (position size), using calculators to discover the odds that something specific will go wrong (stock doesn’t move your way), etc. Included are ideas on how to handle risky situations. Is it better to get out of the trade or use an ‘adjustment’ trade that reduces risk to an acceptable level (compared with the potential reward)? These are all part of risk management, and included are my thoughts on why survival should be any trader’s top priority. Earning money is important—in fact it is our reason for trading—but it ranks behind risk management, unless you plan to have a very short trading career.

Rookies

In the sports world, a rookie is someone in his/her first year of professional play. The term also refers to someone who is new to a profession. This book was written for newcomers to the world of options—not necessarily investment rookies, but option rookies. The strategies detailed are not the only ones available, but they were chosen because they can be understood and put into practice by traders who have patience and discipline. I stress discipline throughout the book because without it you have almost no chance of becoming a successful trader. Most investors who enter this realm are familiar with stock investing from the standpoint of owning individual stocks (mutual fund ownership does not count, but ETF trading does). If that is your experience, it should be a smooth transition when you add options to your arsenal of investment tools.

If you are brand new to investing, then you have more to learn. However, the good news is that you can get started without having formed any difficult-to-break bad habits.

I just posted four articles on various aspects of trading calendar spreads. They can be found at options.about.com

Volatility and News

Although I am a believer in using options to hedge positions and reduce list, there is no doubt that there are many speculators who use options.

The purpose of today’s post is to warn those speculators about a dangerous trap — one that can be avoided.

News Pending

When a news release is pending, option volume increases because the news may result in a gap opening for the stock price (when the news is better or worse than expected). That is when option buyers make good money — assuming that they got the direction right.

However, there is much more to trading options under these circumstances than the novice trader can anticipate. That option volume pushes prices higher and you cannot pay whatever price is asked when buying options. At least you cannot do that and expect to succeed.

The discussion continues with a description of how implied volatility is crushed once the news is released. If you are not familiar with the concept that the price of options in the market place is very dependent on implied volatility, take a look here and here.

One method for significantly reducing the cost of playing this game is to trade call or put spreads instead of buying individual options.

http://goo.gl/LksvAg

Equivalent Positions

It may sound simplistic to say this, but it is important for rookie traders to have a good feel for the positions they own. Of course everyone sees his/her specific position, but many times the investor has a better feel for the risk/reward profile for any position by looking at it from an alternative perspective.

For example, the simple collar position seems to be a nice, safe, conservative position. And it is. However, if you own such a position, I believe that looking at it from a different perspective would give you a clear picture of the position that you “really” own.

Collar Example

Long 100 shares of XYZ, currently trading near \$100 per share
Long one XYZ May 95 put
Short one XYZ May 105 call

Equivalent position: Short one put spread

Long one XYZ May 95 put
Short one XYZ May 105 put

If you are not yet aware that owning a collar is equivalent to being short a put spread, read the discussion and proof at my about.com site.

In my opinion, when you look at a position that shows which put you are short, you have a good understanding of how the position loses money: Obviously when the stock price declines from its current level (\$100). Although the collar owner may be similarly aware of risk, it is possible that the 3-legged spread is too complex and the true risk/reward picture may not be clear.

The reason this concerns me is that investors who would benefit from using collars tend to be stock investors who adopted the collar to gain some portfolio protection. They are not typically “traders” who use, and understand, how options work.

More than Collars

My emphasis is always on education for newer option traders, and the importance of understanding how some positions can be equivalent to others is a topic that is worth repeating.

http://goo.gl/7ANuCF

Covered Call Writing

Writing covered calls is a popular strategy among newer option traders. One excellent reason is that it smooths the transition for a stock investor who is expanding his/her investing methods by entering into the world of options.

Covered call writing (CCW) is one method for reducing risk when owning stock, but it comes at the cost of limiting profits. Here are my thoughts on why someone may want to adopt this strategy. It includes both pros and cons.

It is very easy for us to think about a trade: make the trade, wait a while and then take our profit or loss.

It is very beneficial for us as traders when we have a good record of the thoughts that went into our decision-making process as well as the results of the trade. When we return to read our journal entries, we are removed from the time and place of the trade and can analyze the results as if the trades were made by another trader. We can learn from our past decisions.

The objective is discovery

• Was your reasoning sound? Or did you make a poor decision?
• Recognizing that you made a bad choice, you should be able to understand what went wrong and how you can avoid a similar mistake in the future
• Did you choose a strategy that was appropriate at the time, or did you take a shortcut and rely on using your bread-and-butter strategy without any real thought?

• Were you just lucky and earned a profit despite making errors?
• Is there a lesson to glean? Is there something you want to be sure to repeat next time?

Was the trade a money loser?

• Did you make a mistake? What was it? Did you ignore risk management?
• Many times, the trade was unlucky. Was that true in this example? Be honest.

Trade plan example: Writing Covered Calls.