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How Should a Beginner Approach Option Trading?

The following question seems rather tame, but it addresses a very important issue:

Is there a correct syllabus for new option traders?

Hello Mark,

I’ve just starting to read your Rookie’s Guide book, bought from Amazon. I also read several other options books, while doing my paper trading with OptionXpress with thinkorswim platform.

I also have joined an options course and what they teach are very basic, which is just Buy To Open (Call / Put) and Sell To Close (Call / Put) and pay attention to the candlestick chart for entry point. So making profit from that simple strategy. What do you think of that strategy? They didn’t teach any strategies mentioned on many options books.

Candlestick Charting

Candlestick Charting

But after reading couple of books on options, they all teach the Covered Calls as basic strategy, which from my understanding that one investor has to have real stocks in order to make the options trading. Do I need to buy real stocks? Is that true?

How about if we only open an options account, and didn’t have a real stocks to trade in that Covered Calls strategy? And why I can’t trade the Covered Calls in optionsXpress? Please help me.

Thanks in advance,
Aldo Omar

Paper trading is an excellent idea. It teaches you how to handle your broker’s platform and it gives you experience learning to make critical decisions — entering and exiting positions.

However, this course is a disgrace, in opinion. I do not care how respectable the course giver is, but these lessons are almost guaranteed to see their students go broke when using options. Unless they explain that the course is designed only to teach you something about options and that “buying to open and then selling to close” is NOT a strategy that you ever want to adopt, they are doing you a great disservice. I hope this course is free because it is not worth even that much.

  • First; A trader, and especially a new trader, cannot be expected to know how to use Candlestick charts. It is extremely difficult to “pay attention to” charts and come away with useful information. Think of this way: Candlestick charting is well-known and used my millions of traders around the world. Despite that, the data is clear: The average individual investor does worse than the S&P 500 index. The average mutual fund manager — someone who ears big bucks to pick winning stocks and beat the market averages — cannot beat the averages. Do not get trapped into believing that you can read one or two books on charting and know how to sue the charts. My conclusion is that it is far more difficult to pick entry points than your course teachers suggest.
  • Second; You are learning the simplest of all strategies, and that is a good thing because one should begin with the most basic concepts of options. However, it should have been mentioned as often as possible that buying to open and then selling to close is a death wish. Unless you (A. O.) have a proven track record of predicting which stocks will rise and fall, then you must not — for your financial well being — believe that you can suddenly start trading options and become a successful stock picker. Life does not work that way and using Candlesticks will not turn you into a successful stock picker. The professionals cannot predict stock direction on any consistent basis, and neither can you
  • Third; Even if you work diligently and learn to read the charts successfully, there is more to “buy to open” than simply picking a stock and correctly forecasting the direction of the stock price. Did they teach you that buying out-of-the-money options is not a viable strategy? Did they teach you to pay attention to the implied volatility of the options? In fact, did you learn anything at all about volatility and how crucial it is to an option trader? I assure you of this: If you but out-of-the money options and if you buy them when their prices are relatively high, you will ruin your trading account, even when you get the stock direction right. My advice: If you are going to play the “buy to open” game, at least stick with options that are already several points in the money when you buy them.
  • Fourth; I know that advanced strategies cannot be dumped into the lap of a beginner. Building a sound foundation in option basics comes first. But that is no reason to teach a strategy where the vast majority are guaranteed to fail.
  • Fifth; Yes, covered call writing is a sound basic strategy and yes, it does involve the purchase of stock (in multiples of 100 shares). However, it is still a bullish strategy and the covered call writer can still lose a lot of money if the market takes a dive. Obviously you lack the cash to buy stock. That is okay because there are other ways to use options to generate exactly the same profit/loss profile as writing covered calls. You will get to that in Chapters 13 and 14 in the book that you are reading (The Rookie’s Guide to Options; 2nd edition).
  • Last; The whole idea about using options is to hedge (reduce) risk and still give yourself a good probability of earning a profit on any given trade. Buying options based on Candlestick chart reading is not one of the paths to success. Sure some people can do it, but you don’t want to count on being one of them. Covered call writing is “better” for the new trader – but only when he can afford the downside risk. However, there are other strategies that I would recommend for you. At the top of the list is “credit spreads.” But please have patience. Don’t jump to the chapters on this and related strategies. Go through the lessons at your own pace and if possible, resist the temptation to trade until you feel comfortable.

Aldo,
I hate that course and the sad fact is that this is popular stuff taught by many people.

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Q & A. Weekly’s Put Spreads and Straddles

Two ideas from a reader.

Mark,
I think vertical spreads (bullish put spreads )would be the way to go. Especially on the Weeklys. Find a stock or etf that barley moves, and make sure u sell the profitable side before expiration, and let the loosing side expire… It’s a no brainer for streaming income…

OR buy straddles or strangles during earning season, and only buy highly volatile stocks…same as above.. Close out the winning side and let the other expire worthless.. Better chance using these strategies to make $ than many other strategies .

Bill

Hi Bill,

I agree that vertical credit spreads represent an excellent opportunity to make money with limited risk — as long as position size is appropriate.

However, reality is not quite as simple as you describe it. For one thing, it is difficult for the inexperienced trader to earn income as a straddle buyer.

Vertical spreads

  • Weeklys options tend to be low priced, and that makes the available premium small.
  • If you use stocks or ETFs that “barely move” then the option premium will reflect the non-volatility of these stocks. Translation: very small premium with very little profit potential. We each have out own idea of how much credit to accept for a 5- or 10-point spread, but I do not like the idea of accepting only $0.05 or $0.10, even though the odds of having a winning trade are high.
  • “Close out the winning side” and allow the other to expire worthless is not viable, in my opinion.
    1. When selling credit spreads, the usual practice is to sell OTM options — with the hope that all options will expire worthless. Thus, there is seldom a “winning side.” And when there is, the other side will not be too far out of the money and carrying it naked short is far too risky.
    2. Selling one side leaves the trader with a naked short position. Although a reasonable strategy for the experienced trader, I strongly discourage newer traders from owning naked short positions. When the option is a call, most brokers will not allow their customers to own such positions because (in theory) the potential loss is unlimited.
    3. I like the idea of no-brainer strategies as much as anyone, but in the trading world, these strategies rarely occur and most fall under the umbrella of “arbitrage.” For me, this plan has a small possibility of causing a giant loss (after selling your long option), and that takes it out of the no-brainer category.
  • When trading Weeklys, instead of adopting your suggested approach, I’d prefer selling the options naked in the first place, rather than buy the spread and then sell the long option 2-3 days later. I’m not recommending this plan, but if position size is small, it should work better – especially when the premium for a spread is so little.

Straddles

Buying straddles in earnings season is a high-risk play. It can work, and one advisor whom I know has done very nicely with this strategy. But it is mandatory to do your homework. The timing of the purchase (never at the close of trading when earnings will be announced prior to the next day’s opening) matters. Some stocks lend themselves to the straddle play better than others. Again do your homework.

It is very acceptable to sell the winning side, but in my opinion, that sale should be made sometime near the opening of trading. NEVER enter a market order; and especially not at the opening. Always use limit orders. You bought an option at high volatility and you cannot afford to hold and allow residual time value to decay. Do not turn this into an investment.

Yes, you can allow the non-winning portion of the strangle to expire worthless, but I believe that it is far better to sell it at the same time that you sell the winning portion of the trade. Of course, I would not sell for as little as $0.05 or $0.10 (because miracles do happen), but $0.50 is real money when trading straddles and you cannot simply allow that cash to get away.

One more point: When the earnings news is right on target, your straddle will lose a lot of value. Accept that and dump the position before IV collapses even more than it did at the opening of trading.

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Selling put spreads. A new wrinkle

Mark,
I did a bull put spread- just 2 contracts.
Bought GILD 7/16/2011 38 P
Sold GILD 7/16/2011 40 P

This is the first put spread I have ever done. I’d like to make sure I understand it.
[MDW:This is something to do before you trade, but let’s be certain that you understand NOW]

I own the 38 puts. So if the stock falls below 38 I can sell it.
[Yes. But remember that you bought it as protection to limit possible losses. You can sell that option any time before the close of trading on Jul 16, and the stock does not have to be below 38]

This lowers (limits) my potential loss on the spread to $2 per share if the stock plummets.
[The maximum value for that spread is $2. But don’t forget to deduct the premium collected when selling the spread: Your potential loss is reduced by that premium]

I sold the 40 puts, so if the stock falls below 40 I am obligated to buy it. It is a bullish trade, so I am believing the stock will be above 40 by the expiration date.
[I know what you mean, but for clarity, it is not ‘by’ the expiration date that matters. It is ‘at expiration,’ or the closing price on the 3rd Friday of July. That closing price determines whether the put owner will exercise and force you to honor that obligation.]

If the stock is above 40 at expiration the puts expire worthless and I keep the credit I received (net credit 38 cents per share).
[Yes. That cash is already in your account. And it is yours to keep NO MATTER WHAT HAPPENS. You may decide to spend some cash to repurchase the puts (I know you won’t, but theoretically speaking). But that 38 cents is no longer relevant. It is yours forever]

If the stock is between 38 and 40 the 38s will expire worthless and I will be assigned the stock. That is fine, I am getting it at a reduced price and I like the stock; OR CAN I SELL TO CLOSE THE 38s?
[The price reduction is ONLY the 38 cents credit collected earlier. That’s not much of a price reduction.

[You may sell the 38s at any time before the market closes on that 3rd Friday, if anyone is willing to pay something to buy them]

[With your emphasis on selling the 38 puts, I believe you are adding a new wrinkle to spread trading – keeping the shares. That’s worthy of further discussion – keep reading]

If the stock is below 38 what is best strategy? Since I like the stock I should allow the stock to be assigned to me, and then sell the 38 puts to close (before expiration).
[‘Best’ is not easy to define. In your scenario – keeping the shares, then selling the puts is a very unusual choice because the vast majority of those who trade put spreads have no interest in owning (or selling short) stock. They trade spreads with the intention of earning a profit. There is seldom an interest in owning shares. Thus, the question remains: why did you buy the 38s?]

    This reply arrived via e-mail:
    This is a bit of a hybrid. Given that I am willing to own stock, doesn’t owning the 38 puts provide some protection? Also, if the stock is below 38 near expiration, the 38 puts have value and I could sell them, thus reducing my cost basis for buying the stock?

[Yes. You are correct. Owning the puts provides protection – for a limited time. But that protection is NOT cheap.

Yes again. Selling those puts lowers the cost basis. However, not buying the puts in the first place lowers your cost basis even more (except when the stock moves well under 38) on those occasions when you do buy the shares via being assigned an exercise notice.

Traders who sell naked puts – don’t seek only that short-term trading profit. They are willing to own the shares at a better price (when compared with the stock price at the time the puts were sold) – and almost never buy protection.

You are doing both. You want to own the shares and you prefer to own protection. There is nothing wrong with that. I believe it is always a good idea to limit losses.

However, you are new to options and I want to be certain that you recognize the cost of owning puts as protection. Bottom line: It is expensive. The big question – and perhaps it’s something you have not yet considered – is: What are you going to do for protection after July expiration?


Example: If you own 100 shares and buy one 38 put (two month lifetime), paying $1, then the stock price must rise by more than $1 before you earn any profits. If you buy those puts every other month, then the stock must rise by $6 or 15% every year for you to overcome the cost of the put protection. It’s not so easy to find stocks that rise 15% per year, and when an investor does that, he/she deserves to make some money, not spend that 15% on insurance.


[This is not the place for details, but if you own stock plus puts, that is
equivalent to owning calls – with the same strike and expiry as the puts.] Do you truly want to own calls rather than stock? The answer should (in my opinion) be NO, unless the calls are significantly in the money.

997


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Legging into Spreads

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
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Lock in the Profits

Some recent comments have focused on the decision of when to exit a successful trade – a trade with limited profit potential.

Note. This means we are not discussing a situation in which you own some calls (or puts) and the market is going your way. You either go with the trend, take some money off the table, or exit. I can offer no guidance in that type of situation. What makes that so different is that potential profits remain unlimited.

When profits are capped, things are different.I assume that almost every trader who sells a credit spread or a naked option has some price at which covering makes sense. If a trader sells a 60-day call spread, collecting $2.00 and the position can be closed one-week later by paying 10 cents, that almost all traders would happily pay that dime. Fifty-three days is a long time to hold a spread when the most that can be earned is $10.

It’s a different story when expiration is three days away and the short call is still OTM by 5% of the stock price. For the vast majority, paying even $0.05 to cover seems too high.

Do you accept those premises?

If you agree with my conclusions in the two paragraphs above, then there must be some combination of price and time that is an inflection point. Translation: There is some time element, combined with the cost of exiting, that makes the decision a toss-up.

I know that I will pay 15 cents for a 10-point spread (underlying asset = RUT, Russell 2000 Index) even when it is one week prior to expiration. And I’ll pay 10 cents after that. I seldom collect the last penny.

I also pay twenty cents to cover almost any position when it is not a front-month spread. In fact, I’d probably pay $0.25. The point is that I have a price I am willing to pay that depends on how wide the spread is (how many point separate the long and short legs), the nature of the underlying (an $800 index is not the same as a $30 stock).

I don’t believe that traders must have such pre-determined exit points. Risk management decisions are personal and individual. However, I do believe it’s a good idea and I recommend knowing where you would like to exit. Such information can be part of the original trade plan.

From my perspective, it is better to lock in the profits when there’s not much to gain by holding. To others, every penny is valuable and they cover only when they believe it’s the correct move.

933
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Trader’s Mindset Series: Oblivious to risks

Here’s one of the most perplexing risk evaluations I ever heard (read) from a seller of naked options:

I was never in any danger. The stock was always higher than the strike price of the puts I am short.

This person was convinced that the only time risk must be considered occurs when short options move into the money. If the options were out of the money, and remained OTM, then the options would expire worthless and the seller would have a tidy profit.

I can’t argue with the 2nd sentence. Options that are OTM once expiration day has come and gone are worthless.

However, that mind-boggling first sentence is believed by more people than common senses would suggest.

Once of the basic truths about investing (even when it would be more truthful to refer to it as gambling) is that some people with little experience believe that it’s easy to make lots of money in a hurry. I don’t know why that’s true, but the fact that skills must be developed over time is a foreign concept to such believers.

photo:scopeformoney.com

Confidence that a current investment will eventually work out is common. Stocks decline and many investors like to add to their positions, increasing their risk in a losing trade. The mindset is that the stock only has to rally so far to reach the break-even point. For example, buy 1,000 shares at $50, then buy 1,000 shares at $40 and the beak-even is ‘only’ 45. Add another 1,000 shares at $30 and the trader’s mindset is that this stock will easily get back to $40, the new break-even price.

There is no consideration for the possibility that this company will soon be out of business. This investing newcomer just knows that his original analysis must be correct. This is the mindset of overconfidence. In a situation such as this, it’s also being oblivious to the real world.

The naked put seller

The put seller described above believes that being short an out of the money option is of no concern, as long as it remains OTM. He just doesn’t get it. The possibility of losing a significant sum is staring him in the face and he truly doesn’t recognize the danger.

I’m not suggesting that this oblivious mindset is common. However, as option traders we must be careful to avoid that mindset. I’m sure that every reader here understands the risk of being short naked options. However, being oblivious to other risks can result in a disaster. How large of a disaster? That depends on just how blind the trader is to the true risk of a position.

The spread seller

As an example, let’s look at a trader’s whose preferred strategy is to sell OTM put spreads, rather than selling naked puts. This is a common strategy for bullish investors.

Let’s assume that one trader correctly decides that selling 10 puts with a strike price of $50 is the proper size for his/her account. Even oblivious traders understand that the maximum loss is $50,000. They also recognize that the chance of losing that amount is almost zero, and that it is difficult to know just how large the maximum loss is. Sure, a stop loss order can establish that limit, but stocks have been known to gap through a stop loss, leaving the trader with a much larger loss than anticipated. The ‘flash crash’ was an extreme example of how bad things can get.

What happens when this trader decides that selling naked puts is no longer the best idea and opts to sell 5-point put spreads. Each spread can lose no more than $500 (less the premium collected). The problem arises if the trader, not understanding risk, decides that selling 100 of these spreads – with a maximum loss of (less than) the same $50,000 – is a trade with essentially the same risk.

When a trader is not paying attention, he/she can become blind when the total money at risk is similar for two different trades. It’s easy to incorrectly believe that risk must be similar. In this example, two positions have vastly different risk.

Position size and probability

The trader whose mindset includes being oblivious to reality, is either unaware of statistics or ignores them. The big factor here is probability. There is a reasonable probability of incurring the maximum possible loss when selling 100 (or any other number) of 5-point credit spreads. Depending on the strike prices and the volatility of the underlying, the chances of losing it all can be near near zero to almost 50%, depending on the strikes chosen. Let’s ignore the ‘near zero’ examples because the premium available when selling such spreads is tiny and no one should be trading those on a regular basis.

However, when the chances are one in five, or even one in 10, you know that such results are going to occur (on average) every five or ten months. It takes some good sized wins to be able to withstand those losses. But the truth is that the trader who is not aware of the difference between the chance of losing $50,000 no more than once in a lifetime vs. losing that amount at least once every year has no chance to find success.

One important aspect of risk management is understanding how likely it is to collect he profit or incur the loss. The size of that profit or loss is not enough to tell the whole story.

Please do not be an oblivious investor. Please understand risk and reward for every trade, as well as for your entire portfolio.

914
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Profit and Loss Targets when Trading Options

The beginning

This detailed discussion began here, in the comments section.

Roberto is asking about profit and stop loss targets for an iron condor and also for a ‘classic’ credit spread.

Where we are now

Thanks Mark.

But I still don’t understand why you prefer to set a stop loss around $300 in a trade (10-point credit spread) where $800 can be the maximum loss.

In a classical vertical spread, $200 credit and $800 risk, we agreed that the take profit should be around $150 but we disagree about the stop loss. Can you do a statistical example of why, over the long term, using a stop loss in $300 area, its better than a stop loss in $75 area?

Thanks again

Roberto

***

Hi Roberto,

I do not set a $300 stop loss for all trades that have a maximum loss of $800. That’s not how risk management works. There are many factors to consider.

A huge part of the problem in understanding my original comments stems from the fact that you changed the conditions

I was talking about an iron condor. You switched to discussing half of the iron condor position (credit spread), believing that the situations are similar. They are very different trades, with very different factors that go into choosing the profit and loss limits.

Why is that difference so important? In your classic credit spread, one way to profit occurs when the stock moves much higher (Selling the put spread is a bullish position). When that happens, there is a very good possibility of being able to close the position and take your target profit. Thus, selling a credit spread gives you two ways to win: The passage of time and the correct market move. Those two profit possibilities play a large role in the probability of earning a profit

With the iron condor, there are no profits when the stock moves higher. It just means that the call portion is in trouble rather than the put portion. There are no profits under those circumstances. There is no possibility of taking profits quickly. This position requires the passage of time before the trade can reach its profit target. It is important that you recognize that changes the probability of success by so much, that no matter how you set the risk/reward ratio for a credit spread, it must be set very differently for the iron condor. The iron condor is where this discussion began.

I hope that’s clear to you. The credit spread wins far more often than the iron condor. If you ask: Why not trade the credit spread instead, the reply is that I don’t know whether to sell a call spread or a put spread.

Time out for an important issue

Experienced traders may recognize that there is another big factor that has been ignored: The effect of implied volatility. When trading an iron condor, a big volatility increase can result in being stopped out of the trade quickly. It is true that credit spreads are also short vega, but only half as much as an iron condor. When you establish a relatively small stop loss, you can get forced out of the trade, even when the underlying asset does not make a threatening move – just because IV rose by enough to make the position hit your stop loss target.

That factor alone – the possibility of being forced to exit by a spike in implied volatility is the major reason why I would never use a small dollar value as a stop loss point. To me it is far too risky to stop yourself out of trades that quickly. I don’t believe you can stay in those trades long enough, often enough, to claim your profit. Thus, I choose a larger stop loss and know that my edge is that I’ll be stopped less frequently than you. Is that enough to make my method better? For me, yes. For you? I cannot know that answer.

End of time out

I make trade decisions by doing what I believe gives me the best chance to make money when combining my chosen strategy with my personal risk management decisions.

You must understand that we do not disagree on anything. I believe that a stop loss at $300 is better for me than a stop loss near $75. You believe that a $75 stop loss will be effective for you. We must each trade according to our comfort zones. Neither one of us is wrong. I allow for a larger loss to reduce the possibility that a change in IV will force an early exit.

I can understand why you may believe that one of us must be correct and the other person must be making a mistake. However, neither one of us is wrong. Here’s my best explanation of why believe that no one is wrong here.”

  • If you own the position and the loss reaches $100, or $150, you may become very uncomfortable holding onto the position. You may become upset and feel ill. You may lose sleep. A trader cannot allow that to happen. Even if we are investors and not traders, it’s the same situation. It is wrong to hold positions that make us nervous because it means that too much money is at risk. It is also very unhealthy. Losing money is part of the trading game, and if it’s going to upset you – then you are correct to cut losses before you reach that point.
  • It is far better if we can do a statistical evaluation of the trading plan. However, that’s impossible
    • We have no volatility estimate for the stock in question. I assume that you recognize that a very volatile stock will lose that $75 far more often than a non-volatile stock. And it will take a longer time for the profit level to reach $150 because options of volatile stocks hold their premium longer than options of non-volatile stocks. If you get stopped often and if it more time to make the profit, how can that be a profitable plan?
    • When dealing with statistics, time remaining is a crucial factor – and the time remaining before expiration arrives is unknown in our example trade
  • The single fact that we collected $200 credit trading that ‘classic’ credit spread is not enough information to solve this problem.

Statistics

Lacking enough information to solve the problem, and ignoring trading costs, we know this much:

  • The $75 stop loss and the $150 profit target
    • You can afford to lose twice as often as you win to break even
    • Thus, the probability of the spread reaching the stop loss point must be less than two in three (win once, lose twice, zero gain)
  • The $300 stop loss and the $150 profit target
    • I must win twice as often as I lose to break even
    • Thus, the probability of the spread reaching the stop loss point must be no more than one in three (win twice, lose once, zero gain)
  • You choose $150 as the profit target and $75 as the stop loss because those numbers have proven to be effective, and you have the profits to prove it. The other choice is that you have no such evidence but believe these numbers will be effective. However, using that 2:1 ratio as a strict guideline is a huge mistake. I guarantee that. If you use a ratio, it must change when trading more volatile stocks. It must change when the strategy changes. It may have been useful when trading stocks, but it’s worthless (in my opinion) when trading options

Setting stop losses is necessary. Choosing the price at which to set them is a crucial decision, and no simple formula is going to be satisfactory.

The end

When trading an iron condor, I often give up on the trade when one of the 10-point spreads reaches a price between $500 and $550. Thus, my stop loss is not based on the number of dollars lost. Is that heresy? If I collect $300 for the position, then my stop loss is about $250 (plus the cost to cover the profitable side of the trade). If I collect only $250 in premium, then my stop loss is about $300 (plus the cost to cover the winning side).

I exit the trade when I believe risk has reached the point at which I am not willing to lose any more on that trade. It has nothing to do with my profit target. That is the reason I do not use a risk/reward ratio, and I hope this explanation makes sense. You don’t have to agree with my conclusions, but you should understand the reasoning behind them.

I never said that it is ‘better’ to set the stop loss at $300. I said that is where I am comfortable setting it.

We each have different comfort levels and must trade accordingly. When I trade an iron condor (or credit spread) I am not willing to set exit points as low as you set them. That does not make either of us ‘wrong.’

897
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Buying Call Spread vs. Writing Covered Call Calls

Mark,

I enjoy reading your blog for quite some time now. I’m very glad I found it as it helped me clarify a lot of things regarding options. So thank you for that education.

Because I wanted to know more details especially for risk management and proper trade execution I recently bought your two books Create Your Own Hedge Fund and The Rookie’s Guide to Options. In both books you are explaining conservative strategies as Covered Call, Collar and Writing Cash Secured Put.

I’m trying to test them via Paper trading. However I would like to ask you something related to cash secured puts. When you enter this trade you are bullish. As with covered call you are carrying significant risk when market goes down.

You don’t have to be bullish. All that’s necessary is that you are not bearish. Neutral markets are also good for these strategies. But yes, there is downside risk. No question about that.

One way to protect against such “big” loss seems to me might be to enter vertical bull spread instead. I guess this will be somehow counterpart of collar for call side. I’m wondering why such strategy is not listed in the conservative list of strategies. Is it because it is not income efficient or I’m I missing some other point?

You are not missing anything. If you buy a call spread, (or sell a put spread with the same strike prices), that is equivalent to a collar – same risk, same reward – but much easier to trade. It’s apparent that you already understand that.

The reason this idea was not included in the earlier book (Create) is because of what I was trying to do with the book. The idea was to get readers started using options. I decided that including many examples would be better than adding additional strategies. There is another reason. Many brokers consider spreads to be ‘complex’ and ‘complicated’ and they do not allow their less experienced traders to use spreads. Ridiculous, I know. However, that’s the way it is. So I kept it simple in the first book. In the Rookie’s Guide, the chapters on equivalency and credit spreads make it clear that these trades are all equivalent (sell put spread, buy call spread, buy collar).

The reason for not including ‘debit spreads’ and only writing about ‘credit spreads’ is that the vast majority of traders prefer the spread in which they collect cash, rather than spend cash. We know they are equivalent trades, but sometimes certain trades just ‘feel better’ – especially when the trader has not yet learned that the trades are essentially interchangeable.

I agree that adopting one of these spreads is far (far) less risky than the covered call or cash-secured put. The reward is also less, but I believe it is a good trade-off to take the safer route.

Based on stated above I “tested” such approach last Friday on weekly option with Ford stock (Friday close price 16.27). I sold “Feb 4, 16P” for 0.16 and bought protection “Feb 4, 15P” for 0.03 (i.e. net credit 0.13 which is 0.8% of 16 strike price with DP – downside protection, or downside break-even, 15.87 for week. In theory, for a month I can get 3.2% ROI on weekly – I know this is ideal thinking but much better return than regular monthly option approach. On monthly Feb 18 and same strike bull spread I would get 0.27 credit (all related to Friday prices). If I use naked put on Feb 18, then I would select the 15P for 0.15 because of better DP – 1.15USD.

Yes, Weeklys offer a better return. But that should not surprise you. The less time in the life of any option, the more rapid the time decay and the greater the risk – if the stock moves toward and then through the strike. One month options offer a better return than longer term options. Thus, Weeklys offer a better return than ‘regular’ front-month options. This higher annualized reward does come with elevated risk, so it is not for everyone. Weeklys have become very popular quickly. Buyers like the cheap ‘action’ and sellers like the rapid time decay. If you are comfortable with holding these trades, then there’s nothing wrong with trading Weeklys. I know it’s a paper account, but if you treat it as if it were real, you will learn a lot about how comfortable you feel with those trades.

Do you think I’m picking only “penny/dimes” on this approach? Do I risk too much from your point of view?

No. If you want to trade Ford, only 1-point spreads are available and it is far more important to trade the stock you want to trade (F in this case) than to worry about other considerations. I believe you are making reasonable and effective trades. Just remember that your long-term results are going to depend on how well you manage risk. There is absolutely nothing wrong with selling a $1 spread for that 13 cents. I object to ‘picking up dimes’ by selling a 10-point spread for thirteen cents, but when it’s a one-point spread, that’s equal to collecting $1.30 for a 10-point spread. That’s fine.

Additional question related to it. Is it good to use weeklies on collar/covered call/cash secured put strategy (I’m using IB so commissions on trade are not that significant to overall trade price) – my thinking about weeklies is to address possible steady declining market which makes “proportionally” less move over week than over month?

‘is it good’ to use Weeklys (note the odd spelling)? It’s acceptable is you prefer to trade short-term options. There is nothing ‘bad’ about it. However there is higher risk (gamma explodes when the stock approaches the stock price). Too risky for me, but we each define our own comfort zones.

L.

890

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