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Options Trading Ideas

Some of my thoughts on trading options

    Learn first. Trade later

    • Take the time to understand how options work
    • Recognize when positions are equivalent
    • Do not ignore ‘the greeks’

    Risk management is essential to success

    • Think of risk as you examine various strategies
    • Size is crucial. Avoid large position than can kill your account when the worst happens
    • Adjusting positions is ‘good.’ It cuts risk and gives trader an improved chance to earn money
    • Many new traders blow out an account before beginning to think about risk management

    It’s your money

    • Do not gamble with profits. That cash is your money
    • Minimizing losses is the key to success
    • Earning money is the easier part. keeping it is more difficult

    Don’t open a new trade because it ‘looks ok’

    • Verify that potential profit is worth the risk required to earn that profit
    • Make a trade plan

    Don’t hold short options into expiration

    • The last nickel or dime is for someone else to earn
    • Near term gamma is explosive
    • Short options can result in rapid, large losses
    • Avoid having your fate determined by ‘settlement’ prices for European style, cash-settled options
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Trader Mindset: The Cost of an Adjustment

The setup

A trader buys (or sells if you prefer that terminology) an iron condor, collecting a cash credit of $250. The market moves against the position and the trader decides that he/she is no longer satisfied with the trade. Something must be done. Keeping this discussion simple, let’s say there are two choices.

    a) Close the trade, paying $400 per iron condor. Net loss $150 per
    b) Adjust the trade

  • Define adjustment: Change the position to reduce risk
  • Necessary condition: The new position is ‘good.’ The trader wants to own it
  • The adjustment is NOT made to avoid taking a loss. It is made to reduce risk

Adjustment cost

When the adjustment requires a cash outlay of $50 to perhaps $200, most traders are willing to protect their remaining assets by making the risk-reducing adjustment.

However, if the adjustment requires paying $300 – $350, there is resistance to the idea.

One of the Gold Members at Options for Rookies Premium made the following comment regarding such an adjustment:

I’m not sure I could spend more on my adjustment than I received; that might be tough.

A significant quantity of traders are predisposed to some ideas (mindsets or mental blocks) because they seem so obvious. The logic behind their reasoning appears to be so impeccable that it ‘s essentially inconceivable that the ‘obvious’ belief can be erroneous.

The quote above represents one such example.

The truth

Without an adjustment, the risk of losing too much money has become unacceptable for this trader.

These are the facts, although not everyone is willing to accept them:

  • The iron condor is no longer priced at $250. The current market value is $400
  • Making trade decisions based on the $250 price cannot be efficient because it is not a realistic price

Additional facts, based on the trader mindset:

  • Trader is willing to spend $400 to exit the trade
  • Trader is unwilling to spend $300 to make the trade, even though the new position would be:
  • Safer to own, with risk of additional losses significantly reduced
  • Less dangerous to own because amount that can be lost has also been reduced
  • Good enough to own. That means the trader would be comfortable establishing it as a brand new trade

Bottom Line

Trader is willing to exit, spending $400 because taking losses is sometimes necessary.

Trader prefers not to spend $300 to build a better position that offers a good return in exchange for the risk involved.

Why? Because spending $300 results in a owning a position when the bookkeeping says it can never be profitable (based on the original entry price). The excellent chance of earning money from today into the future is ignored.

When thinking about the cost of adjusting, that decision should be made between the current choices, and has nothing to do with the original price at which the trade was entered. The choice is: exit and pay today’s price; or adjust and pay today’s price. Make the better choice by making the better trade.

That’s the path to success.

995

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Danger: Using one trade to finance another

This is a continuation of an ongoing discussion in the comments section. It all refers back to a post from July 2009.

It began with a comment on this post where Mr X (who manages other pepole’s money) proposed the idea of buying a more useful put (i.e., one with a higher strike price) when constructing a collar. Because that ‘better’ put is more expensive that the traditional put (some small number of strikes out of the money) he included the suggestion of financing that more costly collar by selling a put that is farther OTM than the put owned.

In other words, instead of buying a put that affords 100% protection (after paying the deductible) for the other part of the collar (the long stock/short call portion), he proposed buying a put spread. The idea is to buy an ITM put and sell a put that is 20 to 30% out of the money. He provided statistical data that shows that this was sufficient protection more than 99% of the time. That is reassuring evidence for a trader, but the investor who wants the complete protection of a true collar (think Black Swan), this may not be sufficient protection. It is, however, a reasonable choice for someone to consider.

Quoting Mr X:

So you can actually buy a vertical (buy PUT at the money, sell a PUT 20 to 30% lower). This reduces your protection (can still have a major black swan though), but historically it still protects you against 99% of the market drops. And the cost is cheaper (we are saving 20-30% or so on the cost of the protection).

Bottom line: less costly collar, good enough to work 99% of the time (looking back in time does not mean the same results will occur in the future). As I mentioned: a reasonable alternative. The trade is made for a good reason: It costs less, adds to profits (lower cost = higher profit), and is good enough almost all the time. It’s a very attractive idea – for the more aggressive trader.

Summary

The trader has two choices:

  • Own the traditional collar with an (perhaps 5%) OTM put
  • Own a collar with zero deductible (ATM put)
    • This comes with no Black Swan protection

This was my reply at the time:

Overall, I do like the idea of owning the ATM put. But this will not satisfy everyone’s comfort zone. Is it better to avoid the 5% deductible and give up black swan protection? Not an easy decision.

And that was where we left it. An alternative that works better than the collar most of the time, but which leaves the investor facing the possibility of a financial disaster if a true Black Swan event occurs.


That discussion was re-opened recently when a reader commented on the ideas of Mr. X.

One thing led to another and the discussion reached a level where I felt it necessary to post this for other readers.

It is easy to fall into trading traps, and the one discussed by my correspondent is one of those slippery slopes that can lead to blowing up an account. Below is an abbreviated version. The original comment is here

In my mind, this is the progression of a trader:

Step 1: One learns about a put, so they’d like to purchase a put to protect a long position.

[MDW. This trader is off to a very bad start. Learning about puts is not a good reason to buy them. And this really upsets me. One does not BUY or SELL something that is not yet understood. Puts are too expensive for most people to own. It essentially kills any chance to earn profits.

Step 2: To help finance the put, they sell a call, thus they have a collar. They’re willing to part with the stock at the call strike.

MDW: True, it’s a collar. But look what you just did to this poor trader who owned some stock. He ‘learned about’ puts and bought some. Then he sold calls to create a collar. We don’t know that this trader wants to own a collar or even knows what a collar is. This is blind trading for no reason. You are suggesting that this is a ‘step’ in becoming a good trader: Buy a put because the trader learned that they exist (why did he buy and not sell?) and then sell calls just because the trader owns stock and is willing to sell. Two foolish trades. Two steps backwards in an options education. I don’t like being so hard on a loyal reader, but this is not progress.]

Step 3: Like in step 2, they want to help finance the position, so they think of selling a put on the same stock. (this is where you and I agree that this may not be a good idea)

[MDW: I don’t see how this is progress. If the trade is made ONLY to finance the original trade, it is foolish. The discussion you are quoting does not adopt this strategy. Making trades for the sole purpose of raising cash is the (short) path to eventual ruin.]

Step 4: They realize that selling a put on the same stock may not be a good idea because they don’t really want to own it at that strike price.[MDW: Why does the prospect of buying stock at the put strike price occur to you? Not every put seller wants to buy stock. Most traders would cover the put at some future time, rather than take ownership of the shares. There is no indication that the put sale was made for any other purpose than making a trade: Give up the regular collar with its deductible and trade it for a collar with no deductible, but only limited protection. Why is that bad? When I agreed with you originally, I missed the point that Mr X was buying a better put.]

Essentially, they want to sell the put for the wrong reasons and they’re exposed if the stock drops below that lower strike (I think this is where we’re agreeing). [MDW: Not when you explain it this way. In fact, this trader has an excellent reason for selling the put. It lowers costs and leads to profits >99% of the time. What better reason does a trader need, as long as he keeps risk under control by trading the appropriate number of contracts?]

Thus, they try to think of other ways to finance.

[MDW: Why do you believe the trader is seeking other ways to finance? He found a perfectly acceptable method]

Perhaps they could just use existing funds they already have, or they could use the premium from other positions that they would like to own, like by shorting puts on stock B which they are intending to invest in.

[MDW: This trader does not seem to be someone who has any interest in buying any stocks so why would he want to sell puts on stock B? Selling them just to finance another trade is a very poor idea.]

So that’s my thought process of how one gets to this point. The journey doesn’t seem that unreasonable even if individual steps may be ill-advised (i.e. step 3).

[MDW: To me, the journey is dangerous – with each step leading the trader closer to ruin. I do not expect this trader to survive very long]

Thanks.

Tristan,

The big issue for me is that you actively seek ways to ‘finance’ trades. That is a slippery slope that leads to taking far too much risk. If a position is not good enough to own on its own, then it does not belong in the portfolio. It does not have any ‘need’ to be financed.

How does financing the position make it any better to own? Portfolios should be managed by risk and not by how much cash can be collected to finance other positions.

Sure, some trades provide cash that can be used to meet margin requirements of other trades. But making those trades just to generate cash is not smart.

I understand your thinking: If a trader can finance his trades by making other trades that he truly wants as part of the portfolio, that’s a good thing. It keeps the account stocked with cash and eliminates the need to borrow money from the broker.

Look at it from a simplistic point of view. The trader has some positions He seeks to finance them by opening more positions, each of which comes with a net positive cash flow. In other words, the trader sells option premium. Each of those trades involves risk.

It takes a very disciplined trader to recognize when enough premium has been sold. It’s important to prevent over-selling. Once the idea of selling more options to finance other option positions takes hold, it is almost impossible to stop. It will appear to be free money – until the account blows up in one devastating moment.

950
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ITM Calls as a Stock Substitute

I found this series of questions to be quite valuable. Here we have a relatively new options trader who finds an excellent method for reducing risk, but who gets caught up in a mistake that makes him question his methods.

Mark,

I’ve been using DITM options for swing trades, while utilizing the leverage to potentially increase the return of buying stock outright.

Plus much less downside risk, unless you decide to buy extra options with the cash not used to buy stock. To be clear, I’m hoping that you do not decide to buy 10 calls, paying $8 each, Instead of $100 shares at $80/share. That’s a very bad idea. You must determine your correct position size by the number of shares you would have bought, and buy only one call for each of those 100 shares. Careful position sizing is essential to risk management.

I usually pick the first strike showing a 1.00 delta. My question is whether this is actually a good risk to return strategy based on the changing delta.

You adopted an excellent strategy, but your focus seems to be misguided.

100 delta options are too far in the money – unless it’s expiration week. The major benefit of using this trading method (buying calls instead of stocks) is to gain a large amount of downside protection. As you know, a market tumble can be quite costly for stockholders.

If you chose ‘high delta’ options instead of 100 delta options, you would gain that protection at a very modest cost. I urge you to consider the idea of paying a few dimes over parity for a call option that has a 75-85 delta instead of paying closer to parity for that 100 delta option. This is a personal decision and if you refuse to pay that time premium for protection, so be it.

Example

With the stock trading at $76, don’t buy the 65 calls (price = $11.20). Instead, buy the 70 calls (price $6.50). That extra $30 reduces the potential loss. Consider it to be an insurance policy.

Next, I understand neither your reference to changing delta nor “risk to return strategy”.

1) The risk to return is outstanding. You cut the dollars at risk from a gigantic number (when owning stock) to a much smaller number (by owning a call option). Surely you understand that.

2) Changing delta? If you are unfortunate enough to see the stock decline by enough for the option delta to become < 100, that's GOOD for you. You seem to believe it's costing money. All it means is that you would lose LESS money per point of decline that you would lose if owning stock. I have one question for you: If you are a swing trader, why would be holding a long position in this stock when it declines by so much? That is not how swing traders operate. They are quick to cut losses. Remember, until the stock falls enough to cut delta, you lose $100 per point. 'Changing delta' doesn't mean much in your scenario because 100 delta options don't change delta very quickly.

Say I pay $10 for a call with a 1.00 delta, and based on this, expect about a 10% move in option price for a $1 stock move (give or take some). The stocks drops. At this point the option price and delta will also drop,
which could very easily cause the percentage option loss per dollar to go up based on higher volatility.
.

You are off on several wrong paths here, and that’s the reason for posting this discussion. This is a good learning opportunity for rookie option traders:

a) You should expect the ‘give or take’ to be essentially zero for a 100 delta option

b) You are thinking in percentages, and that is confusing you. As a swing trader, concentrate on what you are doing. You are buying (or selling short) stocks, looking to make a few dollars per share. Using call options changes nothing in your basic plan – except that it reduces risk. Concentrate on dollars and forget those percentages.

c) You do NOT KNOW that the option delta will be less than 100 when the stock declines by one point. You did say these are deep in the money options.

d) If there is a change in implied volatility, you WILL NEVER lose ore than $1 per point in the price of an option when the stock declines. Why? You own the option. You own the vega. You BENEFIT when the implied volatility increases. Thus, any losses would be reduce by that change in volatility. Couple that with your anticipation that the delta becomes less than 100 and you benefit again by losing less than $100 per point decline (in the sock price).

Here’s where you miss the big picture: If the volatility increase is large enough – due to a general market scare – you can MAKE money on the decline when oping calls! Did you know that? Get out your option calculator and see what happens to the value of a call with a 70 strike price when implied volatility goes from 30 to 60 and the stock declines from 75 to 70. Assume options have 30 days before they expire. [Your calls would lose less than $1 in value. If they were longer-term options, they would increase in value]

Should the stock move higher, the volatility may decrease and the delta is maxed out at 1.00. Thus, my option price increases, thereby lowering my percentage gain.

No. Delta may be maxed at 100, but so is the delta of the stock. The long call and the long stock move in tandem. The percentage return is totally unimportant – and in fact, it does snot change. You paid $10, so every one point gain is another 10% return on your investment. Plus, your return is far better than that of the stockholder. I’ll say it again. Forget those percentages.

So I’m wondering if this approach actually causes a disadvantage as the reward potential for say a $2 increase may be lower than the risk potential of a $2 drop because the percentage gain decreases for every dollar going up while increasing for every dollar going down. So I may make 18% on a $2 upside but in exchange for a 30% drop for a $2 drop … again give or take.

No. You illustrated why your idea is good. The bad things you found in the strategy are imaginary. They are contrary to fact. You earn as much on the upside (you may earn a little less if you take my advice to buy options with a small amount of time premium). To compensate, you have an excellent chance to lose less than $1 per one point drop in the stock price.

Sit down. Think about this carefully.

One additional point: These DITM calls don’t do the job for stocks that pay decent dividends because you may have to exercsie for the dividend to prevent losing money.

925
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Sharing what we learn: Pay it Forward

Today only, there is a special promotion for the first 24 (as in 24 karat) people who become Gold Members at Options for Rookies Premium. The bonus is a guarantee of that their membership fee ($37/month) will never increase. I believe this to be an extreme value and am offering it a a pre-launch promotion. Please read the details.


In a recent comment, Mike offered his best advice to Wayne who had described his experience with writing covered calls.

Wayne,

I read thru your covered call example and as I see it you never calculated what the cost basis was for your stock after you sold the call. This would have helped you determine what strike price you should choose for your next covered call if the first had expired. Always keep in mind where your profit and loss zones are each time you place a trade.

Once you stock dropped in price you continued to sell ITM calls (I assume to try to collect the most premium). A better strategy would have been to sell OTM calls knowing what your cost basis is for the underlying and allowing for the stock to recover. The premiums may be smaller but the risk of losing money would be less. You never know when or for what reason the market will change direction in either a positive or negative way. Bookkeeping to me is an important part of a winning strategy. I hope this helps.
I have learned a ton from Mark’s books , blogs and questions he has answered for me. I just hope that I can pay it forward.

Mike

Mike,
I understand the rationale behind your advice. In fact it’s the advice that most traders believe is helpful, intelligent, and the ‘best’ path to follow.

This is one place where I part company with that majority.

1) “This “would have helped you determine what strike price you should choose for your next covered call.”

This seems to be good advice. In fact, it’s terrible advice and leads far too many traders down the path towards decreased earnings. More than that, when these traders earn less than anticipated, there is no logical way for them to discover the error of their ways – because it all seems so logical.

Wolfinger’s Truth: or my trading philosophy

  • Cost basis and other such data are for record keeping only. They must be IGNORED when trading
  • Always choose the best available trade – at the time the trade decision is made
  • Translation: Pretend you are opening a new position. Ignore the fact that it is rolling an existing position
  • NOTHING ELSE matters. It there is no good call to write, then don’t write one. Decide whether to sell or keep the stock
  • This applies to all strategies, not only to covered call writing

2) “Always keep in mind where your profit and loss zones are each time you place a trade”

Wolfinger’s Truth

  • Only think about your profit and loss zones or break-even point when you write your trade plan and decide whether to enter into the trade
  • Once you own the position your goal is to
    • Forget the past
    • Evaluate all positions as they exist today
    • Manage risk based on the current situation
    • Own a portfolio that meets your current portfolio requirements: future profit and loss potential, risk vs. reward, etc.
    • Make money today, tomorrow and into the future
    • It makes NO DIFFERENCE whether you earn $500 nursing a losing trade that gets you back to even or whether you earn $500 with a new, better (more likely to succeed) trade. It’s the same $500
  • Spending time and effort on a losing trade, trying to recover losses is inefficient
  • Spending time and effort on a new position – one that you prefer to own (when compared with that losing trade) – is efficient and offers an improved chance of increasing the value of your account
  • Increasing account value – without increasing risk – MUST be your goal
  • Thinking about break-even points or maintaining profits from older positions – does not do anything of value for you – except that it allows you to believe you are more successful.
  • Avoiding losses makes you feel good. That’s a psychological boost
  • Earning more money makes you feel good. It should make you feel even better and be an even larger psychological boost
  • 3) “A better strategy would have been to sell OTM calls knowing what your cost basis is for the underlying and allowing for the stock to recover.”

    Wolfinger’s Truth:

    • Mike, you can never tell anyone else what would be a better strategy for that person. All you can do is explain what works for you, why it works for you, and then allow the other trader to make his/her own decision
    • ‘Allowing’ the stock to recover is the great bullish myth. Stocks do not always recover Or they take so long to recover that waiting for that to happen represents a huge opportunity cost elsewhere
    • It is far better to earn $1,000 from a new position over the next six months, rather than carefully manage that old position and earn that same $1,000 over a three-year period. Traders who are so pleased with themselves for eliminating the loss from a given trade never recognize the opportunity cost
    • Writing OTM calls is a more bullish than writing ITM calls, and it’s nor right for you to tell anyone to be more bullish than he/she wants to be

    4) “but the risk of losing money would be less”

    Wolfinger’s Truth:

    • When you write OTM calls instead of ATM or ITM calls, the probability of losing money – during the lifetime of the call being written – INCREASES
    • The Truth: It is not the matter of profit vs. loss that determines risk. It’s the size of the profit and loss that is far more important. Writing OTM calls earns a profit less often than writing ITM calls. It also results in larger losses when the stock declines. True it can result i larger profits, but you were writing about less risk of losing money

    and

    Mike: I’m glad you shared your thoughts. Traders have different approaches to trading and adopt different trading philosophies.I know what I preach is best for me and I’m anxious to share it. I know that it makes perfect sense to me. I offer it in this spirit: consider Wolfingr’s Truth and decide whether it makes sense to you. This is the philosophy behind my teaching methods at Options for Rookies Premium.

    920
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My Philosophy on Options Education

Education: An activity that imparts knowledge or skill.

When I work with individual investors or write blog posts and books, my objective is for the reader to learn something he/she does not already know.  That includes providing enough details that the clouds disappear and the reader gains a better understanding of the topic under discussion.  

Careful and detailed explanations take time to explain.  If you require instant gratification and the ability to attend one webinar or lesson and then immediately begin trading, I cannot help you.

Details?  What does that mean? I stress the details that help you reach a better understanding of the lesson material.   Unless the topic is risk management (and that's a big topic) there is no reason to bother with details of events that are extremely unlikely to occur.  My job is for you to come away from a lesson with something of value for your trading career.  And that's true for the trader who devotes only two hours per month to his/her investments as well as the full time trader.

There are trading tidbits that you will accumulate and points of view that you, the trader, will develop over the years.  Rather than wait for traders to slowly gather insights on certain more advanced topics, I prefer to see that you get an inkling of the importance of certain features of options – even when it may be soon soon for some students. 

One example is the idea that two very different-looking positions can be equivalent, i.e., they produce identical profits and losses under all market scenarios. Most beginners don't get introduced to that concept until they are well into their trading.  I believe this idea is so important to an understanding of how options work that I introduce it early.  If anyone does not see the importance, or does not yet understand how equivalency works, no harm done.  The idea has been mentioned and soon enough, as specific trade ideas are introduced, the 'eureka' moment arrives and the concept becomes clear.  Accelerating the date of that moment makes better traders of those in the class.

We all wish we had understood something more clearly, or recognized the true risk of an innocent-looking position earlier in our trading careers.  For example, I believe the successful trader must concentrate on risk as his/her primary focus.  Many others prefer to concentrate on profit and loss, and do anything in an attempt to achieve that profit.  That is dangerous for reasons that may not be obvious.

When you grasp the 'little extra stuff' early in your career, it often makes a big difference in whether you succeed or ultimately give up the game.  The very first rule to understand is: Don't go broke.  It seems obvious, but it's something ignored by too many traders – until it's too late. I help traders learn how to minimize the chances of going broke.  It's not as simple as: "Don't take a lot f risk in one trade."  Some traders lose their accounts slowly and end up just as broke as the person who blew up over a single trade.

When I clarify some previous misconception held by a student, that is truly hitting the jackpot (for me).  Trading is a business that punishes mistakes.  Everyone tells us that we learn from our mistakes.  That's true ONLY when the mistake is recognized. If a trader repeatedly acts on a misconception, those mistakes are difficult to discover – and hence, are going to be repeated.

I love the breakthrough when something under discussion results in an 'aha moment' for the student.  As a writer, I never know when that happens, unless you let me know.

So what do I mean by that introductory statement – to teach something you don't already know?  Here are some examples that appear frequently in my writings:

  • Explaining something from a different perspective
  • Including extra details, just in case they can provide a better understanding
  • Including information to answer questions before they are asked
  • Explaining the rationale behind my opinions. 'Why I believe it's true'
  • Outlining a philosophy based on common sense, and not on traditional rules
  • Being willing to take a minority stance – but always telling readers when most others have a different point of view
  • Encouraging readers to think for themselves before making decisions
  • Continuously stressing the importance of risk management
  • Explaining that choosing a good trading strategy is just the beginning
  • Why trading near-term (front-month) options is more risky that it appears
  • Why it's easier to make money by selling, and not buying, option premium
  • Why selling naked short options is too risky for most traders (unless you sell puts with the intention of owning stock)
  • Sharing the opinions of other option writers and bloggers


One on one

When working with a trader one on one, my philosophy is to help with specific topics of interest to that student.

I don't have 'lessons' prepared in advance. I don't have any specific number of lessons planned.  These sessions are designed to answer your specific needs.

Risk Management

Concerned with capital preservation?  At Options for Rookies we live and breathe risk management.  I stress the importance of controlling risk from the very beginning of your trading education.  This is not a topic suitable for experienced traders only. Why?

If you trade without measuring and controlling risk, the risk of ruin is too high. Don't count on a lengthy trading career when being aware of, and respecting, risk is not at the top of your priority list.

When dealing with the stock market in any capacity, you are dealing with statistics.  You must be alert for unlikely events.  By being aware of the probabilities of winning and losing, you can trade only when the reward justifies the risk. 

You will have many winning trades by doing just that.  However, long shots have their day and black swan (unexpected) events do occur.  Your task as a trader (and mine as a teacher) is to see that you are prepared for the unlikely event. 

As a premium seller, gigantic market moves represent the enemy.  Portfolios can be protected against disaster, if you are willing to pay the price of insurance.  One alternative is to be very careful when sizing trades.  Be aware of the worst case and you can limit losses to an acceptable amount.

It's all part of risk management.

 

886

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Trading Iron Condors. The Opening Trade. Part II

Part I

Continuing my reply to Frank's questions:

We are discussing SPY iron condors and making choices about the options being traded.

 

2) The delta of the sold options is important to the probability of success and the probability of reaching a point that requires making adjustments.  It also plays a role in the cash collected.  Thus, it's a key element when constructing the iron condor.

You currently sell options with a 20 delta and one of your complaints is that you adjust too many times before being able to close the trade.

Do not even think about moving from 20 to a higher delta, unless you KNOW it will be comfortable.  You already 'make too many adjustments,' and thus I believe moving beyond 20 delta would be a big mistake at this point in your learning process.

When this experiment is over and you have drawn some conclusions, that's the time to think about (and hopefully discard) the idea of moving to 23 or 24 delta.  Moving to 30 is NOT going to work for someone who already believes he makes too many adjustments.

 

3) Spread Width plays an important role when choosing your iron condors.  From your questions I can see that you don't have any idea how to make a good strategic choice.  You allow time and premium to be the deciding factors when choosing the iron condor to trade.

You decided to trade 10-12 weeks spreads, chose to sell options with a 20 delta, and decided that the cash premium should be roughly $1.10.  Satisfying those parameters gives you no choice in choosing the iron condor.  Thus, for you, it's 4-point spreads.  That is not an efficient method for choosing trades.  It completely eliinates any judgment on your part.  It ignores your comfort zone (which is something you now realize). Let's see if I can help you make better decisions.

Here's a nuts and bolts idea of how to select your spread width, along with some commentary:

  • Did you know that the 4-point spread is equivalent to owning each of the adjacent 1-point spreads?  in other words, when you trade the 128/132 call spread 50 times, you really traded:
    • 50 of the 128/129 call spreads plus
    • 50 of the 129/130 call spreads plus
    • 50 of the 130/131 call spreads plus
    • 50 of the 131/132 call spreads
  • The only difference is that you save the commissions of trading each of these four spreads by trading them all at one time.  You MUST understand that this is true.  

You cannot trade options without grasping this basic concept:  Trading each of the four spreads is equivalent to trading the 4-point spread.  The risk/reward is identical. 

When you understand the truth of the above, then I hope it becomes clear that choosing the four-point spread is almost guaranteed to be a big mistake. Why?

I understand choosing a spread based on how much premium is collected.  However, people who do that (me) already know the desired spread width.  They do not allow the need to collect a certain premium define the spread width.

In relative importance, spread width comes in far ahead of premium. 

You are not thinking about the position. You made your 'line in the sand' requiements and tht's the end of the thought process.  Trading by rote or very strict rules is not viable – unless you already know that you will like the position forced upon you by the rules.  Clearly that is not the case here.

  • Look at each of the four spreads as an independent trade
    • Do you want to sell the 128/129 call spread?  I know you chose it because the 128C has a 20 delta.  But do you really want to sell this spread?
      • Is the premium sufficient for the risk?
      • Next, do you really want to sell the 129/130 spread?
      • Next, do you want to sell the 130/131 spread?  The premium is getting fairly small
      • Last, do you truly want to sell the 131/132 spread?

I cannot answer any of these questions.  My point is that it is highly unlikely that you want to sell each of these spreads.  If that's true, then sell only the spreads you WANT to sell. Do not sell any other spreads just to get the premium where you prefer it to be.  It forces you to make a BAD trade (BAD because you do not want to own it).

Instead of focusing on a 4-point spread to collect the 1.10 premium, concentrate on the spreads you want to have in your portfolio.  You may decide to stick with the 20-delta and sell only the 128/129 C spread.  Or you may prefer the 128/130.

You also seem to have latched onto the .20 delta option as if it were a requirement.  Perhaps you would feel more comfortable choosing only the 129/130 spread or the 129/131.  You would adjust less often, and that may solve your combination of problems.

Please give serious consideration to each spread that makes up the call and put portions of the iron condor and then choose to trade only the spreads you like.  For margin and risk purposes, it's best to keep the put and call spreads at equal width.  But it is not mandatory.

4) Multiple iron condors with same expiration

You must understand that you already have multiple iron condors in your account.  However, the fact that you don't 'see' the equivalent positions in your account leads you to believe that you own a single iron condor trade.

Nevertheless, I understand what you mean.  If you sell the 130/131 call spread and also sell the 132/133 call spread (and something similar on the put side), then you 'see' two different iron condors.

There is nothing wrong with doing that.  I do that all the time.  However, I initiate the preferred iron condor.  Then if I want to add to my portfolio, I'll choose a spread that is appropriate at the point of entry.  Many times that's an iron condor with different strike prices.  If you plan to open them simultaneously, be absolutely certain that you WANT to own each position and that you are not making the trades because you like the idea of owning a variety of spreads with the same expiration.

 

Bottom line: I cannot overemphasize that it is bad policy to choose spreads that fit some preconceived notions. 

As a rookie trader, you have to observe more trades as you gain the needed experience.  But you can, and I strongly recommend that you do, trade positions with the risk/reward that places each trade squarely within your comfort zone.  When you are more experienced, you can try to expand that zone.  But not now.  Now you are learning to trade options and your primary goal is to survive.  It's great to be earning money on a steady basis.  But this game is not quite that easy and I'm pleased that you are not getting overconfident.

Thanks for the excellent questions.

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Trader’s Mindset Series II. Always Collect Cash

In the first part of this series, I wrote about beginners who ask the wrong questions, such as: 'How much can I expect to earn when trading options?'

This time I'd like to continue on a theme that began yesterday. That theme can be simply stated:

There is a subset of option traders who seldom, if ever, are willing to pay cash.  All  initial trades, all adjustments, all rolls – must be made at a net cost of zero or less.  The only exception occurs when exiting a trade and collecting a profit.

Opening the trade

When selling premium, it's natural to begin by collecting more cash for options sold than you pay for options bought.  And those who sell naked options never think about buying protection or limiting losses – because it cannot be done for free.  The following discussion of this specific trader mindset refers to trading spreads rather than naked options, although the principles are the same.

The opening trade is easy.  The traders wants to collect a cash premium and choose one of a bunch of strategies that enable him/her to do that.

Managing the trade

This part is more difficult.  If all goes well and time passes, then the option values decrease and may eventually reach a point that our trader is willing to spend a small sum to exit the trade.  However, it's likely that the position will be held, hoping all options expire worthless.  Paying a few nickels to exit a trade and eliminate all future risk is not a popular idea.

One of the problems with this mindset occurs when the market does not behave in a manner that is friendly towards our trader's position.  Premium selling and negative gamma are close relatives.  When the market goes against  a position, further moves increase the rate at which losses increase and the position becomes more dangerous.

Traders with a more normal mindset: "This position requires an adjustment because my current risk is too high and I must avoid a large loss" have no trouble making good trades that reduce risk.  Most of the time these trade involve spending cash.

  • Reduce size and buy back some of the position
  • Buy single options for protection
  • Buy debit spreads for protection
  • Buy…

The strategy tends to be to buy something and spend cash.

However, the trader with the mindset under discussion: "I don't want to pay cash for any option trades.  I do want to prevent large losses, but I will find a way to protect myself with no cash out of pocket" has a more difficult time managing the trade.

Clarification: It's may not seem to be a more difficult time for the trader.  He/she is happy to sell extra premium because it affords an opportunity to make even more money.  However, these traders increase overall risk and do almost nothing to take care of the current problem.

When the market rallies and the position is short too many delta, this trader does recognize the need for making an adjustment.  At those times, the most obvious first choice (for the 'take in cash' traders) is to sell some puts.  That not only adds cash to the coffers, but it adds positive delta.  That's a feel good trade.  However, it's very short-sighted. 

What's wrong with getting some useful positive deltas by selling puts?  Two things.  First, it does almost nothing to reduce the current upside risk. The only upside benefit is to keep most or all of the put premium collected.  However, that cash is not enough to offset the losses that accrue as the market marches higher and negative gamma soon makes the position lose money more quickly that it did before the adjustment.  Second, the position now has risk where none existed – downside risk.  And for what?  For the cash collected to 'protect' the upside.  Selling those puts is not a good idea.

What about rolling?  Surely that's a good risk-reducing technique, says our trader.  Well, 'yes and no' says I.

Rolling works when you move to a good position and exit the risky trade.  However, with cash as the driving force behind the roll, the trader often rolls to a position that is already too risky for an initial trade.  It feels good because it includes extra cash and moves the short options farther out of the money.  As I said that feels comforting.

But it shouldn't.  The new trade is probably so far from neutral that it already requires an adjustment.  That sets up even more risk.  And if the call spread was rolled because of a market rally, and if new puts are sold to balance the new position (turn it into an iron condor), then what about those now FOTM puts from the original iron condor? Prudence dictates paying some price to get those puppies off the street, but our intrepid cash collecting trader does not think that way.  In fact, in his/her mind those have already expired worthless and that, in an of itself, reduces the bath being taken on the call side of the trade.

Then there's the situation when rolling isn't good enough.  It's necessary to pay $6 to buy back the (now ITM) call spread and the most reasonable place to roll (to collect lots of cash) is a spread that trades near $4.  Most credit spread traders do not sell 10-point spreads for $4 when the idea is to watch the options expire worthless.  They are far too close to the money.  But the trader with the cash is king mindset will sell 3 spreads for each two bought.  That allows him/her to roll the position at even money (buy 2 at $6; sell 3 @ $4). 

Immediate risk is gone and the shorts are no longer ITM.  However, this is a very short delta position, had a potential loss that is 50% greater than the original, and is likely to create additional problems.  Rolling for a cash credit may feel nice, it may make the trader falsely believes that no loss has been taken and that there is still a good chance to collect the entire premium – but it's a hollow belief.  The truth is that risk has increased.  That is not the path to survival as a trader.

 Exit

This is the easy part for most traders.  Take the profit and move on.  To the cash is king trader, buying in cheap options is a waste of money and the trader believes that options were made to expire worthless.  Another misconception and dangerous belief.

If the mindset described fits you, please at least think about modifying the way you think about trading options – to something more reasonable.

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