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Progression Through Option Strategies

Mark,

You mention in your response to Aldo that you would recommend “credit spreads” as a top suggestion for new traders (assuming they are comfortable). Do you have a kind of progression through strategies you would suggest?

I’ve traded covered calls, naked puts and bought calls/puts based on a course (similar situation to Aldo) and I’m looking to expand my trading strategies into spreads.

Thanks,
Patrick

Hello Patrick,

Good question.

I do have a recommended progression. However, it is not because the trader moves from one strategy to something that is “better.” I recommend beginning with covered call writing (CCW) because it involves stock trading and many option newbies have stock-trading experience. That makes it easier to begin using options.

I also recommend writing covered calls because it is a hedged, reduced risk strategy – when compared with stock ownership. One more important point: CCW positions earn profits more often than straight stock ownership, although profits are limited. I want traders to make money with options, and CCW produces far better results than simply buying/selling options (the method taught in the course you took). In fact, I hate the idea of brand-new option traders trying to make money by buying options. There is far more involved than predicting when a stock price will change. One must have a good idea of whether the options are reasonably priced (that requires an, understanding of implied volatility) and which options to buy (avoid OTM options). And the brand new trader knows nothing about any of that.

Option traders should learn about options and not about reading charts.

Next I encourage the sale of naked puts because it is equivalent to CCW. By switching strategies, the trader must learn about equivalent positions. That knowledge is very important to an option trader.

I then encourage traders to understand a collar position (a covered call plus the purchase of a put option) because it demonstrates how options can be used to limit losses. I’d love to get the new trader interested in learning to limit risk from day one, but it is important not to overwhelm a trader with too much new information at one time. Thus, I begin with a risk-reducing (and not a risk-limiting) strategy.

I consider those three strategies to represent the “Three Basic Conservative Option Strategies.”

Next I encourage the use of credit/debit spreads as a method of taking on far less risk.

The call debit spread can be looked at as something similar to a covered call, but instead of owning stock, one buys a call option. This is where the trader learns the difference between buying calls and buying stocks — each combined with the sale of a call option (essentially the ‘covered’ call).

The credit spread is a high-probability, limited profit strategy and is ideal for most traders. Sure there are other strategies that accomplish specific needs, but for the trader who has a small bullish or bearish bias, these plays are far superior to buying options.

Continuing with the discussion of equivalent positions, the trader should next learn why credit and debit spreads are equivalent strategies. To be more specific: Selling a call spread is equivalent to buying a put spread when the strike prices and expiration are identical. That must be mentioned repeatedly, otherwise some people may believe than selling any call spread is equivalent to buying any put spread. Thus, I’m careful to mention that essential requirement as often as necessary to be certain that it is well understood.

Basically that’s it. Once a trader has those strategies in his/her arsenal, more advanced strategies come from combining one or more credit/debit spreads into something that appears to be more complex. The other more advanced concept is understanding implied volatility and the importance it plays in selecting option strategies:

    –Condors, butterflys — vanilla or broken wing varieties; vanilla or iron varieties are just the purchase or sale of one vertical spread and the purchase/sale of another.

    –Then there are strategies that involve volatility more than just price changes. For example, Calendars and diagonals — single and double fall under the volatility umbrella.

NOTE: A vertical spread involves two calls or two puts on the same underlying with the same expiration date. Both credit and debit spreads are vertical spreads.

Bottom line: I do not suggest learning the next strategy is done because it is a “better” strategy. What I urge traders to do is understand something basic and then move on to something that requires a bit more knowledge. We learn strategies to learn more about how options work – and not specifically as a way to make money. Whenever a trader discovers a strategy that suits his/needs and is comfortable to trade, I suggest pausing and getting some good experience using that strategy before moving on.

Patrick, there is one more concept that is crucial (in my opinion): We all want to adopt strategies that have a good probability of meeting our requirements. In other words, strategies that we understand how to use and which make money. However, it is the trader’s ability to maintain discipline and manage risk that is far more important in determining a trader’s success/failure rate. Choosing “a good” strategy for ourselves plays a role, but it is dwarfed by the need to skillfully manage risk.

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Spread Trading

Hello Mark, and thank you for your kind help.

I would be grateful if you could answer a few follow-up questions.

1a. I am intrigued by the concept of bull put spreads – thank you for bringing them to my attention. Since you seem to prefer them over bull call spreads, could you briefly explain why? Is it just because in the case of the former time decay works in one’s favor and that profits can be retained even if the stock stays steady, or is there something more to them?

I do not prefer selling put spreads to buying call spreads BECAUSE they are equivalent. It makes no difference which you trade. Each spread has the same time decay. The spreads are essentially identical, even though they appear to be different. When you are ready, take this lesson: Equivalent positions.

Understand that some traders are more comfortable collecting cash when entering into the trade and then they can (when it works) watch the spread value decline towards zero. Others are more comfortable buying spread because they know the cash [paid represents the maximum possible loss and they will never have to pay an money to get out of the position. NOTE: The maximum possible loss when selling the put spread is identical, but some are more comfortable when the cash has been paid upfront. It is all psychological and truly makes no difference.

If you are a new option trader (as your questions suggest), then choose the trade that you want to make. If looking at the trade from the buyer’s perspective makes you more comfortable, then buy the spread. As you gain experience, you will come to recognize that it really does not matter whether you buy a call spread or sell a put spread as long as one thing is true: The options must have the same strike prices and expiration date. That is iron clad. Change anything and the positions are no longer identical.

1b. Would you say that the optimal way of specifying the strike prices of the relevant puts is to make the strike price of the short one correspond to the level we believe the stock can reach and the strike price of the long one to a point somewhat below the nearest major support level?

No. Let’s be honest: Neither you nor I know where the stock price is headed. More importantly, your goal is to make money — it is not to be exactly correct on your predictions.

If a stock is priced at $100, you may want to buy the $100/105 or $100/110 call spread [or SELL the $100/105 or $100/110 put spread]. These should earn a profit when the stock rallies, but will lose money if the stock price does not budge, or when it rallies by ~$1. That’s not good enough for me. I want to make money even when I am not as correct as i expected to be.

Therefore, I’d prefer to buy the $95 calls and sell the $100 calls (or buy the $95 puts and sell the $100 puts). Noe I make money even when the stock does not rally. That’s good – but there must be a downside to making this trade — and there is. If the stock price tumbles, the $95/100 trade will lose more money than the $100/105 trade [If you do not know why, then I recommend starting your option education at the beginning and not try to jump in at this level.] Sure, you want to avoid the larger loss, but if you have any confidence that the stock price will increase, then you ought to have even more confidence that the stock price will not move lower.

Choosing the specific spread to trade is important — but please: it has nothing to do with your predictions unless you have a wonderful track record of successful predictions. One trade risks losing more, but comes with a higher probability of success. The other comes with the chance to earn more money, but with a lower probability of success. Choose whichever spread appeals to you more. You are the mast of your own risk-tolerance universe.

1c. Would you say that it is worthwhile to close out a bull spread (be it call or put) as soon as the predicted upper price level is reached, regardless of how far away one is from expiration?

I think you know the answer. If the stock rallies and reaches your target price, then you clearly do not expect it to move higher. So, why would you want to own a bull spread when you do not expect the stock to move higher? Yes, exit. Expiration has nothing to do with this decision.

I note that you said “upper price level” and not your target price.

If your question is really this: “I buy call spreads. Should I exit as soon as the stock hits the upper strike price?”

Then my answer is: “NO.” If you make a trade and have a profit target for your spread in mind (rather than a price target for the stock), then exit when you earn the profit. It does not matter what the stock price is. You will not want to choose the strike prices such that you expect “the upper level” to be reached. You should pick spreads than you believe will make money. That is the primary goal for a trader. You must remember that if you expect the stock to rise from 75 to 85, do not buy the $80/85 call spread. If the stock rallies, but only gets to 79 or 80, you must own a spread that earns a profit.

1d. Am I right in thinking that the margin requirements for any given bull spread (be it call or put) essentially correspond to the amount of cash one has to put up when assigned, so, for instance, if one sold 2 contracts with the strike price of 40, then the required margin is $8000?

NO. When you buy a spread, there is zero margin. You just pay for the spread. When you sell a credit spread, the margin represents the maximum possible value for the spread, but you can use the cash collected to meet some of that margin requirement. If you sell a naked put option, that is where the Reg T margin requirement is essentially the cash required of assigned an exercise notice. But it is reduced by other considerations, including how far OTM the strike price is.

2. You said “If you are only going to buy options (or option spreads), then 10% of your portfolio is far too much in my opinion. But that is because I do not like the idea of predicting the market by buying options.” Am I right in thinking that what you mean is that you are happy with committing more of your portfolio to option positions provided that they are tied up with non-directional strategies?

Yes. When my positions are much less risky than owning calls, and when they are hedged, I am willing to place more money into option positions. But please note: That is my personal comfort zone and it is NOT a recommendation for anyone else.

3. And, finally, one very different question – are you aware of any free software/website that displays not only unusual options activity, but also shows the list of biggest daily transactions and indicates whether the options involved were bought at the ask or sold at the bid? I know that thinkorswim offers this function, but apparently you need a TDAmeritrade account to use their software, and since I’m not US-based, I don’t think that I can access it.

No, I do not. Nor do I like the idea of using that information. It is 100% useless to you. Yes, 100% useless. So what if you know that someone buys 10,000 calls for a given stock? What does that tell you? It does not tell you whether this is a new position of if the buyer is covering a short position. It does not even tell you whether the trader is making a bullish play because there may be another part of the transaction that you cannot see. For example, if he buys 10,000 ATM calls and sells short 500,000 shares, then he owns a market-neutral position equivalent to owning 500,000 straddles. And if he sells short 1,000,000 shares, then he essentially bought 10,000 puts but to the casual observer it loos as if he bought 10,0000 calls.

One more point, even if you do know whether this big buyer is bullish or bearish, or neutral, what do you know about his track record as a call buyer? Nothing. Acting on this type of information is foolish.

Once again, thank you for your time – I really learn a lot from you and greatly appreciate your expert help.
Best wishes,
Jakub

My pleasure.

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Rookies Stuff 03

One of the basic problems for traders everywhere is the notion that any time that you lose money, you must have made a mistake. If you make a trade that should be profitable 90% of the time, then it must be true that the same trade will be unprofitable 10% of the time. Yet, when one of those occasional losses occurs, the trader is sure that he/she did something wrong.

We trade in a statistical world. The odds-on favorite wins most of the time. But not every time. Thus, if you cannot discover a true mistake — if you cannot find something that the evidence told you not to do but you did it anyway — then the chances are good that you were unlucky this time, and that you made no mistakes.

Here is a bit of my trade philosophy that I believe would benefit any trader who adopts it:

When the time comes to make a decision, examine the evidence and make the best decision that you are capable of making. If it does not turn out to be the winning decision, that’s okay. If you consistently make good decisions, you will be a successful trader.

http://goo.gl/VobakB

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Rookies Stuff 02

In Rookies Stuff 01 I pointed out how difficult it is to buy options and then hope the underlying stock price moves (far enough) in the correct direction (up for calls and down for puts) quickly enough (before the options expire) to earn a profit.

Knowing that buying options is the favorite strategy for the vast majority of new option traders, I don’t want to leave anyone without an alternative strategy. For traders who do want to base trades on their ability to predict the future of stock market prices, there is the vertical spread strategy.

Very important point

Consider the two ideas below as something that the very new option trader should learn. It is far better than the strategy of buying puts or calls. However, this is just the entry point for using vertical spreads, These spreads can be used far more effectively by adding a bit of sophistication. Lessons on just how to do that follow in this series. For today, the key takeaway is that spread trading reduces risk (yes, it also reduces potential profits).

Note: A ‘spread’ is a hedged (reduced risk) position. There are many examples, but for our purposes today, the two strategies under consideration are

  • Buy a call spread when bullish
  • Buy a put spread when bearish

When we ‘buy’ a spread, we own the more expensive option and sell the less expensive. As a result, we pay cash to own the position.

Example:

    XYZ is $75 per share

    One possible bullish play is to buy a call spread:

    Buy XYZ Feb 21 ’14 75 calls and sell an equal number of XYZ Feb 21 ’14 80 calls. These trades are made simultaneously by entering a ‘spread order’ with your broker.

The options expire after the close of business on Feb 21, 2014.

The option strike prices are $75 and $80 respectively. In other words, those are the prices that the option owner has the right to pay for 100 shares – if and when that person decides to exercise those rights.

Buying the 75 call gives you the right to buy 100 shares of XYZ at $75 per share.
Selling the 80 call gives you an obligation. You may (or may not, depending on the price of XYZ when expiration arrives) be required to sell 100 shares of XYZ at $80 per share.

Important: There is no reason to fear the obligation to sell shares, even if you entered into this trade without owning any shares. Why? If the stock is above $80 per share and you are forced to sell those 100 shares at $80 per share, then the stock will (obviously) also be above $75 per share so that you can exercise your rights as the option owner to buy those shares at $75. When the smoke clears, you will have bought 100 share at $75 and sold 100 shares at $80, locking in a profit. You would have no remaining position.

This is a bullish position because the spread you bought gains value as the price of the underlying stock rallies.

An example of a bearish trade is to buy a put spread.

Example:

    XYZ is $75 per share
    Buy XYZ Feb 21 ’14 75 puts and sell an equal number of XYZ Feb 21 ’14 70 puts. These trades are made simultaneously by entering a ‘spread order’ with your broker. We are buying the put spread because the $75 put is more valuable than the $70 put. When we buy the more valuable option, we are buying the spread and paying cash.

It the stock moves below $75 per share, then both options gain value. However, the put with the higher strike price gains value more quickly. That means that the spread increases in value and you earn money if the stock declines, as hoped.

If the price is below $70 when expiration arrives, both options are ITM and the spread reaches its maximum value ($500). This is a bearish position because it earns a profit as the stock price falls.

Buying the 75 put gives you the right to sell 100 shares of XYZ at $75 per share.
Selling the 70 put may obligate you to buy 100 shares of XYZ at $70 per share. This obligation will go away if XYZ is higher than $70 when expiration arrives.

There is a lot more to learn about trading spreads. We barely touched the surface. Stay tuned.

*****

The classic 2002 options book on covered call writing is now available as both an ebook ($3.99) or paperback ($7.77, or less).
ShortBookOnOptions

http://goo.gl/8QUIK0

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Rookie Stuff 01

It is easy for anyone who teaches others about how to use options to overlook the most beginnerish topics. It is difficult to recall just what each of us knew way back then, when we began to learn about options.

Some traders have good experience with markets in general because they have been buying and selling stock for years. Others are looking into options as their entrance into the investment world. To me it is obvious that teachers cannot give the same lessons to each group. Previous trading experience makes the learning curve easier to handle.

The following is a brief idea for anyone who wants to begin trading options, and who truly does not know where to begin:

Word of caution to the brand-new trader

You chose a broker and opened an account. Excellent.

If making your first trade excites you, please slow down. Here is an important lesson in just a few sentences:

    If you have a strong bullish opinion on a specific stock, do not believe that all you have to do is buy some call options and that you will make money.

    –First, stocks do not always rally when you expect them to do so.–

    –Second, choosing an appropriate option to buy is a matter of skill. You cannot choose some cheap option at random and expect to make money.–

    –Third, no matter how well your friend did of the one trade idea that he shared with you, the chances are high that he did not share his many losing trades.–

    –Bottom line: It is very difficult to make money when buying options unless you have a proven track record — in writing — of just how skilled you are.

    Options for Rookies advice: Learn first; trade later.

New (2014) ebook

New (2014) ebook

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Educating an options trader

Gaining a sufficient education

The setup: A newbie to the options world is learning about options. He/she picks up certain pieces of information (only those specified) in one sitting or one lesson.

Information packet #1

Let’s assume that you understood this much:

  • If bullish, buying a call is appropriate
  • If bearish, buying a put is appropriate

Education status: Let’s hope that no one believes this information is of much use. Trades made on the basis of this information are likely to result in a loss.

Information packet #2

  • Options are not always reasonably priced
  • Sometimes the trader gets a bargain – increasing the odds of winning
  • Sometimes the trader pays too much – decreasing any chance to earn a profit
  • A reasonable estimate of the fair value of an option can be made

Education status: The intelligent trader knows not to buy calls or puts based on a market bias, but is snot yet ready to begin trading.

information packet #3
Our trader finds a source that explains the basic idea of volatility. Not all the details, but enough to recognize how volatility affects option prices. Enough to recognize that implied volatility (IV) moves from high to low (significantly affecting option prices) in what appears to be a random path. Historical volatility (HV) for a stock is readily available.

Education status:

  • Pay a reasonable price when buying options
  • Understanding the concept of HV and IV allows the trader to trade at more appropriate times and to avoid overpaying for options

Education status: This is enough knowledge to get started – preferably with a paper-trading account. This is nowhere near sufficient, but the trader has a chance to make an intelligent, rather than a random, trade.

The first ‘packet’ was more dangerous than helpful.
The second offers a warning which alerts the trader to proceed with caution.
The third gives the trader a fair chance to pay a reasonable price.
This is enough to enter the game with virtual money.

It is not sufficient. It offers no warning about risk or risk management. The trader stands a chance, albeit a small chance, to earn money.

Information packet #4
Prognostication: It is not easy to predict market direction. Most highly-paid, professional traders cannot do it consistently.

    Personal note: I do not understand why so many people suggest that a trader can learn technical analysis quickly, and with minor effort, and then use charts to predict market direction. Experts tell us that technical analysis is difficult to master, while the hype artists tell us it is a cinch.

    I do not understand why new traders are not immediately taught that being bullish does not mean a stock will move higher. Or that it’s crucial to buy the right options. Or that ‘technical analysis’ is neither easy to learn nor universally accepted.

This information packet is seldom available. Students ‘learn’ that chart reading is easy to master. They believe that being bullish leads to easy profits. This harms most students by providing false confidence.

The truth: Trading is difficult. Making money is not guaranteed. There is no reason to pay high prices for an education.

Education status: Teaching beginners to rely on graphs is harmful. Learning that market prediction is often a waste of time makes a big difference by helping the trader face reality.

Information packet #5

  • It is a bad idea to buy OTM options
  • Buying options requires good timing, as well as picking direction
  • Earning money when buying options is a difficult task. Not impossible, but difficult

Education status: This is more than enough for most people to get started. Unfortunately, it is not the curriculum of many options educators.

The trader who has been exposed to these five packets of information recognizes that the price paid for an option is important and has some idea of how to decide whether the price is reasonable. The newbie learns that there are many factors that go into the decision on buying options. This is more than many beginners get out of their courses.

It is sufficient information. With an idea of when to buy, how much to pay, the importance of timing, the chances of success, the trader’s skill in using charts – a new trader can decide whether to go ahead and spend some time practicing this strategy, or whether to seek another.

Personal note: Far too may ‘educators’ teach so little of what is sufficient and teach only enough to get the novice excited about using options. That works for the educator. That sells more courses and more lessons. The student soon learns that he/she does not know enough to trade effectively, neatly falling into the ‘more lessons’ trap of the instructor.

Students should get sufficient information the first time. Each person learns at his/her own pace, and the time required varies with each person. It is unfair to offer the student too little and then send him/her out to trade.

I’m doing what I can to combat that nonsense, but my efforts are apparently a well-kept secret.

To learn more about my idea of teaching beginners to trade, visit Options for Rookies Premium.

Information packet #6

  • It is mandatory to manage risk with care
  • Appropriate position size is step one in risk management
  • Hedging reduces risk

Does packet #6 add anything of value?

Yes. It completes the ‘sufficiency’ requirement. Enough to make a solid beginning. Lots of practice is required. Skills must be developed and honed, but the student has the background needed for success. Risk management is an essential ingredient of any trading course.

An options education

There are a bunch of well-qualified options instructors. However, some deliberately offer too little – hoping to sell more lessons. Others offer too little because they are not qualified to help traders find success.

When it comes to decision making and the ability to choose trades wisely, too many novices are left to their own devices, instead of being taught the ropes by their teachers.

How is the new trader to judge whom to trust? No beginner knows what it is that must be learned, and is forced to trust the teacher. The truth is that many cannot be trusted.

977
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Misconceptions that will not go away

One of my basic jobs as an education blogger is to field questions from investors who don’t quite get how options work and explain situations in terms they can understand. This is something that I believe I do very well and it’s the reason I prefer to work with people who are in the early stages of their trading career.

However, I do occasionally receive the same or similar question from the same reader. That means that I have failed to do my job, or I have encountered someone who simply does not understand. It’s true that options are not for everyone, but I thought that refers to people who decide that the advantages of using options are not sufficient to overcome the required sacrifices.

Mark,

I thought you did an excellent job of explaining writing covered calls. Still, I am so confused now I almost do not know how to phrase my question. I will try.

1. When I bought a call position on an underlying stock, and the stock price exceeds the strike price and the cost of the option, regardless of time remaining, am I in the money?

2.When I want to sell (to close) my call position, what price do I receive? The bid price?

A note: I have been trading stocks only for 4 years and am up 90%. I am now studying these options but am unsure, scared actually of the bid and ask prices fooling me – even when I correctly select a rising stock price level. So maybe my question is: is it possible for a stock to exceed the cost of the call option+ premium and by option expiry still not make money?

Craig

Craig,

There is a cry for help in your questions. I get your frustration. However, I need your cooperation.

If you don’t know that you can sell at the bid price, how do you trade? That is so basic. You have been trading stock for four years? Really? When you sell stock, do you sell at the bid price? Options are no different.

Somehow you missed the boat. Wherever it is that you learned about options, it has failed you. You came away from your education with wrong ideas and essentially ZERO understanding of how options work. Sure, you know that buying call options may lead to profits when the stock rises, but that’s not enough information.

Let’s see if I can help with a brief reply. You are going to be asked to forget what you believe and to believe something different. Can you do that?

To begin, a covered call is an option you sold. Your question concerns an option you bought. That is an entirely different situation.

1) Forget the price of the option. Forget the premium paid. If the stock price exceeds the strike price of a call option, then yes, the option (not you, but the option) is in the money.

The cost is 100% irrelevant. I explained that earlier.

An option is in the money (ITM) when the option has intrinsic value. A call option is ITM when the stock price is higher than the strike price. A put option is ITM when the stock price is below the strike price.

Please note: The option premium (price paid for the option) is not part of the definition. The term ITM is a definition. It compares only two things: stock price and strike price. Option cost is not part of the definition. Profitability is not part of the definition. You are asking about profitability on one hand and ITM on the other. They are NOT the same thing.

It’s very simple: If you can sell your option for more than you paid, you have a profit. This is no different from trading stock. It’s not necessary to add this to that and arrive at a sum. It’s not necessary to add premium to strike price. All you have to do is compare the cost with the proceeds.

2) Yes. You receive the bid price. However, you are not obligated to accept that price. You may try to get a higher price. How do you do that? Just ask.

Enter a LIMIT order to sell, stipulating the LOWEST price that you will accept. Sometimes that limit order is not filled because no one is willing to pay that price. But it does not hurt to ask. Thus, If the market is $4.00 bid and $4.30 ask, you can try to sell at a price above $4. In this scenario, I suggest asking $4.10. Don’t ask $5 and expect to get anyone to pay that.

Set your limit price above the bid price, but less that midway between the bid and ask prices. In my example, that would be $4.15 or less. That’s why I chose $4.10. If no one wants to pay $4.10, after five minutes you can always lower your limit price to $4.00.

3. Why do bid and ask prices scare you? Stocks also have bid and ask prices. Do you know what you are doing when trading stock? If yes, options trade the same way. The products are very different, but each trades on an exchange, each had bid and ask prices. Why do options frighten you but stocks do not?

4. As to your last question. The answer is no, assuming you meant to ask if the stock price exceeds the strike price plus the premium paid for the option. In that scenario you earned a profit (it may be very small).

But you are misguided when it comes to options. You clearly got off on the wrong foot, did not learn anything practical. You seem unable to get rid of misconceptions that hurt becasue they result in your looking at specific situations in a strange manner.

Suggestion

Start all over. Find a different place to learn. Perhaps a different book (try The Rookies Guide to Options), perhaps some free webinars from your broker…Do something different. Pretend you know NOTHING and begin again.

Advice: When you buy an option, there is no reason to hold it to expiration. In fact, that is a very foolish thing to do.

You bought the option when you wanted to buy it. So why would you consider selling at any time OTHER than when YOU want to sell? Why would you hold to expiration and accept that as a randomly chosen selling time? Don’t do it.

Options have time decay. The longer you hold, the more it costs. Thus, sell the option when you no longer want to own it. Sell the option when you believe the stock is no longer moving higher. Sell the option before expiration and you will not lose all of the time value.

954

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Advice for the new options trader

I ‘borrowed’ (and modified) the following question from the EliteTrader Forum.

I have been studying, paper trading, and real trading – using mixed options strategies with mixed results. I mainly sold call & put spreads and did ok – until I got hammered on one trade. I’ve tried weekly & monthly expiration because I was attracted to these trades and their high probability of profit.

I have a $5k account and pay $1.50/contract flat rate commissions. At the moment, I am being lured into iron condors.

I am not dependent on my account but I want to grow it. I prefer strategies that require low monitoring/maintenance, but I am open to suggestions. What strategies should I try to incorporate and why?

Good news for this trader

This rookie trader is seeking advice, has experimented with several trade ideas, has a good attitude (does not expect instant riches), and incurred a loss from which he has learned a lesson. He appears to be patient and is seeking new ideas to consider.

This person has a nice edge: He has a flat rate commission per contract. That allows him to trade small size (yes, even one-lots) without having to be concerned that the ‘per ticket’ charge will consume too much of any profit. This was an intelligent item to negotiate and I strongly recommend this idea for all traders who trade small size. The savings can be significant – if you can get them.

The not so good part of the story

He is being ‘lured’ into a new strategy, but he should only adopt this play if he feels comfortable using it. In truth, it’s merely a combination of the strategies he has already been using – and in my opinion, anyone who understands the risks associated with selling vertical spreads is ready to consider trading iron condors.

The other problem is the size of the trading account. I understand that brokers allow customers to trade with even less capital, but it is a difficult task. It is simply too easy to lose the entire account when it is small.

Advice

As a young person with a job, he is in position to make a deposit into this account every time he receives a paycheck. That’s an outstanding method for increasing wealth over time. However, with this advantage comes the responsibility of carefully managing risk.

Learning to do this well takes time. The best recommendation I have is to be very careful with trade size because that is the simplest and most efficient method for managing risk for any trader. Smaller is better. Less risk and less profit potential is better – especially when the trader is first getting started. There is plenty of time to increase size as experience and confidence grow.

Patience is necessary because some strategies (such as selling credit spreads) may take some time to perform as hoped. [It’s true that selling a put spread can become very profitable quickly when the stock rises, but in a neutral market, iron condors require patience and good risk management.] Experience does not come quickly.

I also offer this advice for our rookie trader:

  • Rapid time decay may look great on paper, but (as you already learned) it comes with explosive negative gamma, making these trades riskier than they appear
  • Longer-term options come with higher premium and more protection against unwanted market moves. They also lose time value more slowly
    • Trading involves trade-offs. Less risk requires accepting a smaller profit target.
    • Your problem is to find the trade-off that feels ‘just’ right.’ Not a simple task – but it gets easier with experience
  • Choosing a good strategy is important. You want to feel that you understand how to use it effectively
  • However, risk management is more important and will have the greatest effect on your overall performance
  • Which strategies?

    The list is long. Options are very versatile and provide many alternatives. If you are comfortable with credit spreads, they make an excellent choice because losses are limited, margin requirement is small – allowing you to diversify, and they are easy to understand.

    Then there is something you may not yet recognize: Selling the put spread is equivalent to the very conservative collar strategy. More than that, selling put spreads is the same as buying call spreads (same stock, strike, and expiration date), and selling call spreads is the same as buying put spreads (same stock, strike, and expiration date).

    That means you are already using a much wider variety of strategies than you realize.

    I believe you are on the right track. Don’t get greedy. Increase position size one contract at a time, and don’t do that too frequently. Keep asking questions and don’t accept all replies as ‘correct.’ Use your own judgment.

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