Comfort Zone

Here’s part of my investment philosophy

When initiating a new position most investors recognize the importance of placing a trade that they believe will produce a profit. Those who understand the importance of managing risk also understand the risk required to earn that profit. When you are satisfied with both the reward potential and possible loss for a given position, then you are within your comfort zone.

It's also important to remain within your comfort one as the trade progresses and time passes. This is the point that many traders miss. They mistakenly believe that if the position is acceptable when opened, that they don’t have to do anything until the options expire. That is a dangerous way of thinking.

 If market conditions change or if the price of the underlying stock (the stock tied to your options) changes, it’s possible that the position (let’s assume it’s a spread) leaves your comfort zone. This can happen when:

  • The spread becomes very profitable and there is little potential profit remaining. It’s great to have done well,
    but when holding the position until expiration can only earn a small additional profit, the risk of holding becomes too great because the reward potential is too small. If the stock makes an unexpected move, the profit you earned can easily disappear. Take your profits.
  • The underlying stock makes an unfavorable move and another such move would result in a substantial loss. If that potential loss is more than you can afford to lose, then  the risk of holding and hoping that the stock reverses direction is too great – and closing (or otherwise adjusting) the position is probably the wisest step you can take.

Comfort zones should be flexible as you gain more experience trading options. That does not mean taking on more risk, but it does mean that it’s appropriate to change your basic methods as market conditions change. For example, bullish strategies such as writing covered calls may make you uncomfortable (for good reason) when
the market is bearish and you may prefer to trade iron condors instead. That’s why it’s a good idea to be aware of alternative strategies, even when you have no immediate intention of adopting any of them. They become part of your arsenal of useful trading tools.

  • Dr. Brett Steenbargen, whose expertise is trading psychology, makes this point very well in his trading blog (dated May 17, 2008) “It’s difficult to succeed at trading, but–given rapidly changing market conditions – even more difficult to sustain success. It’s not good enough to find winning trading techniques; one has to continually adapt these techniques to an ever-changing environment.”
  • Jeff White, in his blog espouses a similar philosophy for day traders.

 

New Optionspeak
terms:

Spread
– A position consisting of two or more options on the same underlying stock. One option hedges (reduces the risk of holding) the other option in the spread. Example: buy one call option and sell another call. This strategy limits gains, but more importantly, limits losses.

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2 Responses to Comfort Zone

  1. TR 06/18/2008 at 7:52 PM #

    Hi Mark
    Thanks for an excellent commentary.
    I am relatively new to options trading and so far have been mainly writing covered calls on ETF’s I own.
    I have a question for you regarding differences in implied volatility between puts and calls. I did some IV calculations today on SPY
    SPY Jun 135 Call IV = 15%
    SPY Jun 135 Put IV = 30%
    SPY Jul 135 Call IV= 17%
    SPY Jul 135 Put IV=24%
    SPY Jul 140 Call IV = 16%
    SPY Jul 140 Put IV = 25%
    It seems that for the same strike price Put options have a significantly higher IV than Call options. Based on this, am I correct in thinking that a naked put writing strategy will outperform covered call writing? And, how should I take into account dividends when choosing between writing Naked Puts and Covered Calls?
    I look forward to reading your response.
    TR

  2. Mark Wolfinger 06/18/2008 at 9:02 PM #

    Hello TR,
    Option implied volatilities are skewed. That means they are unequal and in fact, the lower the strike price, the higher the implied volatility (IV).
    The major reasons this occurs are
    •Markets fall much faster than they rise
    •As markets rise, there are always people who have stock for sale and that limits the rate at which markets can rally. Thus, investors are willing to pay less (lower IV) for out of the money calls – because there is a reduced probability that the stock will move far enough.
    •As markets fall, sometimes buyers disappear and losses (for stockholders) can be staggering. Hence people pay more to own out of the money puts.
    •More investors and hedge funds want to own out of the money put options as either insurance against a catastrophic loss or to make a killing if a black swan event occurs.
    As to writing puts rather than covered calls, no – you cannot expect to earn a better return.
    When you write a covered call, you must use cash to buy stock and doing so requires that you forfeit interest that you would have earned if you did not have to spend the cash. To make up for that interest expense, covered calls (regardless of the IV you calculated) pay more time premium than the corresponding put.
    EXAMPLE: XYZ stock is 82.
    The Oct 75 call is priced at $9.00. That’s $7.00 in intrinsic value and $2.00 in time value (or time premium)
    When the markets are efficient, as they are almost all the time, the profit potential is the same whether you write the covered call or cash-secured naked put:
    The Oct 75 put will be priced at $2.00 (the same time premium as the corresponding call), minus the interest that can be earned on $75 from today through the October expiration.
    As far as dividends go, the markets take the effect of the dividend into consideration and the puts and calls are priced appropriately. That means that the options “know” that the dividend is coming and calls are priced lower and puts are priced higher than they would be if there were no dividend. Thus, you don’t have to be too concerned about the dividend.
    BUT: If you are planning on collecting that dividend as a covered call writer, you must understand that the call owner has the right to exercise the call at any time – and may do so the day before the stock goes ex-dividend. If that happens, you are forced to sell your stock and you do not collect that dividend. Do not ignore this possibility when you write covered calls, especially when the call is in the money.
    Mark