Learn First; Then Trade

The
questions below were submitted by an option rookie to an online forum. 
I don't want to take pot shots at someone who is troubled and is
intelligently seeking help.  The problem is that he could have asked
questions first and saved himself from being in an uncomfortable position.

Please don't let this happen to you.  Get an options education before you begin trading.

***

"On Monday [Nov 17, 2008], on the advice of an options newsletter, I executed this trade:

"SIMULTANEOUSLY SELL (TO OPEN) SPY 77 PUT, AND BUY (TO OPEN) SPY NOVEMBER 75 PUT, WITH A LIMIT OF 0.14 CREDIT OR BETTER FOR THE SPREAD."

I'm currently losing money on this, as SPY is heading downward.
I'm
not familiar with credit spreads
, new to options.

What am I hoping for
in the above?
SPY is now about $82, was about $86 the other day

But I sort of thought that if I'm buying/selling puts between 75 and 77 that
the goal was to be in between the two for a break-even or above for a
profit.  But as it's above even now…

Well I just don't understand the trade at all.

Can someone explain what the above trade would leave me with as far as potential loss, expected break-even point, etc..?

Thanks"

*****

I
think it's a shame that this investor got trapped into trading options
with absolutely no idea of how he was going to earn a profit or how
much money was at risk in an attempt to earn that profit.  I have
subsequently learned that he bought his first option book, but decided
to trade while waiting for it to arrive.  I sympathize with that
'urgency' to get started because options can be enticing.  I remember
being anxious to get started (in 1975).

To make matters even
worse, this spread can earn a maximum $14 profit, before commissions. [NOTE:  My error.  I thought his was a September vertical spread.  I see that it's a diagonal.  Maximum profit is much higher] 
Because he is new to options, he may have traded a small number of
contracts, and the commissions could easily have eaten half to all of
that tiny premium.

This is not a rare occurrence.  When a trader
first hears about options, it's probably from a fervent options admirer and the
excitement can be contagious.  But, you use real money, it's
important to understand what you are doing first, and trade afterward.

The first problem is the newsletter.  I know most newsletter publishers have
high integrity, but others just want your money.  They want their readers to make lots of money.  But,
let's face reality.  If these people had a trading system that produced
profits consistently, do you think they would sell subscriptions for a
few measly dollars?  Wouldn't it be far more rewarding to trade their
own picks and make a fortune? 

But, there's something far more important that these newsletter publishers completely ignore – and I discuss it frequently
Suitability.  It's simply wrong to recommend a trade to 'everyone.' 
Each individual investor or trader has his/her own comfort zone and
tolerance for risk.  Selling a spread for fourteen cents (less
commissions) when the potential loss is $186 plus commissions is not
very good advice.  Sure the trade  began with a high probability of
success, and still has a reasonable chance to be a winner, but the
risk/reward ratio is way out of line.  This trade is simply unsuitable
for an option rookie.  In my opinion it's not suitable for anyone, but
that's probably going too far.

For any readers who want the
answers to his questions, the break-even point is $76.86 (in reality
it's higher because of the commissions involved).  The maximum loss for
the trade is $186 (plus commissions), but it's even worse than that. [Again, these are incorrect because I missed the fact that this is a diagonal]

If
SPY finishes between 75 and 77 and this investor fails to buy back the
Nov 77 puts, he will own shares on SPY on Monday, following
expiration.  That will possibly result in a margin call and a forced
sale.  But, even if the sale is not forced, he will find himself owning
shares of SPY, and it's not likely he wants to do that.  Thus, if the
market opens lower Monday, his loss will increase, and may even exceed
the current 'maximum loss.'  Of course, Monday may bring a bullish
opening, and he may end up with a profitable trade.  But it's a gamble
he probably prefers not to take.

I hope this investor comes out okay on this trade.  But more importantly, I hope it serves as a lesson learned.

Please avoid this trap.

169


2 Responses to Learn First; Then Trade

  1. Scott 11/20/2008 at 1:09 PM #

    I have a very quick question… are there any limits to how many contracts you can buy? Just hypothetically, say I wanted to buy 100,000 contracts at 1.00– the equivelant of 10 million dollars worth or 10 million shares of stock. Are there any restrictions on how many you can buy of one particular option? If not, in terms of liquidity, would this complicate the unloading process once I decide to sell out?

  2. Mark 11/20/2008 at 1:44 PM #

    Scott,
    Yes there is a limit, but it’s not on a specific option. The limit applies to all options of one type (put or call) on a single underlying asset.
    You did not ask, but that same limit applies when exercising options. That limit applies per day.
    But it’s a very large number that I cannot recall. I believe it’s 75,000 on some issues and 100,000 on others. This information is available. Just send the question to the Options Clearing Corporation and they will tell you. (options@theocc.com)
    If you held position limit quantity of options, it would most definitely be difficult to sell – especially all at one time. If it were in a stock that trades huge option volume, it would be easier, but still difficult. Remember, if you want to sell 100,000 contracts, that means there is shortly going to be somewhere near 10 million shares of stock for sale (call buyers will hedge by selling stock). That will kill the stock price immediately – and that will make it even more difficult to sell your call options.
    Mark