Philosophy of Options Trading. Part I

Part I.  There's More to Trading Than the Mechanics

Any investor can buy or sell options.  The position can be hedged with stock or other options.  You choose a position to own, enter the order (at a limit price), and become the proud owner of that position (obviously, only if that limit order is filled).  Those are the mechanics of trading. 

That's merely the first step in the trading process.  Many traders spend a great deal of time deciding when is the best time to enter the trade, or the best price to get for the trade.  There's nothing wrong with that, especially for very short-term traders.  Beginners are more likely to enter a trade randomly, being anxious to own a position they can follow. 

But buying the position is merely acting on the decision to place the order.  It's also important to manage the trade and exit in a timely manner.  Just because it's a trade involving options does not mean that it's a good idea to hold positions until the options expire.  Once again, rookies may do that – simply because holding requires the fewest decisions.  Perhaps this series of posts can convince those rookies that there's much more to trading options than 'open position and forget it.'

It's true that day traders, swing traders, and investors with either a short- or long-term outlook, all have different objectives when trading options, or any other financial instrument.  The idea I want to be get across is that there's far more to trading than deciding on when to initiate the trade.  To that end, I'll discuss various aspects of trading and how I view them.

I am NOT suggesting that my ideas are 'correct' and that any conflicting ideas are 'wrong.'  I'm merely presenting what I believe are sound principles for investors  – especially rookies – to follow, but I truthfully hope that each of you will question every one of these ideas and consider whether it's appropriate for you and your style of trading. 

The purpose of this short series of posts is to provide a clearer understanding of what is involved with option trading, and to help you reach important decisions about how long to hold a position, how much risk to accept, how much profit to seek etc.  These are my ideas.  They are not gospel, and I encourage you to disagree with anything that doesn't feel right to you.  Perhaps you want to discuss the merits of any specific recommendation.  Feel free to comment and I'll reply.

I'll elaborate in future posts, but to get started, here are a few things I believe to be true:

Choosing the right strategy is important.  You must understand how the strategy works, the risks of owning the position, and how profits are generated.  But far more important than choosing the strategy is your ability to manage the risk of each investment.

When a position has earned a profit and you have the choice of continuing to hold the position or exiting, that profit is your money.  It is not 'the house's' money.  Treat that money with respect.

Trade within your comfort zone.


…to be continued.

351

6 Responses to Philosophy of Options Trading. Part I

  1. marathonman 06/09/2009 at 12:19 PM #

    Hi Mark really love these articles as I have now spent two years learning the basics of options and you know that your book has saved me a lot.
    Today;s column reminded me of some other comments that I see on the blog and other web places and thats how do the pro’s make money.
    For example, you were a market maker for 20+ years, there is no way that I will have that experience or exposure, how do the pro’s manage their money?
    I see that there are things like Gamma Scalping, Trading Vega, adding more Vega into positions, Delta Neutral and other like ideas, in addition to factoring in IV. How would a MM look at these issues, how do they maintain or ensure profitability with the complexities that they have to deal with.
    Where should the focus be in this complex mix of IV, Gamma, Delta, Theta that all interact with each other and interact with each other differently dependent upon how other factors come into play. Are these ideas when executed profitable? or, are they parts of the trading strategies.
    By the way I have spent a lot of time in your book reading about synthetic positions and those explanations have really helped.
    Thanks,
    Don

  2. Mark Wolfinger 06/09/2009 at 9:05 PM #

    Don,
    See blog post tomorrow 6/10/2009 for reply.

  3. Mark,
    Thanks for the tips, I try to read everyday. You said holding is the easiest non-decision and I find myself in this position. I have puts on BX for $11 to expire in Dec, but they are slowly declining and I am not sure what my best options are to reduce my losses?
    Regards,
    Jesse

  4. Mark Wolfinger 06/10/2009 at 8:59 PM #

    Jesse,
    It’s far easier to hold than it is to add to, or close a position. But I consider holding to be a real decision, even though most traders think of it as ‘doing nothing.’ The distinction is that I consider it to be ‘deciding to do nothing.’
    Your BEST option for reducing losses is to get a crystal ball and see where this stock will be trading in six months. assuming you cannot do that, there’s not much you can do with these options.
    The put is barely ITM, but six months is a long time. You can buy protection, but those puts are expensive. You can get out, take the loss and find a better trade. Or, if bullish on this stock, you can hold onto that short put position. At this point you have no idea what’s best, or you would have done it. I sympathesize, but it’s your decision. Is holding ok or does it make you uncomfortable?
    Consider closing a portion of the trade as a compromise.

  5. Sebastian 02/11/2012 at 9:56 PM #

    How do you find those options to invest in? And, how do you know, which are calls/puts, and or buy/sell?

    • Mark D Wolfinger 02/12/2012 at 10:46 AM #

      Hi Sebastian,

      I’d like to help with your question, but I cannot do so in good conscience. Your questions are so basic that I know for a fact that you are not ready to trade options.

      You don’t find the options. You find he stocks, then you have a damned good reason for believe you know how they will move. Then and only then do you look for the appropriate options to trade.

      Puts or calls are part of the definition of any option. When you find the option, you will find the put or call designation

      Buy or sell? If you don’t know whether to buy or sell, then you must slow down. Learn more about options and do not be in such a rush to trade. Selling options is a high risk strategy. Not for you. Buying options is for people who KNOW for a fact that they can predict market direction. It’s a pure gamble for someone who lack options knowledge.