Stocks to Options: It’s a BIG Move

Hi again, Mark.

First I'd like to thank you for your blog, not many authors dedicate that much time to answering questions, especially for free. To be honest I don't know any 🙂 

My job is be as helpful as possible. This is an educational blog. However, it does take a substantial portion of my day and I understand why most bloggers cannot do it.

I have a question i hope you can answer regarding options. I have some basic knowledge and experience in options, but I find owning stocks to be much worry-less for me.

The reason I describe my nature is to help you understand my question. The only factors that make me buy a stock are fundamental. I use neither technical analysis nor stop losses, hoping to be right on the long-term. I prefer owning large-cap companies with good perspectives and great current balances and cash-flows. They represent 95% of my portfolio and I hold them for months to years, until the price gets high enough to be satisfying. I am 29 years old, 75% of my total savings are in the market, 20% are in fixed-income securities, so I guess I can be called risk-hungry.  

You are also reward-hungry, and if your current bills and expenses are covered – with money that is not invested – then you are probably safe from a disaster. Losing a ton of money would not be fun, but if you can survive and build again, then this is viable. As you age, you must consider cutting back to more safety, Especially if your plan works and you become wealthy.

A few years ago I learned about options, got burned the first time I tried to trade them. I learned great lessons from that experience and now I am deciding how options an help me achieve better results with stocks. So I would like to dedicate the remaining 5% for options.

Practically I have 3 ways to go:

1. Trade independent option positions.

2. Trade options vs. my stocks

3. Don't trade options.

I guess I can say that my goal is to increase my portfolio beta. Ideally the perfect goal is to outperform market on bull times and to market-perform at bear.  

I assume you want to increase your portfolio volatility.  I use that term to mean that you want to make/lose more money than you do currently – obviously hoping that the volatility is to the profit side. As a risk taker, I'm confident that the portfolio will be more volatile.  The job is to not accelerate losses.

As you can see I'm 100% delta-positive, and prefer being short theta. There are times when fortune offers great gifts like big bull gaps or strong unexpected rallies, and I prefer to accept those gifts by selling high. In general I don't like to sell options, I'm psychologically incompatible with reducing my long delta, and with capping upside potential with short naked puts.  

There is nothing wrong with only buying calls (apparently neither buying nor selling puts appeals to you).  Being aggressive, you are not happy with limited gains. 

However, you must be aware this is a very difficult methodology when looking to earn money with options.  This is going to be different from your current trading. In addition to picking the right stocks, you now have to be good at market timing. Patience is not an option for the call buyer.

With all that in mind I see the following strategies that can suit my needs:

1. Buying a call with a long stock. Plain and simple – leverage.  Increases initial stock risk as well as possible returns.  

One immediate problem is that you have not defined the strategy in enough detail. There is a HUGE difference between buying in the money, at the money, or out of the money options. You don't strike me as an OTM buyer, but I'd love to know which options you plan to buy.

If you plan to buy ITM, or high delta options, there is no need to buy stock.  If you buy ATM or OTM options, your chances of making money are diminished – unless you are either a good market timer (and you have not so indicated), or else you are just sitting and waiting for one of those market surges mentioned earlier.

Buying the calls and paying the premium makes it less likely that you will earn a profit on any given trade.

So I ask: How good is your track record when buying stock? How good is your timing?


2. Buying a call after the stock falls. Even more risk on one side, a better price for the desirable stock on the other.  

This is the same strategy as number 1. All that changes is the timing, and timing is crucial for the option trader.

 

3. Ratio-spread vs.a stock. Enhances profit till the short call strike, for free. Looks great because of no additional risk, but obliges to sell the stock when actually I may consider adding more.

Same goes to covered-calls.  

At first I thought the plan here was to sell extra call options.  But that's not you.  So you must mean: buy 100 shares of stock, but one call and sell two calls.  If you carry the position to expiration, then I see why you believe the play is 'free.'  In reality, there is a cost.  And you realize that cost.  It's the obligation to sell your stock at the strike price.

Many traders are happy when assigned an exercise notice on a covered call. Because you are not one of them, may I suggest an alternative?  It keeps the huge profit potential alive, but at a cost.  Instead of writing a covered call, write a call spread.  You would still be short that one call option, but you would own another at a higher strike price.

 

4. Selling straddles vs. stock. Acceptable exit on the upside but I may not want to increase some stock positions in case of put assignment.

If you don't want to accept assignment, this is not a good strategy. I suggest not selling puts for any stock that you do not want to add to your portfolio. 

As an alternative, go ahead and sell the puts.  If necessary buy them back at a loss, rather than get long the stock. If you are willing to do that, then this strategy is okay. But keep this in mind. This play, called a covered straddle, it exactly the same as selling two naked puts or writing two covered calls. The covered straddle is popular, but most traders do not recognize the true position.

 

5. Naked independent long calls – same as 1 but with more portfolio diversification.  

This is not for someone who picks stocks based on fundamentals and holds them. This is for people who have the talent to both pick market direction AND time the move. This is the path to ruin for the vast majority of traders.

 

6. Independent long straddles. I consider this spread best suits me. Increased profit on the upside, some portfolio protection from the overall market decline.  

Ok, you get some protection. That's good. But if you expect to make money over the longer term with this methodology, you are living in a dream world. The straddle is very expensive, only works when you get a volatility explosion (raising the straddle price – at which time you must sell), or your stock makes a big move. This does not happen often enough for this to be a viable play – in my opinion.

 

Index iron condors can't exist peacefully with my psychology, I am all one-way directional.  

Nothing wrong with that. The question is: Can you move from stocks – with no time limit on your plays – to owning options, the wasting asset? Can you tolerate the time decay as you patiently wait for your stock to move? If you are making money with your current approach, are you making it because the stocks move quickly, or because they move eventually? Can you live when owning wasting assets? Only you know the answer.


So my question is – do I miss something important?

Market timing, time decay, ability to time the market, rather than just pick stocks that do well over time.  You need to have those specific talents.  If you are good at what you do now, be careful before jeopardizing that income source. 

 

Am I wrong with my judgment on some of the mentioned spreads?

I don't believe you understand how these play out in reality. On paper, owning calls (and/or puts) looks great.  The profit potential is enormous.  In the real world, you don't get those gigantic moves very often.

I urge you to open a paper trading account and try each of these strategies. Repeatedly. Month after month. Then see how well you do compared with buying the stocks outright. Do not go from being a successful investor to becoming a losing options trader. Be certain you have what it takes to be a directional OPTION trader. It requires different skills than it takes to be a successful STOCK investor.

 

Maybe there are better ways to use options in my case, or not use them at all.

If you are unwilling to accept limited gain strategies, such as writing calls against some of your stock holdings, I don't have any other ideas to suggest. You covered most of the directional strategies (there are other, more complicated plays), and if directional is what you choose, then the big decision is whether to play or not.

Options were designed to hedge risk. You have no interest in using them that way, so there is nothing I can tell you except to practice first – or trade one-lots while you gain a lot of experience.  You must learn whether or not you have the talent to time the market moves.

Thanks in advance, your answer will be greatly appreciated.

Good questions.  I also appreciate them.  Good trading.

 

7 Responses to Stocks to Options: It’s a BIG Move

  1. Gus 01/21/2011 at 1:23 PM #

    I know you don’t like selling options, but being stocks your primary trading instrument, selling cash secured puts should be you primary option strategy. Lets say you like MSFT (“large-cap companies with good perspectives and great current balances and cash-flows”) and you like to buy lets say 1,000 shares; if you buy the stock now, you would have to pay 28.14 and that would mean that you like MSFT at 28.14 and of course you would also mean that you really like MSFT at 27. Therefore, my suggestion would be sell the FEB 27 put which pays today $ .42 per lot for a total of $ 420 before comissions.
    Potential scenarios:
    1) Stock goes up. Keep the $ 420 at expiration. Yes, you could have won more if you would have bought the stock outright, but hey, no strategy it’s perfect.
    2) Stock does nothing or goes down a little but it’s above 27 at expiration. Keep the $ 420. If you would have bought the stock outright, you would have lost money.
    3) Stock goes down and falls below 27 at expiration. You are assigned and now own 1,000 shares of MSFT at $ 26.58 (27-.42). Not bad considering that one month ago you liked the same stock at 28.14.
    Margin for this strategy is 1,000 shares times 27= $ 27,000.
    Good luck.

  2. Mark Wolfinger 01/21/2011 at 1:28 PM #

    Hello Gus,
    I like the advice and recommend it for most stock investors.
    The problem here is that this trader wants to make big money. He does not want to miss the occasional big rally and would not be satisfied with earning good money by selling puts.
    He wants to earn BIG money. Selling puts does not satisfy his personal needs.
    Thanks

  3. Tom Sater 01/21/2011 at 7:26 PM #

    Hi Mark,
    First, I am so glad I discovered this site! The hours I have spent poring over the archives convinced me that I CAN use options to reach a risk-comfort level in the market while also potentially meeting my investment / retirement objectives.
    Second, thank you so very much for writing The Rookie’s Guide to Options. I found it straightforward and extremely educational. The explanations and illustrations were clear, and I had several “aha!” moments as I worked my way through it. I continually refer to it and various websites mentioned in its footnotes as I develop my own Excel-based tracking and analysis tools.
    I am in the beginning stages of taking my first steps into options by selling covered calls. As such, one of the things that I’ve been contemplating is how best to approach and trade through “earnings reporting season”, given the heightened volatility that can come with it. My initial thought is that it would be better (less risky) to avoid underlying stocks that have earnings reporting dates between when a position would be entered and the option’s expiration date (assuming one is selling options that expire one month out). This could obviously be done in a number of ways, from selecting underlying stocks that have either already reported or will report sometime after expiration, or by selecting broader-market ETFs which, of course, have no singular reporting date, even though they may move based on reporting-season events.
    I’m curious about your thoughts on this. I know you’ve moved on from simply selling covered calls, but thought you might have some “points to ponder” for those of us who are genuinely rookies at this.
    Thanks,
    Tom
    P.S.: I had to laugh when I called my Scottrade options rep the other day, and was told that I was restricted from selling cash-secured puts because it is “much more risky than selling covered calls” (which I am at liberty to do). I gave him the exact “equivalent position” argument that you so clearly provide in your book, but it soon became obvious that I was talking with someone who was more of an options rookie than I am!

  4. Mark Wolfinger 01/21/2011 at 7:46 PM #

    Tom,
    Welcome!
    Selling options (the covered call by force, or the naked put) into earnings news gets the trader exactly what you said: more risk. However, that comes with higher reward potential.
    I prefer to avoid that higher risk and always recommend that others seriously consider the higher risk before making the play.
    If you trade small size and if you are a higher risk person, this play is okay. This assumes you have a reason to make a bullish play on the given stock.
    If you prefer to take less risk, then I would avoid this situation. It’s a personal preference. There is (as I like to say) no right or wrong here.
    Regards
    Mark

  5. Tom 01/21/2011 at 9:13 PM #

    Thanks, Mark…you’ve confirmed my line of thinking.
    Tom

  6. Dmitry 01/23/2011 at 11:09 AM #

    Mark, can you please provide some indepth info on what would the preferrable steps to leg in IC spread by spread would be? In.ex. if i open the put side today and next week index moves higher i sell the call side, that`s great. But what if next week index moves lower? Rolldown the puts? Take losses and wait for another opportunity? Sell the calls at current prices?
    My second question is: from your experience, would an IC constructed around 1 standart deviation be realy ~68% of keeping all the premium (given we do not make adjustments, in plain theory)?
    Thanks.

  7. Mark Wolfinger 01/23/2011 at 11:48 AM #

    Dmitry,
    In depth discussions are not always possible. That’s the stuff of which lessons and book chapters are made.
    But you don’t need a lot of information about legging into iron condor trades.
    I’ll reply Tuesday in a full blog post.
    Regards