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Guest Blog: Important Trade Lessons

Options for Rookies New Home Page



Bill Burton
is a retired physician who practiced medicine in suburban Dallas for
over 25 years. He became interested in options in the late 1980's. Since
then, he's been perfecting his craft and focuses on equity and index
options over a short- to medium-term time frame, using both directional
and non-directional strategies. Bill contributes to the
options blog at http://markettaker.com/


New Grooves on the Brain

The human brain is a wonderfully complex organ that is masterfully organized in both structure and function. To the observer first studying its anatomy, the most readily appreciable feature is the complex topographical organization of the external cortical surface of the frontal lobes, where higher levels of thinking occur.

The external surface is thrown into broad serpentine ridges (gyri) separated by deep narrow grooves (sulci). I always thought it an apt metaphor that knowledge gained by experience made the grooves more complex, much as the experience gained in life is often reflected in a deeply furrowed brow.

These things I learned the hard way:

  1. Ancient Chinese philosophers realized that with great danger often comes great opportunity. This nexus is further reinforced by the fact that the Chinese character representing both danger and opportunity is the same. Remember that only those who possess and use the necessary skills to survive the period of great danger are in position to profit from great opportunity. Risk control is paramount.
  2. The extrinsic (time) component of the option premium goes to zero at options expiration. Always.
  3. Although statisticians would argue, the probability of occurrence of an extremely unlikely event is much greater if you "bet the farm" on the event not occurring. Never forget that black swans do exist.
  4. The human brain is not inherently logical. It evolved for survival and is prone to make erroneous assumptions and draw incorrect associations. To guard against these potentially costly errors, continuously challenge your assumptions.
  5. Absence of proof does not constitute proof of absence.
  6. Thinly traded options are usually characterized by egregious B/A spreads. You may be able to negotiate acceptable spreads to enter the trade. You will not be able to do so if you need to exit. It is usually better to stay away from these snares.
  7. Option orders executed as spreads always receive better fills than individually placed orders.
  8. Failure to consider current IV in an historic framework for the particular underlying will usually cost money.
  9. Failure to follow predicted changes in volatility prior to a known event (e.g. earnings) indicates there is some factor of which you know not. When discovered, it usually impacts your position negatively.
  10. Failure to use and understand option modeling and option modeling software puts you at a significant competitive disadvantage to other participants in the options market. The only thing more expensive than having appropriate tools is not having them.
  11. It is stunningly easy to "roll more than you can smoke". It is usually disastrous to attempt to smoke all you rolled if you find yourself in these circumstances. This is another reason to model trades and crisply define risk.
  12. If you create multi-legged option beasts by manually entering the orders as opposed to entering from a graphical presentation, you will enter positions incorrectly and end up "upside down" and commit other similar errors more often than you thought possible. You must monitor the magnitude of extrinsic value when short options are ITM. Failure to do that and considering your trade plan in light of these developments, will result in unanticipated early assignment at the most inopportune times. Option positions can be easily adjusted to improve their structure only before they enter the ICU.
  13. Forgetting to honor time stops when holding certain varieties of option beasts can be as costly as forgetting price and/or P/L stops.
  14. Good traders know what they know; great traders also know what they don't know.
  15. If you don't understand the trade and its structure, you will lose money.
  16. Buying OTM options as a single position (as opposed to representing one of several legs of a spread) is almost always a bad idea.
  17. Keep your trade sheets tidy. Allowing short options with minimal value to remain on your sheets as opposed to closing them for trivial cost is not being frugal; it is denying the existence of unforeseen and unforeseeable risk.
  18. When trading options, as in life in general, you will make many errors. Each mistake contains a lesson. Study your mistakes and learn the lesson each teaches. You already paid for the instruction.
  19. Pickpockets prowl the option markets with great regularity. Their bread and butter trade is buying ITM options for less than the intrinsic value. Never sell an option for less than intrinsic value. Be aware of "Plan B" to capture the entirety of the intrinsic value.
  20. If all you have is a hammer, everything looks like a nail. The available option strategies are numerous and designed to accommodate a variety of market conditions. If you limit yourself to 1 or 2 strategies, you are not taking full advantage of the inherent flexibility of options. Learn several strategies, their nuances, and indications for their use.
  21. Avoid having open option positions on stocks that will split. Option trading has adequate complexities without dealing with non standard strikes and changes in contract size resulting from splits. Your head will explode trying to deal with these complications. Avoid them like swine flu; spend your energy elsewhere.
  22. Understanding the various concepts of volatility is essential for success. Volatility can be considered in light of:

    a. What was (SV, statistical vol; HV historical vol; different words and abbreviations for the same thing),

    b. What is,

    c. What shall be (IV, implied volatility, Market Implied Volatility (MIV); confusingly disparate words and acronyms signifying identical concepts)

     

    Of these three, IV is by far the most important. The nexus point is right here, right now. The future is unclear and always will be so. It is essential to understand IV and its various implications.

  23. Be relentless in your pursuit of perfection but accepting of the fact that you are human and will never achieve it.
  24. The first half hour of each day in the option markets is usually quite noisy; the predominant activity is fleecing the sheep. Don't be one of the sheep.
  25. Obfuscation of the basic concepts and structure of option strategies is the everyday business of the option community. The names of various strategies are multitudinous and confusing. Understand the concepts and be conversant with the various names of the strategies; success lies in analysis and execution not nomenclature.

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Iron Condors: Do I Take My Profit or Hold?

Mark,

Great post as always.

I've noticed that in the past, as here, you've
cautioned that milking a trade for the last ten cents is poor risk
management, which makes sense. But that decision seems relatively easy
to make at least in theory, if not in practice.

What about the trade that
is halfway there: say having gained 50% of the total possible profit
for a credit spread? It would seem to me that this is where the real
test of risk management lies and also the most difficult decision to
make in terms of closing or holding because this seems to be where the
most uncertainty occurs. How do you handle that decision?

Thanks,

Burt

***

Burt,

Good question.

Here's how I handle this situation.

I do not go through each of these
steps because I have done it enough times. However this is my thought
process.

1) I don't care how much profit has been earned so far on this (or any)
trade.
I know that this statement makes some readers believe I am
not telling the truth or that I am an idiot.

2) I look at the position I own right now and pretend I can exit
the trade at this price – paying zero commission.

3) Then I decide: Do I want to re-open this trade – at the same price,
and again for zero commission? Or am I happy to be out of the trade? I
consider the price, the date, the price of the underlying…You get it.
It's a new trade. Do I want it or another trade in its place?

4) It really is that simple. If I want to own it – I continue to hold
and do not exit.
If I am happy to be out, then I enter an order to exit the trade at my
price.
If undecided, I cover a portion. How much to cover depends on
the reason for my indecision. This rarely happens. I find it easy to
decide if I want the position in my portfolio. That comes with
experience.

5) Burt – this is why I consider 'do nothing' to be an active trade
decision. Sure, everyone knows buy is an active decision. So is sell
or adjust. But doing nothing is not an act of boredom or disinterest.
It's an active decision to HOLD.

737


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Mark to Market Nightmare

Hi Mark:

Good morning and just curious — By the "Flash Crash" on May, 6th,
2010, By what you know personally, is it still possible that a bull put
spread (sell high strike and buy low strike) makes a trader get a "flash
bankruptcy"???

Although at the end of that day, the market was down only
3.6%. How should people choose the strike price difference to avoid a "flash
bankruptcy"???


Is "total position worst case scenario" the only way???

Thanks!!

Henry Tzuo

***

Henry,

 A very interesting question.
I do not believe you can do anything by choosing different strike
prices.

If the problem exists, I don't believe worst case scenario pricing would solve
anything.

I suggest calling your broker and asking what they do if very wide bid ask spreads
suddenly mark your account to a deficit – when that deficit cannot
possibly be real. i.e. it results in marking such a 10-point spread at
$15. I plan to make such a call and will share the results if I learn anything.  Option trading would become difficult if brokers hurt their customers in this way.

I'd want to know what protection you, their customer, has from such wide bid/ask spreads.


1) First the margin situation:

For the majority who trade with Reg T margin requirements, there is
never supposed to be a problem because margin requires enough cash to
meet the worst possible outcome. But you are asking about worse than
worse case – and who knows what would happen. This is one of those things that 'cannot occur in the real world' -  but I would want an guarantee of some kind.


2) Next the 'account value' problem.


With gigantic market moves and very wide bid ask spreads, much depends
on the fairness of your broker's method for calculating account value.
For example, to be extra conservative, some brokers always determine the
value of any short option as the 'ask' price. They simultaneously
determine the value of any long option as the 'bid' price.

You can see where that leads. When you sold a spread that can never be
worth more than $10, this method can easily result in a spread valued
(marked) at $15 or $20.

Similarly, owners of such spreads that can never be worth less than zero can see the position marked at a negative $5.

Here's an example of a 'fast market' situation:

INDX Nov 700 put:  35 bid; 55 asked

INDX Nov 710 put:  40 bid; 60 asked

The spread market is -15 bid; 25 asked

Spread owners may have their spread marked at negative $15 and shorts may have it marked at $25.  A disaster for both.

If your broker uses midpoints, the spread is marked at $5, and you would be safe.


I don't know whether such brokers immediately
liquidate an account that suddenly is worth less than zero (in deficit) –
or whether there is some fail-safe mechanism to override their absurd
method of valuing an account.


The above is a nightmare. Every position closed results in another
large loss. The entire account can be liquidated, leaving the customer
owing gobs of money. That is easily the basis of a lawsuit.


I hope such a possibility does not exist.
If your broker is more reasonable, but still strict, it's difficult to
know how your broker handles the situation without asking the broker. My broker
immediately liquidates (the minimum possible amount) when a customer
goes beyond the margin limit.

There is no thinking, no
deciding if the marks are bogus, no verification that the marks are reasonable. 

Pretty dangerous situation for the customer. And I don't
know whether such a broker would tell us the details if asked.
If you have an old-fashioned broker who gives you a day or two to meet a
margin call, then this is not an issue. It may pay to use such a
broker, even though they charge higher commissions.
This is truly a case of discovering what your individual broker does to
handle this potential problem.

Regards

732

I wish everyone a happy Independence Day holiday

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As most of you know, I am one of the founders and owners of Expiring Monthly: The Option Traders Journal.  We sell annual subscriptions @ $99/year. 

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***


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Contest to say Thank you Subscribers: Jun 2010 issue, Expiring Monthly

Announcing a contest for subscribers to Expiring Monthly.  Details to be announced in the June 2010 issue, available June 21, 2010.

If you are a serious trader, you will find this prize to be very useful.


Non-subscribers may enter. The prize is a one year subscription to Expiring Monthly.

There will be two winners: One subscriber
and one non-subscriber.


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715



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Blog Post #714. Babe Ruth and Trading Options

Options for Rookies first appeared two years ago today.  Thus, it's our blogging anniversary.

Today's post is #714, and whenever I see that number, it instantly brings to mind the name Babe Ruth.  His career home run record (714) stood for more than four decades until broken by Hank Aaron on Apr 18, 1974. 

As a tribute, this post is dedicated to Babe Ruth and how his career provides excellent trading advice for us.  NOTE: This idea is not original with me. The Crosshairs Trader Blog, posted on this topic earlier this year.

In turn, that blog post was based on an excellent article written in 2002 and published by Credit Suisse/First Boston.  The following quote comes from that source:


Babe-ruth
Babe Ruth

Principle: "The frequency of correctness does not matter; it is the magnitude of
correctness that matters."

Translation for traders: Babe Ruth struck out many times in his career.  But he is remembered as one of the greatest hitters of all time.  Those home runs contributed to Yankee victories far more often that his strikeouts resulted in losses.

As a trader, it is not how often you win that counts.  When you consider your success or failure as a trader, the only number that matters is the number of dollars earned.  Over a short time span, luck plays a big role.  But as you trade longer, you discover that keeping losses (strikeouts) small – even when they occur more than 50% of the time – is the key to success.  Collecting both small (singles) and large (extra base hits) wins makes you a winner.  

Sure it feels good to have a string of winners and I always emphasize that feeling psychologically satisfied when trading is of value.  But when you look at your results, you know it's far better to earn $100k when winning 40% of the time than to earn $60k with a 60% win percentage.

I'm not suggesting being reckless and consistently targeting home runs.  In fact, there is no need to seek them.  Some of your plays are going to work spectacularly well (yes, even when you adopt limited profit strategies).  That's part of the game.

Your task, as risk manager, is to prevent the opposite – spectacular failures from occurring.  You must not ignore risk when trading. 

Skillfully managing risk, and minimizing the significance of your strikeouts, allows those home runs to play a big role in your profit/loss picture.  If those big wins are accompanied by large losses, you are not likely to succeed. 

Do not ignore the value of singles and sacrifice bunts (exiting a trade that has become too risky).  Those are the bread and butter trades that feed your family.  The home runs pay for the luxuries.

714



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Owning Stock vs Owning Calls

Hi Mark,

I think you taught me a lesson on not to get fixated on cost
basis. I have to tell you that cost basis is the thing I am obsessed
with since day one of investing and still is at the moment. It would
take a long way to move away from it but I’ll take your advice to focus
more on risk/reward.

However, I disagree with you on one thing, which is when you compared
the risk of holding stock vs long calls/call spreads. It is obvious
that I can easily lose 100% of my call/call spreads. It is also possible
to lose 100% if I’m long stock, but the possibility is very remote. In
terms of absolute dollars, the amount I can lose in a short period of
time is going to be a little more than the maximum loss in options, but
it is very unlikely that I’m going to lose all my money in DFS.

Long calls to me is a short-term speculative play and long stock is
for a longer term, and I am comfortable with my stock positions not
hedged. The amount I allocate for stocks is a lot more than I allocate
to options (since I’m still a relative rookie in options). The amount of
money I am willing to commit to one option position can only buy
some very OTM calls (which normally don’t end up ITM) but can buy
spreads that are more profitable. That should explain why I’m
comfortable with long stock but not the long calls.

F

***

Hi F,

1) It's my opinion that being obsessed with P/L is non-productive.  I cannot provide evidence that it's true.  The final choice depends on how you decide to manage your portfolio.  From my perspective, I own a position as it exists right now:  Do I want to hold it, sell it, add to it?  That's the decision.  Why should my original cost play any role in that decision?

2) I NEVER recommend owning long calls as a directional play.  I did suggest owning high delta calls as a stock replacement for investors who want to reduce downside risk.

I NEVER will recommend owning OTM calls for anything except protection – and I really don't like owning OTM options for any reason. So, if you took anything I said as a recommendation to buy such calls instead of stock, there was mis-communication.

NOTE:  This conversation refers to owning single options as a directional play.  [The kite spread uses OTM options, and that play is not relevant to this discussion]

3) If you feel comfortable owning stock, then by all means, own stock.  The idea of substituting high delta call options apparently does not appeal to you. 

It's good that you disagree.  Blindly agreeing with someone else is a bad idea.  Don't abandon your methods unless you are sure you are doing what is right for you.

Nevertheless, DFS offers an ideal scenario for stock replacement.   DFS Jun 13 calls carry very little time premium (20 cents).  For that small premium plus the 2 cent dividend, you can own insurance.  If the stock drops by 5 points, that's a lot worse than losing $3 on a call option. 

However, If you consider that time premium to be too much to pay, then your decision is based on complete knowledge of your choices.  That's ideal.

4) This is never mentioned, but stock can be thought of as a call option with a strike price of zero, and an infinite expiration date.  You prefer to own this zero-strike call.  There is an alternative: the Jun 13 call (an 8-week option) has a time premium of ~ 20 cents. 

5) You consider calls to be a short-term speculative play.  That's because you think in terms of which calls you would buy to gamble.  Those calls are very speculative and you are right to commit only small amounts to such plays.

Consider this:  You are willing to commit cash to owning the zero strike call.  And you are willing to speculate with a small sum on an ATM or OTM call.  But, you ignore the possibility of owning a high delta call. 

I know it seems as if I am trying to confuse you and take away your cherished beliefs.  But I find this philosophical discussions fascinating.  Analyzing a position and turning it into something safer, at a reasonable cost, is always worth considering.

But if you can even think about – as you say you plan to do – looking at risk/reward for positions after you own them, then perhaps you can consider stock substitution – especially when the cost is so little.  I agree that it is a more painful decision when the time premium of a 2-month 80 delta call is several dollars (obviously on a much higher priced stock).

6) I recommend owning high delta (~80) call options under these conditions:

a) You want to own stock
b) You believe the stock is headed higher, but don't want to take much risk

Under those conditions, selling the shares and replacing them with high delta calls solves the problem.  Solid participation on the upside and limited losses.

FYI, this trade is exactly equivalent to buying a put option to protect a stock position.

d) I never recommend buying calls.  But if you are a directional player who buys stock, high delta calls are a very reasonable alternative.  I never recommend buying protective puts.  But if the conditions stated above obtain, then stock replacement is an equivalent choice.

Regards

674


Coming in the May, 2010 Issue of Expiring Monthly:

  • Interview with Dr. Brett Steenbarger – trading coach and psychologist
  • The CBOE Benchmark Indexes
  • Pro and Con: Trading with House Money

and much more


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