Trader’s Mindset Series II. Always Collect Cash

In the first part of this series, I wrote about beginners who ask the wrong questions, such as: 'How much can I expect to earn when trading options?'

This time I'd like to continue on a theme that began yesterday. That theme can be simply stated:

There is a subset of option traders who seldom, if ever, are willing to pay cash.  All  initial trades, all adjustments, all rolls – must be made at a net cost of zero or less.  The only exception occurs when exiting a trade and collecting a profit.

Opening the trade

When selling premium, it's natural to begin by collecting more cash for options sold than you pay for options bought.  And those who sell naked options never think about buying protection or limiting losses – because it cannot be done for free.  The following discussion of this specific trader mindset refers to trading spreads rather than naked options, although the principles are the same.

The opening trade is easy.  The traders wants to collect a cash premium and choose one of a bunch of strategies that enable him/her to do that.

Managing the trade

This part is more difficult.  If all goes well and time passes, then the option values decrease and may eventually reach a point that our trader is willing to spend a small sum to exit the trade.  However, it's likely that the position will be held, hoping all options expire worthless.  Paying a few nickels to exit a trade and eliminate all future risk is not a popular idea.

One of the problems with this mindset occurs when the market does not behave in a manner that is friendly towards our trader's position.  Premium selling and negative gamma are close relatives.  When the market goes against  a position, further moves increase the rate at which losses increase and the position becomes more dangerous.

Traders with a more normal mindset: "This position requires an adjustment because my current risk is too high and I must avoid a large loss" have no trouble making good trades that reduce risk.  Most of the time these trade involve spending cash.

  • Reduce size and buy back some of the position
  • Buy single options for protection
  • Buy debit spreads for protection
  • Buy…

The strategy tends to be to buy something and spend cash.

However, the trader with the mindset under discussion: "I don't want to pay cash for any option trades.  I do want to prevent large losses, but I will find a way to protect myself with no cash out of pocket" has a more difficult time managing the trade.

Clarification: It's may not seem to be a more difficult time for the trader.  He/she is happy to sell extra premium because it affords an opportunity to make even more money.  However, these traders increase overall risk and do almost nothing to take care of the current problem.

When the market rallies and the position is short too many delta, this trader does recognize the need for making an adjustment.  At those times, the most obvious first choice (for the 'take in cash' traders) is to sell some puts.  That not only adds cash to the coffers, but it adds positive delta.  That's a feel good trade.  However, it's very short-sighted. 

What's wrong with getting some useful positive deltas by selling puts?  Two things.  First, it does almost nothing to reduce the current upside risk. The only upside benefit is to keep most or all of the put premium collected.  However, that cash is not enough to offset the losses that accrue as the market marches higher and negative gamma soon makes the position lose money more quickly that it did before the adjustment.  Second, the position now has risk where none existed – downside risk.  And for what?  For the cash collected to 'protect' the upside.  Selling those puts is not a good idea.

What about rolling?  Surely that's a good risk-reducing technique, says our trader.  Well, 'yes and no' says I.

Rolling works when you move to a good position and exit the risky trade.  However, with cash as the driving force behind the roll, the trader often rolls to a position that is already too risky for an initial trade.  It feels good because it includes extra cash and moves the short options farther out of the money.  As I said that feels comforting.

But it shouldn't.  The new trade is probably so far from neutral that it already requires an adjustment.  That sets up even more risk.  And if the call spread was rolled because of a market rally, and if new puts are sold to balance the new position (turn it into an iron condor), then what about those now FOTM puts from the original iron condor? Prudence dictates paying some price to get those puppies off the street, but our intrepid cash collecting trader does not think that way.  In fact, in his/her mind those have already expired worthless and that, in an of itself, reduces the bath being taken on the call side of the trade.

Then there's the situation when rolling isn't good enough.  It's necessary to pay $6 to buy back the (now ITM) call spread and the most reasonable place to roll (to collect lots of cash) is a spread that trades near $4.  Most credit spread traders do not sell 10-point spreads for $4 when the idea is to watch the options expire worthless.  They are far too close to the money.  But the trader with the cash is king mindset will sell 3 spreads for each two bought.  That allows him/her to roll the position at even money (buy 2 at $6; sell 3 @ $4). 

Immediate risk is gone and the shorts are no longer ITM.  However, this is a very short delta position, had a potential loss that is 50% greater than the original, and is likely to create additional problems.  Rolling for a cash credit may feel nice, it may make the trader falsely believes that no loss has been taken and that there is still a good chance to collect the entire premium – but it's a hollow belief.  The truth is that risk has increased.  That is not the path to survival as a trader.

 Exit

This is the easy part for most traders.  Take the profit and move on.  To the cash is king trader, buying in cheap options is a waste of money and the trader believes that options were made to expire worthless.  Another misconception and dangerous belief.

If the mindset described fits you, please at least think about modifying the way you think about trading options – to something more reasonable.

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9 Responses to Trader’s Mindset Series II. Always Collect Cash

  1. John 12/28/2010 at 6:37 PM #

    I recently bought (MNKD) a biotech that was due to go before the FDA. So, I figured what would be the high if the FDA gave the thumbs up and what would be the low if they gave a thumbs down. I locked in my position five days before the panel met. Turns out the FDA postponed the decision for 4 weeks. In pre-market the stock went up 5% this was after the news of the decision being postponed. When the market opened, the stock price was still up 5% but both my call and my put were down about 70%!!!! Crazy!!!
    The stock was trading in the range of 8.00 to 8.50. I bought a 7.50 Jan call at about 1.90 and a 6.00 Jan put for about 1.49. When the market opened both the call and the put were creamed!!!!
    What happened? Does this happen frequently?

  2. Mark Wolfinger 12/28/2010 at 7:03 PM #

    John,
    Yes, this happens all the time.
    You bought those options because you knew the FDA was going to issue a statement that was likely to have a huge impact on the price of the stock.
    In that scenario, everyone wants to buy those options and the prices are bid much higher. And they should trade at those higher prices.
    But you report that the meeting has been postponed until after the January expiration (you did not use those words, but the option prices tell me that this is what happened). Thus, there is no big news event before the options expire and there is no reason for the stock to make a move.
    In turn, that means that no one wants to own January options – and the prices tumble.
    Unlucky.

  3. 5teve 12/28/2010 at 9:45 PM #

    John
    I think you purchased the MNKD straddle which is too costly thus it is risky, I’d recommand butterfly play on both sides to reduce the risk, in return you can only earn a profit in certain stock price range. In this case, butterfly play will lose much less than straddle.

  4. Mark Wolfinger 12/29/2010 at 7:49 AM #

    5teve,
    Butterfly is not appropriate for a ‘gamble’ play. John was betting on a huge move.
    Think how you would feel if you got your huge move, but it was ‘too huge’ and the butterfly became worthless.
    Agree it was very costly; agree that is a play with high risk; but who is to say it is ‘too’ risky? That’s a personal choice. It’s a trade that you and I would never make, but John made a reasoned choice. He did not blindly buy the strangle (not straddle).

  5. Noam 12/29/2010 at 3:48 PM #

    Great post mark.
    regarding selling puts: “First, it does almost nothing to reduce the current upside risk” why not? you actually reduce the upside risk by the amount of the premium. so, theoretically you van reduce all upside risk by selling enough puts.
    it maybe risky for the downside but it’s doing the job of reducing the upside risk. isn’t it?
    Thanks a lot for all the help.
    Noam

  6. Mark Wolfinger 12/29/2010 at 4:28 PM #

    Hello Noam,
    Yes, upside risk is reduced by the premium collected when selling puts and put spreads.
    Yes, you can reduce upside risk, and even generate an upside profit by selling thousands of puts.
    Somehow I doubt that you are willing to take that much risk (even if your broker allowed the trade). So how many dare you sell? That’s the big question.
    Let’s look at a typical 10-lot iron condor that begins life with a $250 credit and a maximum loss of $750 per condor, or $7,500 total.
    Assume the market rallies, the call spread is threatened, and you decide to sell put spreads.
    Let’s say you choose to sell a put spread and collect $150 for each. At this price, they are not very far OTM (yes, time remaining is important). How many do you sell?
    A 10-lot gives you $1,500 cash, or 20% of the potential upside loss. In return, it establishes a significant downside loss. And don’t forget it’s not very far OTM.
    Do you like this? You still have a potential loss of $6,000 on a rally and face an $8,500 loss on a market reversal. To me that is not very comfortable.
    And what about selling 50 such put spreads? That covers the entire upside potential loss. Would you take that risk? Would you ever be so bullish that you would sell $7,500 worth of put spreads to guarantee no upside losses – and risk losing more than $40,000 on a market decline?
    These trades are not good risk management as far as I am concerned. Not selling the 10-lot and certainly not selling the 50-lot.
    These premium selling, risk-expanding trades do well when the market trends in one direction (or stands still). But betting on that to continue, taking big extra risk on the premise that the market cannot possibly go much lower is just foolish.
    If your ONLY goal is to reduce upside risk, then by all means go for it.
    But if your goal is to own a portfolio with total risk being within your comfort zone, I don’t see how this type of ‘selling extra options’ can work. To me it represents a disaster waiting to happen.
    Thanks

  7. Noam A 12/30/2010 at 1:03 AM #

    Thanks Mark,
    Appreciate your help, I really enjoy your way of thinking.
    Noam.

  8. Mark Mosley 05/28/2012 at 7:51 AM #

    Allright Mark, I get what not to do in this example, but what would you do if the market is moving rapidly against your call spread? Just buy back the calls you sold at whatever prevailing price and try again on something else or is there another strategy that I am missing to mitigate the loss when the market moves against you and time is short to expiration?

    • Mark D Wolfinger 05/28/2012 at 6:51 PM #

      Mark,

      I never advocate buying an option ‘at the market.’ If you must buy it, and must buy it now, then enter a limit order above the ask price – but at least have some limit.

      I urge you to buy the spread you sold earlier, rather than just buying the short call option. That would close the position with no additional risk. If you cover your short calls, then you are still long some calls and then have downside risk.

      My only warning is that there has to be a limit on how much you are willing to pay for the call spread. In the scenario described, if you delay a long time and the 10-point spread costs more than $9.50 – what’s the point of buying it? You can lose only 50 additional cents and may earn a big reward for holding – if you get lucky and the market reverses direction. I am NOT suggesting that $9.50 be your limit – but there has to be some price above which you believe it is foolish to pay.

      Sometimes, there is nothing to be done. Just buy back your short spread and take the loss. It is not a good idea to try to turn every losing trade into a winner. When time is short, your good choices are limited and I prefer to take the loss, rather than try something that is borderline at best.