Are You Afraid to Make Your First Options Trade?

Is this your situation?

You’ve been trading stocks
for a long time and believe you have a good understanding of how the market
works. Your stockbroker (or financial
advisor) tells you that options aren’t right for you and that only two of his
clients ever bought options – and both lost lots of money. You know that options are different, but you’ve done your homework
and feel ready.

You’ve taken the right steps,
by taking the time to understand options before putting your money at risk. You’ve learned a great deal and used a paper trading
account to get hands-on experience.

You feel that your broker lives under a rock and has no idea of how the
modern investment world works. After
all, the number of options traded has been increasing very rapidly for years.
Can so many people be wrong? But, you
wonder if options are only for hedge funds and other professionals.

You want to take the plunge,
but something is holding you back.  Perhaps it’s because you’ve seen dozens of web
sites promising fantastic profits if you take a seminar or buy an expensive
lesson plan. Those boastful websites make
you distrust everything related to options. 
I understand your
anxiety.

 

Here’s what I know is true

  •  Options are suitable
    for millions of individual investors like you.
  •  If you ignore the
    hype and use options conservatively, the chances of making money are better
    than your current method of owning stocks and/or mutual funds.
  •  It’s easy to make money when using
    conservative option strategies. It's just as easy to lose money if you get careless.  Thus, the difficult part is keeping that money.
  •  To succeed over
    the long term when using options, the most important skill to develop is the
    ability to manage risk. Sure, choosing
    decent strategies is important, but it’s secondary.

 

Your broker had only two
clients who bought options? That tells
you he doesn’t understand how options work and never bothered to learn. And
one of the major reasons his clients lost money is that he was unable to offer
them any guidance.

If you read and understood The
Rookie’s Guide to Options
, you know how much I stress the importance of
managing the risk of your investment portfolio. I share methods for managing risk for specific strategies and provide
all the information you need to get started on a successful option-trading
career.

Options should be used to
reduce the risk of investing, and not as gambling tools. Begin with a simple strategy that involves
stock ownership because you already are
familiar with how that works. Choose
either covered call writing or collars as your initial option strategy. Or, if you paid attention to the careful
explanation of how synthetic equivalents work (Chapter 15), then you may prefer
to choose a strategy that is equivalent to the collar (selling a put spread or
buying a call spread).

No matter how you
begin, if it’s with a strategy you understand well and have practiced using in
your paper trading account, there’s no reason you shouldn’t do well. Not every trade is going to be a winner, but
the probability of success is on your side and you can easily outperform investors
who don’t take advantage of options.

You can make good money with
the six recommended strategies (and if you decide to adopt other methods, that should be okay), but no one is going to hand it to you. Begin slowly, gain experience, and you can make enough money to make learning about options well worth your time.

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Why Am I Writing This Blog?

When people ask what I do for
a living, I tell them I’m an author, trader, and educator. When I continue, mentioning that my field is
showing individual investors how to use stock options safely and profitably, the
questioner loses interest. Why is
that? Say the word ‘options’ and people
close their ears. I am never asked to
‘tell me more.’  I’m disappointed to find
so many closed minds on this topic. 

The truth is that options
were designed as instruments to hedge, or reduce the risk of owning another
investment. Options can be used as a
type of insurance policy to prevent a financial disaster, but the general
public is unaware of that. They all
think options are just too risky.

Many people, including
financial professionals, have the misconception that options are ‘dangerous’
and are used only by speculators. I’m
using this blog, my website, and the books and magazine articles I’ve
written to explain just how the individual investor can begin to use options.
With reduced risk. With enhanced
earnings. The hurdle I must jump over is
getting people interested in reading or hearing what I have to say. Shouldn’t any investor find those two
attributes to be very attractive: reduced risk coupled with more likely profits? But, when the word ‘options’ is included in
the same sentence, that’s the end of the conversation.

It’s true that too many
novices jump into the world of options by gambling. They take positions with little chance of
success. When they lose their money,
they blame ‘options.’ People don’t get
behind the wheel of a car without knowing the traffic rules or how to apply the
brakes. But, when it comes to options,
apparently there’s no time to understand first
and trade later.

I want to help end this
madness. This very versatile investment
tool can help investors succeed, and it’s my goal to help them along that
path. This blog is part of that
effort. 

Comments welcome.

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Investment Clubs

Are you the type of person who
prefers to learn something in a group environment, rather than by yourself? May I suggest that you find a few friends, coworkers
or family members and make it a goal to learn to use options? You never know who’s interested in learning
new investment techniques until you ask.

One enjoyable way to learn
together is to form an investment club. If
you have the patience to refrain from investing real money before you are
ready, you can hold meetings (weekly recommended) at which each member discusses
a topic that he/she studied (books or internet) since the last meeting. You may also want to post a question or
comment here. You should open
a paper trading account with your broker and practice one or two option
strategies and discuss each position whenever you meet. Each member (or team of members, working
together) can ‘own’ one specific position and manage it (in the practice
account), as necessary. At the meeting, discuss:

  • Why the position
    was initiated.
  • Why this specific
    stock or index was chosen.
  •  Include profit
    potential and risk.
  • Is this a market
    neutral strategy, or are you planning to benefit from a bullish or bearish move?
  • Were any trades
    made since the position was opened?
  • Did you close the position to take your profits
    or to take a loss and eliminate further risk?
  • Was the position modified
    (adjusted)? Why? This is a learning process
    and this type of discussion is very helpful.
  • Whether you are ready
    to add another position to your practice portfolio. Do that only if you have meeting time for a
    thorough discussion.

 

If
you don’t have more than two or three positions to discuss, each can get a
thorough airing. The purpose is not to
make money from these trades (yet), but to learn how to adopt, and manage, a
specific strategy. This is an excellent
method for getting a good options background. You have hands on practice, discuss the trades within your group, and
use fake money.  It’s a fun way to learn
– if you have people who are really interested in learning.  If these meetings become social gatherings, it
will not work. This is not your
traditional buy and hold investment club.

Not every member may be able
to contribute as much time as others. Those
with full time jobs can only spend evening hours on their individual education
and probably cannot be as active a member of one of the teams that manages a
position. But, those club members can
examine a position at night and suggest a trade to the rest of the team – a trade
that could be entered the following morning. You can make this work, no matter whether you are retired with lots of
spare time, someone who works at home who can grab a few minutes here and there
to watch his/her position, or someone who is too busy to get involved during
market hours. The most important qualification
to join this investment club is the desire to learn about options.

As you try different
strategies, you will discover which feel most comfortable for your group. You may prefer very conservative methods
where preserving capital comes first. Most
investors are interested in making money and you want to find a method that’s
profitable – and comfortable – at the same time. That’s not difficult.

If you already are a member
of an investment club, speak to the other members about learning to use
conservative options strategies to enhance your clubs performance. Come to the meeting prepared to discuss one
strategy, or bring along a copy of today’s blog.

If you open such a club,
consider posting that news and an occasional progress report.

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Recommended Option Strategies: Writing Naked Puts

Selling naked puts is a bullish
strategy. But it’s more than an option
strategy. In fact it’s best suited for
investors who want to accumulate stocks for their portfolios. When selling naked put options, sometimes
investors get to buy stock at a good price and at other times those investors
settle for a quick profit in the form of a cash consolation prize. It’s a win-win proposition for the right
investor.

But you must be aware that large
losses are possible when you adopt this strategy, especially in a bear market. If you have no desire to buy stocks, then
this is not the best strategy for you. There are other methods for adopting a short-term bullish position for any
stock or index.

Safer Alternative

Begin by selling the
same put as the naked seller – but also buy a less expensive put
option. By purchasing that put, you limit
risk. If you are incorrect in
your bullish assessment of the stock, the most you can lose is the difference
between the strike prices (x 100). Thus, if you
sell one put with a 40 strike price and buy one put with a 35 strike price,
your maximum loss is the difference ($500), less the cash you collected to
place the trade. The naked put seller
can lose much more if the stock takes a nosedive.

NOTE:
If expiration is near and the put you sold is in the money, it’s decision time.  If you are the trader who is not interested in buying stock, it's best to buy
back the put that you sold – to close your position. 
You can sell another put spread (expiring in a later month) if you are
still bullish on this stock.
  But, if you are the investor who accumulates shares at good prices,
allow the put owner to exercise.

Thus, selling naked puts is a
good method, but only when you are willing (or eager) to add the underlying
stock to your portfolio.

Selling naked put options is an excellent strategy – but only if used correctly.  This is not a good play for traders looking for short-term profits.  It allows the purchase of stocks at prices below the current market –
and just in case you fail to buy stock (just as investors who submit limit order to buy stock don’t always get their shares) – you get to keep
the option premium as your prize for playing the game.  And
when you do buy shares, it’s at a favorable price. This strategy deserves more attention by the
world’s investors.

Why am I introducing this
strategy now, when the market is apparently bearish? It’s part of my ongoing plan for this blog,
and that includes discussing each of the six
strategies
that I recommend (and describe in detail) in The Rookie’s Guide to
Options.  Please don’t take this post as a
recommendation to sell naked puts at any specific time.

 

The strategy at work

When you sell a put option,
two results are possible:

  • The option
    expires worthless (or you repurchase it at a low price). In this scenario you don’t accumulate stock,
    but you earn the option premium as your profit.

 

  • The stock price
    is below the strike price (40, in the example below) when expiration arrives
    and you are assigned an exercise notice. (Your broker notifies you that the option owner has exercised his/her
    rights to sell stock at the strike price. As the option seller, you are obligated to buy the shares.) You now own shares at a price you were
    willing to pay.


Each of these results should
be acceptable to the investor who adopts the strategy of writing (selling)
naked puts. You either have a cash
profit or you own stock at a good price – or at least it appeared to be a good when when you sold the puts.

Example:

Let’s
say you want to buy ZYX at $38.50 per share and the current market price is
$41.25. If you sell one ZYX Nov 40 put @
$1.50, you receive $150. If the option expires
worthless, that $150 represents your profit. If the stock is below 40 when the November option expires, you are
assigned an exercise notice and buy 100 shares @ $40. Because you already collected $1.50 premium,
your net cost is $38.50 per share, or your target purchase price. If the stock never traded as low as $38.50,
then you own your shares at a great price.

 

NOTE to more experienced traders: This trade is the synthetic equivalent of
writing the Nov 40 covered call; i.e. if you buy 100 shares of ZYX @ $41.25 and
write one Nov 40 call @ $2.75, your cost is $3,850.  When November expiration comes and goes, you either
own stock at $38.50 or earned a $150 profit.

  • If the call
    option expires worthless, you own shares costing $38.50. That’s the same result as selling the Nov 40
    put.
  • If the stock is
    above 40 and the call option is exercised, you have no remaining position. Instead you have the same profit ($150) as
    the naked put seller.
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News: Record Option Trading Volume


The Options Clearing Corporation reported that 25,264,883 contracts
traded yesterday, July 15, 2008. That’s
a whopping 6.4 percent higher than the previous record set on August 16, 2007.

Thanks to optionMONSTER for
posting this information.

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Example of a Collar trade

Shirt-collar

Important: This is an example and
not a recommendation.

Let’s say you like the idea of buying 100 shares of Google (GOOG) because its price has dipped near 500. You believe that the stock has been oversold and you appreciate the growth prospects of the company, but fear that the current bear market may inflict further punishment on the share price. As I look at my screen (July 14, afternoon), GOOG is trading near $511. For the purposes of this example, let’s assume that you are willing to pay that price.

By the way, if this stock price is too high and you don’t have $50,000 to invest in one position, don’t be concerned. This example is for illustrative purposes only. My idea is to show you how to construct a collar, using a real example. When investing your money, pick stocks that you want to be part of your portfolio.

A collar consists of three parts (legs): Buy 100 shares of stock, buy one put, and sell one call. The put is the insurance policy, giving you the right to sell stock at the strike price, no matter how low the stock may tumble. The call limits your profit potential to the upside, but is sold to generate cash that can be used to pay for the put.

You establish the ‘deductible’ for your insurance policy by selecting an appropriate selling price for your shares, and that’s the strike price of the put option. Let’s assume that $480 is acceptable and if the worst case scenario occurs, you are willing to sell stock at $480, guaranteeing that your loss will not exceed $31 per share. Of course, you may choose a different deductible by selecting a different strike price. The less you are willing to lose, the higher the strike price of the put. And as the strike rises, so does the price (premium) you pay for the put. All insurance policies work that way: reduced deductible requires payment of a higher premium.

Let’s assume you buy 100 shares of GOOG at a total cost of $51,100. Not wanting to hold this stock unprotected, you immediately (you made the decision of which options to trade beforeyou entered your order to buy stock) complete the collar by buying 1 GOOG Aug 480 put and selling 1 GOOG Aug 540 call. You pay $15.70 for the put and collect $18.10 for the call.  For the two option trades, you have a cash credit of $240, reducing your investment to $50,860.

What do you own?

You now have a collar that expires after the market closes on the 3rd Friday of August. In this specific example, you own 100 shares of GOOG and have the right to sell those shares at $480. You are not obligated to sell; it’s your decision. That means the investment can never be worth less than $48,000 – or a loss of $2,860 (Don’t forget to add in commissions and the interest you are not earning because cash was used to buy stock.) You also accepted an obligation – and that’s to sell your shares at $540. If the stock is above 540 when expiration arrives, the call owner will exercise his/her rights to buy your shares – and you are obligated to sell. (You can cancel that obligation by repurchasing the Aug 540 call option – but only if you do before you receive a notification that the option was exercised.)

If you are correct in believing this stock can rally, your maximum profit occurs if the stock is above the 540 strike price when expiration arrives. In that case, you sell your shares at $540mand earn a profit of $3,140.

It’s true that the profits are limited, but you make the trade and have an opportunity to earn a profit. But unlike traditional stock market investments, at the same time your portfolio is insured against a large loss. Trading that profit limit for protection a good deal, IMHO.

NOTE to more experienced traders: The collar is synthetically equivalent to selling a put spread. Thus, if you buy the Aug 480 put and sell the Aug 540 put, you own a position with the same risk and reward as the collar described above. The margin requirement for this position is $6,000 (minus the cash you collect when selling the spread).

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Message to Rookies (and Everyone Else): Avoid Overpaying for Options

Today’s Daily Options Report by Adam Warner  replied to a reader’s question. It concerns a topic that is extremely important to rookies, but sadly, more experienced traders need constant reminders about avoiding a costly trap. 

“Why are puts down with the stock down?”

When you buy or sell options
it’s a mistake to assume the price quoted is always a good, fair, and reasonable price. Many times there is a
special situation that makes these options attractive to own. (For example, when news is imminent. That news may be
an earnings announcement, trial results for a new drug, or an FDA announcement regarding a specific product.)

Why would the options be so attractive? Because the news can produce a significant change in the price of the underlying stock. If the news is good the price may soar. Investors who anticipate that possibility want to own call options prior to the news release. Similarly, bad news
can cause the stock to plummet. Investors who believe that may happen want to own put options prior to
the news release.

Thus, there are always
investors eager to own options when news is pending. That increased demand results in higher and
higher prices for the options. Even if the stock trades in a very narrow range, prices of both puts and calls tend to
increase when eager buyers are willing to pay whatever sellers ask them to pay. Investors who fail to understand this process enter the market, buy their options and think they have a good chance to make
some money.

Alas, it’s not that simple.  Once the news is released, whether the stock
moves higher or lower, there is no longer a demand for the options. In fact, everyone who bought before the news
now wants to sell. As you may imagine,
when supply exceeds demand, prices fall.

That brings us back to the
original question: Unless the stock
makes a major move to the downside, the price of put options can easily
decrease, even when the stock declines.

For specific details on how
this works, take a look at an article (link no longer active) I wrote for SFO in March 2005. The title is “Don’t Pay Too Much For Those Options: The Diary of a Premium Seller.” Overpaying for options is a trap you must avoid if you intend to profit by trading options.

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Collars: The Ultimate Portfolio Insurance Policy

It’s time to take a quick look
at another basic option strategy. This
one is for both rookies and conservative investors.

Collars allow you to own stocks
– even when worried about a bear market – because it establishes a floor for
the value of your holdings. In other
words, you know, in advance, how much you can lose in a worst-case
scenario. Collars are flexible and you
can be certain that losses do not exceed a level you choose. As with any insurance policy, if you want
that loss (the deductible) to be very small, the cost (premium) is higher.

 

What is a collar?

A collar is a position
consisting of three parts:

  • Long stock
  • Short call option
  • Long put option

Collars are designed to
minimize the cost of buying insurance (the put option). That’s accomplished by selling a call option,
collecting a cash premium, and limiting your upside potential. But for investors who are more concerned with
preserving capital than with earning profits, this is an ideal strategy because
it allows you to do both.

To construct a collar, buy
stock, write a covered call option, and buy one put option. Because you own a put, the value of your
stock can never drop below the put’s strike price. You may choose any strike price, but as the
strike price moves higher, you must pay more for that put. No matter how far the stock declines, you
have the right to sell stock at the put strike price – and that’s how any
potential losses are limited.

To offset all or part of the
cost of buying the put, a call option is sold. As with covered call writing, choose a call option that suits your
needs. You may prefer to sell an option
that is at the money, sacrificing upside potential in return for collecting a
higher premium. You may decide to sell
an out of the money option, collecting less cash, but giving yourself the
chance for an upside profit. There is no
‘best’ collar and each of you must find appropriate options to build a position
that allows you to achieve your investing objectives and also falls within your
comfort zone.

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