It’s a Dangerous World

I stress the importance of getting a solid options education
before you begin trading. But it’s not
that easy. The world is filled with bad
advice. Each of you must decide if the
statements made by an author make sense. The following is a brief excerpt from a well-respected options
professional trader, teacher and author.

 

“you can play and risk very little. Options can cost as little as $5.00 to
control 100 shares of stock. And when you buy options, the most you can lose is
what you pay for the option, nothing more. Consequently,
buying options is the best way to start trading options.” (italics inserted)

 

It’s true that not every ‘expert’ agrees with every other
expert and there is often no single ‘best’ answer to an options trading
question.  But the author I quoted states that
buying options doesn’t have to cost much and therefore it’s the best
way to start.

 

I find that statement to be ludicrous and don’t mind saying
so. Just because it costs $5 doesn’t
make it a reasonable option to buy. Just
because you cannot lose more than $5 (plus commissions), that’s not a good
reason to make the trade.

 

Why would any investor want to begin trading options with a
high probability of losing money? Sure
it’s nice to get some hands-on trading experience – and that’s a great way to
learn. But, why begin trading by making
a trade that has a very small chance of earning money? Why buy a call option, watch the stock move
higher and not understand why the $5 option is still worth only $5. What would that teach an investor? Wouldn’t anyone prefer to begin an options-trading
career by adopting a strategy that has a much better chance of earning a
profit? I know I would.

 

This writer doesn’t tell his readers that when you buy an
option for $5, there’s little chance of ever making money.  Why? One
reason may be that there’s so little time remaining before the option expires
that the chance of the stock making the required move is tiny. Another reason is that the option is so far
out of the money that the stock is extremely unlikely to move far enough for
the option owner to earn a profit. I’m
not suggesting anyone sell such
options (that’s even worse than buying them because there’s too little reward
for the chance that something unusual happens), but I would never recommend
buying them.

 

This author goes on to say:

 

“Avoid
entering spreads or option writing.”

 

Spreads are a method for reducing the risk of trading
options and are resoundingly recommended by me. Of the six
strategies
I recommend for option traders (including rookies), four of them
are spread positions and one is similar to a spread because it’s a hedged,
risk-reducing strategy. And that one is
the option writing that this author tells novices to avoid. Let me be clear on this point: In my opinion,
writing covered calls is a better strategy than simply buying and holding
individual stocks and I strongly recommend it as a good method for learning how
options work. But, there are better,
safer strategies you can use – after you understand how options work. I suggest
writing covered calls as your entry point into the options universe, but once
you understand what you are doing, it’s best to move on to another of my six
recommended strategies.

 

This author then offers this advice:

 

“start
by taking some very small positions”

 

And I completely agree with that statement.

 

I sincerely hope you find my writings to be helpful,
well-reasoned and that they help you earn lots of money – and at the same time,
reduce the risk of investing in the stock market.

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http://www.mdwoptions.com


Reminder: My website
contains a great deal of useful information for the options rookie, including
discussions on:

  • The basic concepts of
    options, including, “how does an option work.”

 

  • My trading philosophy
    contains ideas you can use. These were
    developed over my 30+ years as a professional options trader.

 

  • A basic discussion
    of volatility and why
    it’s important for trading options.

 

  •  A discussion of
    how the theoretical
    value
    (also known as fair value) of an option is determined.

 

  • A calculator you can
    use to determine an option’s theoretical value.

 

  • Graphs of the CBOE
    volatility index (VIX) [now updated weekly on this blog]

 

  • My eBook, available for free
    download.

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What other bloggers are saying

Money management

Managing
money and managing risk play an important part in my trading philosophy.  Jim Farrish, a contributor to greenfaucet.com,
makes these points – and I agree with them:

  •  "manage your money – not the market or others opinions. "

  • “It is easy to
    get caught up in what the market is doing and forget about what you are doing.”

 

  •  “As an investor I
    want to manage my money relative to what I want to accomplish. What others
    think is interesting, but in the end it is your money, your goals and your
    decisions that matter.”

 

  •  “Use a defined
    strategy for getting in, getting out, and a defined target/goal. Know why you
    are investing… Focus on managing your money based on what
    you want, and let others do what they want.”

 

Comfort Zone

I
recently blogged
about defining your comfort zone and learning to trade within it.

Here is an
intelligent post from The Kirk Report (link no longer active) with a different perspective. Please keep in mind that his advice is geared
to the experienced trader and rookies should first understand where their
comfort zone is before adopting his suggestions.

  •  “High achievers
    (in life and in the market) frequently step
    outside their comfort zone.”
  • “The key for
    today is to first understand what your comfort zone is and then take a step
    outside of it.”
  • “Remember, the market
    doesn't reward comfort and decisions that ‘feel’ good.”
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Opinion: The New Automatic Exercise Threshold Has Been Reduced to One Cent

Warning: All in-the-money Options are Exercised
Automatically. To prevent such options
from being exercised on your behalf, you must notify your broker ‘not to exercise’
– and the only day you are allowed to do that is the last day the option trades
(typically the 3rd Friday).


The powers that be, and
that means the Option Exchanges and the OCC (Options Clearing Corporation) have
deemed that it’s to your advantage to exercise an option when it’s in the money
at expiration – even when the intrinsic value (amount that it’s in the money)
is only a penny or two. Thus, the
threshold for deciding when an option qualifies for automatic exercise has been
reduced from five cents to one penny. This change took effect as of June 21,
2008.

 
Note: Your broker is not
responsible for this change and although the broker is the beneficiary of this
absurdity, please don’t blame your broker.

 

For most individual investors this change presents no problems.  But for the few whom it will inconvenience, a
nasty surprise awaits. It’s true that
anyone who owns an option is responsible for knowing whether the option is in
the money. It’s also true that the
brokers make extensive efforts to notify all option traders. Yet, there are always some people who slip
through the cracks. Sometimes careless
investors forget about options they own and a sudden change in the stock’s
price could result in an option moving beyond the strike price by a penny. I don’t believe it is right to punish these
investors.

 

To me this change is wrong.  The reason for the change is to streamlines
the exercise process. In other words, it
makes their jobs easier and the needs of the individual investor are ignored.  This problem is especially difficult for the
options rookie who trades only one or two contracts at a time. Consider this situation:

 

You
own one Jul 90 call option on MDWO, and the official closing price on
expiration Friday is $90.01 per share. As an intelligent investor, you tried to sell your call, but there were
no buyers. Thus, you find yourself owning
the call when the stock market closes for trading on the 3rd Friday
of July. Previously, you could ignore the option and allow it to expire
worthless. But, that is no longer
possible. If you do nothing, the option
will be exercised. An option contract
specifies that the option owner has the right, but not the obligation, to exercise the option any time before that
option expires. This new threshold
cancels your rights and forces you to exercise, unless you take specific action
to prevent the exercise. When you look
at your portfolio Monday morning, you find that you own 100 shares of MDWO and
that you paid $90 per share, or $9,000.

Because
almost all brokers (there are exceptions) charge a fee to exercise an option
(let’s assume the cost is $15), you discover that you paid $15 to own this
stock. You also owe interest on $9,000
to carry this position over the weekend. Because you have no intention of owning the stock, you are forced to
sell the shares, incurring yet another commission. If lucky, you sell at Friday’s closing price
($90.01). It cost you $15 plus interest
plus the sell commission to ‘make’ the $1 of intrinsic value that you gained by
being forced to exercise. Wasn’t that
nice of those ‘powers that be’ to protect your one dollar of value?

This is not a good deal for
the small trader.

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European vs. American Style Options. Part II

Last time I discussed the
difference between American and European style option. Today I’ll answer the questions: Why should you care and which style option is
advantageous to trade, assuming you adopt my recommended
strategies
.

 

  • European options
    may not be exercised prior to expiration. If the owner of a Europeans style option wants to remove the position
    from a portfolio, the option must be sold. Advantage: European.

When
you are assigned an exercise notice on an option you sold short, it’s not a significant
event when the settlement occurs in shares of stock. Why? Because the stock
position that results from the assignment leaves your portfolio essentially the
same as it was (measuring risk and reward) before the assignment. But when the option is cash-settled
receiving an assignment notice earlier than you expected can produce a big
problem with increased risk. Here’s why:

If,
for example, you sold the OEX July 580/590 put spread (sold the 590s; bought
the 580s), you have a position that loses money when OEX drops and makes money
when OEX rallies. Assume that the market
is very bearish one afternoon, and OEX declines to 560. Also assume that bullish news is announced one
minute before the closing bell and the markets start to move higher. Responding to the news, OEX moves higher and closes
at 563.

Here’s
what happens to you if you are assigned an exercise notice on the Jul 590
puts.

a. You first learn that
you have been assigned early next morning, before the market opens for
trading.  That means that you repurchased those options yesterday but were unaware of that until the assignment notice arrived.

 

b. Remember, these
options are cash-settled and no shares exchange hands.

 

c. When assigned an
exercise notice on a cash-settled option, you are obligated to buy the 590 put
at its intrinsic value as of the previous
day’s close.
In this example, that’s $27 (590 strike price minus 563 OEX
price = 27). That’s $2,700 per
option.

 

d. Your position is
now naked long the 580 puts. Not a
problem? Remember the market turned very
bullish at the close of trading – and that’s the reason the owner of the put
options exercised them.

 

e. Sure enough, the
futures are significantly higher this morning, and when the market opens, your
580 puts are trading at 16. You have two
choices.

 

 i. Sell those puts
at 16. If you do that, you effectively
pay $1,100 for a spread that is never worth more than
$1,000. Not a happy situation.

 

 ii. Hold the puts and
hope the market falls. But, that’s a
risky play and you can lose all or most of the remaining value (currently
$1,600) of each option.

This
cannot happen to you when the options are European style.

 

  •  European options
    are all cash settled. Depending on the
    strategies you adopt, it’s usually more convenient when options settle in cash. Minor advantage: European.

 

 

  • Settlement price.
    American options settle at the closing
    price of the underlying asset at the close of business on the 3rd
    Friday of the month. That’s simple and
    straightforward. But, the settlement
    price of European options is determined by the price of each component of the
    index – when it opens for trading the morning of the 3rd
    Friday. As discussed,
    you never know where the market will open, and options that appeared to be
    safely out of the money and apparently were going to expire worthless suddenly
    become worth hundreds, even thousands, of dollars apiece. That’s a very large risk for option sellers,
    and in my opinion, if you are short any European style options, it’s better to cover
    them (buy them back) sometime before the market closes on Thursday, and not
    gamble by waiting for the market to open on Friday to learn your fate. Advantage: American.

 

If
you take the precaution of not allowing yourself to be exposed to a surprise
Friday opening by closing positions on
Thursday, then European options have significant advantages over American.

If
you understand that trading individual stocks is riskier (but the rewards tend
to be greater) than trading indexes, then you may prefer index trading – and that
comes with the added advantage of European style options.

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Q & A. Adjusting An Iron Condor Position

Based on your suggestion, I
have started to paper trade iron condors. I have a question for you on
something that I found interesting on the behavior of my RUT iron condor.

On June 30th I sold a 10 RUT
Aug 08 IC's 670/680/720/730. RUT was around $700 at the time.

This morning when I checked I
found that that RUT had fallen to 668 (below both my Put strikes). I was
expecting that I would be losing money on the trade at this point but to my
surprise I was still positive by $300 for the trade (not considering
commissions).

What do you make of this? Was
this because IV increased in the last week? Does this mean that it may be OK to
wait until the the stock breaks the long put/call strike price before
adjusting?

TR

Reply:

I'm pleased that you began
paper trading, but more than one comment in your post concerns me:

1) I know it's just paper
trading, but it's difficult to have these iron condor positions and 'check'
only occasionally. Although it's
wonderful when you can leave positions alone, adjustments are often required to
keep risk in line. Please check more
frequently. Daily, if possible.

2) One thing you never want
to allow is for a position to reach the maximum possible loss. And that can occur only when the index moves
through both strikes of the call or put spread. In this case, both puts were in the money and you have not yet made an
adjustment. That is not a good way to
manage risk.

3) When discussing P/L always
write or speak in terms of 'per spread,' not in terms of your position, If you are $300 ahead and have 10 iron
condors, then you are $30 ahead, not $300. Otherwise it's far too difficult to discuss a trade.

4) No, it's not okay to wait
so long before adjusting. This is some
sort of fluke. I don't see how you can
still be profitable when the index has moved so far against you. As you will see as you gain experience, it's
best for your long-term survival to adjust positions much sooner.

Why is your position
profitable?  Probably because both your put options are ITM and IV has increased. You were short vega (volatility) when you opening the trade, but you are now long vega.  Otherwise this iron condor would be losing money.

When you buy an IC, an IV
increase works against you, so an increase in IV is the reason your
position is showing a profit this time – is because your long put is much closer to the money than your short put.  A very uncomfortable position.

As far as adjusting goes,
here are some truths:

a) You will not make the
winning decision all the time

b) Any method – such as not
adjusting at all – will work some of the time.

c) Make the best decision you
can at the time you must make a decision. If it's a losing decision, c'est la vie. Win some, lose some, but do not get crushed.

d) Your goal is to make money
month after month and year after year. To do that you must avoid going broke. To me that means avoiding large losses, and that translates into
adjusting positions gone bad. When the
short option goes ITM, it's time (or past time for many) to make an
adjustment. You can buy in some or all
of the current position, buy protection etc. There is no 'best' way to adjust. But, ignoring the trade, IMHO, is not the way to go.

Mark

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European vs. American Style Options

Most options you are American style, but some European style options are very popular with investors. Too many don’t understand how these options differ. Today, we’ll list those differences. Next time I’ll explain why these differences are important.

 

Ability to Exercise

The owner of an American option has the right to exercise – any time before it expires. All options on individual stocks are American style.

Owners of European options can exercise only when expiration arrives. Options
on the major indexes (OEX is an exception) are European. Some examples of actively traded European style options:

  • SPX: Standard & Poor’s 500 Index
  • DJX: Dow Jones
    Industrial Average
  • NDX: NASDAQ 100 Index
  • RUT: Russell 2000 (small cap) Index

 

Settlement Price

American options are easy to understand. When the markets close for trading on the 3rd Friday of the expiration month, the final, or closing, price is the settlement price.  If the option is in the money (that means it has an intrinsic value), it is exercised. The call owner buys shares (and the call seller sells shares), the put
owner sells shares (and the put seller buys shares).

Under the current (recently revised) rules, all in the money options are automatically exercised (although an option owner has the right to notify his broker NOT to exercise such options). Thus:

· If JKLM closes at $49.99 or lower on the 3rd Friday of Nov, all JKLM Nov 50 puts are exercised. The put owner receives $5,000
cash and sells 100 shares of JKLM (for each option). All puts with higher strike prices are exercised.

 

· If JKLM closes at $50.01 or higher on the 3rd Friday of Nov, all JKLM Nov 50 calls are exercised and the call owner pays $5,000 cash and receives 100 shares of JKLM (for each option). All calls with lower strike prices are exercised.

 

European options are different.

Cash Settled

When a European option is exercised, no shares change hands. Instead, owners of options with an intrinsic value receive that intrinsic value in cash. That cash is automatically deposited into the option owner’s account. Similarly, cash is removed from the account of investors who are short (sold, but did not repurchase) the
option.

Example:

The settlement price (see below) of the SPX Jul 1260 call is determined to be 1264.59. Thus, the intrinsic value is 4.59 (difference between strike price and settlement price).

Owners of the SPX Jul 1260 calls receive $459 for each option owned.

Owners of the SPX Jul 1250 calls receive $1459 for each option owned.

Those who are short the SPX Jul 1260 call must pay, and $459 is removed from their accounts.

As a result of cash settlement, owners lose their options (due to
expiration), but are compensated by collecting the intrinsic value of the option, in cash.  Option sellers must pay that intrinsic value to satisfy their obligations under the contract.

Cash settlement is far more convenient than buying and selling shares of stock, making expiration easier for most involved.

 

Calculating the Settlement Price

These indexes also have a final or closing price. But that price is NOT a real-world price determined at any specific time. Instead, the opening price of each component of the index is determined
on the morning of the 3rd Friday of the expiration month. These options do not trade on Friday. The last time they trade is the previous day (Thursday afternoon). Once all stocks in the index have opened for trading on Friday morning, the settlement
price is calculated – as if all stocks in the index were trading at that opening price at the same time. Because all stocks in the index never trade at their opening prices at the same time, the settlement price is not a real price. The official price is not published until hours after the opening (in some cases, not until the end of the day). 

Many times the official settlement price is higher than the day’s official high or lower than the day’s official low, resulting in confusion for traders who do not understand the process. This occurs because the index price is not a real world price. Suppose the market is bullish at the opening. Often, those buyers push stocks to the highest price of the day. When stocks open at different times, some stocks will have already begun to trade at lower prices, and the ‘current’ index price reflects those lower prices. But remember, the settlement price counts only those opening ‘high’ prices. Thus, the settlement price can easily exceed the highest price seen for the index during the day.

To be continued

 

Optionspeak:

Intrinsic value – the amount by which an option is in the money. In other words:

  •  The difference between the price of the stock and the strike price of a call option, when the stock price is higher than the strike price.
  •  The difference between the price of the stock and the strike price of a put option, when the stock price is lower than the strike price.
  •  Many options have zero intrinsic value, and are out of the money.
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Q & A European vs. American Style Options

Hi Mark,


It might be interesting to post all euro style indexes and why euro style is
advantageous.

I was wondering if you might know of a European style index
of the coal and oil industries (separate indexes) on which options can be
traded.

Hope you're doing well.
Don

 

Hello Don,

Good idea. The
comparison of European and American style options is on my short list of items
to discuss soon. Perhaps I’ll use your
suggestion to boost that topic to the top of the list.

I don’t know of any European style indexes in those
industries.

Mark

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