Options can do great things for investors

Imagine that you never heard about options. Assume that you fancy yourself to be a good stock picker and market timer. You often repeat a trading slogan: “Have a hunch? Bet a bunch.” The results are pretty straightforward. If your hunch was correct, you get to sell your stock at a profit. If incorrect, you usually take a loss, but may break even.

That was the life of an equity trader in the good old days (before 1973 when listed options began trading).

The Options World

Option traders can adopt the same strategy and buy a bunch of calls or puts when they want to play a hunch. The results are often as expected: stock moves in the right direction, earn a bunch. Stock does not do as expected; lose a bunch.

But that is so inefficient and (in my opinion) a silly way to trade options. One of the fascinating things about trading hedged option positions (spreads) is that you can make money, even when you are wrong.

    EXAMPLE
    — XYZ is $58 per share.
    –You are bullish and expect the stock to move past $60 over the next month (two months, tops).
    –Instead of buying calls, consider selling a put spread.
    –Sell the 2-month 50/55 put spread, collecting an $80 premium.
    –If the stock moves higher, the spread expires worthless and you keep the whole $80
    –If the stock remains stuck near $58, you win again as the options expire worthless.
    –If the stock price moves lower (not what you expected to happen), you are a winner if the decline is not too large.

Imagine earning a profit when your prediction is incorrect! It is a wonderful feeling to know that you do not have to predict the future to earn money.

Of course this trading style (credit spreads) has drawbacks. Profits are limited to the premium collected. If the stock undergoes a good-sized rally, that will be a disappointment. All traders like the opportunity to earn a large profit. To offset this negative feature (limited profits), the put spread seller earns a profit far more often than the stock or call buyer.

I love the trade-off: Limited profits in return for more frequent gains. The other great advantage of selling the put spread is that losses are limited. This is not something that occurs to bullish traders, but this $58 stock may be trading below $50 tomorrow. Spread traders are never exposed to unlimited losses. If your trading history has always consisted of buying options, consider trading spreads.

This is the heart and soul of trading put credit spreads. It is much easier to find a stock that does not decline below the put strike price than it is to find a stock whose price will increase.

Let me repeat that: It is easier to find a stock that will not decline than it is to find a stock whose price will increase. In traditional investing, the traditional path to profits is to buy something that increases in value. When selling put spreads, a rally is appreciated, but it is not needed to earn a profit. This is an eye-opener for the novice trader.

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Why I Write

Between blog posts and books, I have written and published more than one million words.

That’s a lot of words and raises questions: Who am I to offer education and advice? Why would anyone care to read this stuff?

The short answer is that I care. Over my career as a market-maker I’ve seen customers entering orders that made little sense. It is true that when someone enters an order, we market makers never knew what position that person already owned and whether the new order was a hedge. However, customers were not very sophisticated in the 1980’s and there was no industry-wide attempt to educate them — as there is today. Thus, they made mistakes. They paid too much for options, and they adopted losing strategies. I sincerely wanted to help provide an education.

Once I left the CBOE trading floor (mid-2000), I started a small education business. Writing is a major part of that. I love writing books about options. I appreciate more than I can express in words when a reader sends an e-mail expressing gratitude or telling me how much a specific book has helped. I’ve made some friends through a correspondence that began with a simple question about options.

So I continue write articles with lessons, tips, suggestions and ideas to consider. And I’m still publishing books. To current readers, thank you for the time we spent together. To new readers of this blog: I bid you welcome and hope that you find my heartfelt efforts to be trustworthy.

At one point, I considered writing to be a solitary activity, but I received so many appreciative e-mail messages that I soon understood that a bond had been created between us. For many readers — perhaps the majority — that relationship is fleeting. For others, it is closer — perhaps as between you and a teacher/mentor/friend.

I write because I have a passion for teaching people how to get started using options to make a better financial future for themselves. It is as simple as that. I am not a trainer of professional traders. Nor can I help a rookies trader become experts. And I certainly do not want to encourage anyone to become a market speculator using options. But I do preach the importance of managing risk and never exposing yourself to a loss that is larger than you are willing to accept.

I pass along some of my thoughts: how I handle a trade from entry to exit. I don’t suggest specific traders; I have almost no rules cast in stone. I teach traders to be logical in their thoughts and to dismiss old ideas that they know just do not work. Come along and jon me. Enter into a discussion — your comments and questions will be more than welcome.

I know there are many millions of investors who will never care about, and never learn about, options. I write for those who want to take some of the risk out of investing and for those who want to increase their chances of earning enough money to provide a supplement to their ‘regular’ earnings.

I have James Altucher to thank for this writing mindset. I am sure that because of the way he writes and the very personal topics that he discusses, readers have a wide range of opinion about him. I think his sense of humor is top notch, I trust his advice. But I’m sure that others think he is a mental case. Nevertheless because he shares so much of his personal stuff, I thought that I could share a piece of mine.

IntroToOptions

New (2014) ebook

New (2014) ebook

Coming soon

Coming soon

http://goo.gl/4dNYsf

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Selling Naked Puts: Accepting Assignment

One of the more difficult situations for naked put seller occurs when the option is in the money on expiration Friday. I have suggestions for both traders and investors.

Investors

One good strategy for you, an investor who wants to own shares of a specific stock, is to write (sell) one put option for each 100 shares you are willing to buy. By choosing an appropriate strike price, the trader is assured of an acceptable outcome. (Either buy the shares or keep the premium as a consolation prize.) At least buying stock was acceptable at the time the trade was made. If it ever becomes unacceptable (probably because the stock price has declined too far), the investor should repurchase the put option, forget about trying to recover losses, and move on to the next trade.

When the put option is ITM, accept assignment. Translation: do nothing and allow an exercise notice to be assigned to your account. Once you own stock, you may write covered calls or simply hold the stock. This plan works most of the time when you have a long-term outlook.

However, it may be a good plan for a long-term investor, but it is a poor plan for the short-term trader.

Traders

You, the trader, should have a different mindset, and almost never want to own the underlying stock. Do not accept assignment. Cover the short put position, regardless of whether you earned a profit or incurred a loss.

You sold the puts to earn a trading profit. When any trade does not work as anticipated, the winning trader cuts losses and finds another trade.

I know that the advice is often given that it makes sense to accept assignment on short puts and write covered calls until the stock is eventually sold and then begin the process again by writing a naked put. When the plan doesn’t work; when a severe bear market (or some company-specific news) crushes the stock price, the trader loses a lot of money. This is not how a trader operates. The trader is not someone who gets married to a position for the sole purpose of refusing to realize a loss.

A trader is someone with a short-term trading plan. That plan includes a target profit and a maximum acceptable loss. The trader takes that profit when it becomes available. The successful trader understands the importance of limiting losses and accepts such losses when they occur and never holds losing positions hoping they will eventually become profitable.

Remember

When you make a trade remember who you are and make a trade plan that is suitable for your investing style.

New (2014) ebook

New (2014) ebook


Writing Naked Puts

http://goo.gl/eswuZV

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Mutual Funds Under-perform

RPSeawright offers an important blog post for people who own mutual funds. He titles the post: “A chart is worth a thousand words“.

It is a great presentation of just how badly highly=paid professional money managers perform and why owning mutual funds is a very poor idea for the vast majority of investors. This is not a plug for ‘do-it-yourself investing. It is a piece of advice: index funds outperform actively managed funds most of the time and charge lower fees.

His charts cover the 10-year period ending Dec 31, 2013.

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Recent News: About.com

I have two important announcements

One

Beginning today, Feb 4, 2014, I am the option blogger for about.com.

This project is so new that I do not yet have the URL, but I believe it will be: www.options.about.com

About.com provides articles and videos concerning a multitude of topics, authored by experts. With approximately 90 million users each month, this is one of the most-visited sites around. The new channel is part of the larger money channel.

My plan is to reach out to as many people as possible, the only requirement is that they have some desire to learn about options and how to use them effectively. I’ll be offering my usual high-quality lessons and commentary and the plan includes replying to every question submitted by readers.

Pay us a visit. I’ll add the official URL when I get it.

Two

I have been giving away an e-book entitled: Introduction to Options: The Basics. That book has now been expanded and updated as a Kindle ebook. Important note: This is a basic introduction to options for people who know nothing about the topic. There are no lessons that get the reader started with trading. Instead it is designed to give readers an idea of whether they have any interest in studying my favorite investment tool, options.

Amazon requires a minimum price of 99 cents for Kindle books.

Here is a link to the older, shorter (and free) .pdf version.

This book is part of the “Best Option Strategies Series”

IntroToOptions

http://goo.gl/uzfkVd

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Rookies Stuff 03

One of the basic problems for traders everywhere is the notion that any time that you lose money, you must have made a mistake. If you make a trade that should be profitable 90% of the time, then it must be true that the same trade will be unprofitable 10% of the time. Yet, when one of those occasional losses occurs, the trader is sure that he/she did something wrong.

We trade in a statistical world. The odds-on favorite wins most of the time. But not every time. Thus, if you cannot discover a true mistake — if you cannot find something that the evidence told you not to do but you did it anyway — then the chances are good that you were unlucky this time, and that you made no mistakes.

Here is a bit of my trade philosophy that I believe would benefit any trader who adopts it:

When the time comes to make a decision, examine the evidence and make the best decision that you are capable of making. If it does not turn out to be the winning decision, that’s okay. If you consistently make good decisions, you will be a successful trader.

http://goo.gl/VobakB

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Rookies Stuff 02

In Rookies Stuff 01 I pointed out how difficult it is to buy options and then hope the underlying stock price moves (far enough) in the correct direction (up for calls and down for puts) quickly enough (before the options expire) to earn a profit.

Knowing that buying options is the favorite strategy for the vast majority of new option traders, I don’t want to leave anyone without an alternative strategy. For traders who do want to base trades on their ability to predict the future of stock market prices, there is the vertical spread strategy.

Very important point

Consider the two ideas below as something that the very new option trader should learn. It is far better than the strategy of buying puts or calls. However, this is just the entry point for using vertical spreads, These spreads can be used far more effectively by adding a bit of sophistication. Lessons on just how to do that follow in this series. For today, the key takeaway is that spread trading reduces risk (yes, it also reduces potential profits).

Note: A ‘spread’ is a hedged (reduced risk) position. There are many examples, but for our purposes today, the two strategies under consideration are

  • Buy a call spread when bullish
  • Buy a put spread when bearish

When we ‘buy’ a spread, we own the more expensive option and sell the less expensive. As a result, we pay cash to own the position.

Example:

    XYZ is $75 per share

    One possible bullish play is to buy a call spread:

    Buy XYZ Feb 21 ’14 75 calls and sell an equal number of XYZ Feb 21 ’14 80 calls. These trades are made simultaneously by entering a ‘spread order’ with your broker.

The options expire after the close of business on Feb 21, 2014.

The option strike prices are $75 and $80 respectively. In other words, those are the prices that the option owner has the right to pay for 100 shares – if and when that person decides to exercise those rights.

Buying the 75 call gives you the right to buy 100 shares of XYZ at $75 per share.
Selling the 80 call gives you an obligation. You may (or may not, depending on the price of XYZ when expiration arrives) be required to sell 100 shares of XYZ at $80 per share.

Important: There is no reason to fear the obligation to sell shares, even if you entered into this trade without owning any shares. Why? If the stock is above $80 per share and you are forced to sell those 100 shares at $80 per share, then the stock will (obviously) also be above $75 per share so that you can exercise your rights as the option owner to buy those shares at $75. When the smoke clears, you will have bought 100 share at $75 and sold 100 shares at $80, locking in a profit. You would have no remaining position.

This is a bullish position because the spread you bought gains value as the price of the underlying stock rallies.

An example of a bearish trade is to buy a put spread.

Example:

    XYZ is $75 per share
    Buy XYZ Feb 21 ’14 75 puts and sell an equal number of XYZ Feb 21 ’14 70 puts. These trades are made simultaneously by entering a ‘spread order’ with your broker. We are buying the put spread because the $75 put is more valuable than the $70 put. When we buy the more valuable option, we are buying the spread and paying cash.

It the stock moves below $75 per share, then both options gain value. However, the put with the higher strike price gains value more quickly. That means that the spread increases in value and you earn money if the stock declines, as hoped.

If the price is below $70 when expiration arrives, both options are ITM and the spread reaches its maximum value ($500). This is a bearish position because it earns a profit as the stock price falls.

Buying the 75 put gives you the right to sell 100 shares of XYZ at $75 per share.
Selling the 70 put may obligate you to buy 100 shares of XYZ at $70 per share. This obligation will go away if XYZ is higher than $70 when expiration arrives.

There is a lot more to learn about trading spreads. We barely touched the surface. Stay tuned.

*****

The classic 2002 options book on covered call writing is now available as both an ebook ($3.99) or paperback ($7.77, or less).
ShortBookOnOptions

http://goo.gl/8QUIK0

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Rookie Stuff 01

It is easy for anyone who teaches others about how to use options to overlook the most beginnerish topics. It is difficult to recall just what each of us knew way back then, when we began to learn about options.

Some traders have good experience with markets in general because they have been buying and selling stock for years. Others are looking into options as their entrance into the investment world. To me it is obvious that teachers cannot give the same lessons to each group. Previous trading experience makes the learning curve easier to handle.

The following is a brief idea for anyone who wants to begin trading options, and who truly does not know where to begin:

Word of caution to the brand-new trader

You chose a broker and opened an account. Excellent.

If making your first trade excites you, please slow down. Here is an important lesson in just a few sentences:

    If you have a strong bullish opinion on a specific stock, do not believe that all you have to do is buy some call options and that you will make money.

    –First, stocks do not always rally when you expect them to do so.–

    –Second, choosing an appropriate option to buy is a matter of skill. You cannot choose some cheap option at random and expect to make money.–

    –Third, no matter how well your friend did of the one trade idea that he shared with you, the chances are high that he did not share his many losing trades.–

    –Bottom line: It is very difficult to make money when buying options unless you have a proven track record — in writing — of just how skilled you are.

    Options for Rookies advice: Learn first; trade later.

New (2014) ebook

New (2014) ebook

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