show me your1.droppdf.com/files/wcgtq/show-me-your-options-the... · one bad season could lower the...
TRANSCRIPT
ShowMeYourOptions!
BooksbySteveBurns
How I MadeMoney Using theNicolas Darvas
SystemNewTrader,RichTraderHowtoGetMoreFollowers onTwitter
ShowMeYour
Options!
TheGuidetoComplete
Confidencefor
EveryStockandOptionsTrader
SeekingConsistent,PredictableReturns
SteveBurnsChristopher
Ebert
Allrightsreserved.Nopartofthispublicationmaybereproduced,storedinaretrieval
system,ortransmittedinanyformorbyanymeans,
electronic,mechanical,photocopyingorotherwise,without
thepriorpermissionofthecopyrightowner.
ISBN:9781607964193
©Copyright2012bySteveBurnsandChristopherEbert
PublishedbyBNPublishing.
We wrote thisbook to givestock traders astockoptionbookthat was neitherso simple that itinsulted theirintelligencebutat
thesametimenotso complicatedthatitwasbeyondcomprehension.We also wantedto make it a funread as opposedto feeling like a
boring collegelecture. Webelieve we haveaccomplishedthesemissions.
op·tion
[op-shuhn]–noun1.thepowerorrightofchoosing2. something thatmaybeorischosen;choice
3.theactofchoosing4.stockoption5. a privilege acquired, asby the payment of apremium orconsideration, ofdemanding, within a
specified time, thecarrying out of atransaction uponstipulated terms; theright, as granted in acontract or by aninitial payment, ofacquiringsomethinginthefuture
-Dictionary.com
CONTENTSForewordChapter 1 options are notassets,theyarebets.Chapter 2 every optioncontract has a buyer and aseller; one is long, one isshort, but which one has thebestoddsofwinning?Chapter 3 strong trends arethe friendof anoptionbuyerand the enemy of an option
seller.Chapter 4 time is an optionseller’s friend, but theoptionbuyer’senemy.(theta)Chapter 5 volatility is theoption buyer’s friend but theoptionseller’senemy.(vega)Chapter 6 howmuch of themove do you get for themoney?(delta)Chapter 7 stocks for rent:coveredcallsChapter 8 selling lotterytickets:nakedoptions
Chapter 9 buying lotterytickets: deep out-of-the-moneyoptionsChapter10 trendsdeterminewho wins: strangles andstraddlesChapter 11 the twins: everyposition has a syntheticrelativeChapter 12 spreads: ratio,calendar,diagonalChapter13thewindbeneaththe pro’s wings: butterfliesandcondors
Chapter 14 dealingwith thebehavioral problems ofimmatureoptionsChapter 15 A trader’schoices: insurance, stoplosses,orruinChapter 16 your method,yourrules,youredgeAppendix A: relative timevalueofoptionsbasedonthetime to expiration of thecontractAppendix B: odds andexpected payout of selected
optionstrategiesAppendixC:therelationshipbetween option premiums,deltas, standard deviations,andprofitprobabilitiesAppendix D: timeprogressionpayoutpotentialAppendixE:expandedtableofsyntheticpositionsAbouttheAuthors
Foreword
FOREWORD
Steve Burns and I met by chance,however it was inevitable that wewould bump into each other given oursimilartradingstylesandhowactiveweare on Twitter in our niche. I waslookingforsomeonetocontributebookreviews on my blog and I discoveredthat Steve had reviewed a mindboggling amount of bookswith honest
andconcisesummaries.Consideringtheknowledge that he has accumulatedfrom all those books that he read, Ibelievehimtobe theperfectcandidateto share his knowledge with aspiringtraders tohelp themavoidmanyof thepitfalls that new traders can run into. IapproachedStevetoseeifhewantedtopost his reviews on my site and soonafter we formed a strong relationship.Steve's ability to sift through the sheeramount of information available inmyriadbooksontradingandtakeawaythe important aspects traders need tofocusontobesuccessfulisremarkableindeed.
Through Steve Iwas fortunate enoughto be introduced to the "Options
Scientist" Christopher Ebert. Stevementioned that Christopher had a firmunderstanding of options andwas verycreative with his option strategies, butthatisanunderstatementasIwouldsayheisinthetop1%ofunderstandingtheinsandoutsofoptionsasyouwillsoondiscover as you progress through"Show Me Your Options." WorkingwithChrisas the residentoptionsguruon zentrader.cahasgivenmea chanceto learn from one of the best. Chris isvery generous with his time and isalwayswillingtoansweranyquestionsI may have and offer suggestions onhowtostructureanoptiontrade.
This book has forced me to look atoptionsinawholenewlightasitdives
from the basics into extremelyadvanced strategies in an easy to readformat. It could have moreappropriately been named, "Everythingyou've ever wanted to know aboutoptions, but didn't know to ask." TheycoverstrategiesthatIdidn'tevenknowexisted.Havingbeentradingsince1998I'll be the first to admit that I'mintimidated by complex optionstrategies,butthatcomesfromalackofunderstanding.We fear what we don'tknow.Thisbookmayrequireasecondreading foroptionnovices likemyself,but I highlighted many passages torevisit and for themost partChris andStevepresentthisinformationinastoryformat from the standpoint of amentor/student that is very relatable.
Once armed with the new informationsuch as how to use straddles andstrangleseffectively,IcanexpandhowI personally trade and invest throughtheuseofoptions.
There are two kinds of traders in thisworld.Thosewhouseoptionsandthosewhodon't.IbelieveSteveandChrisareeffectively bridging the gap. Beingprimarilyamomentumtrader, Iwasalittlesurprisedtoseetheauthor'sviewsoncoveredcalls,butitmakescompletesenseafterreadingtheirlogic.
TheproblemwithCoveredCallwritingis that you get a small premium torelinquish theupsideprofit on a stock,butyouretainthewholedownsiderisk.
Itislikedoingtheoppositeofwhatyouwant to do in trading; you are lettingyour losers run and cutting yourwinnersshort.
From this standpoint you should neversell calls in a strong trend as you arecapping your winnings, or as theydescribe more appropriately, a "stopwin",which flies in the faceofwhat alotofoptionexpertswilltellyoutodowith stocks in your portfolio. "Strongtrendsarethefriendofanoptionbuyerandtheenemyofanoptionseller,"Thebook is an education that you willdefinitelygetyourmoneyoutof,ifyouapply their principles and variousstrategies.
When I was approached about writingthisforwardIwashonouredandexcitedbecause I believe this is the book thatcould help me wrap my head aroundoptionsandhelpboostmyequitycurve.Iwastheirtargetmarket.Someonewhohas always wanted to implementoptionsintheirtradingbuthasn'tfounda book that discusses the manystrategies without losing me in theprocess-untilnow.Optionstalkcanbevery technical but "Show Me YourOptions" is broken down into bite-sizechapters and useful options analogiesthatwillhelpanybodymuddle throughoptions trading and come out on theother side with a couple of strategiestheycanuserightnow.Themeasureofa great trading book is whether I can
take what I read last week and injectthat into my trading on the next.Missionaccomplishedguys.
JeffPierce
@zentrader
zentrader.ca
Chapter1OPTIONSARENOTASSETS,THEYARE
BETS.
Stock Trader heardthe alarm go off. He rolled
over in bed and hit hisbelovedsnoozebutton.Itwastime to head off to his dayjob, but his mind rarelystopped thinking of hissecond job of trading.Trading would be his ticketout of the nine-to-fivecorporate world. He wantedto move from being anemployeeofacompanytoaninvestor in the company. Hewantedhismoneytoworkforhim and be able to stop
working for money. Hisdream was financialindependence. Of course, allhis fellowemployees thoughthe was nuts. Most of hisfriends at work could notcomprehend ever not havingajob,orthatnothavingajobshould even be a goal. StockTrader,though,wasdifferent;he ignored all the negativityand doubt and just kept ondoing what others believedwasimpossible.
He beat the S&P 500yearafteryear
He went to cash andavoideddowntrends
He sold stocks shortand made money indowntrends
Manymonthshemademore trading thanworking
He built his accountsover time even duringmarketcrashes
As he lay in bed herealized why he continuedworking so hard at trading.Hewantedthefreedomtodowhat he wanted, when hewanted. His goal was notmaterial things, oddlyenough. He wanted time, hewanted freedom, and he didnot want to be a slave to
earning a wage and payingbills.
“Isn’tthatgambling?”They would ask him in aconcerned and slightlycondescendingtoneatwork.
“No, it is a businesslikeanyother.Iusethesameprinciples as any otherbusiness. I buy and sellinventory,IfollowtrendsandImanagerisk.Iparticipateinauctions and use best
practices to get an edge overmy competitors. Thecompany we work forgambles more than I do,”Stock Traderwould respond.Unfortunately, his audiencereallydidn’tunderstandwhathewastalkingabout.
With only a fewlikeminded friends, StockTrader continued along hisjourney in the stock market,trading,reading,andlearning.
He truly loved the stockmarket. He would watchCNBC like other menwatched ESPN. While othermen were entering fantasybaseballandfootballleagues,hewasenteringstocktradingcontests online. For him itwas not just about makingmoney; it was a passion ofhis, a challenge of bothstrategy and wit.Determinationandwillpowerseparatedmanywinnersfrom
thelosersinthestockmarket.He loved the stock marketgame.
Hehadalways lovedstock trading. He had beenfascinated with quotes andwhat made stocks move upand down from the time hewasasmallchild.Asamatteroffact,hehadanaccountandwas trading something for aslong as he was legally oldenough to do so. When he
was too young for stocks, hehad collected and tradedcoins, baseball cards, andcomic books. He did notknowitatthetime,buttheseactivities were training himforthemarkets.
When a certainsuperhero was popular, thatcharacter’s comic bookswould go up in value. Amovie release, cartoon, ortelevisionshowcouldcausea
bullmarketinthatsuperhero.Thispreparedhimtoseethata hot product could send acompany'sstocksoaring.
Future record settingexpectations for a rookiebaseball star set his cards onanuptrendas longashemetexpectations for home runs,batting average, and RBIseach season, much likeearnings expectations drovestock prices in the market.
One bad season could lowerthevalueoftheplayer’scardsjust like a bad earningsannouncement could lower astock’s price. Rookie cardscouldmakebigmoneyiftheircareers took off, just likesmall cap companies in thestockmarketiftheirproductsand earnings took off in anuptrend. Hall of Fameplayers' cards stayed aboutthe same, their growth yearsbeingbehind them.Everyone
knew where the Hall ofFamers would end up, muchlikemost big cap stocks thatjust meander along at aboutthe same price with theirgrowth years being behindthem.
When he was young,he visited coin shows andmade purchases for hisgrowing collection. Yearslater, as he sold his coincollection, he learned the
difference between whatsomething was purported tobeworthbyabookonpricesversus what a buyer waswilling to pay for it. Therewas evidently a difference inthe price of the coinsdepending on whether herented a booth and boughtcoins from people trying tosell them, or if he went to acoin show and bought coinsas a customer. This taughthim about the bid/ask spread
in themarket even before hehad tradeda stock.Therearewholesale buyers and retailsellers inmost industries; thestock market was nodifferent.
With an energy drinkin hand, he sat down andpulleduphisaccounts,aswashis daily ritual. He had twodifferent accounts: one taxdeferred for “retirement” anda brokerage account. He
stared at the numbers:$201,617 in his retirementaccount and $103,725 in hisbrokerageaccount.It took15years of trading and someluck to build his accounts tothis size. Many who knewabout his success thought hewas just lucky and had noidea about the long hours hespentstudyingthemarketstoachieve his success. Unlikehis peers at work, he hadsidestepped the last bear
market that mauled many ofthe buy-and-holders. He was33 years old and had playedto win. He had used trendtrading and some swingtrading to achieve someoutstanding results. Heworkedveryhardtobeintheright place at the right timeandtoseizetheopportunitiesthelastbullmarketgavehim.He also used the lessons ofpast bear markets, whichmauledhim,toknowwhento
getoutandsellshort.Movingaverages, support andresistance on the charts,prices, and volume were hisconstantfriendsandadvisors.
He had felt ready totrade for a living on manyoccasions. The dilemma hefaced was that he wanted toproduce a consistent incomefrom his capital whileexposing it to minimal risk.He was at a place in his
trading career that he had totakewhatheconsideredtobevery large position sizes tokeep getting outperformingreturns. All he really neededwasa15%-20%annualreturnand he was financially free.While he had accomplishedthat many times, and evenmany years in a row, theproblemwas that returns likethatyear afteryearwouldbeworld class. Even thefraudulent money manager,
Bernie Madoff, did notproduce consistent returnswhich matched StockTrader’sgoals.
StockTraderneededaway to trade with less riskand yet produce a relativelysafe, regular income. Histrend trading, while it hadrunsofhugereturns,alsohaddraw downs of capital. Hehated draw downs; themethod of trend trading he
used had losing years,especially in very range-boundandchoppymarkets.
So that day at work, StockTrader kept thinking throughhisoptions: “Highyield junkbonds? If they werediversified enough and if Ibought them on a pullback Imight be able to get 8% ayear in interest. That is notenough. Real estateinvestment trusts pay
dividendsbut not enough formetomeetmyneeds.”
“Could I swing tradefor consistent returns?Probably,untilatrendcausedadrawdown,” thoughtStockTrader.
“I really want theoddsconsistentlyinmyfavorifthatwillbemysolesourceofincome.”
That night, as Stock
Traderwas doing his normalInternet surfing, afterchecking market quotes ande-mailandsendingouta fewtweets, he noticed a post inhisFacebookgroup“WinningTraders.” Itwasfromanewmember with the user nameOptionz Traderz. StockTrader did not like it whenpeople did not use their realnames on Facebook. Hethought that they needed togo to Twitter or MySpace if
they were going to haveavatars and screen names.Facebookwasforrealpeople.
Helookedatthepost.
OptionzTraderz: Who elseonherehashadsuccesslikeIhave had trading the tripleleveragedETFoptions?
No comments wereposted.
“Thispersonlovesthe
letter ‘Z’ and has a pinkCadillacforaprofilepicture.NowheistalkingabouttripleleveragedETFoptions?Heisa different breed,” thoughtStockTrader.
He waited, still nocomments.
Stock Trader felt theneedtofillthevoid.
StockTrader:Imostlytradestocks, not options. I believe
options are too risky. Usingtriple leveraged ETF optionssounds like options onsteroids; theyare toorichformyblood.
He received a postedresponseonFacebook.
Optionz Traderz: I believetheyrepresenttheopportunityofalifetime;theycanbeusedto manage risk while givingyouamountsof leverage thathave only been available to
professionalsinthepast.
StockTrader: You can alsoloseatthefastestpaceever.
OptionzTraderz: The sametrading rules apply to 3xoptions as to the rest of themarket.Thedifferenceisthatyoucangetthefullupsideofatripleleveragedtrendwhilethe downside is controlledwith only the price you payfor the option being at risk.They are tools to increase
leverage and limit downsiderisk. You can win big andlose small with these. In thepast, theonlywaytoachievesimilar returns was to eitheropen a large number ofcontracts or tie up a bigchunk of capital bypurchasing the sharesoutright. Utilizing tripleleveraged ETFs cuts downsignificantly on commissionsandfeeswhentradingoptionsandenablesahuge reduction
in the amount of money atrisk when trading theunderlyingshares.
StockTrader: Ihavealwaysthought of options as lotterytickets.
Optionz Traderz: They are.The good news is that theodds of winning are on theback of each lottery ticket,and I have been working ondeterminingtheoddsforeachoptionstrategy.Iftheoddsof
each strategy are known inadvance, it makes it easy tosort out the good strategiesfrom the bad. However,unlikelotterytickets,youcantilt the odds in your favorwith a good tradingmethodology, just like instocks.
StockTrader:Iwanttoownanasset,notalotteryticket.Ihavenotheardofverymanyoptiontradingsuccessstories.
Generally,Ithinktheyattractunder-funded rookies whobuy far out-of-the-moneyoptions that the professionalsgladly sell to them to collectpremiums.
OptionzTraderz:Iftheprosmake that kind of easymoney, why don’t you selldeep out-of-the-money 3xoptionsandreallycleanup?
Pause.
The wheels in StockTrader'sheadstartedturning.“Whydidn’the?”Hethoughtabout it. “Would it be worthit?Howmuchpremiumcouldhe get from two or threestrike-out options? Didn’tprofessionals love the IronCondor,orwhateverthatwascalled? Would this createcash flow that he needed?What would be the risk of aBlack Monday or marketcrash?”
Stock Trader saw anew member had just joinedthe Winning Traders group.He glanced at the name,Rookie Trader. He couldn’thelpfeelslightlyannoyedthatsomeone who thought ofthemselvesasarookiewouldjoin a group set upspecifically for experiencedtraders. The thought quicklypassed when another postappeared.
OptionzTraderz:DidI loseyou?
Stock Trader: No, youactuallyperkedmyinterest.
Optionz Traderz: The 3xoptions do have someadvantages over traditionaloptions and some even haveweekly options that trade.They also have very goodvolume for near months andclose-to-the-money options.They are popular and for
goodreason.TheThetadecayon 3x options is verygenerous, although theincreased rate of decaypresents an additional riskthatneedstobemanaged.
Stock Trader: I did sometrend trading with the tripleleveraged ETFs, so I amfamiliarwiththem.
OptionzTraderz: The sameprinciplesof successful stocktrading apply to option
trading, risk management,psychology; and you need atrading a method that givesyou an advantage throughbetter probabilities. Thedifferences are that for tripleleveraged options the optionseller gets a much largerThetapremium, so if an IronCondor works for regularoptions it can be even moreprofitablefor3xoptions.Theoptionbuyergetstheleverageofa3xETFwithaminimum
investment compared to thedollar amount controlled. Hecanbuyin-the-moneyoptionsandget thefullmovementofa trend and at the same timehave his daily returnscompound when he is rightand a trend continues for thelength of his option contract.Also, a trader can go eitherlong or short in the marketwith the same effort and getthecompoundingon thewaydown in abearmarket.They
are powerful derivatives ofderivatives. They are likederivatives 2.0 or derivativessquared. I believe they givegood traders the opportunitytomake a lot ofmoneywithlimitedrisk.
Stock Trader: How longhaveyoutradedoptions?
Optionz Traderz: Nineyears.
StockTrader:Howhaveyou
done?
Optionz Traderz: I lost myentire account the first year,broke even the second year,and have not had a losingyearsince.
Stock Trader: Have youmade much money, OptionzTraderz?
Optionz Traderz: I boughtmy condo and my Cadillacwithcash.
Stock Trader: That is yourreal car on your profilepicture?
OptionzTraderz:Yes,whatdidyouthink,itwasadreamcar?
Stock Trader: You neverknow on social media whoyouarechattingwith.
Optionz Traderz: I thoughtitwouldbefuntotalktradingonline with like-minded
traders.
StockTrader:Itis.Gladyouare in the group.Wemainlytalk stocks and marketdirectioninthisgroup.
Optionz Traderz: I havetraded winning strategieswhere it didn’t matter whichdirectionthemarketwentin.
Stock Trader: O.K., nowyouhavelostme.Howisthatpossible?
OptionzTraderz:Youknowthe old Iron Condor – selloptionsout-of-the-moneyandbuy options further out-of-the-money. As long as thetrend doesn’t reach the longoptions and they expireworthless, you win,regardless of the trend’sdirection; you are justpredicting the lack of thetrend’smagnitude.Thekeyisto manage the risk of thepositiontheoneor twotimes
outof tenthat theunderlyingactually reaches the strike ofthe long options. In optionsyou can buy a hedge or buyback the option instead ofusing stop losses.Optionson3xETFs can also be used tocreatealloftheotheroptionscombinations available onnon-leveraged funds. One ofmy favorites, the ReverseIron Butterfly, can make anice profit when theunderlyingmovesupordown
by as little as one dollar,sometimes less. Think aboutit: would you rather have aReverse Iron Butterfly using3xoptionsor1x?Sometimesthe cost to open bothButterflies is similar, but thetriple leveragedButterfly hasthree times the odds ofsuccess.
Stock Trader: Hmm… Ihavenevertradedlikethat.
Optionz Traderz: I have; it
is sweetwhen youwin eighttimesinarow.
Stock Trader: There areoptionsystemswith80%winrates?
Optionz Traderz: Yes, butthe key is managing the twolossescorrectlysoyoudonotgive back your profits fromthe eight wins. The optionmarketisveryefficient.Overtime, given a large enoughnumber of trades, all options
strategies tend tobreakeven.Theoddsare thathistoricallya system with 8 wins and 2losses will take back all thewinning dollars with thosetwo losses. The key is tomanage those losses throughhedging or unwinding theposition. Each option systemhas an inverse system, justlike there are long and shortstockstrategies,bullandbearETFs, and more recently, 3xand inverse 3xETFs.Option
systems have mirroropposites. If you lost the 8times ina rowon theout-of-the-money options that youwere long, the odds are youwouldmakeitbackonthe9thand 10th trades. This issimplifying but you get theidea.
Stock Trader: No HolyGrail,justriskmanagement.
Optionz Traderz: Riskmanagement, discipline, and
a thoroughly tested tradingsystemaretheHolyGrails.
StockTrader:Well, I agreewith that; it is the samewithstocktrading.
Thenapostcameinfromanewmemberofthegroup.
RookieTrader: Good grief!Youtwogetaroom.
Stock Trader: Very funny.Well, it was great chatting
withyou.Iamgoingtosleeponwhat you have said.Veryinteresting.
Optionz Traderz: I lookforward to chatting againsometime.
A little while latertherewasapostfromthenewmember. Stock Trader hadalready shut down hiscomputer so he was notawareofthediscussion.
Rookie Trader: Seriously,you two are made for eachother. You make optionssound so complicated. Youuse terms like longandshortand Condors and leverage. Ijust got some stock optionsfrom my employer and theytoldme it was easy tomakemoneyonthemandtherewasnorisk.
Optionz Traderz: TheoptionsthatStockTraderand
I were discussing aredifferent from the ones youare talking about. It isconfusing to a lot of people.The options you own areperks offered by employerscalled Employer StockOptions. They give you theright to buy your company’sstock at a specified pricesometime in the future. Youcan make money onEmployer Stock Optionswhenthestockpricegoesup.
The options we werediscussing are StandardizedOptions that are traded onmajor market exchanges,similar to theway stocks aretraded on Wall Street andotherstockexchangesaroundthe world. Unlike EmployerStock Options that are onlyavailable toa selectgroupofemployees, StandardizedOptions are available toalmost anyone who opens atradingaccount.
Rookie Trader: I saw whatyou wrote about makingmoney no matter whathappens in the stockmarket.Thatsoundslikesomekindofscam.
Optionz Traderz: I canassureyouitisnotascam.Itisaprovenmethodoftradingthat consistently producesmoreprofitsthanlosses.
RookieTrader:Ifthat’strue,whyisn’teverybodydoingit?
Optionz Traderz: A lot ofpeople are doing it. But itinvolves risks, just like anyother investment. Someinvestors are not comfortablewiththerisks.Otherinvestorsdo not take the time to learnthe risks andendup losingalotofmoney.
Rookie Trader: You saidyou made enough money tobuy an expensive car and acondominium.
Optionz Traderz: It ispossible. However, it is noteasy money. If you want toprofit from trading options,you will need to understandhowtheybehave.
RookieTrader:IfIcantradeoptions and make enoughmoney to buy a car and acondo, then I want to knowhowoptionswork.Howdo Igetstarted?
OptionzTraderz: Therearemany books about options.You can find a huge amountof information on theInternet. Also, you mightwant to watch videos, takeclasses, or attend seminarsdedicated toexplainingallofthedifferentoptionstrategies.
RookieTrader: Is it reallythatsimple?
Optionz Traderz: Iwouldn’tcallitsimple.Ifyou
want to trade options andmake consistent profits, youwill need to dedicate sometime to learning about them.Youwillalsoneedtopracticetrading.Itisnodifferentthanlearning how to do any job.To be good at anything, youneedtolearnandyouneedtopractice.
RookieTrader:Practice?
OptionzTraderz:Yes,afteryouhavestudiedoptionsand
all of the strategies, youwillneed to design a tradingsystemthatfitsyourpersonaltaste. Then you will need topractice trading your systemuntilyouaregoodatit.Thereare several ways you canpractice. A very simple wayistoopenahypotheticaltradeand use historical prices tosee how it would haveperformed in the past. Next,you might want to tryopening a fictional trade to
see how it performs in realtime. There are manywebsites that offer virtualtrading for free. When youare satisfied with the results,you can continue practicingbyopeningasmalltradewithreal money. When you havepracticed enough, you willhave the confidence to tradeoptions in real timewith realmoney.
RookieTrader: I am glad I
joined this group. You havegivenmesomerealhopethatIcanbeaswealthyasyou. Ican’twaittogetstarted.
Optionz Traderz: Good tohear it. It has been nicetalking to you, but I reallyneedtogetsomesleepnow.
The next evening,Stock Trader was sitting athis computer with his usualenergydrink.Hecheckedhisaccounts: $201,675 in his
retirement account and$103,599 in his brokerageaccount. After seeing thatmarkets were mostly flatworldwide, he tuned intoCNBC for a while. Hewatched for a few minutes,but the report about a globalsurplus of bananas did notkeep his attention for verylong.
Soon hewas cleaningup his e-mail and looking at
his Facebook page. Oncethere, he saw that therewereadditional comments in theWinning Traders group hehad visited the previous day.He read through thecomments between OptionzTraderz and Rookie Trader.“Why is thisguy,withallofhis experience, taking thetime to discuss options withsomeone so inexperienced?”he thought. Then his eyeswere drawn to the pink
Cadillac icon in the“members online” section ofthepage.
That pink Cadillacstuck in his mind. Assuccessful as he was attradingstocks,hehadnotyetfound a trading system thatcould justify selling his oldpickup truck and buying hisdream car. Stock Trader hadthought about hisconversation with Optionz
Traderzalldaywhilehewasat work. Was it reallypossibletomakemoneywithoptions no matter what themarketwasdoing?Couldthisbe his ticket to having thelifestylehewanted somuch?So many questions filled hismind that there was nothingelse he could think about.Now was his chance to getsome answers. He begantyping.
StockTrader: What do youthink about that RookieTrader? How long do youestimate it will take him toloseeverything?Igivehim2months,tops.
Therewasapauseforafewminutes.
“Maybemycommentwas offensive,” Stock Traderthought. But his fears wereallayed when after a fewminutestherewasanewpost.
Optionz Traderz: I alwayslike tohelppeoplewhowantto learn about options. Afterlosing everything in my firstyear of trading, I feel like Iam helping others avoid thesamemistakesthatImade.
StockTrader:AlldaywhileIwasatworkIcouldn’tstopthinkingaboutwhatyousaidabout making money nomatterwhat themarket does.I would really like to learn
howyoudo it.As successfulasIhavebeenatbuildingmyretirement funds and mybrokerage account, a methodof investing that generatesconsistent income is what Iam seeking the most at thispointinmylife.Ifoptionsarethe answer, I hope you willshareyourtradingsecrets.
Optionz Traderz: I enjoysharing.It’srefreshingtofindpeoplewiththatsameinterest
in options. Sometimes I talkaboutoptionswithmyfriendsandIgetnothingbutablankstare, as if I were the mostboringpersononEarth.
Stock Trader: I don’t findoptions boring at all. Tome,they seem like the mostexciting trading tools I haveeverencountered.
Just as Stock Traderwas beginning to enjoy theconversation, it was
interrupted by a new postfromthebeginner.
Rookie Trader: I thought itwasgoingtobeeasytolearnoptions,butwhenIlookedupsomeinformationaboutthem,all I found was a bunch ofcomplicated equations. Howcan you two possibly getexcited over some stupidequations?
Optionz Traderz: Iunderstand your frustration
with the formulas. I studiedcalculus in college, and evenwith my mathematicalbackground the differentialequations that are used todetermineoptionspricingaredifficultformetounderstand.Frommyexperience,itisnotnecessary to understand theformulas to make a profit.Thereisplentyofinformationavailable on options that caneasily be understood withouta mathematics degree. I
suggest you keep lookinguntil you find a book thatexplains options in amannerthatmakessensetoyou.
Stock Trader: I have toadmit I was a littleintimidated when I startedtrading options and saw theBlack-Scholes model and allof its equations. When Iencountered terms likeImplied Volatility and “theGreeks,” I thought I might
have been in over my head.But I stuck with it and amgladIdid.
Optionz Traderz: Black-Scholes is merely anexplanation of how themarket determines thepremiums for options. Ibelieve it is important tounderstandwhy the formulasexist. Implied volatility andthe Greeks are helpful aswell, but understanding them
does not necessarily increasea trader’s profitability.Profiting from options is notabout formulas; it is aboutdeveloping a trading systemthatworksintherealworld.
Stock Trader: I agree withyou there. If profiting fromoptionswasonlyavailable tothose who understood theformulas,wewould live in aworld where the optionscientistscontrolledallofthe
wealth.
Optionz Traderz: I don’tknowwhetherornotIshouldbe insultedby that comment,as I see myself as a sort ofoptionscientist.
StockTrader:Ididnotmeanto insult you. I really wouldliketoseemoreofyourideasonhowtoprofitregardlessofwhat the stock market isdoing.
Then anotherinterruption came from thenovicetrader.
Rookie Trader: Hey, youtwo, I saw you talking aboutthe Holy Grail earlier. I justbought a subscription to awebsitethatsaysithasfoundtheHolyGrail.All I need todoissellCoveredCallsandIam guaranteed thousands ofdollars of income everymonth. What do you think?
Not bad for a 22-year-oldwho doesn’t understandformulas,huh?
Optionz Traderz: Yes, it ispossible to generate incomewith Covered Calls. But youneed to understand the risksbefore you start trading. Ireally hope you test it for awhilebeforeyoustarttradingwith real money. WritingCoveredCallscouldlookliketheHolyGrail inaflatorup
trendingmarketandyoumayevengetbyinamarketthatisslightly trending down,reselling Calls on the waydown.Theproblem is that ina sharpmarket downtrend ora crashyouwill take the fulllosseswhile only receiving asmall premium and will notbeabletoregainthelossesinan uptrend because the Callholderwillgetthefullupside.I would like to discuss thismoretomorrow.
Stock Trader: It is hard tobelieve that I, too, was thatnaïve at one point. I guesseverybody has the samereaction when they areexposed to options for thefirst time.Insomewaystheylook so simple to trade; inother ways they seem toocomplicated to understand.Andtherearesomanysharksin the water just waiting toprey on the next trader’sinexperience.
Optionz Traderz: Younailed it! That was myexperience, exactly. I amlookingforwardtotellingyouhowIwasabletoprofitfromoptions; unfortunately I havea service appointment at theCadillac dealer early in themorning.IfIdon’tgettobedsoon, I might oversleep. I’llbe here again later tomorrowmorning though. I can tellyoumorethen.
Stock Trader: O.K.,tomorrowmorningitis.
Chapter2EVERYOPTION
CONTRACTHASABUYER
ANDASELLER;ONE
ISLONG,ONEISSHORT,BUTWHICHONE
HASTHEBESTODDSOFWINNING?
Stock Trader opened
his eyes. “No alarm?” he
thought.Oh, itwasablissfulday off – no job and noresponsibilities.He could getup when he chose and dowhat he wanted. He wishedevery day could be likeSaturday; maybe one daythey would be. He almostslippedintoamilddepressionon some Saturdays whenthere was no market tofollow.He enjoyedkeypartsofeverytradingdaywhenthestockmarketwasopen.When
heawokeontradingdays,hewas curious how the Asianmarkets closed; next hewould look at what levelsEuropean markets weretrading; and then he had tosee the action in the pre-market in the United Statesand of course the futures.Afterhehadhisenergydrinkandlookedat theupdates,hewould move on to his dayjob. However he made surethathecheckedintoseehow
themarketopenedandwhereitwasbeforelunchtime.Thenhe liked seeing where themarketwas twohoursbeforethe close. Finally, at the endof the day, he studied theclosingpricesona long-termchartandexaminedtheday’svolume.
His watch lists weregenerally composed of themajor indexes: the S&P500,the Dow Jones Industrial
Average,andtheNasdaq.Hewouldwatchthesealongwithaboutfivestocksonwhichhewas bullish. By watchingthese fluctuations over theyears he got a feel for themarkets. He used hisobservationstobuildsystemsthat he used in his trading.Thesesystemsweredesignedbasedonwhatthemarkethaddone in the past. They weremainly built on past priceaction that he believed was
caused by other trader’semotions.Hethoughtalotofthe market behavior wascaused by emotions, and hislong-term charts helped himpredictthoseemotions.Thesesystemsworkedforhim.
He had moved awayfrom his discretionary shoot-from-the-hip trading. He nolongerbelievedhecouldbeatthemarketbybeingamarketgenius.Henowbelieved that
by placing high probabilitytrades he would win in thelongrun.
HisminddriftedbacktowhatOptionz Traderz hadpostedintheonlinegroup.
“An 80% win rate?Could options put the oddsthatmuchinmyfavor?Whatweretherisks?”
With those kinds ofodds, he could pay bills
through his trading on aregular basis. He had tradedsystems that had given himthose kinds of winningpercentages, but in stocksthose results were more afunction of the marketenvironmentthanalong-termsustainable winningpercentage.Techstocksweregreat for day traders in thelate 1990s, and then trendtraders cleaned up in the fallof2008by shorting financial
stocks. However, when thetech bubble burst in early2000 and when the marketreversed and got choppy inearly 2009, those sametradersrealizedtheywerenotthe geniuses they believedthemselves to be. He nolonger had any delusionsabouteasyover-performance;he knew you earned yourkeepinthemarkets.
He wondered if
options,withalltheirmovingparts, were something hecould use for a steadyincome. He really liked theidea of selling the suckerbets,thefarout-of-the-moneyoptionsthatamateurslovedtobuy. If they were going toexpire worthless eight timesandheonlyhad tocut lossesearlytwice,thatwouldbehisticket. He had to look upsomeoptiontablestoseehowmuch he could get for them
and calculate his marginrequirements. He wasintrigued.
He went over to hiscomputer and signed onalthough itwas not his usualroutine for a Saturday. Heusuallyreadandrelaxedearlyinthemorningandsurfedtheweb at night. But he signedonanywayandwenttohise-mail.Hehadane-mailinhisinbox from his Facebook
account; it was a friendrequest from OptionzTraderz. He already felt thatOptionz Traderz wasviolating a Facebook rulewith the use of a misspelledname. In his mind, this guywas now violating a secondFacebook rule of his; hewouldchat ingroups,buthisFacebook account was forfamily and real friends only.He did not know who theheck Optionz Traderz really
was.ButtheresatthefamiliarCadillac on the message inhisinbox.
“This guy is toomuch,”saidStockTraderoutloud.
He clicked to acceptthe friend request, but hedidn’t really know why hewasdoingso.Theycouldjustas easily chat online withouthaving to be Facebook“friends.” He was doing
things he usually did not do;it seemed Optionz Traderzhad a knack for easilycrossing Stock Trader’sboundariesonthefirsttry.
In the late morning,Stock Trader pulled up hisFacebookaccountandclickedon his Winning Tradersgroup. Only a few of hisbuddies were online. Helooked at some of the postsfrom the previous evening.
Posted were the usualprognosticationsofwherethemarket was going: whichstocks were hot and wheresupportandresistancewasinthe major averages. Therewere also a few annoyingpenny stock pumpers thatwereconstantlypushingsomegarbage penny stock on theover-the-counter market. Hereadoneofseveralposts.
PennyTrader:ZXLLjusthit
.06cents,likewepredicted.
StockTrader:Whocares?
Penny Trader wasoffline,probablyenjoyinghisSaturday,sonoresponsewasforthcoming. Stock Traderfelta littleboredomcreepinginwhenhesawthispost.
RookieTrader: I have readovertheinformationfrommyCovered Call Holy Grail. Ihavedoneit;Ifoundasystem
thatcannotlose.Iwillnotbeable tomake the thousands Ithought I would, though,becauseIdonothaveenoughmoney to invest right now.But I can make hundredseasily!
Stock Trader: Are youserious?
Rookie Trader: I have thesimulatedrecords toprove it.In back-testing, it workedperfectly. You simply get a
great stock and sell three-month-out Call options, overand over again. Even if themarket trendsdown,you justsell another option. Yougenerateincomeeverymonthandkeepthestock.Ihavetheproof in all the thoroughback-testing.
Optionz Traderz: I believewhatyouareseeingiswhatiscalled“curbfitting,”whereinhindsight people create a
systemthatworks.Intherealworld, in real time, thingsdonot always work outperfectly.
Rookie Trader: How can Ilose if I still own the stockand sell Calls against it forincome? Looking at the Callprices, I should collectenough premiums to coverthe cost of the stock itself in18monthsonsomeofthese.
OptionzTraderz:Oh,letme
count the ways. It will workout fine ifyouhavepickedagreat stock and you are in abullmarket.Unfortunately,inthe realworld, there arebearmarkets, down trends, BlackSwan events, scandals, andbankruptcies. If CoveredCalls were the golden ticketinto the Willie Wonkafactory, we would all quittradingandgo in andeat thechocolate. If you foundgreatcompanies in a bull market
youcouldmakemoremoneybuying Calls in those hotstocks,notsellingthem.
RookieTrader:Huh?
Stock Trader: Preach it,brother!
Optionz Traderz: There isno Holy Grail in trading.There are probabilities, riskmanagement, historicallywinning systems, discipline,and trends. But no system
winsallthetime.LookingforaHolyGrail is a sign of notunderstanding the market.Many investors thoughtselling out-of-the-moneyNaked Puts in the lateeighties was the Holy Grail,andtheywonalmost100%ofthe time until BlackMondayin 1987 bankrupted many ofthem in a matter of a fewdays.
Rookie Trader: But I have
theback-testsrighthere.
OptionzTraderz: I am surethey hand-selected somewonderful stocks like anApple or a Google, not anEnron or a Global Crossingduringanaccountingscandal.IamsuretheydidnotpickanExxon or aBP during an oilspill. I bet they never wouldhave selected Internet stocksinMarchof2000orfinancialstocks in 2008.Any of these
choices would leave a hugehole in your strategy, unlessyou had strong stop lossrules. A Black Monday ormarket meltdown wouldreallydevastateyourstrategy.
Rookie Trader: But itexplains how in the long runitisawinningsystem.
Optionz Traderz: If youselect the right stocks itmaybe.What does it say is youraveragedrawdown?
Rookie Trader: What isthat?
Optionz Traderz: Howmuch you can expect to losewhen the market movescontrary towhat isneeded tobeprofitable.
Rookie Trader: It says italwayswins,everymonth.
Optionz Traderz: Now Iknowyouhavebeenconned;
all systems have losingmonths and years. There isonlyoneoptiontradethatcanneverlose.Wouldyouliketoknowwhatitis?
RookieTrader:Ifyouknowof a trade that can’t lose, ofcourseIwanttoknow.
Optionz Traderz: Pick anystock, then sell a CoveredCall and buy a Put at thesamestrikeprice.
Therewasapauseforafewminutes.
Rookie Trader: You are agenius! This trade can neverlose.Nomatterhowmuchthestockdrops,IcanusethePutto sell itwithout any loss. IsthishowyoumadeallofyourmoneytobuyyourCadillac?
Optionz Traderz:No, I didnot. If you look closely, thetrade I described wins 100%ofthetime,butthemaximum
profit is always zero. Youwould probably even lose alittle on the bid-ask spread,plus you would havecommissions to deal with.There is no risk in this tradeand therefore there is noreward. The reward of anoptions trade is exactlyproportionaltotherisk.ThereisnoHolyGrailwithoptions.
StockTrader: If those guyshad the Holy Grail, they
would be managing bigmoney, not selling $100black-box systems. Goodgrief!Writing Covered Callsis not rocket science; youdon’t need to buy a programtodoit.
Optionz Traderz: Theproblem with Covered Callwritingisthatyougetasmallpremium to relinquish theupside profit on a stock, butyou retain the whole
downsiderisk.Itislikedoingtheoppositeofwhatyouwantto do in trading; you areletting your losers run andcuttingyourwinnersshort.Afriendofmineoncedescribeda Covered Call as the exactopposite of a stop loss. Helikes to refer to a CoveredCallasa“stopwin.”
Stock Trader: That soundslike the worst thing you cando.Itmakesmewonderwhy
theyaresowidelypromoted.
OptionzTraderz: It is oftentouted as the safest way touse options, but in reality itcanbealosingsysteminbearmarkets. In raging bullmarkets you give up theuptrend and in bear marketsyoureceiveallthelosses.Theefficiency of the optionsmarketandcommissioncostsmake it a poor bet most thetime.Withthatsaid,thereare
times, especially whenvolatility is elevated,when itmakes sense to sell CoveredCalls.Othertimesitmightbesafer to sell a Straddle orStrangle.
StockTrader:Awhat?Thatsounds violent. I guess Ialways just accepted thebelief that the Covered Callwasoneof the safestoptionsstrategies.
Optionz Traderz: Selling a
CoveredCall is justasystemand one of many strategies.They all have inverse bets,and all work best in specificmarket environments. If youaretheCallbuyeryougetthefullupside,butarelimitedtolosingonlytheamountoftheintrinsicvalueandtimevalue.There are times you shouldbuy Calls and other timeswhen you should sell them.From my years of optionsresearch, it is evident that all
systems, left to rununmanaged, revert back totheir mean and investorsbreak even. The onlyway tooutperform is throughmanagingtheinherentrisk.
Stock Traderz: I neverthoughtofitthatwaybefore.Options systems are likestock systems, and the wayyou win is to manage therisk?
OptionzTraderz:Yes. Risk
iswhatoptionsareallabout–asellerselling theirownriskfor a price. The seller of aCalloption is rentinga stocktothebuyerof theoptionfora set period of time, whileretaining all of the risk. Thebuyer is paying the seller aset amount of money forcontrol of the profits of theunderlyingstock,butwithoutthe risks inherent to owningthestock.
Stock Trader: Sellingoptions sounds risky, but Ihave had a lot of people tellme that sellingoptions is theonlywaytomakeaprofit.
OptionzTraderz:Thanks totheBlack-Scholesmodel andmarket efficiency, thepremiums usually reflect thecorrectpriceofalltheknownrisks involvedat the time thecontract is opened. Selling isno different than buying.All
you have to do is beat theefficient market andcommissions and you willmake a profit. Are youfamiliar with Matthew 13 intheBible?
StockTrader: I am familiarwith the Book of Matthew,but Idon’thave thepassagesmemorized. What does ithavetodowithoptions?
Optionz Traderz: Thatpassage is a perfect analogy
tooptions.Itreads:“Asowerwentforthtosow;Andwhenhesowed,someseedsfellbythe wayside, and the fowlscame and devoured themup:Some fell upon stony places,where they had not muchearth: and forthwith theysprung up, because they hadno deepness of earth: Andwhen the sun was up, theywere scorched; and becausethey had no root, theywitheredaway.Andsomefell
among thorns;and the thornssprungup, and choked them:But others fell into goodground, and brought forthfruit, some a hundredfold,some sixtyfold, somethirtyfold.” Options are likeseeds. You want to get themostoutofeachone,soyouneedtochoosethebestplaceandtimetouseeachone.
StockTrader: I see. So youare saying that by just
opening options as if I wererandomly planting seeds,market forces wouldimmediatelydevourthevalueof some of them; otherswould be in thewrong placeat thewrong time tomake aprofit, and somewouldbe inthe right place but wouldhave thevaluechokedoutofthem by whipsaw. The onesthatremainedwouldmultiplyinvalue.
Optionz Traderz: Blindlytradingoptionsisthesameasblindly sowing seeds. Forevery winning buyer there isa losing seller, and for everywinning seller there is alosingbuyer.Unlikethestockmarket, the options marketdoesnot increaseordecreasethe totalamountofwealth; itjust shifts it around.The keyto making money withoptions ismanaging the risk.You will have much better
luck if you plant your seedsingoodground.
Stock Trader: How do youdothatinoptions?
OptionzTraderz:The sameway you do in regulartrading: methodology anddiscipline. The rules don’tchange, just the complexity.Goingfromstocks tooptionsislikegoingfromcheckerstochess. Pieces startmoving innine directions, not just four.
It seems much morecomplicated, but the basicsare the same.You are tryingto out-maneuver youropponentandgettheirpieces.
Stock Traderz: That isanother good analogy, but Ihave always been told thatoption sellers make moremoney than option buyers.That always soundedbelievable tome because theoption buyer needs to have
theunderlyingstocknotonlygoin-the-money,butgodeepenoughtocoverthepremium.Don’tsellershavebetteroddsthanbuyers?
Optionz Traderz: Neitherone has better odds; alloptions are created equal.There are times that optionsellersmakemoneyandtimeswhen option buyers do.Market conditions determinewhich side has the better
odds. On average, sellingoptions is no better thanbuying. I have seen studiesthat indicate that marketsmovesidewaysabout75%ofthetimeandtrend25%ofthetime. Even with 75-25 odds,an option seller is no betteroffthananoptionbuyer.Theseller’s winning profits,whichinmyexperienceoccurtwo-thirdsofthetime,willonaverage be wiped out by thelosses thatoccurone-thirdof
the time. Likewise, buyerswill rarely make money, butwhen theydo theywillmakealot.
I think the perception thatsellers make more moneystems from two aspects oftrading. First, sellers makeprofits twice as often asbuyers; and second, manysellers are market makers.Market makers who selloptions do make consistent
profits, but not becauseselling is more profitable;their profits are the result oftheir ability to sell options atthe higher ask price and buythem at the lower bid price.Thinkofthemaswholesalers,making money on the pricemarkuptotheretailer.
Stock Trader: Now Iunderstand what you aresaying.Inabearmarket,Callwriters and Put buyers are
makingmoney, and in a bullmarket it is just theopposite.In amore common sidewaysmarket, all of the buyers arelosing their profits, and thesellersaremakingupfortheirpreviouslosses.
Optionz Traderz: Exactly!Youcanbuyanylistedoptionforaprice. It isup toyou todetermine which side of thebethasthebetterodds.Ifthemarket just experienced a
huge move and had alsobecomevolatile,itmightbeagreat time to sell far out-of-the-money Call and Putoptions to benefit from theincrease in premiums due tovolatility. If there were ahuge systemic risk in thefinancialsector,itmightbeagood time to buy three-month-out Puts that are at-the-money on the wholesector. If you were to find astock that you thought was
thegreatestthingsinceslicedbread, rather than buy theshares,youcouldbuy in-the-moneyCalls,getmuchbetterleverage,andbeabletouseasmaller amount of capitalwhile also limiting yourdownside risk. You can useoptions just like you usestocks; the key is tounderstandhowtheyfunctionandtherisksinvolved.
Stock Trader: You are
actually beginning toconvince me that optionscould be less risky thanstocks are. That is quite anaccomplishment.
Optionz Traderz: Whenused correctly they can helpreduce risk substantiallywhile leaving the profitpotential in place. There aremany different ways to usethemforprofitsbecausethereare many ways that they
work.Youjusthavetofindastyle that fits yourpersonality, and above all,define your maximum riskandprofitgoalbeforeplacingthetrade.
Stock Trader: I am veryinterestedinlearningmore.
Rookie Trader: I could e-mailyouguystheHolyGrailsoyoudon’thavetothinksohard.
Stock Trader: Ugh! I amgoing to run some errandsand look at some optiontables.
Optionz Traderz: I amgoing to get a margarita andsitbythepool.
Stock Trader wasfeeling much better thanusualforaSaturdaymorning.Even though there was littlefinancial news for him tofollow,hewasgrowingmore
confident that tradingoptionswas going to be his key tofinancial freedom. He wasimpressedbytheexplanationsthat Optionz Traderz hadgiven, although he had toadmit that he was a littlesurprised to learn that everyoptionsstrategyhasthesamelong-term odds ofprofitability. However,knowing that one vital pieceofinformationmadehimfeelmuch better about options
than he had ever felt in thepast.Ifeveryoptionsstrategywascreatedequal,hedidnotneedtobesoconcernedaboutlearning every strategy.Instead, he needed to learnhow to best apply thestrategies that he didunderstand.
Stock Trader’ssuccess in the stock marketwasbasedononesimplerule:Win more money than you
lose. Profiting as a stocktrader required only that hetake advantage of trends,going long in up trends,selling and selling short indowntrends. Charts of priceand volume gave him all ofthe information he needed tospotatrend.OptionzTraderzhadopenedhiseyestoanewway of trading, one whereprofits could be had insideways markets as well astrends.“IfIwasabletomake
substantialprofitsinthestockmarket simply by putting theoddsinmyfavor,surelyIcando that even better withoptions,”hethought.
Stock Trader’s mindstarted wandering. Hethought about a time manyyearsearlierwhenhisbrokerhad recommended a mutualfund that had a historicalreturnof8%peryear.At thetime, it seemed like a great
waytogetstartedinthestockmarket–buyingadiversifiedfund with a history ofprofitability, managed byprofessionals. But he couldnotforgetthe5%saleschargetaken off the top, nor thethree years of losses thatfollowed. Looking at optionstables, he could not help butnotice that a lot of year-outPut options had premiumsthatwereless than5%of theunderlying stock price. “If
only I had known this yearsagoIwouldhavejustboughtstocks and protective Putsinstead of mutual funds,” hethought. After all, thepremiums on the Puts wereaboutthesameastheloadona mutual fund. “Not onlywould I have had the sameupside potential as a mutualfund, but I would not havesuffered those three years oflosses.”
As he researched oneof the five stocks he wasfollowing, he noticed that ithad just pushed throughresistance on high volume.The ten day moving averagehad also just crossed abovethe twenty-day average. Heknew the emotions thatinvestors would feel withsuch movements; outsiderswould be enticed to buy,those who were short wouldfeel the need to cover their
shorts, and the buy-and-holders would feel lesspressure to sell. In the past,Stock Trader might havechosen to buy the stock onMonday morning, if it heldabove resistance on goodvolume. Instead, he foundhimself looking at the optiontables to find the premiumsforin-the-moneyCalls.
It seemed OptionzTraderz had affected his
entire outlook on trading.“Here is a guy I have onlyknown for a few days, that Ihave never met exceptthroughFacebook,andyethehaschangedthewayItrade,”he thought to himself. StockTraderhadnevermetanyonewith an understanding ofoptions likeOptionzTraderz.He liked having someonenew to talk to about trading.Itwasn’tthathedidnotenjoydiscussing the markets with
his longtime friends, but thiswassomeonewithsomefreshideas about a new way totrade. Although they weretraders of two entirelydifferent instruments, hewassurprised at the similarity oftheir trading philosophies.But he could not help but tothinkonething:“Amargarita,really? You have to bekidding me. What a girl’sdrink!”
Chapter3STRONG
TRENDSARETHEFRIENDOFANOPTIONBUYERANDTHEENEMY
OFANOPTIONSELLER.
Stock Trader awoke
onSundaymorning,hismindracing through optionstrategies before he even gotoutofbed.Hewasponderingwhathisnew friendhad saidabout all bets from bothbuyersandsellersrevertingtothe mean over time. He
thought the same wasprobablytrueinstocktrading.Hehadheardmanyastoryofa hot-shot hedge fundmanager, thinking he knewthe markets inside and out,then proving his skills byhavingagreatyearmanagingafund, returningmaybe40%gains in an otherwise downyear for the broader market.This guy got millions inbonuses and was treated likea rock star; money poured
intohisfund.Butthen,manytimes the strangest thingwould happen; he would beflat the next year andmaybedown10%thenextyear,andto add insult to injury, down30% the 4th year, eventuallygiving back all his previousgains. What had happened?The zero-sum game and theefficient market brought thetrader back to the meanaverage. The ‘rock star’trader simply traded the
correct way during oneparticular marketenvironment, but failed toadapt when the environmentchanged. He may have beenbuying all the dips during abull market, but doing thesame in a future bearmarketonly resulted in a successionof losses – losses thatwouldsometimes exceed the gainshe achieved in the precedingbull market. Even the mosttouted investment con in
history, “buy-and-holdinvesting,” brings manyinvestors back to even afterperiods of ten years,especiallywhentheeffectsofinflation are taken intoaccount.Theresultofbuyinginto these ‘rock star’managed funds can bedevastating to a portfolio,even in an average market,andcripplingduringaseverebearmarket.
Stock Trader hadmade most of his moneytrading trends. He thoughtthis style gave traders anadvantage over the majorityof market participants. Someof history’s best traders didnot try to predict the futurepricesofstocks.Theysimplyreacted to the current price;they looked for the trend.They had different ways ofmeasuring trends. Somelovedtobuybreakoutstonew
highs; otherswanted to tradetrend reversals; many usedmoving averages, and someboughtastockorindexwhenthe highest price, over a setnumber of days, had beenreached. Even though theywere trading using differententries and exits, andalthough some of them weretrading commodities andcurrencies in addition tostocks,theyallwereinsearchofthesamething:identifying
and trading trends. StockTraderwondered:“HowcanIuse options to trade trendsmore safely and with moreleverage? What does anoption trend trader look like?Whatoption strategieswouldbe best suited to trendtrading?” Stock Trader hadneverheardofanoptiontrendtrader before, but he wasconfident that such peoplemustsurelyexist.
Stock Trader alsocombined risk managementinto his trend trading. Hewouldlethiswinnersrunandcut his losers short. Hewantedtolosesmallandwinbig. He had found that mostsuccessful trend traders oftenhad many small lossespreceding their really bigwins.Mosttrendtradersweresimply ‘betting’ that marketsand stocks would eventuallytrend strongly in one
directionortheotheroverthelong term. If their bet waswrong they would take theirmoney off the table quickly,usually only risking 1% to3% of total capital. Thisallowed them to be wrongmany times withoutdestroying their account.When they were right, thebest trend traders allowedtheir winning trades to runwith the trend, utilizingsystematicstopswhichwould
cause them to sell out on apull back, often to amovingaverage or recent low price.He and other trend tradersrequired only one thing: thattheir big winning trades payfor all their small losses andgive them an overall profit.Stock Trader was thinkingthroughalloftheseprinciplesandtryingtoconnectthemtooptiontrading.Howcouldheuse options to control riskwhile trend trading? How
could he use options tocapturetrendswithouthavingto predict anything? It wastimetogettheanswerstraightfromthesource.
Stock Trader lookedto seewhowas online in hisFacebookgroup.
He clicked on hisWinning Traders group andopened the group’s box. Hesawthathewasjoinedby:
RookieTrader
PennyTrader
PennyPumper
GhostofDarvas
“Good Grief!” hethought.
He felt a desire tochatwithOptionzTraderz.
Penny Pumper: ZXLL is at.06 and is projected to go to
$1.00; you need to get innow!
RookieTrader:CanyousellCoveredCallsonZXLL?
Stock Trader: PennyPumper: I will pay you adollartogetoutofthisgroupand go pump the over-the-counter penny stock garbageout of a boiler room.RookieTrader: Can you do math?Howdoyouselloptionsoffa$.06 stock? OTC stocks do
nothaveoptions; theydonoteven have much volume onthesharesthemselvesmostofthe time. Good grief, guys,really?
No response fromRookie Trader or PennyPumper.
Optionz Traderz: Is thisgroup for winning traders orjustanyone?
Stock Trader: Anyone can
join.
Optionz Traderz:Obviously!
Stock Trader: Glad to seeyouonline. I have theoptionquestionoftheday.
Optionz Traderz: I hope Ihavetheoptionansweroftheday.
Stock Trader: What is thebestway touse trend trading
methods with options? Sayyou have indications thatthereisahighprobabilitythatthemarketorastockisaboutto trend in one directionsharply;howdoyouplayit?
Optionz Traderz: That is agoodone!Ifyouwerebullishonastockoveralongperiodof time, Iwould suggest youplay a slightly in-the-moneyLong Call, two or threemonths out. But you would
onlywanttodothisonstocksthat have options traded in asufficient volume to ensurethat the bid and ask spreaddoesn’t eat up your profitsgoinginandgoingout.Beinga relatively long-term play,youwouldmostlikelydobestby avoiding the currentmonth options because theTheta decay is accelerated inthe final month of an optioncontract.However,ifyoufeltmore comfortable using the
current month options, youcouldloweryourexposuretoTheta decay by buying Callsa little deeper in-the-money.Depending on how confidentyouwereaboutthelikelihoodandmagnitudeofanuptrend,you might also considerbuying the Calls, a strike ortwo out-of-the-money whichwould not only limit yourexposure to decay butwouldlower yourmaximum risk aswell. Other times, when the
market might be giving offsignals of an impendingbearish trend, you could justdo the reverse, buy PutsinsteadofCalls.
StockTrader:How about ifI am just betting on a trend,notpredicting? I justwant towinifthereisatrendineitherdirection.
OptionzTraderz:Well,thatisalittlemoredifficult.LongStrangles and Straddles are
trend grabbers. But theirefficiencyingrabbingatrendcomes at a high cost. Themarket is very efficient atpricing all options and evenmore efficient at pricingcombinationsofoptions,suchas Strangles and Straddles.Chances are the premiumsrequired to open these typesof trades would reflect theprobability of the underlyingstockpricemovingbynearlyone standard deviation, a
relatively rare scenario.WithStraddles and Strangles,strongtrendsarethefriendofan option buyer and theenemyofanoptionseller.
Stock Trader: I have seenother option traders discussstandard deviations andthey’ve always lost myattention at that point. Ivaguely remember learningabout the‘bellcurve’ inhighschool, and how the curve is
determinedbyusingstandarddeviations, but I have neverfully understood how itappliestooptiontrading.Isitreally necessary to studystandard deviations in orderto put together an optiontrade?
Optionz Traderz: Yes andno. Standard deviations canbeveryhelpful, but their useisbynomeansarequirementfor success. Despite the
complex-sounding name,standard deviations are not acomplex subject. I believe Ihavefoundasimplemeansofunderstanding them. If youwould like, I believe I canhelpexplain.
Stock Trader: Forgive mefor sounding skeptical, but ifyou think you can make meunderstand standarddeviations, give it your bestshot.
OptionzTraderz:O.K.,heregoes. Simply put, a standarddeviation is the averageamountofchangeinastock’sprice over a specific amountof time. Let’s say you arestudying a stock that istradingat$25onthefirstdayoftheyear,andoverthenext365 days it moves up anddowninarangebetween$15and $35, and ends the yearwith a price of $26.Lookingat the closing prices from
each day of the year, youmight find that the averagedailypricewas$27,buteachday’s closing price deviatedfromthataverage,somedaysby only a few pennies, andother days by as much astwelve dollars. You mightalso notice that the averageamount that the stockdeviated from that $27 pricewas$2.
While it is helpful to know
the average amount that thedaily stock price deviatesfrom the1-yearaverage, it isnot so useful in predictingfutureprices.Astockthathasa move of several dollars inone day and then remainsnearly flat for the remainderof the year is actually moredifficult to predict than astock thatmovesupordownconsistently by a few centseveryday.Inordertoaccountfor the added difficulty
presented by largemovements in price, it ispossible to make predictionsby exaggerating the effect oflarge price swings in somefairly simple calculations.Thiscanbeaccomplishedbysquaring the daily pricedeviation from the 1-yearaverage, averaging the result,and then taking the squareroot of the result. By doingso, you might find that thesquared amounts average out
to $9 and the square root ofthat is $3. That last result isthe most important because$3 represents the standarddeviation of the stock price.Based on past performancethe stock can be expected tobewithinarangeof$3lowerto $3 higher than the currentprice after one year oftrading.
Stock Trader: O.K. Thatmakes sense. But I am not
sure I understand why Iwould need to know that inorder to trend trade usingoptions. Just because thestock price had a standarddeviation of $3 last yeardoesn’t mean it will be thesamethisyear.
Optionz Traderz: You areexactly right, and you havejust pointed out an importantdifference between what weliketocallHistoricVolatility
and Implied Volatility.Historic Volatility is simplythe observed standarddeviation of the underlyingstock price during a specifictime frame. But the optionsmarket is tooefficient torelysolely on Historic Volatilityto determine prices. Instead,options rely on ImpliedVolatility, which againsoundscomplex,eventhoughit is reallynothingmore thanthestandarddeviationthatthe
market is predicting willoccurduringthelengthoftheupcomingoptioncontract.
The market is very efficient;ithastobe.Tradersdon’tjustgive their money away.Millionsoftradersaroundtheworld, many of themprofessionals, are studyingthesamestocksasyou,allinan effort to make as muchmoney as possible. They areutilizing sophisticated
software to analyzeperformance; they arekeeping up with the latestnews and events that couldaffect the stock price; andthey are using computerizedtrading platforms to executetheir entry and exit points attheoptimaltimes.Andasyoujust pointedout, just becausea stock had a standarddeviationof$3lastyeardoesnotmean themarket expectsit to remain at that level.
Takingintoaccountalloftheavailable information onEarth, market forces mightinstead predict a standarddeviationof$5.
Stock Trader: So, let’sassumethemarketdidpredictmy stock would have astandarddeviationof$5nextyear. First, how would I getaccess to this type ofinformation,andsecond,howwouldIuseittobenefitfrom
atrend?
Optionz Traderz: A fewdays ago we were chattingabout every option contracthaving a buyer and a seller.For everyCall seller of yourstock, each believing thestock would go up by lessthan $5 next year, therewouldbeaCallbuyerwhoseresearch pointed to a rise ofmore than $5. In order tomake a profit, each seller
wouldbehopingtocollectatleastenoughtimepremiumtocoverhisrisk,andeachbuyerwould be hoping to pay nomorethannecessarytogethisreward.When the buyer andsellerwereabletoagreeupona price of an at-the-moneyCall, it has been myexperience that most of thetime that price would likelybesomewherearound40%ofonestandarddeviation,or$2.The premium on at-the-
moneyoptionsisusuallyveryclose to40%of themarket’spredictionofthestockprice’sstandard deviation over thelength of the contract. Or toput it another way, if youlookupthepriceofanat-the-money option that expires inone year and multiply it by2.5, you will get a roughestimate of the impliedstandarddeviationor ImpliedVolatility of the underlyingstock. If the at-the-money
optionsaretradingfor$2,themarketistellingyouthatonestandard deviation isapproximately 2.5 times thator$5;thepriceofyourstockat the end of one year willlikely be $26, plus or minus$5.ThisisimportanttoknowbecauseifyouweretoopenaLong Straddle, you wouldprobably pay $4 in totalpremiums,andthestockpricewould then need tomove upor down by nearly one
standard deviation in orderforyoutomakeaprofit.Mostof the time, stocks do notexceed a range of onestandard deviation, so thiswouldmostlikelybealosingtrade.
Stock Trader: Wow. I’msorryIdoubtedyou.Thatisagreatexplanation.Soitseemslike it is possible to use aStraddle to bet on a strongtrend without predicting the
direction.ButIwouldneedtobeconfident thata trendwasgoing to occur because thetrendwouldneedtomovethestock price by 80% of onestandard deviation before Iwould make a profit. DoesthatmeanIcouldalsochoosetobet on thedirectionof thetrendbyjustbuyingaCalloraPut,andIwouldseegainsifI the stock moved in thatdirection by 40% of onestandarddeviation?
Optionz Traderz: You arecorrect. One-sided at-the-money long options usuallyrequireatrendofatleast40%of one standard deviation,while two-sided trades,although being profitabletwiceasoftenrequireamoveof 80% to be profitable.Either strategy couldwork ifthe market conditions werefavorable. You might alsoconsider a Long Strangle,whichsimplyinvolvesbuying
a Call and a Put out-of-the-money.TheeffectivenessofaStrangle depends on thevolatilityofthestockandthetime to expiration, but as ageneral rule of thumb,increasing the strike price ofthe Long Call by $1, whilelowering the strike price ofthe Long Put by $1, willloweryour initial costby$1.Each altered trade saves younearly fifty cents, so you aresaving nearly $1 in total
premiumswhilegivingupthefirst$1inprofits.Youwouldbe putting much less capitalat risk if the trend neverensued. Also, in the absenceofatrend,bothoptionsoftheStrangle would expireworthless, saving you thecommissions and fees youwould otherwise need to payto close a Straddle. In thecase where a trend diddevelop,yourprofitwouldbenearly identical to a Straddle
because although your profitwould be $1 less per sharethantheStraddle,youpaid$1lesstoopenit.
Stock Trader: That is veryinteresting. A Long Stranglecostsmuch less to open thanaStraddle,butbothstrategieswork similarly incapturingatrend. Iwould not have eventhought to take intoconsideration the cost of theadded commissions. I am
reallyenjoyinglearningaboutoptions from you. This issuch a nice way to spend aSundaymorning.
Optionz Traderz: Thankyou. It is so refreshing to beable to talkaboutmy tradingwith someone who trulyseems interested. SometimesItalktomypettortoiseaboutoptions, because he is theonly one who doesn’t getboredandwalkaway,atleast
notveryfast.
StockTrader:That’s funny!Idon’t think Ihaveevermetanother trader who discusseshis tradeswith a tortoise.Doyou have any other ideasabouthowIcoulduseoptionsasatrendtrader?
Optionz Traderz: Let’s sayyouwanttobetonatrendinthe triple leveragedexchangetraded fund TNA. It iscurrentlytradingat$91atthe
end of July and you can buyan October $91 Call for $11and a $91 Put for $11. Onecontract of each costs a totalof $2,200, and you capture100% of the trend, on 100shares, in either direction.This particular Straddlewouldgiveyoucontrolofthefullmove,ineitherdirection,ontheequivalentof$9,100inunderlying stocks, for fourmonths. But instead of$9,100, you have reduced
your down side to $2,200while retaining an unlimitedupside. Four-month-outoptions are relativelyinexpensive to hold becausethe uncertainty in themarketduring that timeframe helpsthem retain a fair degree oftime premium; the Thetadecay is very slow. As yougetclosertoOctoberyoumayexperience a price discoveryif a strong trend makes onesideofyourtradeworthmore
than theoriginalcostofbothoptions. This is like lettingyour winners runautomatically with a knowndownside, something I haveheard other trend tradersswear by. You lose if theunderlying ETF does nottrend at least $22 in fourmonths. The good news isthat the efficient market, infixing the premium of theoptions, has baked-in theprobability that the
underlying shares will trendone way or the other by atleast $11. So you wouldrealistically only expect tolose half of your capital ifyou were wrong about astrongtrendandthemarket’sprediction of the magnitudeofatrendwasmoreaccurate.When you analyze the tradein thismanner, it isas ifyouare putting only half of your$2,200atriskwhilecapturinga full trend above $22 on
$9,100 worth of underlyingshares, over a four monthperiod. In sharply trendingmarketsTNAhashistoricallymoved as much as $5 in asingle day, and you canimagine how far it can go infourmonths.
StockTrader:Wow!Thatisa very interesting concept,capturingafulltrendineitherdirection at a preset price. Ilikethat.Icanseemanyways
that Straddles could be usedto trend trade. And the bestpart is I would not need topredict the direction of thetrend.
Optionz Traderz: Straddlesare really good trendgrabbers, but they have adownside, just like everyother option strategy.Because they require thepurchaseoftwoat-the-moneyoptions, they require amove
of nearly one standarddeviation in order to beprofitable. The market isvery efficient in determiningoptionpremiums,butitisnotperfect. Over the long term,the market is about 68%accurateinpredictingamoveof one standard deviation.While that is a respectablepercentage, if it were thegrade on a college exam, itwould at best deserve a ‘D.’Because a Long Straddle
requires the purchase of twoat-the-money options, eachoption premium beingapproximately equal to 40%of a standard deviation, thecombined position requires amove of at least 80%of onestandarddeviationinordertogenerateaprofit.Themarketgets a ‘D’ trying to predict aprice change of one standarddeviation,andit’sevenworseatpredictingsmallerchanges.The chances of the market
correctly predicting a moveof 80% of a standarddeviationarecloserto56%.
Stock Trader: So are yousaying that when I open aLong Strangle, I will lose ifthestockpricedoesnottrendat least 80% of a standarddeviation, which is theamount required to offsetboth premiums, and I shouldexpect a loss 56% of thetime?
Optionz Traderz: Exactly.Butasatrendtrader,youareprobably already accustomedto losing most of the time,right?
StockTrader:Thatisagoodpoint. Losing trades do notbother me as a trend traderbecause I control my lossesand I always know that myfuture gains will eventuallyoutweighthem.
Optionz Traderz: It works
thesamewaywithoptions.Ifyou opened the StraddleusingtheOctoberoptionsanda trend had not materializedby September, you couldclose it early and cut yourlosses. You can also reduceyour losses by reducing theinitial capital youput at risk.As I was saying earlier, aStrangleisalmostaseffectiveas a Straddle. You use lessmoney to open a Stranglewiththeunderstandingthat it
usually gives you a slightlywiderpricerange(whereyoucould lose 100% of yourcapital) than you would getwithaStraddle.
Sayyoudecidetogoout$11inpriceonbothsidesandyoubuy the TNA October $102Call for $7 and the $80 Putfor $7 when the underlyingsharesaretradingat$91.Younow have an outlay of$1,400, insteadof the$2,200
required to open a Straddle.TNA then has to go up ordown $25 for you to get tobreak even, within the nextfourmonths.Theshareshaveto move $11 first to get toyourstrikeprice,thenanother$7 to overcome the timevalue on your winning side,and then another $7 toovercome the cost of yourlosing side of the trade. TheStrangle is a slightly lessexpensivebet,butwithlower
oddsofwinning;a$25movehas a slightly lowerprobability than a $22move.But justaswith theStraddle,you could cut your losses byclosingtheStrangleearlyifatrenddidnotdevelop.
Stock Trader: O.K., I amgoing to have to digest thatone mentally; $1,400 couldallowme tocapture100%ofany move on TNA greaterthan $11, over a four month
period. Straddles andStrangles seem like they aregood bets for trend traders.They lose more often thanthey win, but the wins areunlimited.
Optionz Traderz: They aregood long option bets, butonly when the market or aspecificstocktrendmorethanthemarketexpectsduringtheperiod of time the option isvalid.Theyarebadlongbets
when markets are stable orrange bound, but good shortbets during those markets.The expected volatility ispriced in; hence the trend isaccounted for in the optionpremiums. No Holy Grail,justanalternativewaytobuyinto trends at a price thatnormally reflects the trueamountofriskinvolved.
Stock Trader: So wouldStraddles and Strangles be
best used if I expected astrong trend, especiallywhenI believed that the expectedtrend was not adequatelypricedintothepremiums?
Optionz Traderz: Yes, thatis correct. In thepast, I havehadsuccesson the longside,playing Straddles on volatilestocks just before earnings. Ilimited my holding time tojust the few days around theearnings announcements to
limit Theta decay. But afterearnings are released, thebaked-in volatility collapses,so I often had to close mypositions almost immediatelybecause they usually lostvalue very quickly when Iwaswrong.
Stock Trader: I think Iunderstand what you weretryingtoaccomplish:openingaStraddlewhenyoubelievedthat the anticipated earnings
wereinsufficientlypricedintothe premium, then cuttingyour losses if you wereincorrect. That seems like agood plan. You say you didthis in the past. Didsomething make you stoptrading this way or are youstillplacing the same typeoftrades?
OptionzTraderz:Itwasoneof many strategies I haveused.Thesedays,Ipersonally
prefer the short side ofStrangles and Straddles; theyhave winning odds of 56%,on average. When I lose, Ican cutmy losses to preventbig draw-downs. When thestrategywinsforthebuyer,itsometimeswinsbig,butIcanoften close out before losingtoo much on my shortposition. I am the winnermostofthetime.Towin,thebuyer needs to not onlyovercome market efficiency,
but alsoTheta decay and theBlack-Scholes option pricingmodel; that is no easy task.The odds are definitely infavorof thesellerwinninginaStraddleorStrangle.Ihavefound that I am morecomfortableasan‘anti-trend’option trader. I discovered itto be much less stressful formetomakeconsistentprofitsand occasionally cut a lossthan itwaswhen Iattemptedto weather a series of small
losses in a quest for that onebig win. But that’s just me;alltradersaredifferent.
StockTrader:SoIguessifIwant to trend trade usingoptions, I should pick myLongStraddles andStranglescarefully. If I comprehendthis correctly, I am probablygoing to see losses at least56% of the time. Fromwhatyou told me last week, Iwouldhavetoassumethaton
average my winning tradeswould yield about the samegainsasmycombinedlosses.If I constantly tradedStraddles or Strangles, Iwouldeventuallybreakeven.But if I can give myself anadvantage, even if it is asmall advantage, I willeventuallyseeaprofit.
Optionz Traderz: ByGeorge,Ithinkyou’vegotit!Allyouneedtodoisincrease
your probability of success,limit your losses, or both.That’s it! It does not matterwhether you are tradingstocks, options, futures,commodities, or any otherinstrument; the rules are thesame. Increase your wins,decreaseyourlosses,orboth!It’sthatsimple.
Stock Trader: The 56%losing odds of a LongStraddle seemabitdaunting.
I may have to reconsiderwhether that strategy wouldwork for me. As a trendtrader, I usually have to dealwith some losses, but I washoping to find an optionstrategy that would give mebetteroddsthanthat.
Optionz Traderz: Straddlesand Strangles reflect thecombinedpredictionofeverytraderontheplanetregardingthemagnitudeofatrend;itis
very difficult to outwit theentire market and overcomethe odds. I think that is thereason I started tradingShortStraddles. The confidence ofhaving56%oddsinmyfavorand the relatively smallnumber of trades required tocut my losses suits mypersonality.Asatrendtrader,you might want to considerLongCallsorPutsinstead.Ifyou can predict the directionofatrend,aLongCallorPut
isamuchbetterchoicethanaStraddle or Strangle. Thepremium of an at-the-moneyoption is about 40% of astandard deviation, and themarket is only about 38%successful in predicting atrend thatprecisely.Notonlydoes the option market do apoor job of predicting themagnitudeoftrendswiththatdegree of accuracy, but itdoes even more poorlypredicting the direction of a
trend. If you can predict thedirection of a trend, you candouble your odds on a LongCallorPut,ineffectreducingthe market’s odds from 38%to 19%. That means a LongCall or Put, at-the-money,willmakeyouaprofit81%ofthe time if you are correctabout the direction of thetrend.
StockTrader: It sounds likeShortStranglesandStraddles
have given you a consistentway to make money bettingagainsta trend.But if Iwantto trend trade with options,maybe Long Straddles andStranglesarenotthebestwaytodoit.Inmystocktrading,Iuse charts of movingaverages and volume to helpmedeterminethedirectionofa trend, so I think I mighttake your advice and stickwith one sided option trades.81% odds are what I was
lookingfor.
OptionzTraderz:Onesidedoption trades are highlysuitablefortrendtrading.Theoption market is veryefficient at predicting thefuture price movement ofstocks,butmuchlessefficientatpredictingthedirectionofatrend.Iliketothinkofitthisway: the market looks atvolatility more as a fear thatprices will fall, rather than a
fear that prices will merelychange. What this means isthat most of the time Putoption premiums reflect thecombined fears of everytraderintheworld.Putsellersfear an increased risk andraise their ask price. Putbuyers see an increasingopportunity and raise theirbids.Ontheotherhand,mostinvestorsdonotfeelthesamefear when they think aboutprices going up. So, Call
option premiums, while theyshould reflect the ‘fear’ ofrising prices, insteadrepresent the required paritywith Put options. If Calloptions truly represented the‘fear’ of rising prices, theywould become moreexpensive in bull markets.Butinanup-trendingmarket,where fears decrease, in turndriving down the premiumson Put options, Callpremiumsmustalsodecrease.
If the price of Calls did notdecrease in parity with thePuts, it would be possible tomake free money by buyingstocks,alongwithlowpricedPuts, while selling higherpricedCallsatthesamestrikeprice. Free money is notsomething that an efficientmarkettolerates.Theresultisthat inanup-trendingmarketin which traders tend to beless fearful, thepremiumsonall options, including Calls,
mayactuallydecrease,givinga trend trader a perfect Call-buyingopportunity.
PennyPumper:Yougotthatbackwards.Calloptionpricesgo up when the stock pricegoesup.
Optionz Traderz: Iapologize if Ididnotexplainthat clearly enough. What Imeant was that the premiumof an at-the-money Callduring a down-trend is often
higher than the premium ofan at-the-money Call in anup-trend. If a stock quicklydeclinesfrom$50to$40,the$40 Callsmight be priced at$5, butwhen the same stockrebounds to $50, the $50Callsmightonlycost$4.
Penny Pumper: Or youcould just avoid optionsaltogether and buy ZXLLbefore the 1600% increasethat is certain to occur next
week.
Stock Trader: PennyPumper: If you are making1600% returns,what are youdoing pushing stocks onFacebook?Youshouldbeoutenjoying your yacht. Goodgrief! Optionz Traderz: Inever thought of the price ofLong Calls becoming moreaffordable in an up-trend.That would be a gift to atrendtrader.
OptionzTraderz: I agree. Itissomewhat likeagift.Callsare often under-priced in atrue rally. Straddles andStrangles are cheaper to buyin an up-trend as well, buttheygetratherexpensiveinadownturn. In a down-trend itis sometimes better to use aLong Put instead. I havetradedoptionsthatwayinthepast.Whenthatlastmajoroilspilloccurred, Ididnotopena Long Straddle. I bought
Puts only, on the oilcompany’s stock that wasresponsibleforthemishap.
StockTrader:WhatIthinkIlikemost about trend tradingwith options is that I cancontrol my risk. If I want torisk2%ofmytotalcapitalona trade, instead of setting a2% stop loss on the stock Icanjustbuyoptionswith2%of my capital. I can then letthestockpricefluctuatemore
withouttheriskofastoplossbeing tripped.My down sideislimitedtothesameamountI would have risked buyingthe stock, but I still capturethe full upside of amovement.Ireallylikethatitalsoenablesmetostretchmyequity intomorepositions, ifIdecideto.
Optionz Traderz: Optiontrading is really not muchdifferent than stock trading.
Bothcanbedoneusingmanydifferent strategies and bothareallaboutriskandreward.If you wanted to buy 1,000shares of TNA at $91, youwouldneedtoputup$91,000and use a stop loss of about$2inordertorisk2%ofyourcapital. I don’t know aboutyou, but a $2 stop loss onshares that sometimesfluctuate$5inasingledayismuch too close for mycomfort. To try to simulate
the same position, you coulduseLongCalls.But I shouldpoint out that it is not assimple as just taking your$2,000, the amount youwould have risked on theshares, and using it to buyoptions. By doing so, youwouldbeforcedtoeitherbuy10 contracts far out-of-the-money, or settle for a muchsmaller number of contractsat-the-money. Let’s say theOctober $91 Calls on TNA
werestill selling for$11; theonly way to catch the sametrend as if you owned 1,000shares would be to open 10contracts at-the-money, andthat would cost you awhopping $11,000. But thatis far less than the $91,000you originally needed. Asalways, not wanting to riskmorethan2%ofyourmoney,you would need to employsome sort of stop loss. Thegood thing here is that four-
month-out option prices, at-the-money, initially onlymoveabouthalfasfastastheunderlying shares. It is likelythatitwouldtakea$4declinein TNA to result in a $2decline in yourCalls, so youcould set your stop lossfarther away than youwouldif you owned the actualshares. In effect, this givesyou double the amount ofprotection againstimmediately being stopped
outbywhipsaw.
Stock Trader: I see whatyou’re getting at. Optionsaren’t so much aboutreducing risk as they areabout changing the way theriskwillaffectatrade.Inthecase of using Long Calls inplaceof longshares, Iwouldbe taking away a lot of the‘risk of ruin’ in case of asudden, violent, downturnbecausemymaximumlossis
reduced from $91,000 to$11,000. Another benefitwouldbelesseningofmyriskof being stopped out bywhipsaw. But thosereductions of risk would bebalancedbytheincreasedriskIwouldbetakingbyopeningmyselfuptotimedecay.
Option Trader: Again, youare correct, and I have moregood news. There are manydifferent ways to trend trade
with options while alsochoosing exactly the type ofriskexposurewithwhichyouare comfortable. Maybe youwouldn’t be able to stomachrisking $11,000 on an all-or-nothing trade, even thoughyou were confident in yourabilitytospotatrend.Despiteyour trust that you wereprotectedbyyourstoploss,afear of the shares gapping-down, falling in priceovernight and opening the
nexttradingdayatapricefarbelow your stop loss, mightmake you lose sleep. As analternative,youmightinsteadconsider opening a VerticalSpread: buying ten October$91 Calls for $11,000 andselling ten $95 Calls for$9,000. Your maximum riskwould be locked-in at thesame amount you previouslydecided was appropriate,$2,000.However,yourtrade-off for locking in the
maximum loss would be areduction in your upsidepotential to a maximum of$2,000. Another trade-offwith Spreads is that theyrespondveryslowlytotrendsin the underlying; and whilethis would allow you to cutyourlossesveryefficientlyifthetrendwentagainstyou, itwould also mean that youwouldneedtoholdontoyourwinners right up untilexpiration to see the full
benefitofatrend.
Stock Trader: I neverimagined there would be somany ways to trend tradeusingoptions.Itisinterestingto see that option traders areabletochoosethetypeofriskthatmakesthemcomfortable.When I trade stocks, I use amethod of risk managementthatreducesmystress.IhavefoundthatwhenIdonotfeelstress trading stocks, I am
able to stick to my provensystem and avoid allowingmyemotionstotemptmeintotradingatthewrongtimes.IfIcanfindasystemoftradingoptions that makes mecomfortable, I imagine Ishouldbeabletosticktoitaswell.You’vereallygivenmesome new ideas to thinkabout.Well,Idon’twanttakeup your entire Sunday, but Iam interested in learningmore.
OptionzTraderz:Youaren’twasting my Sunday. I reallyenjoy talkingwith you aboutoptions. I’d like to talk awhile longer, if that’s O.K.with you. But I probablyshouldgetgoinginawhile.Itissuchaniceday,andmypettortoiselikestotakewalksintheyardwhen it’ssunny likethis.
Stock Trader: I won’t takeup any more of your time. I
need some time tomyself tomentally digest what youhave said. Having developeda stock trend trading systemthat served me well, I guessall that I need to do now islearn how to apply thosesame principles to develop asystem using options. I amalmostashamedtoadmitthatthe option market onceseemed so much differentthanstocksthatitprovokedafear of the unknown, even
though I have been tradingstocksforsomanyyears thatI feel I should no longer beafraid of anything. It wasalmostasifstockswerefromMars and options were fromVenus.Butafter talkingwithyou, it is now apparent thatboth markets have the samegoal: avoiding risk andgeneratingincome.
Optionz Traderz: I agree.Stock options are the best
way I know of generatingincome while controlling therisks of trading. Many stocktraders are just too afraid oftime decay to even considerlookingatoptions.
Stock Trader: I am nolongerscaredofoptions.Iamfascinated with all thepossibilitiestomakemoney.
Optionz Traderz: Good tohear it! I’ll leave you withone more option trend trade
to think about before I go: aSynthetic Long or Short. Togo long, instead of tying up$91,000 on those shares ofTNAyoumighthavewantedto purchase, you could havebought ten $91 Calls for$11,000, and sold ten $91Puts for $11,000. The tradewouldhave cost younothingto open, but it would havebehaved nearly exactly thesameasowning1,000sharesoutright, assuming you met
your broker’s marginrequirements.Itwouldbelikebetting on a trend with freemoney. If you had beenbearish,youcouldhavedonethe opposite, created aSyntheticShort,bybuyingat-the-money Puts and sellingCalls at the same strike.EnjoyyourSunday!
Stock Trader: That soundsalmost too good to be true,betting on a trend without
putting any money upfront.Enjoy your Sunday too, andhave fun walking yourtortoise.
PennyPumper:Ifyoureallywant to catch a great trend,buyZXLLnow!
PennyTrader: I agree.Onedollar,herewecome!
Stock Trader: And I amselling both of you guysshort.
Optionz Traderz: Thoseguys are so annoying. Yourpostsummedupmythoughtsperfectly. Way to go, StockTrader!
Chapter4TIMEISANOPTIONSELLER’S
FRIEND,BUTTHEOPTIONBUYER’S
ENEMY.(THETA)
“Monday morning…
great,” thought Stock Traderas he was roused from hisblissful sleep by thatannoying alarmclock. Itwastime to get to work so hecouldpayhisbills.Everyday
he pondered how he couldcreate a steady stream ofincome to pay his billswithouthavingtosellhisownpersonal time for money.Even with all his success inthe stockmarket and a heftyaccount size, he lacked theconfidence to trade for aliving. He rationalized tohimselfthatthereasonforhisfear was justified becausetraders had losing years, andhis type of trend tradingwas
more suited for long termcapital appreciation than formeeting daily livingexpenses. Long ago he hadwritten in his trading journalthe secret formula forwinningasatrendtrader.
TheMarket Trends =I make money as a TrendTrader.
No Trend in theMarket = I lose money as aTrendTrader.
He smiled as thememory of that revelationcametomind.Whenhewasanewtrader,hisegohadtoberight.He felt like a failure ifhe took a breakout in a hotstock and it floundered andretraced back below thebreakout. He eventually wasable to accept that a losssimplymeant thathis systemdidnotwinonthatparticulartrade,anditdidnotmeanthat
he was a loser. He hadlearnedtoseparatehissystemandmethodfromhisego,andthat meant he didn’t need toberighteverytime.
BabeRuthdidn’thitahomerunduringeveryat-bat,and he didn’t fall into adepression every time hestruck out. Hall of Famebaseball players didn’t winevery game; they simply hadexcellentstatistics.
His morning routinewas on auto pilot: shaving,showering, and dressing. Hewas not thinking about theroutinebecausehismindwaspondering options and alltheirmovingparts.
“I wonder if optiontrading is just like trendtrading. If you use the rightsystem in the right marketenvironment, you makemoney. The market behavior
istheultimatedeterminantofwhether you make money,not your inherent tradinggenius,” thought StockTrader.
On his commute towork, he was frustrated thathe was selling his ownpersonal time for money, ormaybe it was the realizationthat he was just not gettingenoughmoneyforthetimehewasdedicatingtowork.
Then he had arevelation. Option sellerswerejustsellingtime.Optionsellerswereselling therightsto own stocks at a specificpriceforasetperiodoftime.Option buyers were simplybuying time. Of course, thistime value was based onmany factors, such as thestock’sHistoricalandImpliedVolatility, time to expiration,and the amount of intrinsicvalue already present in the
option. Option sellers, itseemed,were just selling therightstocontrolasetamountof shares. They were sellingthe right to leverage stocksforaspecifiedtimeperiod.
Thesellergetstokeepthe‘timepremium’nomatterwhat happens. That is theseller’s defined maximumgain. The buyer receives thefull profits of the stock hecontrols, if thereareany,but
his maximum loss willalways be the time premiumhe paid to control the stockposition. Intrinsic value is aseparate considerationbecause it functionsdifferentlythantimevalue.
In his mind he couldseesandsrunning throughanhour glass. Options are notassets because theydeteriorate as time goes byand go to zero if there is no
intrinsic value at expiration.That was one of the thingsthat had always scared StockTrader away from options.They trulywere defined betsover a period of time forwhichbuyershadtopayasetamount. They were notassets; they were tools.Stocks did not expire or losevaluedueonlytothepassingoftime,butoptionsdid.
Stock Trader was
sitting on the interstate inbumper to bumper traffic onhis way into the city. “If Iwas trading from home, Iwould not have a morningcommute in rush hour,” hethought.Moreofhisprecioustime was being wasted, andthis was now his morningroutinealmosteveryday thatheworked. “If Iwas a stockoption I would expire,worthless, before I got towork,”hethought.
“Wastherealheartofall option trading nothingmore than the buying andsellingoftime?”hepondered.“With stocks, you can onlygolongandshortonprice;isitpossibleinoptiontradingtogolongandshorttime?”Ifhewas able to survive thishorrendous commute andfinallymakeithome,hisfirstprioritywould be to find outwhatOptionz’ thoughtswereabout the elementof timeon
tradingoptions.
After a long day atwork, followed by twogrueling hours on theinterstate, Stock Traderfinally arrived home. Heretrieved a nice cold beerfrom the back of hisrefrigerator. Like mostbachelors, he had the typicalgrocery stock: beer, pizza,chips, dip, and a few frozenitems. But his mind was not
focused on food; it wasfocused on options. He didnot even want to let thefinancial network’s talkingheads catch him up on theday’s fundamental news andprices. All he wanted to dowaslearnmoreaboutoptions.
“What did those guysreally know about tradinganyway?” While some ofthem started out as tradersand became journalists, the
majorityofthemweremerelyjournalists reporting thefinancial news. He thoughtmost of them werehypocrites, not evenfollowing their own advice.While reporting on investingand trading, they wereactually invested in theirgood old buy-and-hold401Ks. He occasionallywatched financial newsnetworks, mostly forentertainment,likesportsfans
watchsportschannels.Hedidnot need journalists to tellhimhow to trade;charts toldhimallheneededtoknow.
Stock Trader finishedhis beer and realized hewasn’t really hungry, so heskippeddinnerandwentrighttohiscomputer.
AfterhemadeittohisFacebookaccount,heclickedon his Winning Tradersgroup. He saw that he was
joinedby:
GhostofDarvas
OptionzTraderz
PennyTrader
PennyPumper
RookieTrader
TrendMan
Ghost of Darvas: So if Ibelievedastockwasgoingtobreak out to a new high, I
could buy the stock’s Calloptionandgetahugeamountof leverage with much lesscapital?
Optionz Traderz: Yes, andalso a much biggerpercentage return on thecapitalyouareusing.Youdonot have to purchase theoptions until the stockactually breaks out. But ifyou do buy options at thepriceofthebreakoutandyou
are correct, then you get thefull intrinsic value of themove above the breakout,after having bought theoptions for their time valueonly.
GhostofDarvas:SoallCalloptions that are higher thanthe currentpriceof the stockare only worth time value?Howistimevaluederived?
Optionz Traderz: The timevalue is based on variables,
like Historical Volatility andImplied Volatility, currentprice of theunderlying asset,strike price, risk free rate ofreturn and the probability ofthe option being in-the-money. There is a complexformula, which is probablyonly understood by mathwhizzes, but you can get agood understanding of astock’s Theta value belooking at an option chain.The at-the-money options
have the highest time valuebecausewhentheyareat-the-money, they have a 50/50chance of going in-the-money.Asyougofartherandfarther out-of-the-money theprobability becomes less andless. It is possible that a twostrike out-of-the-moneyoptionmightonlyhavea25%chance of going in-the-money, so it could be pricedathalfasmuchas theat-the-moneyoption.
Ghost of Darvas: Whatabout in-the-money optionstimevalue?
Optionz Traderz: If youlook at the in-the-moneyoptions in the chain youwillnoticethatthetimevaluegetslessandlessasyougodeeperanddeeper in-the-money.Godeep enough in-the-moneyand you will have pureintrinsic value and no timevalue.
Ghost of Darvas: I do notunderstand that. Why wouldanyone buy or sell an optionwithalmostnotimevalue?
Optionz Traderz: Hedging,leverage, and locking ingains;therearemanyreasons.The reason that there is littletime value in deep in-the-moneyoptionsisthatthereisvery little chance that theywill expire worthless. Atexpiration the value of these
options is not determined bywhether or not they are in-the-moneybuthowdeeptheyare in-the-money. Tradingdeep in-the-money options isalmostthesameastradingthestock itself, which has zerotimevalue.Thevalueoftheseoptions is almost entirelydependent on the movementofthestock’spriceregardlessof the amount of time thatpasses, whereas the passageof time has an equal chance
of causing at-the-moneyoptions to either expire withintrinsic value or worthless.The buyers of these optionscan get the full move of theunderlying with a relativelysmall amount of capitalcompared to trading theshares at their full value.Thosebuyershavetheriskofthe price moving in theopposite direction, but theirrisk is much more limitedthan being long or short the
underlying shares; andbecausetheoptionshaveverylittle time value, theyexperience very little timedecay. For example, Callsellershavealreadybeenpaidto give up any upside trend,but instead of selling timevalue,as theywouldwithat-the-money options, they areselling intrinsic value. Aslongas theunderlyingsharesdo not increase in price, thesellers make a profit. Some
traders and investors maywant to delay trading theirstock because of taxconsequences, so they sell adeep-in-the-money optionagainst their position to lockin the gain for a period oftime.
Ghost of Darvas: It isinteresting that the DarvasstockoptionsIhavelookedatare very cheap when buyingthemout-of-the-moneyatthe
next possible price breakout.Why is that? I would thinkthattheoptionsforthehotteststockswouldbeexpensive.
Optionz Traderz: Thepricing for those options isbased on the probability thatthey will be in-the-money atexpiration.As aDarvas styletrader,youknowthatsomeofthe best opportunities forbuying stocks are when theyare trading in a range for
several days, and then breakout above that range withhigh trading volume. Whenthose stocks are stuck in apricerange,theprobabilityofabreakoutisperceivedtobelow, so theCall optionswithastrikepriceatthetopofthatrangeareusuallyfairlycheap.
Ghost of Darvas: Are yousayingthat theoptionpricingreflects theprobabilityof theoptionbeingawinner?
Optionz Traderz: Yes andno.TheBlack-Scholesoptionmodeldeterminespricing,butthere are also supply anddemand pressures in theoptionbeingtraded.Onsomeunderlying stocks there arevery few options traded, andthis has a huge impact onprices. Be sure to be carefulwithlowvolumeoptions; thebid/ask spreads could reallyeatintoyourprofits,resultingin large percentages losses
when buying and selling.Gravitate toward the mostliquid options on yourwatchlist.With somany to choosefrom, there is no reason toaddtheriskoflossduetothebid/ask spread to the list ofthings that you need toovercome in order to beprofitable.
Ghost of Darvas: Goodpoint.Ineverreallylookedatthepricespread.Someofthe
hot stocks on my watch listaresmall-capupandcomers,with low trading volume andeven lower volume on theoptions, and many do nothaveoptionsatall.Oneofthestocks I have been followinghasat-the-moneyCalloptionswithabidpriceof$4.00andan ask price of $5.10. Thatmeans if I bought 10contracts at market price Iwould pay $5,100, but if thetrade immediately went
againstme,Iwouldbeforcedto sell for $4,000, or less. Icould lose more than $1,100in one day, due almostentirelytothebid/askspread.IguessIwillhavetobeveryselective.Butyouhavegivenme some great ideas for aDarvas-style trading systemusingstockoptions.
Optionz Traderz: Glad Icouldhelp.
Stock Trader: It’s good to
see some honest traders inthisgroupforachange.Asatrend trader, I often use theDarvastechniqueasaguide.
Ghost of Darvas: Darvaswas a genius. His tradingsystem is so simple, but itworkssowell.Allitinvolvesiswatchinga stockwhen theprice range is inside a ‘box’and then buying it when itbreaks out above the box,using a stop loss for
protection.NowIamlookingfor a way to trade the sameway,butwithoptions.
StockTrader:Samehere. Itlooks like Optionz Traderzhad some good advice foryou.
GhostofDarvas:Definitely.I’m glad I joined this group.I’monmywayoutrightnow,but I’d be interested insharing ideas on Darvastradessometime.
Stock Trader: That soundsgood. I’m here in theWinning Traders groupalmosteveryday.
Optionz Traderz:You two,getaroom!
StockTrader:Veryfunny. Iguessyou like touseoptionstotrademanydifferentways.
Optionz Traderz: Good toseeyouonline.Yes, theyare
great tools to have in mytoolbox. The problems withsome option traders is theyonlywanttotradethefarout-of-the-money lottery tickets,looking for the big win andnot even considering all thedifferentwaystotrade.Whenall they want to do is knocktheballoutofthepark,everyball looks like it is in thestrikezone.
Stock Trader: I have seen
this also.Many of them alsoonlytalkabouttheirbigwins,not about all the losses theyhad thatwere twice asmuchas their wins. It’s just likesomegamblers,whotellonlyabout their winning trips toLas Vegas, while quietlylosingonalotoftheirbets.Ithinkalotofpeopletradeforthe adrenaline rush and thesportofit.
Optionz Traderz: I only
tradeforthemoney.
Stock Trader: Me too. Doyou have any ideas aboutways to make Theta tradeswithoptions?
OptionzTraderz:Well,youknow long options are longTheta and short options areshort Theta. Each day anoptiondeterioratesat therateofitsTheta.Anoption’stimevalue is usually, but notalways, worth less at the
closethanitwasworthattheopen because the timeavailable for it to beprofitable is less by one day.If the underlying priceremains stable, an optioncontractwithaThetaof-0.12will lose $0.12 of its valueeveryday,evenonweekendsand market holidays. Thisrate of decay accelerates inthe last month beforeexpiration,as theoddsof theunderlying price changing
become much lower asexpiration day approaches.Many option traders avoidgoinglongoptionsinthelastmonth to avoid the majorityofthetimedecay.Also,manyoption traders like to selloptions in the last monthbeforeexpiration so theycanprofit from time decay. Isometimes sell weeklyoptions where Theta is verygenerous.
StockTrader:Ihavenoticedthe acceleration in timedecay. It almost seems likeevery time I buy options,Thetaeatsupthevalue,evenwhen I am correct about thedirection of a trend. Iunderstand how Delta workswith options, but Theta hasalways been a more difficultsubjectforme.Awhileback,Ibought1,000sharesofstockonabreakoutanditdidreallywellinthefirstweek.Butthe
gainswereallonlowvolume,so Iwas fairly confident thatthe trend was going toreverse.Iwasn’treadytosellatthatpointbecausethestockwas only a couple of weeksaway from the ex-dividenddate and holding onto theshares would have qualifiedme for a substantial profit.Thinking that I could lock inthe profit by buying at-the-money Puts, I looked up theGreeks. The Puts showed a
Deltaof0.50,soIbought20contracts. I thought I wasDelta-neutral; if the stockpricewentdown$1, Iwouldlose $1,000 of my gains onmy 1,000 shares, while myPutswouldgoup inpricebyfiftycentsbecausetheirDeltawas0.50;andbecausemy20contracts covered 2,000shares, I thought I wouldrecover that $1,000. As itturned out, I was partiallycorrect. The stock price fell
$1 over the next week, butmy Puts only went up invalue by $500. I ended upselling everything at a $500loss and that caused me toalsomissoutonthedividend.It seemed like I made theright decision, creating aDelta-neutral position, butThetadecayateupallofmyprofits.
Optionz Traderz: Timedecay, or Theta, is really the
mostimportantconceptinallof option trading. Optionpricesaredeterminedbyrisk,and risk in the markets issimply a factor of theuncertainty of how time willaffect prices. Delta, Gamma,Vega, and all of the otherGreeksarenothingmorethandifferent ways of expressingthe effect of the time relatedriskofbeinglongorshortonany particular option. AnunderstandingofTheta is the
key to success with options.You can spend timeresearchingalloftheGreeks,but in the end, I think youwill find,as Ihave, that theyareallderivativesofTheta. Idiscovered option trading tobemuchsimplerwhenImadeThetamymainfocus.I thinkThetamaybethereasonyourtrade failed, and I may beable to pinpoint what wentwrong,ifyoulike.
StockTrader:Thatwouldbegreat.
OptionzTraderz:Youwerecorrect in your assumptionthat your position was Deltaneutral, at least initially. Butyour position was not Thetaneutral; the timevalueof theoptions you purchased wasdecaying every day youowned them. To be Thetaneutral, you would need tosell time value in order to
offset the time value youwere buying. Instead ofbuying 20 Put contracts, youcould have made yourposition Theta neutral bybuying10Putsandselling10Calls. But I should point outthattheoptionmarketisveryefficient, and it considerseverything that affects thepriceoftheunderlyingstock,including dividends. On theex-dividend date, a stock isexpected to fall in price by
the amount of the dividend,or at least a portion of thatamount. That makes Putsmore expensive than theywould be otherwise, whileCalls get cheaper. It is likelythat buying 10 Puts at aninflated price due to theanticipated dividend andselling 10 Calls at adiscountedpricewouldresultin a net cost approximatelyequaltothedividend.
Stock Trader: I think I getwhatyouaresaying.Inorderto use options to lock in thegains on my stock I wouldneed to use a strategy thatwas Theta neutral, so that Iwould not experience timedecay.
Optionz Traderz: Exactly,and there are other strategiesthatareThetaneutralorveryclose to it. You could havesimply bought deep in-the-
money Puts with very littletime value; but again, theprice of those Puts wouldhave been inflated to reflectthe decline in price that wasexpected on the ex-dividenddate.
Stock Trader: So I guessoptions are not usually goodtools for locking in gains. Iprobably would have donejust as well selling the stockwhen I sawweakness, rather
than try to protect my gainsusingoptions.
Optionz Traderz: Exactly!But there are times whenusingaThetaneutralpositionto lock in your gains mightcomeinhandy.Let’ssayyoujust had a great year in themarket and have a hugeamount of unrealized gainsthat are all taxable. It ispossibletouseoptionstolockin those gains, but delay
realizing the gains until thefollowing tax year. You canSynthetically Short yourgainers by selling aCall andbuying a Put at the samestrike price, but use optionsthat expire after the currenttaxyear.Youwouldstill selleach stock with all of itsgainsintact,butyouwouldbedelaying the sale, and thatcould save you a bundle ontaxes. The position is Thetaneutral, so you would not
experiencetheeffectsoftimedecay.
StockTrader:Wow,Ineverthought about using optionsto savemoney on taxes. ButI’m more interested inlearning how to profit fromTheta. Do you have anyideas?
OptionzTraderz:Ofcourse,you probably would want tosell options when the Thetadecay takes place the fastest,
the last month. Some traderseven like trading the weeklyoptions, which have evengreater Theta decay. Youcould sell out-of-the-moneyoptions that you believe areabove resistance and have avery low probability ofgetting there. You could sellthose sucker bets,which is ahigh probability system, oryoucouldsellbothCallsandPutsat-the-moneyonastock.This puts the odds in your
favor–aShortStraddle, likewe talked about yesterday.There is also a play called aCalendar Spread, where youbuy a long term option andthen sell a short term optionatthesamestrike.Youprofitfromthefaster timedecayofthe shorter term optioncompared to the longer termoption. The only losingscenario on a CalendarSpread occurs when theunderlying shares move a
hugeamountintheshorttermand then level off or reversethetrendinthelongterm.
StockTrader:Hmm,thatallmakessense,puttingtheoddsin my favor and benefitingfromtimetickingaway.ButIstill don’t fully grasp theconcept of Theta. Why is itthat stock options with amonthly expiration only costabout twice as much asweekly options; shouldn’t
theycostfourtimesasmuch?
Optionz Traderz: Theta isnot as difficult to understandas you might think, and itreally is important tounderstand Theta to besuccessfulwithoptions.Icantry to explain, if you wouldlike.
Stock Trader: Here we goagain. I know I shouldn’tdoubtyouanymore,sogiveityourbestshot.
Optionz Traderz: Timevalue simply represents theuncertainty of what effecttime will have on a futureevent. I was thinking abouttime value just this pastweekend. I had takenmypettortoise for a walk and wassitting by the pool enjoyingmymargaritawhenIrealizedhe had wandered off. Iquicklygotsomeoftheothercondo owners to help me
searchandwestartedfanningout inalldirections.Luckily,wefoundhimafterjustafewminutes,butwehad tocoveralargeareatodoso.
Stock Trader: I’m glad tohearit.Iknowhowmuchyoulike your option tradingbuddy. But what does atortoise have to do withoptions?
OptionzTraderz:Thinkofitthisway.My tortoiseusually
walksveryslowly,constantlychanges direction, andsometimes stops altogether,just as stock prices do. Butwhenhewandered away, theareawehadtosearchbecamelargerandlargerastimewentby.Thesearcharearepresentstheuncertaintyofhislocationduetothepassageoftime.Asitturnedout,wehadtosearcha rather large area, but inreality he was not very faraway when we found him.
Ultimately, it is his distancefrom my chair that normallyconcerns me; his distancefrommychairbythepool.Itisthesamewithoptions.Youare not concerned with theamountofareaofuncertaintyoftheunderlyingpriceduringthecontract,onlythedistancethepricemightmovefromitsstartingpoint.
Stock Trader: I follow youso far, but I don’t yet
understand how it relates toTheta. You have notdisappointed me with yourpastexplanations,sogoon.
Optionz Traderz: O.K., sowe all remember learning inmath class how the areaof acircle is πR². I even had onemath teacher who wouldalways follow that equationwith the remark, “No, theyaren’t;pieareround.”Idon’tthink any of us ever laughed
at his attempt to be acomedian,but itwashiswayof trying to get us toremember the equation. It isimportantbecausetheareaofa circle is related to thesquareoftheradius;ortoputitanotherway,theradiusofacircle is related to the squarerootofthearea.Iftheareaofa circle becomes four timeslarger, the radius doublesbecause 2 is the square rootof 4. So when we were
searching for my tortoise, astime went by we had toexpand our search over alarger and larger area, eventhough his distance frommychairwasnotincreasingveryfast. Think of the effect oftime on stock prices like thesearch area for a tortoise.Astime goes by, the area of thecircle that would representthe search area grows, butyou are only concerned withthedistanceofthestockprice
from its startingpoint,whichisthesquarerootofthatarea.Thedistanceof a stockpricefrom its starting point is its‘speed’ or volatility,multiplied by the square rootoftime.
StockTrader:NowIthinkIam starting to understand.Stockpricesdon’t just goupor down consistently; theymeander around, like yourtortoise does when you take
himforwalks.Sowhile theycoveralargerandlargerareaastimegoesby,thepricesdonot change nearly as fast asthe area they cover. If Iunderstand correctly,predicting a stock price fourweeks away would involvefour times the search area ofpredictingthepriceoneweekaway.Butthesquarerootof4is2,sotheuncertaintyoftheprice four weeks out wouldbe about double the
uncertainty of the price aweekaway.
OptionzTraderz:Exactly. Iliketalkingwithyoubecauseyouareaveryfastlearner.
StockTrader: Thanks, youare a good teacher. If Iunderstand your analogy, itexplains why a lot of themonthly options are aboutdouble the price of weeklyoptions because theuncertainty is not four times
as much, but two timesgreater.
Optionz Traderz: Yes, butonly for at-the-money andout-of-the-money options.Intrinsic value on in-the-moneyoptionsisthesamenomatter what their expirationdate. So although the timevaluewouldstillbedoubleonthe monthly in-the-moneyoptions, the actual premiumwould not be twice as much
astheweeklyonesbecauseaportionofthepremiumwouldbebasedonthesameintrinsicvalue. Deep in-the-moneyoptions, having very littletime value, might havesimilar premiums despitehaving different expirationdates.
StockTrader:That’sagoodpoint.Itisonlythetimevalueofanoptionthatisdependentontheexpirationdate.Would
the same process apply toother expiration dates? Doesanoptionexpiringinoneyearhavedoublethetimevalueofan option expiring in threemonths?
Optionz Traderz: Yes andno. Using the square root oftimeasadifference,youwerecorrect in your assumptionthat because 12 months isfour times as long as 3months,youwouldexpectthe
furtheroutoptionstohavethesquare root of four,which istwo, times the time value.However, that is not alwaysthe case in the real world;option premiums aredeterminedbyaveryefficientmarket. For example, themarket might be predictinglowvolatilityinthenextthreemonths but increasingvolatility over the comingyear. In such a scenario, thelonger term options might
havemorethantwotimesthetime value. But as a generalrule, you are correct; acontract with an expirationdate 12 months away willhave a time valueapproximately double that ofathree-monthcontract.Ihavea chart that shows the effectof the expiration date onTheta.I’dbehappytoshareitifyoulike.
Stock Trader: Sure. I’d be
interested in seeing it. Ialreadydoalotofmytradingbased upon charts. I knowsome traders who don’t usecharts at all, but I preferthem. To me, charts are atrader’sbestfriend.
OptionzTraderz:Iagree. Ican’t imagine what I woulddo without charts. I’msendingitnow.
Astimepasses,thesearchareadoubles,butthepredicteddistancefromthestartingpointistheradiusofthesearcharea,whichisproportionaltothesquarerootofelapsedtime.
StockTrader:Thatisagreatchart. I always thought ofstock prices moving in onlytwo directions, up or down.ButIcanseehowpicturingastock price like a tortoise,movingleftandright,aswellasupanddown,makessense.
The area where the stockpricewillbein10minutesistwicethesizeoftheareaafterfiveminutes,butthedistancefrom the center does notdouble because the radiusincreases at a rate equivalentto the square root of time. Ithink I am finally starting tounderstand Theta now; it islikethesquarerootoftime.
Optionz Traderz: Younailed it. Theta is a
logarithmic function,equivalent to the square rootof time. I have two morecharts thatshowtheeffectoftime decay on an option.They are basically the samechartinreverse,butyoumayfind them helpful. I’msendingthembothtoyou.
Thetimevalueofoptionsisbasedupontheuncertaintyofthepriceofthe
underlyingstockduetothepassageoftime.
Asexpirationdayapproaches,optionslosetimevalueatanacceleratingrate.Amonthlyoptionmaylosehalfofitstimevalueduringthefinalweekof
trading.Optionz Traderz: I shouldalsomentionthatthesechartsonlyapplytooptionsthatareat-the-money. Time value isalwaysthegreatestonat-the-money options. Theta onlyapplies to the amount of thechange in the price of an
option due to time, but thetime value of an option canchange for other reasons. Adecrease in volatility cancause a loss of time value;that ismeasured byVega.Achange in the underlyingstock price will cause an at-the-moneyoptiontolosetimevalue, and that is measuredbyDelta.Eveneventssuchasa change in risk-free interestrates can cause a decrease inthe time value of an option,
whichiscommonlymeasuredasRho.
Any one of those scenarioswould not only result in achangeintimevalue,butalsothe rateof timedecay.Whenfactors other than time lowerthe time value of an option,Thetawillalsodecrease.Justasanexample, ifyoubuyanat-the-money Call and itsuddenly goes in-the-money,itwilllosetimevalue,butits
actual price may increase iftheincreaseinintrinsicvalueisenoughtooffsetthedropintimevalue.However,becausethe time value of the Call islower when it is in-the-money, Theta will decrease,soyouwouldthenexperiencealowerrateoftimedecay.Ifyou look at deep in-the-moneyoptions,manyofthemhavenotimevalueatall;theyoften trade at par with theunderlying stock because
Thetaisnearlyzero.Whenanoption has no time value, itcannotlosevalueduetotimedecay, although it can losevalue for other reasons suchasDelta.
Stock Trader: Theta isaffectedbyfactorsotherthantime. I’m going to have tomentally digest that. I thinkI’m getting too tired to askyou to explain that now, butmaybe another day. I think I
am really starting tounderstand Theta though.Now that Iknowmoreabouthowitworks,Ishouldbeableto minimize the risk of timedecaywhen I apply it tomytrend trading. I think it willhelpmeputtogetherasystemthat, as you pointed out,should give me an 80% winrate when I am right aboutspottingatrend.
OptionzTraderz:Anddon’t
forget to manage risk whenyouarewrong.
Stock Trader:Yes, an 80%winrateisnottheHolyGail,justawinningtradingsystem.
Optionz Traderz: I prefershort Theta trading,which isbasicallytheoppositeoftrendtrading.Insteadofafewhugewins paying for a bunch oflittlelosses,Ihaveabunchofsmall wins and then cut myfew losses short before they
become big. I benefit fromTheta eating up the value ofthe options, but I have tobeware of intrinsic valuecausingmetolose.
Stock Traderz: That isdifferent; I do not know if itfits my personality. All daywhile I was at work, I wasthinkingthatsellingtimewasgoing to be the path to mysuccess with options. Butnow,IthinkImightbebetter
off sticking to developing asystemoftrendtrading.
Optionz Traderz: Just likein stock trading, you mustfind a system you arecomfortable trading anddevelop faith inyour system.If understanding Theta helpsyoudo that, I’mgladIcouldhelp.
StockTrader:I’mdefinitelycomfortable trend trading.Thankstoyou,Inowknowa
lot more about how Thetaworks, and that shouldmakeme more comfortable trendtrading with options. ShortTheta trading seems liketradingperishablegoods;theyhave an expiration date onthem. I think I would feelmuch less stress buyingTheta.
OptionzTraderz:Itisfunnythatsomethinkonlytheselleris at an advantage due to
every option contract havinga time of expiration. Theydon’t want to buy optionsbecausetheyknowtheyhavetoberight,not justabout themove, but when it takesplace. Obviously, you areable to see that there is alsovalue in being a buyer.Optionsareazerosumgame;the option seller has to beright about the stock notmovingtoacertainpriceinadesignated time frame; the
buyer has to be right that itwillmovetothatprice.
StockTrader:Inanefficientmarket both sides are alwaysequal at the time the trade isexecuted.
Optionz Traderz: Exactly.Selling Theta is a lot likeselling lottery tickets. Youcan make a lot of moneybecause the odds are in yourfavor, but you have to alsopay the winners. Some
traders,likeme,prefersellingthe tickets and then buyingthemback if they look likeawinner just before the lastlotterynumber iscalled.Youseem more like the type oftrader that would preferbuying lottery tickets andselling them if the first few‘numbers’ in the lotterydrawingmadethemlooklikealoser.
Stock Trader: Good point.
Well it’sbeennice talking toyou, but it’s getting late andafter this afternoon’scommute,I’mwipedout.
Optionz Traderz: I shouldget going soon too. It’s beennicetalkingoptionswithyou.
GhostofDarvas:Ihopeyoucan answer one morequestion before you go.Should I trade my Darvassystem principles but justadjustthemtooptions?
Optionz Traderz: I thinkoptions may work for you.For instance, you may wantto only buy two-month-outoptions at-the-money at thetime of a breakout, to keepthesamebuypointyouwouldhave used to purchase thestock. That would alleviatethe stressof trying topredictbreakouts and minimizelossesdue to timedecay,butstill capture the full move in
intrinsicvalue.
Ghost of Darvas: Greatadvice, as always. Thanks.Youhaveagoodnight!
Stock Trader: Nice chat,Optionz, and thanks for thecharts.StockTraderout…
Chapter5VOLATILITY
ISTHEOPTIONBUYER’S
FRIENDBUTTHEOPTION
SELLER’SENEMY.(VEGA)
ItwasThursdaynight
andStockTrader’seyesweregettingheavierandheavier.Itwas 11:10 p.m. and onceagainhewasuppasthisusualbedtime. He was looking atthechartsofthestocksonhis
watch list. Now he foundhimself looking at redcandlestick after redcandlestick.
“Yuck!” he thought.“Thesechartslookterrible!”
Hehadbeenwatchingthesesamechartsintentlyforover a month, during whatappeared to be a slow grinddownward. His system hadtaken him to cash, as thestocks on his watch list all
lost their 10-day movingaverages nearly three weeksearlier.Whilehewaswaitingfora reversalbackabove the10-day, they lost the 20-daymoving average.Nevertheless, he had keptwatching intently over thepast week. “The 50-daywould be a chance to enterlongagain,”hethought.Thatwas often a great place forsupport in an overall longterm up-trending market.
Also, if the market leaderslost support at the 50-daymoving average and hadtrouble retaking it a fewtimes, thatwould be amajorsignofachangein trendandthe probable beginning of abear market. His watch listwould thenmorph into a listofstockstosellshort;nothisfavorite way to trade, but awaytomakemoneyintoughtimes.
Oddly enough, hemissed his entries becauseboth the 50- and 100-daymoving averages were lostwithin days. The Dow JonesIndustrialAveragewaslosing100 points a day, sometimesmore. Tonight wasparticularly interestingbecause the S&P 500 indexhad closed right on its 200-day moving average, theNasdaqcompositewasa fewpoints above its 200-day
movingaverage,andtheDowAveragewasasafe50pointsabove the 200-day movingaverage. One of StockTrader’s systems had him golongtheS&P500Indexwhenit bounced off and headedback up in price at the 200-day, or short the index if itlost that last critical supportlevel.Hisholdingswerenowin cash, waiting for adirection; it was too soon totake a position because this
was neither a reversal nor alossofsupport.Thepricewaslying right on the fence,creatingawaitinggame.
Itwasnow11:30p.m.andtimeforsleep.
Beep, Beep, Beep,Beep,Beep,Beep
Itseemedasifhehadjust fallen asleep, but thealarm clock was nowsummoning a tired Stock
Trader to put on his tie andget to work. The open roadandhisdayjobawaitedhim.
He rolled out of bed,trulyexhaustedfromhislate-night chart observations. Hesleepily walked to the livingroom and clicked on thetelevision; as always, it wasalready tuned to his favoritefinancial news station. Heretrievedhislastenergydrinkfrom the back of his nearly
emptyrefrigeratorandalmostdropped it when he saw thatthe European markets weredownover5%.
“What the…!” cameoutofhismouth.
Then he rememberedhewasflat;allhiscapitalwassafelyincashequivalents,nostocks. He felt like a bullethad just whizzed past hishead.
Immediately he waswide awake. “What is goingon?”hethought.
Commentators talkedabouthow the leaders inoneEuropeannationhadfailedtopassausteritymeasurestogetmorebailoutmoneyfromtheInternationalMonetary Fund.They would default, theirbondholderswouldbewipedout, and companies whichsoldinsuranceonthosebonds
wouldlosebillionsofdollars.This was unexpected news,an outcome that seemed tohave a low probability justyesterday, and the marketswerereactingviolentlytothenews.
“Wow! A socialistparadise collapsing under theweight of governmentregulationandentitlements…truly shocking,” said StockTrader out loud, barely
attempting to restrain thesarcasminhistoneofvoice.
HesawaquotefortheU.S.Dowfutures.Theywerealso down 5%. “No surprisethere.”
On his commute towork he kept pondering themeaning of all of the recentfinancial turmoil. Heconsidered himself to be atechnical trader. He hadmissed his short entry, so
nowwhat?Was it too late toshort and too early to golong? That gap down causedhim tomisswhat he thoughtwas the ‘meat’ of the move.Should he open a shortposition at the open? Thatwould be keeping to hissystem. Should he use atrailing stop to exit? Thesewere not easy decisions tomake; these were strangecircumstances, for sure. Hequickly came to his senses
and decided to watch themarket but not place anytrades.
Years earlier, he haddiscovered that one of thekeys to his success wasavoiding emotion. He hadfound that he could avoidemotion if he planned histrades when the market wasclosed, then placed tradesbased on hiswinning systemwhen the market was open.
Trying to plan a trade whilewatching financial news ontelevision on a day whenmarkets all over the worldweredown5%,wouldbelikeplacing a bet on the SuperBowlwith the score tied andonly two minutes remainingin the fourth quarter.Emotions were controllingthe market today, and hemadeadecisiontosticktohistradingrules.Hewouldwatchthe market as if it was a
football game, but he wouldnotplaceanybetsduring thetrading day. Tonight, whenthe markets were closed, hecould study the recenteventsand plan his trading fortomorrow, hopefully withsome help from OptionzTraderz.
He was watching thequote at the open. The DowAverage opened down 4.5%,and then fell some more,
down 5.5% at one point.Thirtyminutesafter theopenit rallied, so it was only 4%down from the previous day.It was exhausting to watch,but he did not feel theadrenaline rush that he knewother traders were certainlyexperiencing. His accountswere all safely tucked awayin cash – orwere they?Thiswas one of those days themarketwassodisturbingthatStockTrader felt the need to
check all his accounts andensurewithoutanydoubtthatthey were all completely incash. This was not a normalfunctioning market; anythingcould happen. Othergovernmentscouldtakesomekindofbailoutactionandthatcould lead to a rally, or itcouldbeexposedthatamajorfinancial business wasdefaulting on its debt andgoing bankrupt, setting off asystemic problem in the
financial system. This wasnot a market Stock Tradercared to trade. Truly,anythingcouldhappen.Butitwas as entertaining to watchfrom the sidelines as anysportchampionshipgame.
Throughoutthedayhewas drawn to get quotes.Hewas fascinatedwith thepriceaction. Finally at the end ofthe day the market closeddown over 6%; this was a
675-pointhaircutofftheDowJones IndustrialAverage.Hewas relieved to find thatindeed all of his longpositionshadbeenclosed.Hewas100% in cash.Days liketoday made Stock Tradercherishhistradingsystem.Hehad not made any moneytoday, but so many peoplelost so much money thatbreaking even on a day likethis meant he had still faredbetterthanmosttraders.
“Wow!”
Onthedrivehomehewas very interested to knowhow Optionz had done. Didhe have one of his ShortStraddles on? If so, hecertainlymusthavebeenhurt.
Whenhegothome,hedid not even take his shoesoff; he went straight to thecomputer. Optionz Traderzwasonline.
“Great”,hethought.
He did not go to theWinning Traders group; hewanted to sendhimaprivatemessage so as not to open atradingwound.
StockTrader: How are youdoingtoday?
OptionzTraderz:Verywell.WhataCRAZYDAY,huh?
StockTrader:Iknow,right?
I was right at a crossroadslooking for an entry signalandsafelyincash.Todaywasso stressful I had to doublecheck all my accounts toensureIhadnolongpositionson. I felt almost as though Ihad an obsessive-compulsivedisorder.
Optionz Traderz: Whentrillions of dollars in valueevaporate, it is good todoublecheckonthesafetyof
yourhundredsandthousands.It’s not O.C.D., it’s a soundtrading practice. Trading isstressful enough withoutworrying if you forgot aboutalongposition.Ifitgivesyoupeace of mind to doublecheck your investments on acrazy day like today, do it!Today’s trading was unlikeanythingIhaveseeninmanyyears. It would be crazy nottoobsessoveryourpositionson a day like this. And it
wouldbeevenmoreinsanetorisk leaving them open overtheupcomingweekend.
Stock Trader wasanxious to know whatpositions Optionz Traderzhadonthisday.Thecuriositywasdrivinghimcrazy.
StockTraderz:Manypeoplegotreallyhurttoday.
Optionz Traderz: Tell meaboutit,Ireallyfeelsorryfor
the guy that sold me thosePutstwodaysago;thathastohurt. However the guy Ibought the Calls from didwellaslongastheywerenotCoveredCalls.Ouch!
StockTradersuddenlyfelt a little envious. He wasconfident thatbeing100% incash had saved him fromhorrible losses. He hadbroken even today, whilemillions of other traders had
lost big time.He hadmissedoutonagreatopportunity togo short becausemost of themovehadoccurredovernight.Even if he had attempted togoshortinthepre-market,hewould have missed nearly90%ofthemove.ButOptionzTraderzactuallymademoneytoday? How was thatpossible?
Stock Trader: What? Youbetbothways?
OptionzTraderz:Yes,somemarkets lend themselves totrading Theta, and others arebest for trading Vega.Whenthe markets meanderedaround slowly last winter, Imade a killing selling Theta;but with the recent spike involatility, it makes muchmore sense to capitalize onVega.
Stock Trader: I rememberyoumentionedVegalasttime
we talked, but it seemsconfusing. Volatility isalways changing, so how doyou know when it is best tofocus on Theta and when toshifttoVega?
OptionzTraderz:Vegaisanimportant concept in optiontrading. Usually it is not asimportant as time-decay orTheta in my opinion, butthere are occasionally dayslike today when volatility
spikes that Vega can not beignored. There are no setrules for capturing profitsfromVega, but I’d be happytosharemythoughtsaboutit.
StockTrader: I’dappreciateit. All day, I thought I wasdoingbetterthanmosttradersby not losing money whilemost others were. It wouldhave been nice to be able toprofit from the rise involatility, but I didnotknow
howtodoit.I thinkIhaveagood understanding of Thetanow, butVega seems a littlemorecomplex.
Optionz Traderz: Vega isnot complex at all; in fact, itissimplerthanTheta.Vegaisnothing more than the effectof volatility on optionpremiums. When volatilityincreases, stock prices makewild swings up or down orboth. That makes predicting
the price of a stock on somefuturedatemoredifficultthanit would be if prices werestable.
Stock Trader: I understandthe basics of volatility. Highvolatilitymeans there isa lotofuncertaintyinthemarkets;low volatility means pricesare flat or rising. But I’mhaving trouble relatingvolatilitytoVega.IthinkifIunderstood Vega, I would
have been able to profittoday,justasyoudid.
Optionz Traderz: Well, Ihavegoodnews.Thetais themost difficult concept ofoption trading. If you wereabletounderstandTheta,youwill have no difficultygrasping all of the other‘Greeks,’includingVega.
Stock Trader: That’sreassuring. Theta was noteasy to comprehend, but
when you showed me thecharts that used your tortoiseas an analogy, I understoodcompletely.
Optionz Traderz: I havefound analogies to be veryuseful when it comes tounderstanding options, sohere’s another one for you.Thehomeowner’sassociationformycondoforbidscatsanddogs–that’swhyIhaveapettortoise.Someotherresidents
have pet birds, lizards, evensnakes. But there is an olderlady that lives on the otherside of the complex and shehas a pet rabbit. I think herrabbit may help youunderstandVega.
Stock Trader: I guess Ishouldn’tbesurprised.Ifyouwereable tousea tortoise toexplain Theta, then I won’tquestion your use of a rabbittoexplainVega.
Optionz Traderz: That’sgood to know. Sometimes Ithink my analogies are socrazy that my tortoise is theonly one who will listen tothem, but I really enjoysharing them with you. It’snice to have a real personinterested in my ideas aboutoptionsforachange.
Stock Trader: It’s great tohave met someone like youthat can explain options in
such detail. But I feel like Ioweyousomethingforallofyour insight. If thisconversation was in personinstead of on Facebook I’doffer you a beer for yourthoughts.
Optionz Traderz: Well,thanks for the offer, but I’dreally prefer a margaritainstead.
StockTrader:As expensive
as a margarita might be, itwouldbewellworththecost,given the advice you havegiven me about options sofar. I am really intrigued byyour analogy of Vega andyourneighbor’srabbit.
OptionzTraderz:O.K.,heregoes:My neighbor takes hermorbidlyobeserabbitoutforwalks, just like Idowithmytortoise; he likes to eat thegrass and weeds by the pool
too. But as big as he is, hemoves much faster than mytortoise. I can’t count thenumberoftimeswehavehadtoformsearchpartiestolookfor her rabbit when itwandered away, while mytortoisehasonlygottenawayonce.
Stock Trader: So are yousaying that the rabbitrepresentsVega?
Optionz Traderz: Well, it
represents higher volatilitythan a tortoise. ImpliedVolatility in stocks is quitesimply the predicted ‘speed’thattheywillchangeinprice.I think I have another chartthatmayhelpyouunderstand.
StockTrader:Thatwouldbegreat. Your charts have beenveryhelpful.
Thesearchareafortherabbitisabout25timesthesizeofthesearchareaforthetortoise,representingtheincreaseduncertaintyofthelocationofastock
pricewithhighervolatility.Optionz Traderz: As youcan see from the chart, thesearch area is exponentiallylarger for the rabbit.However, when tradingstocks, it is not the searchareathatisofconcern,butthedistanceof theprice from its
startingpoint.Therabbitmaycoveramuchlargerareathanthe tortoise, but its distancefrom the starting point isequal to the radius of thecircle.Onaverage, the rabbitwill be about five timesfurtherawaythanthetortoise.It works the same way withstocks. A stock with anImplied Volatility of 50%will generally move fivetimesthedistanceofonewithan I.V. of 10%, over a set
period of time. The result isthatthetimepremiumsonthehigh volatility ‘rabbit’ stockwouldbe about five times ashigh as those on the lowvolatility‘turtle’stock.
Stock Trader: I think I seewhereyouaregoingwiththisnow. If I buy at-the-moneyCall options on one of thestocks onmywatch list, andvolatility suddenly doubles,the time premium should
double too, even if theunderlying price remainsunchanged.
Optionz Traderz: You’vegotit,exactly!That’sallthereis to understandingVega; nocomplicated formulas. Vegais simply the change in thetime premium of an optiondue to a change in volatility.And you are correct that anat-the-money option coulddouble in price if volatility
doubled. I have two morecharts to send you. I thinkthey might help you seeexactly how volatility affectspremiums.
Direxion Financial Select SectorSPDR(ETF)NYSE:XLFLastTrade12.73
OptionsExpiringSeptember17,2011
Thepremiumtoopenastraddleatthe$13.00strike(at-the-money)onXLFisabout$1.12,soonewouldexpectthepremiumtobeapproximatelythreetimesthatamount,or$3.36,if
volatilitytripled.
Direxion Daily Financial Bull 3xShares(ETF) NYSE:FAS LastTrade13.85
OptionsExpiringSeptember17,2011
Thepremiumtoopenastraddleonthe
$14.00 strike (at-the-money) optionsonFAS is about $3.12, roughly threetimes the premium to open a straddleon XLF, because the ETF is triple-leveraged, causing its share price tomoveatthreetimesthespeedofXLF.Implied volatility on FAS isapproximatelythreetimesthatofXLF.Stock Trader: That is areally good example. I knewvolatility affected optionpremiums, but I neverimagined it would be sosimple. I used to struggle to
understand the equations inthe Black-Scholes pricingmodel, but this makes it somuch easier. If volatilitytriples,thepremiumstriple;ifvolatility drops 10%, optionpremiums fall by 10%.Thanksforclearingthisup.
Optionz Traderz: You’rewelcome.IthinkI’lltakeyouup on that offer to buyme amargarita now . Butseriously, you need to
remember that the effect ofvolatility, or Vega, onlyappliestothetimevalueofanoption. Vega does not affectintrinsicvalue.Anoptionthatis deep in-the-money or out-of-the-money always hasmuch lower time value thananat-the-moneycontract,andtherefore it is affected muchlessbyVega.
Stock Trader: That makessense. Increasing volatility
wouldmake itmore difficulttopredictthefuturepriceofastock,butiftheoptionisdeepin-the-money,there’saprettygood probability that it willstaythere,soitismucheasiertopredictitsoutcomethananat-the-moneyoptionwith50-50 odds of expiring in-the-money. So I guess the effectof Vega would always begreatest on at-the-moneyoptions, the ones that are themostdifficulttopredict.AmI
right?
Optionz Traderz: Exactly!It’s sort of like betting onhorsesattheracetrack.Ifyoubet on a horse with that isshowing 9 to 1 odds ofwinning, it’s likely you willwin.Thesamegoesfor1to9odds; it’s fair tosayyouwillprobablylose.But1to1oddswill drive you crazy. Ofcourse, taking a 9 to 1 betwillmakeyoumoney,butnot
much of it; it costs a lot toplace a bet with such greatodds.Thebigmoneyismadeandlostonthe1to1odds.
Optionsarenodifferent.Soitshould come as no surprisethatat-the-moneyoptions,theones with 1 to 1, or 50-50odds, are the most heavilytraded; that is where thebiggest potential profits are.Mostanythingthataffectstheprice of an option, such as
time to expiration orvolatility, will have a morepronounced effect on at-the-money options. When it’sstarts to rain during a horserace, it’s not the guy whochose the 9-to-1 bet that issweating bullets; it’s the onewith the 1-to-1 bet who isunsure whether his pick is a‘mudder.’
Stock Trader: That isanothergreatanalogy.Iguess
the good news is that in theoptions market there is noracetrack to take a cut of thewinnings. With options, thewinners always walk awaywiththesameamountofcashthat the losers have lost. Iwonderifallthoseguysdownat the racetrack understandhow much better their oddswould be if they startedbetting on stock optionsinsteadofracehorses.
Optionz Traderz: That’s agood question. I doubtmanyof them would make theswitch. Betting on horses ismoreemotional thanoptions,inmyopinion.Ithinkmostofthem do it for the adrenalinerush.
Stock Trader: You’reprobably right.Most of themwould be bored to deathtrading options, even if theydidendupwithmoremoney
intheirpocket.
Optionz Traderz: You hitthe nail on the head.Racetracks are great placesfor emotion andentertainment,buttheyarenoplace to earn a living, exceptfor a few lucky folks.Whenyoutradeoptions, thereisnoracetrack to take a cut of thewinnings, and that isdefinitely good news. Now,here’ssomemoregoodnews.
The majority of the time,Implied Volatility increaseswhen prices fall to lowerlevels. That means if yourtrend trading system led youto buy a Call, and theunderlying price suddenlydropped, the time premiumon the Call might actuallyincrease due to Vega.Sometimes the increase isenough tooffsetmuchof theloss of time value due toDelta. Fear increases Put
premiums more than greedincreasesCallpremiums.
StockTrader:That’sagoodpoint. If I am going to trendtrade using options, Vegacould helpme cutmy losseswhen I am incorrectpredicting the direction of atrend. I guess it would alsowork with Puts. If I boughtPuts to protect one of mylong stock positions, Vegacould help amplify the
increase in their value in thecaseofavolatiledownturn.
Optionz Traderz: Yes, andtherearemanyotherways totrade Vega. When volatilityspikeswayup like itdid thisweek, I usually like to sellNaked Calls. The premiumsare very generous now andprices are continuing to fall.Of course, I’m not reallysellingVegabecauseVegaismerely a measure of
volatility’s effect on optionpremiums.IamreallysellingTheta, but taking advantageof the increase in premiumsand the subsequent increasein the rateof timedecaydueto Vega. However, in myopinion,thecurrentmarketismuchtoovolatiletotakeriskswith Theta. Yes, thepremiums are much higherthan they were just a fewdaysago,buttherisksarejusttoobig,evenformytaste.
I prefer betting on volatilityinstead. I have been playingLong Strangles in the SPY,and also Long Calls on theETF pair FAS/FAZ. Whenthe prices move violently,like they have done recently,I can profit nicely from theStrangle on SPY. I can alsoprofit from the Calls on oneside of the FAS/FAZ pairgoing deep in-the-moneysoonafterIopenit,whiletheCalls on the other side
maintain much of their timevalue. This method worksbest in either volatile orsharplytrendingmarkets,andI prefer to use front monthoptions. When you buy out-of-the-money Strangles yourprimary risk is Theta decay,whileyoucapturemoveswithintrinsicvalueand increasingDelta. However, you need asharpmove,quickly,andPutsget more expensive in avolatile market that is
trending downward. So youdo have the Vega risk; ifvolatility collapses it couldcausethevalueofyourLongStrangle to collapse alongwithit.Usually,whentradingStraddles or Strangles,increased volatility is theoptionbuyer’s friendand theoptionseller’senemy.
Stock Trader: I don’t wantto sound critical of yourtrading system, but why
would you have used aStrangle when you couldhavejustboughtPuts?
Optionz Traderz: Mytrading ismainly technical. Ireally did not know if wewould get a breakout to thedownside or a sharp reversalupwards if the EuropeanUnionputtogethersomekindof a rescue. Nowadays,governments seem toconstantly interfere with
trends. So I have beenopening Straddles andStrangles, three-weeks-out,over thepast fewweeks,andplanned toclose themoutonsharpmoves.Todaywasoneof those moves. I did verywell; my Put side increaseddramatically more than myCallsidelost.Itincreasednotonlyinintrinsicvalue,asmyright to put a price onsomeone becamemuchmorevaluable because of the
increase in probability that itwould retain that value atexpiration (Delta), but alsobecause the insurance itprovided becamemuchmoreexpensive due to theincreased volatility of themarket(Vega).
StockTrader:So thiswasanon-directional tradeandyoumade money. You did notpredictanydirectionjust thatthemarket would soon trend
sharply?
Optionz Traderz: Yes andno.Iwasnotbettingsomuchthatitwouldtrend,justthatitwould be volatile. I closedmypositionstodayforaheftyprofit and opened a newStrangle at-the-money again.Ialsodidthisafewdaysagowhen the market gapped uphuge at the open, amidrumorsofanensuingbailout.ThatmorningIclosedoutmy
LongStrangleintheSPYfora nice profit, then openedanother and made anadditional profit when themarketlosttheearlymorninggains and collapsed in pricebefore noon. It got a littleridiculous, like I was a daytrader using volatility-pumping to make money. Iusually expect one largemove a week to make meprofitable, not two in onemorning!
StockTrader:I’mnotsureIunderstand. Why didn’t youjustletyourprofitsrun?ThatiswhatIwouldhavedone.
Optionz Traderz: Withvolatility increasingeachdayand intra-day moves of over200points in theDow, I justdonotfeelcomfortablewithadirectional trade. When myPutsidewentmanystrikesin-the-money,itwasnolongeraStraddle; it was a Long Put
with intrinsic value, while atthe same time a Long lowprobability Call. I wanted totake mymoney off the tablewhileitwasthere.Iwantedtoget Delta neutral again andonly be long Theta in thismarket.
StockTrader:Inmystyleoftrading I would have let myprofitsrunonthePutsideandclosedmyCalls.
Optionz Traderz: That is a
viableplanforatrendtrader.I personally can’t stomach atrend trade in this kind ofmarket. The average dailyrange is just so wide. I feelmore comfortable riskingTheta in this environment,and I have learned that mycomfortwithmytradesisthemainkeytomysuccess.
Stock Trader: Yes, sweatypalms do not make for goodtradingdecisions.
Optionz Traderz: Neitherduewildly swinging, volatileprices. Many timesvolatility=stress=panic. Whatbetter way to capitalize onvolatilitythantoopenaLongStrangle or Straddle and sitback and watch the show,withonlyTheta andVegaasrisks? I am risking a smallamountofmyequityandwillprofit in either direction aslong as there is a strongmove.
Stock Trader: I get it,thoughIwouldprobablyhavelet it run its course andwatched which direction thetrend finally went for reallybigprofits.
Optionz Traderz: That isalsoavalidsystemandcouldmake you some seriousmoney. I trade, though, forlivingexpenses,notlongtermcapitalappreciation,soItendto takeprofitsquicker than a
trend trader who is lookingfor homeruns. I am happywith a high batting averageand getting runs batted in tohomeplate.
StockTrader:Wow,youarejust full of analogies today.But that makes sense. I alsowanttotradeforalivingoneday soon. So let me see if Ifully get the Long Straddleand Strangle conceptcompletely. The market is
getting volatile; the dailyranges for the main indexesare getting wider and wider.We are in a general marchdownward in prices, but notwithout some big up days inbetween. A long straddlewould be like going to twotradersandmakinganoffer.
Tothefirstbearishtraderyousay,
“The Dow is at11,000.Iwillpayyou$2,000
but you have to pay me thefull move the Dow movesabove 11,000 on $110,000worth of the DowDiamondsExchange Traded Fund,‘DIA’, over the next fourweeks;howeveryoucankeepthe $2,000, just pay me myprofits.” This would be like10 LongDIA Call contracts,or1000shares.
To the second trader,who isbullish,yousay,
“The Dow is at11,000.Iwillpayyou$2,000but you have to pay me thefull move the Dow makesbelow 11,000 on $110,000worth of the DowDiamondsExchange Traded Fund,‘DIA’ over the next fourweeks;howeveryoucankeepthe $2,000, just pay me myprofits.” This would be like10 Long DIA Put contracts,or1000shares.
The beauty of this trade isthatonadayliketoday,whentheDowmovesover6%,thepersonwhosoldyouthePutsissweatingbulletsbecauseheowes you $6,600 in intrinsicvalue in one day, plus timevalue, so it could cost himover $7,500 to buy back hisShort Puts from you. At thesame time, the guy that soldyou theCalls is prettyhappyhe may have made $1,500andwouldprobablybehappy
to by back the Calls he soldyouyesterdayfor$2,000,atafire-salepriceof$500.Allinall,youwouldlose$1,500onthe Calls but earn $5,500 onthe Puts. That amounts to a$4,000 profit or theequivalent of a 100% returnon capital in one day.However,closing the trade isnot mandatory because youwouldhavethechoicetoletitrunitscourseandown100%of thedownside trendfor the
remainder of the month,which could further increaseyour profits. You have thechoice of taking your profitwhile it is ‘on the table’ orlettingthebetplayoutfortherestofthemonthtomaximizeitspotential.Inthemeantime,you are allowing two othertraders,thesellersoftheDIAoptions,totakealotofriskinavolatilemarket.ButyoucanfeelconfidentwhenyouopenaLong Straddle that you are
the most likely to come outahead because in a volatilemarket the losing sellerusually loses more than thewinningsellerwins.
Optionz Traderz: I believeyou have it, although I havetosay thatwasauniquewayofexplaining it. It really is agreat way to profit fromvolatility,nottomentionhowit gives me defined risks onmylongoptions,soIcontrol
mylossesandmyriskofruininawildmarket.Also,fromapsychological perspective, Ihave very little stress duringtroubledtimes,soIsleeplikea baby at night while othertraders are up all nightwatching all the world’smarkets and the future’smarkets, attempting to readthe next market direction.Whatabigwasteoftimethatis! In my opinion, tradingoptions eliminates a lot of
that waste. I sometimes useoptionsontheiPathS&P500VIX Short Term ExchangeTraded Note, VXX to profitfrom volatility. Whenvolatility is low, far out-of-the-money Calls on VXXsometimescostonlypennies,but they can be huge profitmakerswhenthemarketgoesberserk like today. Some ofmy Calls on VXX had a300% return today, despitethefactthattheyarestillout-
of-the-money. I closed themthis afternoon and took myprofitswhile theywere thereanddecidednot toopennewCalls because Vega hascaused the premiums to gettoohighformycomfort.
StockTrader: ImustadmitthatIamveryimpressedwithyour option trading prowessinthismarket.Youmusthavedifferent systems in differentmarkets?
Optionz Traderz: I have agarage full of differentvehiclesfordifferentterrains.
StockTrader:Huh?
Optionz Traderz: I don’ttakeaFerrariout4-wheeling,so I don’t sell close-to-the-money Naked Puts in amarket that is collapsing inprice.
In a flat market, I sell shortStraddlesat-the-money.
In a range bound market, Isell Short Strangles, withCalls above resistance andPutsbelowsupport.
Inaragingbullmarket,IbuyCalls on hot stocks and sellNakedPuts.
Inabearmarket,IbuyPuts.
In a wildly volatile, 400points up today 500 pointsdown tomorrow, rollercoaster market I buy long
StraddlesandStrangles.
Stock Trader: So the moralof the vehicle analogy isdon’t trade the wrong optionstrategyinthewrongmarket?I guess that must be one ofthe most important rules foran option trader: use thestrategy that is best suited tothecurrentmarketconditions.But when do you bring outthepinkCadillac?
Optionz Traderz: On
Saturdaynight.
Stock Trader wasfeeling a new sense ofconfidencethathewouldoneday be able to trade optionsas a means of financialindependence. OptionzTraderz seemed to maketrading stock options appearto be simpler than he everimagined. Previously, StockTrader had found that timedecay and Theta were
difficult to understand, butOptionzmadeitsoeasywhenhe changed it into a simpleequationrelatedtothesquareroot of time. Then he hadshown how volatility andVega are even easier tounderstand, affecting optionpremiums without anycomplex equations at all.Allthose days he had spentresearching the Black-Scholes pricing modelsuddenlyseemedlikeawaste
oftime.“IwonderifOptionzis correct about all the otherGreeks being this easy;whatabout Delta and Gamma,couldtheybesimpletoo?”hethought.
Itwasgettinglateandthere was another gruelingday ofwork ahead, so StockTrader decided to wait untilthe next evening to find theanswers. But he woulddefinitely have to inquire
aboutDeltathenexttimetheytalked. Maybe now that heknew how Theta and Vegaworked,agraspofDeltawasallthatremainedtosatisfyhisdesire to trade options for aliving.As tempting as itwastoaskforanswersnow,StockTrader’sstomachwasempty,his eyelids were gettingheavier,andheslowlydriftedoff to sleep in his chair infrontofthecomputer.
Chapter6DELTA:HOWMUCHOFTHEMOVEDOYOUGETFORTHE
MONEY?
Stock Trader slowlyopened his eyes anddiscovered that he was stillsittinginhiscomputerchair.
“Good grief, whereamI?Whatdayisit?”
It was still dark; hiscomputerwas in sleepmode,just like he had been. Heclickedthemousetobringthemonitor back up and helookedtoseethatitwas3:21in the morning and it was
Saturday.
He loved Saturdaybecausehewasparoled fromhiscubicleonthatday,butatthe same timehewas a littlesad that the markets wouldnot be open, as they hadbecome his major source ofentertainment.
Almost immediately,thoughts of Vega and Thetabegan to float through hismind. He started pondering
how these option variableswouldaffecthistrading.Suchdynamics did not exist instocks. With a stock, whatyou see is what you get, butwith options he owned datedcontracts.
With options he hadto be right about a stock'smovement within atimeframe, and changes involatilitycouldalsohelphimorhurthiminhistrading.
He looked downcasually at the time and sawthatitwasnow4a.m.
“My name is StockTrader and I am an‘optionaholic,’” he said outloud.
He made himself getup and go to bed, where hecontinued to think aboutoptions. He figured he couldrisklesspertradebutstillgetmost of the movement when
hewas right. It was possiblethathecouldlosecapitalatafaster pace than with stocksbut greatly limit his losseswith a clearly defineddownside. He figured anoption contract has a built-instop loss due to much lesscapital needed to buy acontract; would optiontrading prove to be moreprotectivethanastoplossona stock’s price? Stop losseson stocks do not protect
traders from aftermarket andpre-market gaps in price.Withthewaythemarketwascurrently moving he did notfeel confident in theprotection of a traditionalstop loss. Stop losses wereineffective on gaps on theopen in the wrong direction.When the broader marketmoved over 4% andindividual stocks were beinghammered with up to 10%lossesinonetradingday,and
with the majority of thosemoves happening with gapsdown at the open, StockTraderwas beginning to feelmore comfortable withsmaller option positions thanlarger stock positions. Thiswastrulyacrazymarket.
“While long optionsmay not protect mecompletely, they do limit thelosses to the price of thecontract which is far less
capitalatrisk,”hethought.
Stock Trader startedto envision how when hebought contracts, the sellertookonmuchmore risk thanhe did. He liked that. Theseller would benefit fromtimedecay;hewouldbenefitfromafavorablemoveintherightdirection.Asabuyerhewould benefit from anincrease in market volatilitywhilethesellerwouldbenefit
fromacollapseinvolatility.
He started to believethat the option buyer mightactually have an advantagethroughactual capital at risk.Buthewasunsureofwhetherhe was correct, and histhoughts went back toOptionzTraderzsayingitwasazerosumgameandtheriskto the seller was reflected inthe premium. He had readconflicting studies, some
showing 30% of optionsexpiring worthless, othersindicating that the rate wascloser to 80%.Whatever theactual rate, he felt reassuredby Optionz Traderz'philosophy that the winner’swinnings, whatever theirpercentage might be, wouldbeoffsetbytheloser’slossesinthelongrun.Still,althoughhe couldn’t put his finger onit, therewassomethingaboutsellingoptionsthatmadehim
feel uneasy. He felt muchmore comfortablecontemplating option tradingasabuyer.Iftherewasawayto keep option trading in hiscomfort zone, it wouldgreatly increase his chancesfor sticking with a winningsystemandultimatelyleadtohis success. Thanks toOptionz, he was now muchmore comfortable with theconcepts of Theta and Vega,but what about the other
Greeks?
His thoughtswondered toDelta. Thiswasinteresting. If options had novaluewhentheyexpired,theywereworthless.Heneededtofully understand how Deltafunctioned to help in histrading.Hecouldnotjustfliphisstocktradingsystemsoverto option trading and expectthe same returns. He figureditwouldbe like applying the
rulesforcheckersintoachessgame andwonderingwhy hehad lost. He had to fullyunderstand what he wasdoing BEFORE he startedtradingoptions.Hewantedtolearn about options withouthaving to pay higher thanneeded‘tuitions’intheoptionmarkets themselves, withlosses hemight not yet evencontemplate. He felt he hadalready paid his full tuition,sufferingsubstantiallossesas
a stock trader beforeeventually finding asuccessfultradingsystem.Hewanted to avoid those initiallosses this time. If he wasgoing to convert his stocktrading system to optiontrading, he would do it therightway.
He knew that soldiersdid not go into combatwithout full military trainingandhewouldbenodifferent.
Hewouldunderstandoptionsbefore he traded them.Luckily he had his ownpersonal option sergeantrunning a very friendly bootcamp.
Heneededtocontinuehiseducationinoptions.
He picked up hissmartphoneandlookedatthetime;itwasnow8a.m.
“Would Optionz be
online this early?” hewondered.
There was only onewaytofindoutforsure.
He went back to hiscomputer and sat in his deskchair. He looked on hisfavorite social media site forgoodnews.
Online Friends:OptionzTraderz
Bingo!
Stock Trader chose adirect chat, instead of thegroupsetting,toavoidalltheannoyance involved withignorant know-it-all tradersand those relentless pennystockpumpers.
Stock Trader: You are upearlythismorning.Optionz Traderz: I guess
mysleepingpatternisgearedwiththemarkets.
Stock Trader: I have beenthinking about transitioningmy stock trading to optiontrading and wondered whatyour thoughtswereabout thebest way to do this withoutactually getting worseperformance by notconsidering the Greekscorrectly.
Optionz Traderz: That is agreat question. There aremanyfactorsyouwillwanttoconsider.First,youwillhaveto make your options matchyour timeframe. Youshouldn’t trade weeklyoptions if you plan on yourtrade working over twomonths;atthesametimeitisnot usually a good idea today-trade two-month-outoptions.Just toillustratehowimportant matching your
optionstoyourtimeframecanbe, consider this:Abuy-and-hold stock trader whoattempts to protect his tradeusing monthly Puts wouldpay about three times asmuch in combined premiumsoverthecourseofoneyearashe would buying one set ofPutsexpiringinayear.
Stock Trader: That makesperfect sense. If one of thestocks on my watch list
usually had breakouts thatonly lasted a few weeks, Iwould be wasting moneypayingtheincreasedpremiumon two-month-out Calls.What do you think are themain variables to consider inconverting my trend tradingsystemovertousingoptions?
Optionz Traderz: In myopinion, Theta is the mostimportant concept tounderstand when converting
tooptions.Unlessyouhaveastreak of incredibly goodluck, you will not make aprofit unless you understandhow time affects options.NextisVega,becauseevenifyou understand time decay,you don’t want to besurprisedbyvolatility’seffecton options. WithoutconsideringVega,youruntheriskofpayingoverly inflatedpremiums during periods ofhigh volatility.Or youmight
find yourself closingotherwise profitable trades ifvolatilitycausedyouroptionstomoveinawaythatyoudidnot expect. Time andvolatility are really the onlytwo major things that affectthe price of options. If youcan comprehend those twoconcepts, then you are wellon your way to beingsuccessful. But if you aregoing to adapt your stocktrading system to options,
Delta might prove to be themostimportantconceptofallforyou.
Stock Trader: I definitelywouldn’t consider myself anexpert when it comes to theGreeks, but I think I have abasicunderstandingofDelta.FromwhatIhaveread,Deltacauses the price of an optionto move up or down at afraction of the pricemovement of the underlying
stock.Ifastockpricegoesupby $2.00 and I own a Calloption with a Delta of 0.50,wouldn’tDeltacausemyCalltogoupinvalueby$1.00?
Optionz Traderz: Yes andno. Unlike Theta and Vega,Delta does not have anydirect effect on optionpremiums; it is simply ameasure of the observedeffects of time and volatilityastheunderlyingpricemoves
upordown.
StockTrader:I’mnotsureIunderstand. If time andvolatility are the only factorsthat determine option pricesandDelta has no effect,whywouldunderstandingDeltabemoreimportantthanThetaorVega?
OptionzTraderz:Theta andVega are the two mostimportant factors of severalthat go into option pricing,
andalthoughDeltaisnotoneof thosefactors,I thinkIcanexplain why it still might bethemostimportant.
Stock Trader: Oh, great,here we go with anothertortoisestory.
Optionz Traderz: LOL!Sorry to disappoint you, butno tortoise and rabbitanalogies this time. I hopetheyhelpedyougainabetterunderstanding of Theta and
Vegathough.
Stock Trader: They wereveryhelpful.Sowhatdoyouhave inmind this time, lionsandtigersandbears?
Optionz Traderz: Notexactly. Even with as muchsuccess as I have had withoptions, I wouldn’t considermyself to be the Wizard ofOptions.That’sfunnythough.So here goes. You alreadyknowhowtimeandvolatility
affect options. Risk-freeinterest rates also have aneffect. When interest ratesrise, rather than risk moneyon stocks, traders can putmuch of their money in arisk-free account, then use amuch smaller amount to buyCalls.ThatdrivesupdemandforCalloptions,whichcausespremiums to rise slightly,whichismeasuredbyRho.Inmy experience, the effect ofRho is so small, especially
when trading options only amonth or two beforeexpiration, that it cangenerallybeignored.
Stock Trader: That’s goodtoknow.IfIcanignoreRho,it is one less thing to thinkabout.
Optionz Traderz: I agree.The less you have to thinkabout,themoreyoucanfocusonthepartsofoptionswhicharethemostimportant.There
are a dozen or so additionalGreeksthatinmyopinioncanalso be ignored. There areGreeks that measureeverything from the ‘charm’ofanoptiontoits‘color’;butit has been my experiencethatDeltaisthekeytooptiontradingsuccess.
Stock Trader: That’sinteresting. I believe that issimilar to stock trading.When Iclutterachartwitha
dozen technical indicators, itdoes nothing but take myattention away from themovingaveragesandvolumeindicatorswhichIhavefoundto be the most useful in mytrend trading system.However when I focus on afewkeyindicators,itismucheasierformetospotatrend.
Optionz Traderz: I’m gladyou agree. With that said,there are a couple of factors
thatarenotGreekswhichyoushouldn’tignore;oneofthoseis ex-dividend dates.Dividends are like unwantedpests to an option trader.When a company announcesan upcoming dividend, thepriceofCallsdecreaseswhilethe price of Puts increase tocompensate for the expecteddrop in price on the ex-dividend date. It normallydoes not have a huge effectonpremiums,butyoushould
atleastbeawareofit.Also,ifyouownCallsonastockthatis about to go ex-dividend,youmightconsiderexercisingthem early even if they areout-of-the-money if youexpect the dividend tooutweigh the loss of theremaining time premium.Conversely,ifyouhaveShortCalls on a stock nearing ex-dividend, you should payclose attention to youraccount because there is an
increased risk of earlyassignment,notonlyonCallsthat are in-the-money, butalso those that are slightlyout-of-the-money.
StockTrader:Wow!Ineverthought of that, but it makessense. If I owned a Call thatwas 10 cents out-of the-money and was so close toexpiration that the bid pricewas 25 cents, it might beprofitable to exercise it early
ifthedividendwasenoughtooffsetthecombinedlossof35cents. But if the stock priceusually falls on the ex-dividenddate,wouldn’tIjustbe setting myself up for aloss?
Optionz Traderz: Notnecessarily. Stock prices aredependent not only on theassets and obligations of thecompany, but on theexpectation of future
earnings. A dividend createsan additional obligation forthe company, but it normallydoes not affect futureearnings.Theresultisthatallother market forces beingequal,thepriceofastockwillnormally fall by only afractionof the amountof thedividend, most often in thepre-markethoursonthedayitgoes ex-dividend. So usingyour example, if the stockconsistently paid a dividend
of $1.00, and the pricehistorically dropped 50 centsthe morning of ex-dividend,thatwould still bemore thanenoughtooffsetyour35-centloss.
StockTrader:Ineverwouldhave thought to exercise anout-of the-money option andcertainly would never haveexpected to get assigned anout-of-the-money Short Call.That’s something I will
definitely consider from nowon. So now I think I have apretty good understanding ofThetaandVega.IwillignoreRho, and I will pay closeattention to my optionsaroundex-dividenddates.ButI’mnotsureIunderstandhowthis is all going to tie in toDelta.
Optionz Traderz: O.K. I’mgetting there. But first, thereisonefinalfactoryoushould
watch: liquidity. Liquidity isoften more important thanTheta, Vega, Rho, anddividends combined. As Ioften like to remind optiontraders, it has been myexperience that every optionstrategy left unmanaged willeventuallyreverttothemean,andgivenasufficientnumberof trades will break even. Iattribute most of my successwith options to be the resultof managing my trades.
Management is different forevery trader, but it mightrequiretakingyourmoneyoffthetablewhenitisthere,oritcould involve closing yourlosing trades quickly whileletting the winners run. Itcould also employ tacticssuch as rolling options to adifferent strike or a differentexpirationwhenthetradegetstoo risky. Whatever themeans undertaken tomanagethe trades, it will almost
certainly become necessary,at least occasionally, to openor close positions. Doing sowith options that don’t havesufficientliquidity,thosewithlargespreadsbetweenthebidpriceandtheaskprice,couldquicklyleadtoruin.
Stock Trader: I think I seewhat you’re saying. If I buyCalls at the ask price with abid/ask spread of 50 cents,even if I am correct in
predicting a trend and thepremium rises by 50 cents, Iwould probably only breakevenifIsoldthematthebidprice.
Optionz Traderz: Exactly,andifyouonlybreakevenonyour winners, how are yougoing to offset your losingtrades?
StockTrader:That’sagoodquestion. I guess the answeris to stick with options that
havegoodliquidity.
Optionz Traderz: Oh, yes,liquidity is a big deal withoptions. Likewe have talkedabout before, you have to bemore selective about whichoptions you trade when youconvert from stocks tooptions.Options do not havethe depth of liquidity thatmoststockshave.Evenifyoutrade themost liquidoptions,they have wider spreads,
especially at strike pricesfartherawayfromthecurrentprice or expirations fartherout in time than the currentmonth.
Stock Trader: So while Ibenefit from leverage withoptions, I am at adisadvantagewith liquidity ifI get too far off the currentbeatenpath.
Optionz Traderz: Exactly,the stocks andETFs on your
option tradingwatch listwillprobably be much shorterthanyourstocktradingwatchlist.
StockTrader: I guess Iwillneedtotradeinthe‘bigriver’options and stay out of the‘smalloptioncreeks.’
Optionz Traderz: Yes,generallyitcoststoomuchtojump in and swim in thesmallcreeksandthenmoretogetout.
Stock Trader: I guess Icould lose my shirtswimminginthesmalloptionstreams.
Optionz Traderz: LOL.O.K.,nowforthefinalpartofthe equation: Delta. If youalways hold your optionpositions until expiration,there is no need to considerDelta. Delta disappears onexpirationday,soeitheryourposition will expire with
intrinsic value or it won’t.But I’m sure you see thevalue in managing youroption positions to enhanceyour long term profits. Evenif you are able to avoid thepitfalls of reduced liquidity,you will eventually find itnecessarytocloseorrollyourpositions before expiration,either to increase profits,reduce losses, or both. Youcould use complex formulasinvolving time decay and
volatility to calculate theexpected results of thoserequired trades, but Deltacombineseverythingintoonesimple formula. When youhaveanopenoptionposition,Delta is yourmost importantindicator.Likeaspeedometerin a car, it tells you youroption price’s velocityrelative to the underlyingstock. But just as a car’sspeedometerdoesnot controlthe car’s speed, Delta does
not control the price of youroptions.
Stock Trader: Delta showsme the amount of money Iwillwinor losebasedon thecombinedeffectsofeachandevery factor that determinesthepriceofanoption.Soit’slike a summary of all of theGreeks?
Optionz Traderz: Exactly.Just like driving a car, youwould go insane trying to
calculate all the differentvariables that affect yourspeed – the amount ofpressure you are applying tothe accelerator pedal, theuphill or downhill grade ofthe pavement, windresistance, tire pressure, etc.It is so much easier to justlookatthespeedometer.
StockTrader:That’sagoodpoint. So if Delta is like aspeedometerforoptions,how
would I apply it to a systemoftrendtrading?
Optionz Traderz: Well,there are two ways you canuse it. Profitability fromtrading options, as with anyothertypeoftrading,requireseitherincreasingyourprofits,decreasing your losses, orboth. If you have a provensystem that allows you topredict trends, you are wellon your way to increasing
profits.Youcouldsimplyuseyour system to help youchoose the best entry pointfor an option trade and thenignoreDeltaandalltheotherGreeks by letting each traderide out the entire contractuntilitexpired.Inmostcases,thatwouldbe a validway toensureprofits.Aslongasyouwere accurate about thedirectionofatrendmorethan50%of the time,chancesareyouwouldbeprofitableinthe
long run. However, I’massuming you are probablylike most trend traders whodo not rely solely onincreased profits for theirsuccess; they also limit theirlosses. If you are going tolimityourlosseswithoptions,Delta should help youdetermine not only the mostappropriate option for yourstrategy, but also the bestpositionforeitherastop lossoratrailingstop.
Stock Trader: That makesperfect sense. When I tradestocks, Ioftenseta stop lossjust below resistance.Sometimes I use a movingaverage to determine aresistanceprice,othertimesIuse a recent low. So howwould you suggest puttingTheta, Vega, and Deltatogether to create a winningsystem?
OptionzTraderz: Ifyouare
using options to trade aclassical stock tradingsystem, Theta and Vega willbelessofafactormostofthetime.Your ability touse lesscapitaltotradeandwinmoreon a percentage basis whenyou are right will be muchmore important than timedecay or volatility premiumincreasing and decreasing –well, at least most of time.Thereofcoursewillbetimesthatthemarketdoesnotmove
at all and time decay costsyou some capital, as well astimes when volatilitycollapses and causes theoptions you own to fall inprice, but this should be theminority of the time if youhave a robust system. Thetaand Vega are importantGreeks, but Delta is the onethat will help you makemoney.
Stock Trader: That’s good
tohear.SoputtingThetaandVega to the side, what areyour thoughts on tradingusingDelta?
Optionz Traderz: Delta isoftenthemostdifficultpartofoptions for new traders tograsp. Unlike stocks, wherethepricesmoveupanddownexactly the amount thatmarket forces are pushingthem, option prices usuallymove at a slower rate.When
the price of a stock goes upby$1,theat-the-moneyCallsusually increase about 50centsbecauseDeltaisusuallynear .50 with at-the-moneyoptions.
Stock Trader: I’ve alwaysnoticed that at-the-moneyCalls increase in price atabout half the rate of theunderlying, but I have nevercompletely understood thereasonwhy.
Optionz Traderz: I think Icanexplain,ifyoulike,andIpromise, no analogiesinvolvingpets.
StockTrader:Thatwouldbegreat.
Optionz Traderz:O.K., sayyoubuyanat-the-moneyCallfor $1.00 and the stock priceimmediately goes up $1.00.WhenyouinitiallyboughttheCall, the odds that it wouldendupexpiringin-the-money
were 50-50, and that is thehighest possible amount ofuncertainty possible in anoption trade. Later,when thestock price has risen by$1.00, the odds are muchgreater that the Call willexpirewithintrinsicvalue,in-the-money. The odds aregreater, so there ismuch lessuncertainty about theoutcome at expiration, andless uncertainty means thatthetimevalueoftheoptionis
much less. So while theintrinsic value of your Callwould increase by $1.00, thetime value would likelydecreaseby50cents.
Stock Trader: I’ve noticedthat on some of my favoritestocks,Deltaonat-the-moneyCallsislowerthan0.5andonothersitishigher.Ifthereisa50% chance of these optionsexpiring in-the-money,shouldn’ttheDeltaalwaysbe
0.5?
Optionz Traderz: That’s agreat observation, and it’sdefinitely worth discussing.ThestrikepriceofaCallwithaDelta of 0.5 is based uponoddsbeing50-50thatsuchanoption will be in-the-moneyatexpiration.
Stock Trader: I understandthat, but I’m looking atoptions on a stock that istrading at $75. Why would
the Delta on the $75 Callsonlybe0.44?
Optionz Traderz:Does thatstockpayadividend?
Stock Trader: Let melook…Yes,thereisa68-centdividend and the ex-dividenddateisnextweek.
OptionzTraderz:Thereyouhaveit.Theoddsarethatthestock pricewill drop slightlyafter the ex-dividend date to
reflect the amount of moneythat the company will beobligated to pay out asdividends to its shareholders.So the odds of the $75Callsexpiringin-the-moneyarenot50-50 because all othermarketforcesaside,thestockwould be trading slightlylower than $75 after the ex-dividenddate.Thechancesofthe $75 Calls being in-the-money at expiration areslightly lower than 50%, due
tothedividend.
Stock Trader: O.K., I canunderstand that. DividendslowerthelikelihoodofaCallclosing out with intrinsicvalue, butwhywould the at-the-money Calls on one ofmy ETFs have a Delta of0.67?
Optionz Traderz: I think Icanexplainthattoo.Muchofthe time, 0.5 is a goodapproximationofDeltaonat-
the-money options, but it isjust that: an approximation.Volatile stocks and ETFs,especially those that aredouble- or triple-leveraged,haveatendencytoincreaseinvalue much faster than theylosevalue.
StockTrader:Sotheat-the-moneyDeltacouldbehigherthan 0.5 because there is agreater chance of the priceincreasing?
Optionz Traderz: Yes andno. The odds are the same,but the outcomes aredifferent. Consider a volatilestock that increases in price20% for three consecutivemonths. Due tocompounding, the pricewould be nearly 73% higherat the end of the lastmonth.Now, assume the same stockdeclines20%eachmonth.Attheendof the thirdmonth, itwouldhavelostabout51%of
itsvalue.
Stock Trader: I see. Theextreme volatility wouldmake the expected gainsmuch greater than theexpectedlosses.
Optionz Traderz: Exactly.The underlying shares canonlylose100%oftheirvalue,but it is possible they canincrease in value by morethan100%.Mostofthetime,stocks do not see such wild
swings, so at-the-moneyDelta is often very close to0.5. But on very volatilestocks and ETFs, Delta is areflection of the limiteddownside potential and theunlimited upside. Thechances of the underlyingprice going up or down arestill 50-50, but the potentialprofit or loss from each ofthose possibilities is notequal.
Stock Trader: Now Iunderstand.Deltaisnotjustameasure of the odds that anoption will end up in-the-money, but howdeep in-the-moneyitwillbeatexpiration.
OptionzTraderz:True.Soifyou are buying Calls, youneed tonotonlyconsider thestrike price, but also theDelta.IfyoubuyCallswithavery low Delta, you won’tmakemuchmoneyunlessthe
underlying shares see largegains.
Stock Trader: So I guesswhatyouaresayingis that ifIuseoptions to trendtrade,Ishould probably buy Callswith higher Deltas so that Ipickupmoreof themoveoftheunderlying.
OptionzTraderz:Exactly.Ifyoursystemhasagoodtrackrecord of predicting trends,thenyouwill likelydobetter
with in-the-money andpossibly at-the-moneyoptions because they havemuch higher Deltas. Thereare timeswhen Iuse farout-of-the-money options in mytrading, but for a trendtradingsystem,Ithinkthein-the-money ones will workbest for you. When you areright about a trade you wantto profit, you do notwant toberightandstilllose.
Stock Trader: How is thatpossible?WhenItradestocksand I am right aboutpredicting a trend I almostneverlose.
Optionz Traderz: Say yourchartsareindicatingabullishtrend, so you decide to buyfar out-of-the-money Calloptionsbecause theaskpriceappears very cheap. Youmightbetemptedtothinkyouaregettingagreatdealonthe
Calls and anticipate a greatreturnonyourcapitalatrisk.You are sure that your stockwill go from$100 to at least$110 in one month, so youbuyone-month-out$110Calloptions. The Delta on yourCall options might be .10.Whatisnotrealizedbymanyof these other ‘river boatgambling’tradersisthata.10Delta means there is only a10% chance the stock willmake it to $110 in a month.
That is a 10% move in thestock for goodness sake.These options are nothingshort of lottery tickets; yourstock might go up to $105over two weeks and theseoptionswouldprobablymovelessthanadollar.
Stock Trader: Less than a$1?Butthestockmoved$5.
Optionz Traderz: Your farout-of-the-money $110 Callhas zero intrinsic value. The
only reason such an optionexistsisthatthereisaremotepossibility that it will haveintrinsic value at expiration.When you buy out-of-the-money options, you do notcapturetheunderlyingstock’smove in intrinsic value; youonly capture the increasedvalueintheoddsthatitcouldbe worth something atexpiration. You only captureDelta,andDeltaisverysmallwhen you are so far out-of-
the-money. Also, your oldfriends, Theta and Vega,would likely eat up most orall of the increase in valuewhile you were waiting forthemove.
Stock Trader: So if I heldthrough toexpirationand thestockgot to$109.50, I’dstilllose100%ofmycapital?
Optionz Traderz: That istrue, however if it did movethat close to the strike price
thentheDeltawouldincreasebecausetheprobabilityoftheoption having intrinsic valueat expiration increased. Asthepricemovegets closer tothe strike price, your Deltagains velocity and youroption begins to be worthmore faster. If you exited attheright time thatcouldbeaprofitable trade. However,like you said, if you wereconvinced that it was notgoing to end up expiring in-
the-money and you held itanyway, you would lose100%ofyourcapital.
StockTrader:ThatiswhatIwouldbe tempted todowithmytrendtradingmethods,letthewinnersrun;butinoptiontrading I would run out oftime.
Optionz Traderz: As youget near expiration, theprobability value of youroptiondisappearsandyouare
left with Delta value only,which will increase nearexpiration if you are in-the-money. That is good if youare in-the-money but bad ifyouarenot.
StockTrader:What do youmean when you say Deltavalue expands nearexpiration?
OptionzTraderz:Just as anexample, a one strike deepCall optionwith threeweeks
until expirationmight have a.70 Delta because the oddsare70%thatitwillstillbein-the-money when it expires.However, the same optionwith one week to expirationmay have a .90 Delta,because the odds that it willendupexpiringin-the-moneyare 90% due to the fact thatthereismuchlesstimefortheunderlying price to move intheoppositedirection.
Stock Trader: So Deltaincreases as an option nearsexpiration, while time valuedecreasesatthesametime?
Optionz Traderz: Yes. Itmay be helpful to think ofThetaandVegaasthechangein the rent being charged forcontrol of the underlyingstockatthestrikepriceoftheoption.Remember,whenyoubuy options, you are buyingtime.When you buy options
based on Delta, it is likebuying the probability of anoption keeping its intrinsicvalue or gaining intrinsicvaluebeforeexpiration.
Stock Trader: So are yousaying that in-the-moneyoptions have a higher Deltathanthosethatareout-of-the-money, so I should focus onthem as a means ofconverting my trend tradingfromstockstooptions?
Optionz Traderz: Exactly.Thedeeperin-the-moneyyougo, the higher the odds arethat the option will stay in-the-money;soDeltaincreasesas you go deeper in-the-money and decreases as yougo further out-of-the-money.ThereisanotherGreek,calledGamma, that describes thechange in Delta, but as longasyouunderstandhowDeltachanges, there is no need toadd Gamma to your list of
thingstoworryabout,atleastinmyopinion.Aslongasyouunderstand that Deltaincreases as you go in-the-money and also increasesclosertoexpiration,you’llbefine.
Stock Trader: That’s goodto know. So even if I buyCalls a few strikes in-the-money I will not capture100% of the price moves intheunderlyingstocksbecause
the odds are not 100% thatthey will close with intrinsicvalueatexpiration?
Optionz Traderz: That iscorrectmostofthetime.
StockTrader:Thosearetwosurprising points. First, evenin-the-money options do notmove 100% with theunderlyingstock,andsecond,Delta increases as expirationgetscloser.
Optionz Traderz: That isone reason thatweeklydatedoptionscostmoreinthelongrun than monthlies andfarther-out options. Theycapture Delta values quickerand lock them in faster. Onmost weekly options, pricediscovery at expirationhappens every Friday at theclose of regular trading. Theodds of these optionswandering away fromintrinsic value are generally
50% less than those ofmonthly options, given thatthey have three fewer weeksin which to discover theunderlying stock’s price atexpiration. Differentprobabilities associated withlonger timeframes causedifferentpricevalues.
Stock Trader: We are backtotortoisesandrabbits,huh?
Optionz Traderz: Similar,but unlike Theta and Vega,
Delta isbasedontheoddsofthe intrinsic value still beingthere at expiration. Thoseodds are determined almostexclusivelybythepositionofthe underlying price inrelationtothestrikeprice.Anat-the-money option willusuallyhaveaDeltanear0.5,regardless of the amount oftime to expiration or theamountof ImpliedVolatility.An at-the-money option on arabbit stock has the same
chances of expiring in-the-money as one on a tortoisestock;theoddsarealways50-50. The same goes for anoptioncontractthatexpiresinoneyearcomparedtoonethatonly has one day toexpiration. If it is at-the-money the odds are still 50-50 and both would have aDeltacloseto0.50.
Stock Trader: That makessense.SoifanearmonthCall
has a Delta of 0.5, and oneseveralmonthsoutalsohasaDelta of 0.5, why choose totradeoneovertheother?
Optionz Traderz: Goodquestion. It depends on howyouplantomanagethetrade.Gammameasures howmuchDelta is expected to changewhen the underlying pricechanges,andGammaismuchlower on optionswith longerterm expirations. So if you
opt for the longer term, youwill experience much lesstime decay, but you will getmuch less move for themoneybecauseDeltachangesmuchmoreslowly.
Stock Trader: So what doyou think would be the bestwaytoconvertatrendtradingstock system tooptions,withDeltainmind?
Optionz Traderz: I wouldsay if you want to capture
maximumDelta, trade a fewstrikes deep in-the-money onnear term monthly options.You will pay much higherpremiumsthanyouwouldonout-of-the-moneyoptions,butyou will capture Delta muchquicker. Not only would thevalueofyouroptionsincreasemuch more on the in-the-money options, but youwould have opportunities totake a larger chunk of yourprofits off the table early if
your charts indicated apossiblereversalofthetrend.Also, when you are wrongaboutthedirectionofatrend,Deltawouldactuallydecreaseas your deep in-the-moneyoptions get less deep. Asintrinsicvaluedecreases,timevalue increases at anaccelerating rate and thatcould help cut your losses.Even with reduced losses,youshouldcutyourlossesthesameway youwould if they
werestocks.
Optionssometimeschange invalue by much largerpercentages than stocks,sometimes100%ormoreinasingle trading day, so do notlet the percentage gains andlosses spook you. You areactually using much lesscapital but shooting for thesame dollar gains. Becautious about increasingposition size. If youareused
to trading 500 shares ofApple then trade fivecontracts, you may betempted to increase to 1,000shares by using 10 contractsfor increased leverage; butyou can still lose the sameamount, dollar for dollarinitially, with larger tradingsizes that are in-the-money.This could negatively affectyour risk management andyourriskofruin.
Stock Trader: So keep mypositionsizesthesame?
OptionzTraderz:Yes,manyare tempted to trade hugepositions with all the extraleveragethatoptionsallow.Ifthey get lucky the first timeand make a lot of money, itmakes them arrogant and ontrack for a blow up. Whenyouhavetradedoptionsforafew years, you may get to apoint where you are
comfortable enough toincrease your position sizesusing options for leverage,butIwouldnotrecommenditforbeginners.
StockTrader:Sooptionsdonot suspend the rules of riskmanagement.LOL.
Optionz Traderz: No, butfor many traders optionsincrease the chances of themgettingLasVegasfever.Theywin big and lose big but
inevitably their big lossesoutweightheirbigwins.
StockTrader:Really?
Optionz Traderz: Amateursare drawn like moths to aflame to cheap, deep out-of-the-money Call options.Manydon’trealizehowmuchthe odds are stacked againstthem, usually 10 to 1 orworse. The sad thing is that,as with all option strategies,they would probably break
evenoverthelongtermgivenasufficientnumberoftrades,butmost loseall theirmoneybeforetheygettotheonebigwin.
Stock Trader: So I need tokeep the odds in my favorwithmystocktradingsystemby buying options thatalready have intrinsic value,so I do not have to be rightabout the amount of themagnitudeofthemoveofmy
stockasmuchasIneedtoberightaboutthedirection.
Optionz Traderz: Nowyou’vegotit.
StockTrader:Ineedtokeepmy position sizing the sameand manage my percent atrisklikeIalwayshave.
Optionz Traderz: Yes. Ifyou have always put 2% ofyourtotalcapitalatrisk,thenthat is all you should be
risking with options. Stoplossesworkwithoptions likethey do with stocks. Onedrawback to options is thatyou need to be right aboutdirection and also overcomethe time value loss; that is avariablethatyoudonothaveto worry about with stocks.Theta decay needs to beconsidered, but properposition sizing and beingright with your trade willgreatly help this variable.
Vegashouldalwaysbeinthebackofyourmind too.But Ithink youwill find thatmostofthetimeitwillnotbetimedecayorvolatilitythataffectsyour trade; it will be thechange in the price of theunderlying will determineyour profits and losses, andDelta will show youwhat toexpect.
StockTrader: O.K., I thinkthat was some great
information. Unfortunatelyweareoutofmetaphors so Iamgoingtocallitamorningandgosurftheweb.
OptionzTraderz:Foroptioninformation?
StockTrader: No, I think Iwill study the behaviors oftortoisesandrabbitssoitwillhelpmeinmyoptiontrading.
Optionz Traderz: That isfunny.
It was now 10 a.m.and Stock Trader was wideawake,althoughhisneckwassore from sleeping in hischair the previous night. Hewas feeling more confidentthan ever about tradingoptions. Optionz had givenhim some valuable adviceaboutTheta andVega, but ifhe was going to profit fromoptions, he knew he wouldneed to study Delta a littlemore. First, he needed to get
something to eat. He openedthe refrigerator, but foundonlyastalesliceofpizzaandsomemustard.Sohedecidedto go down to thesupermarketandgetapackofenergydrinksandafewothersupplies so he could studysome option tables on a fullstomach.
On the way to themarket,hegotstuckintraffic.“Good Grief, here it is
Saturday morning, not rushhour on Monday, and stilltraffic is only moving at 20miles an hour on anexpressway built for 65,” hethought. As he sat in traffic,his mind drifted back tooptions and howDelta couldhelp him. Suddenly,something Optionz had saidearlier started tomake sense.Delta is like the speedometeron a car.He did not need toconcern himself with all the
variables that controlled thespeed of his car. To knowhowfasthewasgoing,allhehad to do was look at thespeedometer, and his waspeggedat20.
Stock Trader wouldmuch rather be able to driveat the posted speed limit andget where he wanted to befaster. He realized he wasprobably saving somegasbygetting better fuel economy
drivingat sucha slowspeed,however, a speed of 20 wasnot what he wanted. Hewouldmuchratherpayalittlemore for gas and get to thesupermarket and back homemuch faster. It wouldprobablybenodifferentwithoptions. To convert his trendtrading system to options, aDelta of .20 would probablynot be what he was lookingfor; a Delta of .65 would bemorelikeit,evenifitcameat
ahighercost.
“Finally,abreakintraffic,”hesaidoutloud.SoonhewasdonewithhisfoodshoppingandonhiswayhometolookupDeltaonsomeofthe
optionsforthestocksonhiswatchlist.Thetrafficwasgonenow.“ItlookslikeIwon’texpireworthlessafterall,atleastnotthisweek,”he
thought.
Chapter7STOCKSFOR
RENT:COVEREDCALLS
Oneevening,asStock
Trader was eagerly scanningfor who was online in his
Winning Traders group, helooked through the list ofpeopleonline:
RookieTrader
PennyTrader
GhostofDarvas
PennyPumper
“No OptionzTraderz?” He found himselfdisappointed.
Helookedatthepostsonthegroup’swall.
He waded throughpenny stock post after pennystockpost.
ELAY.145x.16keepaclosewatchonELAY!!
“Whatgarbage.”
EXTO making some Noisetoday!!!!
“Wow, fourexplanation points; thatmust
beareallyhotcompany.”
EXTOchurningnicelyhereand bounced off itssupport at .009, watchfortheconsolidationtocontinue while EXTOsets up for its next legup!!!“Whattheheckisthat
price? Could I buy 1,000shares for a penny? GoodGrief!”
He was just aboutnearing the point where hecould not take any more ofthis shameless pennypumping, but out of curiosityheclickedthelink.
Hereadthatthequotewasindeed.0094,butthenhesawthenameofthecompany,“ExitOnlyInc.”
He found himselflaughing out loud. Howironic that a penny stock,
which a trader probablycouldonlygetintobutnotoutof, would be named “ExitOnlyInc.”Hecouldnothelpit any longer; hehad to posthis opinion on theconversationthread.
StockTrader: This piece ofgarbage should be named“Entry Only Inc.” Groupmembers, you would bebetter off just burning yourmoney than buying any of
these pink sheet pennystocks;atleastthefirewouldgive you warmth for aminute.Youconmenneedtogetoutofthisgroup.
Feelingcompleteafterhiscomment,hecontinued tolook at topics andconversationthreads.
As he was browsingthrough the topics andthreadsofthegroup,hecameacross a post from the night
before that he foundinteresting. Then, as helookeddowntheconversationthread, he saw his tradingbuddy’s name. The threadreallygrabbedhisinterestsohebegantoreadit.
Income Trader: Anyone inthis group familiar withsellingCoveredCalls?
Optionz Traderz: I havestudied and traded just abouteverykindofoptionstrategy.
Income Trader: Do youthinkCoveredCallswouldbea good way to generateconsistentreturns?
Optionz Traderz: I knowpeople who do that. Theymakegreatreturnsintherightmarket,with therightstocks,whentheymanagetheirrisk.
IncomeTrader:Really,howdotheydoit?
OptionzTraderz:Well, firsttheyhave toknow their risk;if you want to manage yourrisk like they do, theunderlying stock on whichyou write an option is thekey. That is where your risklies, in the stockgoingdownnot in the option going up.When you sell a CoveredCall, you collect thepremium. But just becauseyou are generating incomedoesn’tmean you can ignore
the risk of the stock pricedecreasing. If your stocksuddenly experiences a largedeclineinprice, thepremiumwouldnotbeenoughtooffsetyour loss. Your underlyingstocks should be withcompanies that you believeare great investments. Thestocks you pick will be thekey to the whole systemworking.
Income Trader: What
should I look for in a stockbefore I consider writingCalls?
OptionzTraderz:Youmightwant to look for a stock thatyou would consider to be agood long term investment;of course, youwould need astock that not only hasoptions available on it, butone which has options thattrade on good volume. Youreally want stability, not
volatility. You need a solidprice support on the chartsfrom a technical aspect andthe company’s fundamentalstobesolid.Intoday’smarket,financial stocks, oilcompanies, and technologystocks are no longer the safebets they once were.Financial meltdowns, oilleaks, and a company’stechnology becomingobsolete are more commonthanever.
IncomeTrader:Wow,goodpoints. What am I lookingfor? A stock I can call 'OldFaithful' and is alwaysreliable?
OptionzTraderz:Ithinkso,the kind of stocks WarrenBuffettlikes.Greatcashflow,steady dividends, no realcompetition, at a great price.Lowriskideas.
IncomeTrader:O.K.,onceIgetallofmysuperstarstocks,
thenwhat?
Optionz Traderz: You canwrite monthly out-of-the-moneyCalls,basingthestrikeprice of the Calls on a pricetarget maybe right above theresistanceofthecurrentpriceof the stock. Or if that doesnot provide reasonablepremiums,thenyoualsohavethe option to write three-month-out in-the-money orat-the-moneyCalls, over and
over,asameansofcollectingthe premiums with someadditional downsideprotection. With the morerecent availability of weeklyoptionsoncertainstocks,youcould write an option at-the-money each week to lock inyour return, orone strikeoutso you would keep all thecapital gains between thestarting price and the Call’sstrike price, and then justwrite a new one over and
overeachweek.
Rookie Trader: I thoughtyou said this was not theHoly Grail. You talked meoutofit;nowyouaretalkinghimintoit?
Optionz Traderz: I am nottalkinghim intoanything;heaskedmeaboutthestrategy.Iam getting to the down side.Mymainargumentwithyou,Rookie,wasthatyoubelieveditwas theHolyGrail, that it
couldn’t lose, and also thatyou were conned by a blackboxtradingsystemwithbackfitted historical test results.Weneverreallygotpastthat,so I never got a chance toexplaintheproperwaytouseCovered Calls. Youexhausted me just trying tomake you understand that itwas just one ofmany optionstrategies.Butifyouevergetserious about learning thewaymosttradersfindsuccess
with Covered Calls, I’d behappytotellyou.
Rookie Trader: O.K., I amallearsnow.
OptionzTraderz: Then stepaway from the keypad for awhileandread.
Income Trader: So are yousuggesting building aninvestment portfolio of thebest and safest stockinvestments, and then
overlaying thatwithCoveredCallstoenhancethereturns?
Optionz Traderz: That ishow the pros that I know doit.Therearemoneymanagersthat run portfolios that do soexactlythewayIexplainedit.Theymakegreatreturnsoverthe long term. You’llprobably do best with adiversifiedportfoliosothatifoneofyourstockstakesabighit, you will offset the loss
with the income from theothers. You should alsoconsider diversifying acrossdifferentsectors for thesamereason. Some traders I knowuse ETFs instead of stocksbecausetheyhaveadegreeofdiversification built in. Still,you need to be careful withETFs, especially those thatare devoted to one singlesector of the economy. Byusing several safe underlyingstocks or ETFs, Covered
Callscouldputyouonapathto much better returns thanyou would normally expectfromtradingequitiesalone.
Income Trader: Now thedownside?
Optionz Traderz: Yes, tokeep it real. Many tradersdon’t realize that CoveredCallsareequivalenttoNakedPuts. With Naked Puts youtakeonthefulldownsideriskof the stock for a small
premium,andthisisthesameprincipleasCoveredCalls.IfCalls are sold in-the-moneyor at-the-money you get nobenefit from any upsidemovement. Just like NakedPuts,youonlygettokeepthepremium.The key is pickingthebest stocks. Ifyoupickastock, then it craters, it ispossible to lose a lot ofmoneyquickly,evenwiththecontinuous selling of Callsinto a down trend and using
thebuyingbackandsellingofnew options like a parachutetocushion losses.Sometimesthat parachute is just noteffective enough to preventyou from crashing into theground. Choosing the wrongstock early in this systemcould hurt your capital. Thatis why I advise you todiversify if you are goingwitha longerholdingperiod.If you decide to use shorterterm options, diversification
becomeslessofafactor.
Income Trader: CoveredCalls are like Naked Puts? Istill do not get that. NakedPuts sound too risky. Mybroker allows me to sellCovered Calls but will notallow Naked Puts. WhywouldIbeallowedtodoonebutnot theother if theybothhave the same amount ofrisk?
OptionzTraderz: O.K., say
you owned 100 shares ofApple at $400 in Septemberand wrote a Call on it forOctober at $400 for a $16premium and it falls to $300– what do you lose atexpiration?
Income Trader: Um…$10,000-$1,600… Crap.$8,400?
Optionz Traderz: Correct,plus commission andslippage.Now travel back in
timetoSeptemberanddothetradeagain.Thistimeyoudonot own Apple but insteadyousellaNakedPutcontractwitha$400strikeinOctoberfor$16anditthencrashesto$300 at expiration; what doyou lose this time?Remember, you have to buyApple at $400 even thoughthemarketpriceis$300,soitwill be worth only $300 themoment it is ‘put’ on you.But you get to keep the $16
premium. Also remember,100sharesisonecontract.
Income Trader:$400x100=$40,000,$300x100=$30,000, $40,000-$30,000=$10,000, $10,000-$1,600=$8,400
Optionz Traderz: I wasgetting worried you wouldhavetoopenaspreadsheettofigurethatout.
IncomeTrader:Sorry,Iwas
never great at math. $8,400,that is truly weird, that aCovered Call acts like aNakedPutatthesamestrike.I never thoughtof that.Theyhave the same risk profile ofa Naked Put. I would neverhave considered sellingNaked Puts, even if mybroker allowed it, because Ithought they were muchriskierthanCoveredCalls.
Optionz Traderz: A
CoveredCallislikeaprequeltoaPut;youaregettingpaidfor a stock you have already‘put’ on yourself. Brokersknow how risky these tradesareandpreferyoutotaketheriskonyourself,asaCoveredCall, instead of exposingthem to the Naked Put risk.That is why Naked Putsrequire a higher level ofprivilegeswithmost brokers.It is not that Covered Callsare less risky, it is that you
arecoveringtheriskyourself,notthebroker.
Income Trader:Wow, veryinsightful!Youshouldwriteabook.
Optionz Traderz: Maybe Iwilloneday.
IncomeTrader:What aboutoverallmarketrisk?
OptionzTraderz:WhilethissystemmayfeelliketheHoly
Grailofsystemsandlikeyoucan’t lose in bull markets,bearmarketswillgobble thissystem up. Calls and Putsbecomemoreexpensivewhena sharp downtrend causesvolatilitytospike.Thatmightsound like a good thingbecause you can collecthigher premiums, but thehigher premiums also comewith added risks. First, youwouldbetakingonmoreriskby holding shares of stock
whenthemarketispredictinga generalized downturn.Second,Deltashrinkswithanincreaseinvolatility,soCallschange in value much moreslowlyinrelationtothepriceoftheunderlying.Soifpricesdid continue to decline,Implied Volatilities wouldlikely rise, and with theresultingcontractionofDelta,youcouldsufferasignificantloss on the underlying stock,but make almost no profit
buying back the Call. Theslower rate of Delta wouldcause the Calls to decline invaluemuchmoreslowlythanthey would in times of lowvolatility. With theunderlying price declining,you would likely be able tobuythembackatalowercostthanwhenyousoldthem,butyou probably wouldn’t seemuch profit unless you keptthem open until expiration.Waiting for expiration day
would mean risking evengreater losses on the stock,unless you had the ability toun-cover them. And I’massuming you don’t have theability to carry Naked Callswith your broker becausethey present an even greaterpotentialrisktoabrokerthanNakedPuts.
Income Trader: So ifvolatility suddenly rose, Imight be better off staying
awayfromCoveredCalls forawhile, at least until I got asignal that the market wasnearingsupport.
Optionz Traderz: Thatwould depend on the degreeofvolatility.Aslightincreaseshouldn’t scare you away. Ifthere was aminor correctionin the market and ittemporarily drove upvolatility, you might tryshortening the term of your
contracts, maybe to as shortasaweekor two.Shorteningthe termwould allow you toprofitfasterfromtheCallsincase the trade started to goagainst you and could allowyou to get out of themarketmuch earlier in a scenario inwhich that ‘minorcorrection’turned out to actually be thebeginning of a bear market.Another thing to considerwould be selling the Callsslightly in-the-money to give
you some additionaldownsideprotection.Youarecorrect, though, that in amarket which has fallenthrough support levels andvolatility has increasedsignificantly, it is probablybest to avoid the temptationof the higher premiums onCovered Calls, at least untilthingssettledown.
IncomeTrader:SoitsoundslikeCoveredCallsareagreat
waytotrade.AllIneedtodois be careful about whatstocks I pick, adjust thelengthofthecontractandthestrike price based onvolatility, and stayoutof themarketwhen it turnsbearish.That seems like it shouldprovide consistent profitsyearafteryear.
Optionz Traderz:‘Consistent’ depends on howyou define it. This system
will almost certainly havelosingyears,but itwinsoverthe very long term throughdiscipline. You will usuallyhave to follow this systemlong term in order to see thebenefits.Another part of thissystemthatmayseemstrangeis that you give up hugepotential profits in runawaybullmarkets.Insuchmarkets,you are collecting yourpremium butmissing the biguptrend runs thatyour stocks
may experience. I knew oneperson who called theCovered Call system a stopgain, because your shortoption limits your upside. Inrunaway bull markets youonly collect the premium; inviciousbearmarketsyoutakethe full drawdownminus theCalloptionpremium.
Income Trader: Well, thatdoesn’tsoundgood.
OptionzTraderz:Well, it is
not that I am trying to beoverly negative. All optionstrategies work well undercertainmarketconditions,butnot in others. They areprofitable based on whetherthe market environment isconducive to that particularstrategy. A big key with theCovered Call system and allotheroptionstrategiesforthatmatter is controlling risk.Allthe stocks in your portfolioshould have stop losses
predetermined.Theycouldbeat a price that is under whatyou perceive as support in achart, or they could be apercentage of loss you arewillingtoaccept.Ifthereisamajor negative breaking-newsannouncementaboutthestock on which you haveShortCalls, by allmeans cutyourlosses;sellthestockandbuyback theCalls.After thestorm has passed andeverything has settled down,
you may be able to buy itbackatagreatpriceandstartallover,writingCalls.
IncomeTrader: I really didnot even think aboutcontrolling risk; it hadn’tevenenteredmymind. Iwasso focused on the Callpremiums.
Optionz Traderz:Controlling risk isoneof themost important parts of anysuccessful option trading
system. Do not forget whenyou look at historical chartsthat ifyour stockhadahugerun up before an earningsannouncementandyouhadtogive that up to the optionbuyerwhenyouboughtbacktheCall, then it subsequentlytankedafteryouwroteanewCall, you would have givenup all of the gain and takenon all of the loss, with onlythetwopremiumstooffsetit.
Income Trader: I neverthoughtofthateither.
Optionz Traderz: Anothercostofthestrategyisthatyouhave to pay a commission tobuy the stock, then acommission to sell the Call,and yet another commissionto either buy the Call backbefore expiration or allow itto be exercised. You shouldconsideralloftheseexpensesand make sure the options
you are selling have enoughpremiums to make itworthwhile.Youwillneedtosell Calls at the righttimeframes to collect enoughpremiums to offsetcommissions. With manystable big cap blue chipstocks, the relatively lowpremiumscausedbytheirlowImplied Volatilities mightrequire selling two- or three-month-outoptionsinordertogetabigenoughpremium.
IncomeTrader:Wow! Thatisalottothinkabout.
OptionzTraderz:The goodnews is that great companiestendtohavestableprices,andhistorically the overall stockmarket has trended up morethan down. If you buy theright stock at the right priceandtradeCoveredCallsonitin a bull market, you couldpotentially remove theunderlying cost of the stock
in a matter of a few years,sometimesless,andthereafterbe playing with the house’smoney. With Covered Calls,youwin if the stock goes upor stays the same. You alsobreakevenas longas itdoesnot go down asmuch as theCall premiums you received.Youonlyloseifitgoesdownmore than theCallpremiumsyoucollect.
IncomeTrader: Better odds
and more ways to win? Butwith less potential upsideprofits and the full downsidestillopenafterthepremium.
OptionzTraderz:Yougotit.Andhere’sonemorethingtothink about. Because aCoveredCallbehavesexactlythesameasaNakedPut,youmight find it helpful beforeyou trade a Covered Call toask yourself: “Would I placethissametradeifIwasusing
a Naked Put instead?” Sayyouwanted to sell a Call onthose 100 shares of Applestock you owned inSeptember, when it wastrading for $400. You mightbe tempted to sell aCoveredCall at the October $410strikefor$12;butwouldyousell aNakedPut at the samestrikeandexpirationfor$22?
Income Trader: Wow, Inever thought of it like that
before. I guess I would bemuch more cautious aboutselling theNaked Put, but inreality, Iwouldbeopeningatrade that had the samepotential profit or loss as aNakedPut.
Optionz Traderz: Exactly.Like most traders, if youchosetosellaNakedPut,youwould probably choose onethatwas out-of-the-money toavoid some of the risk of
having it get exercised. Youwouldn’t collect as muchtime premium as selling at-the-money, but you wouldloweryourriskofassignmentconsiderably. If you weregoing to sell aNakedPut onApple, maybe you wouldchoosea$390strikeifitwastrading at $400. If a NakedPutatthatstrikemakessense,then a Covered Call at the$390strikeshouldalsomakesense.So let’ssayyouchose
to sell one Call contract forOctoberatthe$390strikeandcollected the $22 premium;how would this affect yourlossifthepricefellto$300?
IncomeTrader: Giveme aminute…IthinkIcandothisone without a spreadsheettoo. $400x100=$40,000,$300x100=$30,000, $40,000-$30,000=$10,000, $10,000-$2,200=$7,800. Crap, that’sstill a $7,800 loss, but is
better than the $8,400 loss Iwouldhavehadonanat-the-moneyCoveredCall.
Optionz Traderz: Now forthebestpart:damagecontrol.Let’s say Apple immediatelyfalls from $400 to $390 theday after you sell a CoveredCall at the $390 strike. Youcould roll the Call down to$380 and maybe collect anadditional$6premium.Whatdoyouthinkwouldhappenif
you continued to roll downandthepricecontinuedtofall$10everydayfor10days?
Income Trader: Hmm…Well, Iwouldultimately lose$10,000 on the stock, but Iwould collect $600 inpremiums each time I rolleddown, so I would get back$6,000 there, plus I wouldkeep the original $2,200premium $10,000-$6,000-$2,200 =1,800. So by
managing the trade, I couldcut my loss from $7,800 to$1,800?
Optionz Traderz: You gotit! And at the expiration ofthe final contract, you couldroll it out to the followingmonth and cut your lossalmost to zero, if the pricehad finally found support; oryou could simply choose toholdonto the shares thatyounow owned at a very
favorablecostbasis.Theonlyscenario where youwill losemoney rolling Calls down inadowntrendisonewherethestock price falls too quicklyto be able to capture enoughadditionalpremiums.
Income Trader: You’vegivenme somegreat ideas. Inever would have thought toconsider selling CoveredCalls in-the-money. I havealways looked at the out-of-
the-moneyones.
Optionz Traderz: That is aviable system for an investorwho is looking to simplysupplement the growth of aportfolio with some extraincome. But for an optiontrader whose priority is togenerate income, in-the-money Covered Calls are amuch better choice, in myopinion. You give up all oftheincreaseinintrinsicvalue
in an uptrend, and althoughyou do run a slightly higherriskofearlyassignment,suchanassignmentwouldresultinyou keeping the entirepremium.Allyouwouldneedto do would be to buy thestock back and start sellingCalls again. But you giveyourselfamuchbetterchanceto be able to cut your lossesbyrollingin-the-moneyCallsdownduringadowntrend.
IncomeTrader:I’mnotsureIunderstand that.Wouldn’t Ibe able to roll down out-of-the-money Calls the sameway?
Optionz Traderz: Yes andno.Youwouldbeabletorollthemdown,butDeltaonout-of-the-moneyoptionsismuchlower than those that are in-the-money, so each time yourolled,youwouldcapturelessofthemoveoftheunderlying
than you would with in-the-money Calls. You shouldkeep in mind that the timevalue on a Call that is $10out-of-the-money is the sameas the timevalueonone thatis $10 in-the-money. Forexample,withAppleat$400,the$390strikeOctoberCallson Apple might have $12 intime value and $10 inintrinsic value for a total of$22; meanwhile the Calls atthe $410 strike would only
have$12intimevalue.
So, you can see the effectDelta would have if youconsider the process ofrolling Calls from at-the-money,wherethepremiumis$16 to a strike $10 lowerwherethepremiumis$22,inthis case netting you a $6credit.Butrollingthemdownthe same amount when theyare $10 out-of-the-moneyonlygetsyouabout$4which
is the difference between the$12 out-of-the-moneypremium and the $16 at-themoney premium. When youarerollingCallsdownthereisa big difference between aDelta of 0.6 and a Delta of0.4.
Income Trader: That’s agood point. So I guess itcomesdowntowhether Iamtrading options strictly forincome, or whether I am
using them as a means ofsupplementing the incomeonmystocks.
Optionz Traderz: Exactly.Every trader is different, soyou have to choose whichmethod makes you morecomfortable.When times aregood and prospects forgrowth look favorable, youmight feel more comfortablesimply collecting the $12time premium on the out-of-
the-money Calls and thenrealizing some gains in theunderlying stock during anuptrend. However, if themarket is questionable, youshould at least consider thefact that selling them $10deep in-the-money wouldgeneratethesame$12intimepremium.In-the-moneyCallsnot only give you extradownsideprotection,buttheyoffer a much betteropportunitytorollthemdown
tocut losseswhennecessary.Either method has an equalpotentialtobeawinninglongterm trading system, but it’sup to your individualpreferences to choose whichstylebestfitsyourpersonalityand the current condition ofthemarket.
Income Trader: You’vegivenmealottothinkabout.Thanksforalloftheadvice.
Optionz Traderz: Before
you go, you should alsoconsider another method ofdamage control. It is notpossiblewhenyouaretradinga high priced stock likeApple, where you are onlytrading one contract; but onlower priced stocks you canreduce the number ofcontracts when the pricemoves against you.Let’s sayyou bought 600 shares ofXerox in September for $27and sold sixCalls at the $25
October strike for $3 each.Again, assume the priceimmediately starts droppingand ends the first week at$25. While you are safe forthemomentbecausethepriceis still higher than your netcostbasis,youwouldhaveanopportunity to lower yourrisk.Todoso,youcouldbuyback two of the Calls,probably at a profit of about$1 each and then sell 200shares of the stock at a $2
loss per share. To make upfor the $1 net loss, you canthen roll the remaining fourCallsouttoNovember,stillatthe $25 strike, and probablycollect an additional $1 percontract.
IncomeTrader:Thatmakesa lot of sense. I would belowering my risk by cuttingthenumberofsharesIownedfrom 600 to 400 in case theprice continued to drop.And
by rolling the remainingcontractsoutforanadditionalmonth, I would collectenoughpremiumstonotonlycover my loss on the 200shares I sold, but also givemyselfsomeaddeddownsideprotection on the ones I stillowned.
OptionzTraderz:Exactly.Itsounds like you’re reallystarting to understand whatCovered Calls are all about.
I’mgladIcouldhelp.
Income Trader:Very muchso.Thanksagain.
Optionz Traderz: You’rewelcome.Oh,Ialmostforgot,there’s one more thing IwantedtotellyoubeforeIgo.Try not to let any initiallosses scare you away fromsticking to your system. Ioncemet a guywho sold in-the-money Covered Calls ona stock that immediately
starteddroppinginprice.Thestory,ashe tells it, is thathewas able to continuously rollthe Calls out and down, andalthough it took him tenmonths, he was eventuallyable to get out of the tradewith a small net profit whenthestockeventuallybottomedout.
Income Trader:Wow, thatreally makes Covered Callsseemlikeagreatsystem.
RookieTrader:Maybe theytrulyaretheHolyGrail.
“That guy neverstops,”saidStockTraderoutloud.
Chapter8SELLINGLOTTERYTICKETS:NAKEDOPTIONS
“Upandat‘em!”
Stock Trader hadgotten into the strange habitof talking to himself in theearly morning hours as if heand his body were twodifferentpeople.
He would know heneeded to get up and get towork each morning. Hewould know he needed hispaycheck to pay bills.Unfortunatelyhisbodywouldnot be cooperative. It loved
sleep.
“O.K., I need to getupnow,”StockTradersaidasthealarmdronedon.
Snooze.
“Good, another tenminutes.”
Ten minutes later hewasup,gettingdressedwhileconsuming an energy drink(not a small one, but one of
thedouble-sizedbigboys).
“I wish my energydrink came in a Big Gulpsize,” he thought, only halfjoking.
After throwinga littlefitinhismindaboutworkingtoday, he was eventually onthe road, showered andshaved, with tie locked inplace.
“Crap,Ineedgas!”
Hediscovered that hewasnot theonlyonerunningon empty this morning. Hisgas tank was dangerouslydumpedon“E”.
He stopped at hisfavorite gas station andpumpedgasuntilhistankwasfull.
“Goodgrief,over$50to fill the tank of this littletruck?”
He walked into thegas station for his secondenergy drink of themorning,a new personal record forcaffeineconsumptionsoearlyinthemorning.Ashewaitedinlinehethoughtitwouldbea good idea to break thishabit; it couldn’tbegood forhim.
It was a busymorning. The station hadthree lines open, one
apparently for lottery ticketsonly. The multi-state powerball jackpot was up to $400millionnowandpeoplegrewmore interested and greedybytheday.
Stock Trader startedtothinkaboutthis.
“What a ridiculousplan, spending hard-earnedmoney for a 1 in a 100million shot towin.Orwerethe odds even worse than
that?”
He had once heardthattheoddsweremuchmoreinfavorofgettingkilled inacar wreck on the way topurchase the lottery ticketthan to actually win a bigjackpot.
The popular phrase,“Somebody’s got to win,”wasevenlessimpressive.Histhought was: “That is notreally true; the only reason
the jackpot is so high isbecauseweek afterweek haspassed without a singlewinner; and even thoughsomebody’s got to wineventually, millions andmillionshavetolosetoo.”
Contrary to theopinions of his co-workers,he did not gamble in histrading; he played in favorwith the odds. In the lottery,everyone thought theywould
be that one person who beatthe odds. Most of his co-workers played the lottery,where they had no controlovertheodds.
Hewas getting closertothefrontofthelinenow.Itseemed like every person infront of him was buyinglottery tickets. Some werebuying just one. Others, likethe older lady who he wasbehind in line, were buying
several.
“What a bunch ofsuckers,”hethought.
When he finally gotup to the front of the line topay, he asked the clerk aquestion. “Are you alwaysthisbusywiththelottery?”
“The bigger thejackpot, the busier we get,”thecashierreplied.
“So the more moneythey think they will win themore they spend for achance?”askedStockTrader.
“Correct,” the cashierresponded.
As Stock Traderturned towards the door, hesaw that the linenowsnakedall the way down the breadaisle and past the dairycooler.Hethoughttohimself,“They really have no regard
for the odds. The odds ofwinning aren’t any betterwhen the jackpot is higher.Thejackpotissoridiculouslyhigh anyway; why wouldthey wait in line to play for400milliondollars,butavoidplaying when the jackpot isonly 40 million? Isn’t 40million enough for thelifestyle they want? Thestates are able to makebillionswiththisgame.Thesecustomerswouldmakemuch
moremoneyiftheywereabletoselllotterytickets,notbuythem,” Stock Traderconcluded.
As he walked to histruck he thought, “Hmm,selling lottery tickets. I amsurethatOptionzwouldhavesome opinions about how todo that most effectively byusingoptions. Itmakessensethough. How profitablewould it be to take the other
sidesofbetswherethebettorhas no regard for the oddsagainstthem?”
Stock Trader hadtrouble focusing on hisworkand getting through the day.Hismindkepttryingtofigureout the best way to profitfrom selling options. Hepicturedhimselfsellingreamsof scratch off lottery ticketsand making far more moneythanhepaidtothewinners.
On his drive home atthe end of the day he kepttrying to remember optionpricing on the far out-of-the-moneyoptions.
Whenhegothomehefollowed his tradition ofgoingstraighttohiscomputerandtohisonlineworld.
He first looked at theoptionpricesforApple.OverthepastsixmonthsApplehadonly penetrated its 200-day
moving average once. If hesold front-month options atthe 200-daymoving average,would hewin five out of sixmonths?
“What is that, aboutan83%winrate?”
“What is the price ofnextmonth’sPutsatthe200-day $350 level? Let’s see…With three weeks left toexpiration, it is $3.00 for the$350strike,whileAppleisat
$400, and it has a Delta of-.13. So thatwould imply an87% chance that they wouldexpireworthless?I likethoseodds,” Stock Trader thought,viewing the online optioncalculator. “Even if I onlysold two contracts, I wouldhave an 87% chance ofmaking $600; much betteroddsthanthefolksatthegasstation had of winning thelottery.”
HethoughtabouthowsellingUncoveredCallsatthe$450 strike would probablygethimthesamepremiumasthe $350 Puts. “I would notwant to sellUncoveredCallson a hot stock like Apple,though;thisthingcouldgotothe moon at any earningsannouncement.” Still, it wassomethingtothinkabout.
“I wonder if Optionzisinactiononline.”
As Stock TradersignedonhesawthatOptionzTraderz was online; hedecided he would cut to thechase.
StockTrader:Optionz,whatare your thoughts aboutselling far out-of-the-moneyNaked options for cash flowandreturns?
Optionz Traderz: Hey, Ididn’t see you join in. Ooh,options‘aunat-u-rel.’
Stock Trader: I wasconsideringwhether itwouldbe worthwhile selling NakedPuts on Apple near the 200-day moving average, whichhave a Delta of about .10.Thoughts?
OptionzTraderz: The goodnewsisthattheoddsarewayin the sellers favor with thefarout-of-the-moneyoptions,especiallywiththe.10Deltas.Thatmeansyouwinnineout
oftentimes.Thebadnewsisthatyoudonotgetpaidverywellfortakingonthefullriskof a major move goingagainstyou.
StockTrader:What do youmean?
Optionz Traderz: Well,everything isgreatwhenyouhave those nine wins in arow;youmaythinkyouhavefound the Holy Grail oftrading. Then that darn 1 in
10 loss could take back theother nine wins. One hugemove against your positioncan wipe out the entire sumof the nine little profits; orworse yet, a 1 in 100 losscould blow up your entireaccount. Black Swans arevicious.
Stock Trader: Huh? Firstturtles, then rabbits, andnowthere are birds involved inoptiontrading?
Optionz Traderz: Ha ha,sort of. For most of thehistory of Westerncivilization people thoughtblackswansdidnotexistandwere impossible; all swanswere white. This wasgenerally accepted as factuntilexplorersstumbleduponthe first black swans. Oops,theywerewrong.2008wasaBlack Swan year in thefinancial markets. Many ofthethingsthathappenedwere
thought to be impossible.Didn’t housing pricesconsistently go up followingWorldWarII?CitigroupandFord could never trade forunder a dollar; Bear Stearnsand Lehman BrotherssurvivedtheDepression;theycouldnevergobankrupt;AIGand General Motors wereDJIA components they couldnot go bankrupt, and on andon. Black Swans arediscovered more often than
investorswouldsuspect.Youhave to be eternally vigilantwhen selling Naked options,sothefirst‘impossible’eventwillnotbeyouraccount’slasttrade.
Rookie Trader: You arealwayssonegative.
OptionzTraderz:Iambeingnegative for a reason. Youmust always consider riskfirst and go from there. Butonceyouunderstandtherisk,
there are ways to makemoney trading Nakedoptions.
StockTrader:Goon.
Optionz Traderz: Sometraders start winning withNaked Puts and get theseductive siren call to keepincreasing their positionsizes.Theystartbelievingtheunthinkable can’t happen,untilitdoes.
StockTrader:Besides2008?
Optionz Traderz:Well, foranother example, the 1987Black Monday crash. Thatdaynotonlyblewup traders'accounts but some of themtook down brokerages withthem. The reason that themargin requirements are sodifferent for Naked optionsversusCoveredoptionsisthattheriskisonthebrokerageifthetradercan’tcoverit.
Stock Trader: Yes, 1987was not a good time forNakedPuts.
OptionzTraderz: That yearwas a rocket ride up andseemed to be a Put seller’sparadiseuntilOctober.
Stock Trader: So Octobertook everyone off guard?Thatiswhyriskmanagementis#1again?Howdidyoudothatyear?
OptionzTraderz:Iwaswaytoo young to have been atrader then. I was inelementary school in 1987. Ilearned this from books andstudying charts. The FlashCrash of 2010 was anotherBlackSwan,andIwasinthemarket during that one.Fortunately, I was tradingNakedCalls at that time andnone of my trades wereaffected.
Stock Trader: You are ayounggun,huh?
Stock Trader hadalwayspicturedOptionzasa50-something, middle-agedman;itwassurprisingtohimthat someone under 40 hadthis level of knowledge ontrading. He wondered ifOptionz was younger thanStockTraderhimself.
Optionz Traderz: Youngand strong. Anyway, like all
other systems, it is not abouthowmuchyoumakebuthowmuch you keep. Before yousell any Naked option, youneed to go ahead and have astop losswhereyouwill buyit back if you are wrong. Oryou may want to place acontingent order to buy orshort theunderlyingshares ifthepricereachesadangerouslevel, or even trade anotheroption tooffset the risk.Youneed an ‘abort’ plan or
adjustment plan for thateventual bad move againstyou.
StockTrader:O.K.,what tosell?
Optionz Traderz: ThemethodologyinsellingNakedoptions is no different thanstock trading.You could sellNaked Puts under what youbelieveisapricesupportandsell Naked Calls above whatyoubelieveisresistance.You
must consider the timeframealso. If you are selling one-month-outoptions,youmightconsider selling your Nakedoption at a price that isunthinkable for the stock toget to within a month. Inselling options you aredealing with both price andtime. While selling a one-month-out Naked Put at the200-daymovingaverage,inahot market’s leading stockthat ismakingall-timehighs,
the buyer of your Put mayhave no chance of the stockgetting to that strike. If yousell it a year out, then yousuddenly have amuch betterchance of your strike beinghitsometimeduringtheyear.
StockTrader:Priceandtimemustbothbeconsidered.
Optionz Traderz: Youshould keep inmind that theoptions are always priced atfair value at the precise
moment that the contract isopened. In today’s world,there are few if any optionsthatareover-pricedorunder-priced. Taken at face value,optionsareazero-sumgame;the premium of every optionreflects the odds that it willcreate neither a profit nor aloss for both the buyer andthe seller upon expiration.That’snottosaysellersdon’thave an advantage overbuyersbecausetheydo.
Stock Trader: Wait aminute! You said optionswere a zero-sum game.Howcan the seller have anadvantage?
Optionz Traderz: Actually,sellers have severaladvantages. First, taking intoaccount all options at everypossible strike price,statistically sellerswill profitabout twice as often asbuyers; sellers, as a group,
win about 67% of the time.Sellers of out-of-the-moneyoptions have even betterodds. Even the lowestperforming options forsellers,thosethataredeepin-the-moneywillstatisticallybewinnersmorethan50%ofthetime.
Stock Trader: But as youhave said before, sellers winmore often, but when theylose,theylosemore.
Optionz Traderz: That iscorrect,butsellershavemuchbetteroddsof startingwith aprofit right out of the gate,whereas buyers often beginwith a string of losers andthen have to run the raceplayingagameof‘catchup.’Sellers then have the optionof quitting while they areahead, while the only choicefor a buyer is to keep tryingortakealoss.Ofcourse,I’mnot implying that this
statistical advantage is areason tochoose sellingoverbuying; in my opinion thatpreference should dependonlyonthemarketconditionsatthetimeofthetrade.ButIfind it reassuring to considerthe advantages when I sellNakedoptions.
StockTrader:Goodpoint.IfI know I have an advantagewhen I trade stocks, it givesme confidence. I guess the
same would be true ofoptions.
Optionz Traderz: Here’sanother advantage of sellingthat may boost yourconfidence when you selloptions: premiums are ofteninflated to account for BlackSwans. Just as an example, Ilooked up those Puts onApple that you were talkingabout. The closest ones Icould find to a .10Delta for
nextmonthwere at the $350strike and the last trade was$3.00. That means the $3.00premium reflects theprobabilitythatApplewillbetrading at a price somewhathigher than $347 one monthfrom now, a pointwhere thesellermakesasmallprofit.
Stock Trader: O.K.. Thatfirst part makes sense. Sowith Delta being 0.13 onthose Puts, there is a 13%
chance that the underlyingprice will be $347 a monthfrom now. So why are younow saying that the Puts atthe $350 strike would bepricedinfavoroftheseller?
Optionz Traderz: You arecorrect that in theory thepremium is based on theprobability of the underlyingprice falling to $347, whichwould be the point wherebuyer and seller both break
even. However, that $347value is not based on theBlack-Scholes model, whichassumesthatstockpricescangenerally predicted by a bellcurve. In reality, overextended periods of timeprices do not conform to aperfectbellcurvebutonethathas fat tails. The fat tails arecausedbyBlackSwaneventsand also by unexpectedearnings or other good newsthat causes unprecedented
run-upsinacompany’sstockprice.Overaperiodof10or20 years, such unpredictableevents are likely to occurseveral times, so the stockactually spendsmore time atthe edges of the bell curvethan would otherwise beexpectedbypurelytheoreticalmodels.That’swhatgivesthebell curve its fat tails.Emotions do have an effecton trading, and thoseemotions occasionally do not
fit an un-emotional statisticalmodel.
StockTrader:This is reallyinteresting.Goahead.
Optionz Traderz:Well, wealready talked about BlackSwans, like the Crash of1987, and I know you knowabout Darvas because I sawyou chatting with anothertrend trader about hismethodsawhileback.
Stock Trader: Wow. Youhave a great memory. O.K.,goon.
Optionz Traderz: Well,Darvas noticed that stockstended to rallyafter theyhadbroken through a resistancelevel, or ‘box.’ So someonesellingafarout-of-the-moneyNakedCallmight not realizethat they were taking on ahidden risk, that if the stockhad broken through to such
an‘unthinkably’highpriceasthe strike price of that Call,there was a good chance itwasoutofitsboxandheadedforfurthergains.Likewise,ifa Naked Put seller saw theunderlying fall to their‘unthinkable’ strike, itwouldmean that the ‘unthinkable’hadalreadyoccurredanditisquite likely the price wouldfall even further. Thatconcept was pretty muchignored until 1987. A lot of
Naked Put sellers had notconsidered that if a BlackSwan event occurred andtheir far out-of-the-moneystrikeshadbeenhit,therewasa good chance they wereheadedforsignificantlosses.
Stock Trader: I had neverthought of that. So I guess Ishould expect far out-of-the-money options to be pricedbased on the stock eitherenduring a 1987-style Black
SwanoraDarvas-stylerally.
Optionz Traderz: Exactly.The further out-of-the-moneyyou go, the more likely it isthat thestockprice isheadedfor a radical move if itsurpasses your strike. Youcanactuallysee theeffectonhistorical charts. Prior to1987, Implied Volatilitiesbasicallyraninastraightlinefromveryhighvolatilitiesfordeep in-the-moneyoptions to
very low volatilities for farout-of-the-money options,whatmanycallthe‘VolatilitySkew.’ After 1987, ImpliedVolatilities have taken on acurved appearance that sometraders call the ‘VolatilitySmirk.’ Implied Volatilitiesare higher at the edges thanwould otherwise be expectedby purely statistical models.Theresultisthatdeepin-the-money and far out-of-the-money options have
premiums that reflect theaddedriskofeventsthatonlyoccur rarely, maybe onceevery few years or even asmuch as twenty years. Theend result is that today’soptionshavepremiumswhicharemorereflectiveofreal-lifetrading. I’m sending you achart that shows the ImpliedVolatility Smirk for theNovember 2011 Calls onIBM.
StockTrader:Thatmakes a
lot of sense. The optionsmarket is truly efficient, somuch so that it adapts andlearns from changes in themarket.SowhydidittaketheCrash of 1987 to change theway option premiums aredetermined?
Optionz Traderz: In early1987, options were still arelativelynewproductforthegeneralpublic.Thepremiumsof out-of-the-money Puts
were mostly based on theopinion that if a strike washit, the underlying priceprobablywouldn’tgoveryfarbeyond that point. Then theCrashof1987showedtradersthat they had been wrong; ifan out-of-the-money Putstrike is hit, especially onethatisfarout,thereisagoodchancethatthepricecouldgowellbeyondthatstrike.
Stock Trader: I never
thoughtofitthatwaybefore,but you’re right. If a stockwas performing well andsomethingsuddenlyhadsuchanegativeaffectthatthepricefell through the 200-daymovingaverage,Iguesstherewouldbenoreasontoexpectthat my strike price stillrepresentedasupportlevel.
Optionz Traderz: You’vegot it. Today’s optionsmarket, having learned an
important lesson from pastBlack Swans, prices out-of-the-moneyoptionsatahigherpremium than wouldnormally be predicted by apurely theoretical model, toguard against losses thatsellers would endure if therewasarepeatofthoseevents.
Stock Trader: I think I seewhat you are getting at. Intheory, the$3.00premiumofthe $350 Puts on Apple is
based on the probability ofthestockpricefallingto$347on expiration day, but thatprobabilitytakesintoaccountevents that rarely occur. Soeverymonththatoneofthoserare events does not occur,thesellerhasbetterodds.
Optionz Traderz: Younailed it! I think that’sanother reason for thewidespread perception thatoption sellers make more
money than option buyers.Sudden, unexpected ralliesand Black Swans are pricedinto every option, and if youconsistentlyselltheseoptionsover a long enoughtimeframe, you shouldaccumulate enough of their‘bonus’ premiums to pay foran occasional radical pricemove. So most of the time,option sellers make moreprofits thanoptionbuyers. Inaddition, experienced option
sellers take steps to protectthemselves, so they collectthe extra premiums,sometimesforyearsatatime,while also limiting theirlosses when a Black Swanplays out. Successful sellersof Naked options are likelottery agents who collectmoney from selling ticketsandthenshutdowntheentirelottery at the first sign thatone of those tickets containsthejackpotnumbers.
StockTrader:That’sagreatpoint.We seem to be on thesamewavelength here. Iwasthinking just this morningthat selling Naked options islike selling lottery tickets. Iguess what you are sayingmakes sense. If I amcollecting lots of income byselling options at-the-moneythat have lots of timepremium, it’s like I am thegovernment running a lotterywhen the jackpot is $400
million.Because of the largenumber of people buyingtickets, there is likely tobeasufficient amount ofpremiums to pay all of thewinners.But if I sell optionsfar out-of-the-money, it islike I am selling lotterytickets when the jackpot issmall. Although the odds ofhaving to pay a winner aremuch lower, with fewerpeoplebuyingtickets,thereisamuch greater chance that I
will end up paying out on awinning ticket before havingcollected much money insales.SoifIamgoingtosellNaked Puts on a stock at aprice far out-of-the-moneythat I believe representssupport,howdoImanagethetradetoprotectmyselffromaBlackSwan?
Optionz Traderz: First, ifthe odds are very small thatthe price will be reached in
the allotted timeframe, thenthepriceyouwillget for theoption will also be verysmall. You have to alwaysask yourself: “Is itworth therisk?”There’snoneedtosellaNakedPutfortencentsifitmeans you are riskingthousands of dollars; sure,you will most likely get tokeep the $10 premium percontract,buthowmanytimeswouldyouneed todo that tocover the losses on even one
badtrade?
Stock Trader: So, I guess Ineed to sell far enough out-of-the-money to give megoododds,butnotsofarthatthe premium is too small tomakeupformylosses.
OptionzTraderz:Again,yesand no. It might soundcounterintuitive,butyoumayactually find that it is moreprofitabletosellPutsthataredeepin-the-money.
StockTrader:Huh?
Optionz Traderz: I know itsounds crazy, but hear meout.Assuming youwere stillinterested in trading thosePuts onApple that youweretalking about when it wastrading at $400, you wouldsell Naked Puts at the $350strike for $3.00. As long asthe underlying price stayedabove$347,youwouldmakea profit. Themost profit you
could make on that tradewould be $3.00. Now,consider that the timepremiumon the$450Puts isalso$3.00.So,whynotsellaPutatthe$450strikeinstead?
Stock Trader: You’re rightso far, that does seemcounterintuitive.
Optionz Traderz: O.K., solet’s walk this though. Sayyousella$450Putfor$53.00and then short 100 shares at
$400.Now, if the stockdoesfall to support at $350 youstill get the same $3 profit,becausewhenthestockisputon you at $450 it will coverthe shares you shorted at$400 for a loss of $50, butyou will keep the $53premium.
Stock Trader: I neverthought of that, shorting astock and selling an in-the-money Put. I guess it would
behave the same as a Nakedout-of-the-money Put, but Iwould be protected if thestockfellthroughsupportandkeptongoing.
Optionz Traderz: That istrue; you would have muchmore downside protection.But always rememberwhat Isaid about options and risk:the risk never goes away, itjust gets shifted somewhereelse. In this case you have
totally eliminated yourdownside risk, but onlybecauseyouhaveshiftedittothe upside IfApple suddenlyclimbsabove$453,youhaveused up all of the gains youwould receive when the Putexpires worthless, but younow are in a position whereyou will have to buy 100shares at a higher price inordertocoveryourshort.
Stock Trader: Wait a
minute, isn’t thatexactly likeaNakedCall?
Optionz Traderz: Bingo!Any position you can createwith a Put can also besynthetically created with aCall at the same strike price.ShortingastockandsellingaPut, which is often called aCoveredPut, is equivalent toaNakedCall.
Rookie Trader: That’sstupid. If it ispossible touse
a Call to trade the sameposition as a Put, why aretherebothkindsofoptions?
Optionz Traderz: It’s notstupid, although I have toadmit,youhavefinallyaskeda really intelligent question.For many traders, Nakedoptions are not available, sothey have no choice but touse the equivalent syntheticposition. But mostly, it allcomes down to whether you
want to tie up your assetswithonestrategyorfreethemup for use in other trades. Italso involves yourpsychologyandhowyouplanto manage the trade once ithasbeenplaced.IfyousellaCovered Call and theunderlying price falls, youmight not mind owning theunderlying shares. On theother hand, someone sellingthe equivalent Naked Putmight not want to own the
stock at all. In fact, aNakedPut seller might be preparedtoshortthestockifthestrikepricewashit.
Rookie Trader: I’m sorry Isaid it was stupid. I reallythoughtoptionsweregoingtobe easy to learn, butsometimes they just seem socomplicated.
Optionz Traderz: Apologyaccepted. There are alsomargin requirements to
consider. If you buy a Call,your account only needs tohave enough equity to coverthe premium; but if you buytheunderlyingandbuyaPutyou will need a lot moreequity, not only to purchasethe shares but also the Put.But I don’t want to misleadyou here. Just because youcanbuyaCallwithverylittleequity doesn’t necessarilymean you shouldn’t haveenough purchasing power to
buy the underlying shares. Ifthe Call goes in-the-moneyand you don’t have enoughequity to buy the stock, youwill be forced to sell theoption before it expires inorder to avoid amargin call,and that would mean youwould give up any futuregainsyoumighthaverealizedonthestock.
Rookie Trader:That makessense. I just wish I could
learnthisallmuchfastersoIcould start making big timemoney.
Optionz Traderz: You canmakealotofmoney,butyoureally owe it to yourself toeducate yourself first;otherwise you risk losingeverything. When you tradeoptions, there are alsocommissions to consider.Except for day trading, stocktrading normally involves
holding onto winning tradesandonly sellingwhen a stoploss gets tripped or atechnical indicator pointstowards a reversal. But withoptions,youcanstartrackingupcommissionsandfeesveryquickly, especially if youtrade weekly options. If youare selling a Covered Callbecause you are bullish on astock, and you are correct,youwill enduppaying threecommissions: one to buy the
stock,onetoselltheCall,andanother when the Call isassigned. Some brokerscharge inflated commissionsfor exercise, so you mightend up paying the equivalentof fourcommissions.But thesamepositionopenedusingaNaked Put would only incurone commission, the one tosell the Put, which wouldthenexpireworthless.
Stock Trader: I really
admirethepatienceyouhavewithRookie.
OptionzTraderz:Iwasoncearookietoo.Ifheisgoingtofailasa trader,at least Iwillhaveaclearconsciencethatitwasn’tmyfault.
Stock Trader: Now that Ithink about it, Naked Callsmight actually be a better fitformy trend trading.When Itrendtradewithstocks,Iliketobuywhenpricesaregoing
up,notdown.IfIsoldNakedCalls at a resistance level, Icouldthenbuytheunderlyingsharesifmystrikewashit.
Optionz Traderz: That isalso a good plan. You couldalso consider selling NakedCalls at a moving average.Just as an example, if yousoldCallsoneweekout,youmight want to use a 20-daymoving average as a strikeprice, and then buy the
underlyingshares if thepricehit the moving average. Notonly would you be buyingwhen prices were on theirway up, but youwould havesome downside protectionagainstwhipsaw.
Stock Trader: I’ve alwaysconsideredNakedCalls tobetoo risky.Doesn’t the riskofunlimitedlossesoutweightheincometheygenerate?
Optionz Traderz: It is true
that losses are theoreticallyunlimited. But try thinkingabout it thisway.How oftendo you see the Dow Jonesrise 500 points in a week?Compare that to the numberof times the index has fallenbythatamount.
StockTrader:That’sanothergreatpoint.Ireadsomewherethat prices ordinarily falltwiceasfastastheyrise.Thatmeans I should have many
more opportunities to hedgemy trade if prices startedclimbing towards my strikeonaNakedCallthanIwouldto control my losses on aNakedPut.
Optionz Traderz: Exactly!Even though the risk on aNaked Put is limited to themaximum loss thatwould besustained if the stock pricewenttozero,thelikelihoodofa Naked Put trade quickly
going bad is much higherthan a Naked Call doing thesame.EvenifyousellNakedCalls around news events,such as right before anearnings announcement, thecollapseofvolatilityaftertheannouncement will likelylimit your losses if theannouncement happens tosurprise investors with greatnews. On the other hand, ifyou sell Naked Puts prior toearnings and the news is
disappointing, the increase inImplied Volatility couldcauseyoutolosemoneyveryfast, as the options are notonly increasing in intrinsicvaluebutalsopickinguptimevalueduetoVega.
Stock Trader: I neverthoughtof it like that before.Given the same amount ofchangeinthepriceofastock,Naked Calls don’t losemoney as fast asNakedPuts
because volatility usuallydropswhenpricesarerising.
Optionz Traderz: Yes, andwhenyoulookatitthatway,NakedCalls are actually lessrisky than Naked Puts,despite the theoreticalpossibility of unlimited risk.This is especially true onETFs where diversificationmakesasuddenupwardmovelesslikelythanitwouldbeonan individual stock.Andyou
always have the option ofbuying a Call at a higherstriketoprotectyoufromtheoccasional takeoverannouncement or some othernews release that suddenlysends the stock soaring. Sayyou decided to sell NakedCalls on Apple at the $450strike; you might be able tobuy Calls at the $500 strikefor $1.00, essentially turningthe position into a VerticalSpread.
StockTrader:That’sagoodidea. I would limit mypotential profit, but I wouldhave some added protectionin case the stock really tookoff.So Icould tiemyNakedoption selling into my stocktrading, selling Puts when Iam bullish and Calls when Iam bearish? Sell Puts onmarket leaders and Calls onmarket laggards? Sort of justoverlay option selling onmypre-existing profitable
systems?
OptionzTraderz:Those areall good strategies. Manypeople sell options for aliving. The secret tosuccessfullysellingoptionsisto not get greedy and over-sell, and also to manage thebiglosseswhentheybegintooccur.That is another reasonthat option sellers have anadvantageoveroptionbuyers.Sellers can manage their
losses, sometimes eventurning losses into gains, buttheonlychoiceforabuyeristocutlosses.
Whenyoubuyanoptionandit expires worthless, it isdead, that is the end. Butwhenyousellanoptionanditends up in an unfavorableposition, there will be timeswhenyoucanbringitbacktolife.JustaswediscussedwithCoveredCalls,whenaNaked
Put trade starts to go thewrong way, you can eitherrolltheoptionsouttoalowerstrikeorkeepthesamestrikeand roll them out with alowernumberofcontracts.
StockTrader:Iwouldhavenever thought of it thatway.IfIbuyoptions,Ireallyhavenorecoursewhenatradegoesbad except to watch themslowlydieorputthemoutoftheir misery early. If I sell
optionsandtheygodownthewrongpath, Iwillsometimesget the chance to keep themaliveforanothermonthorso,giving them a second chanceat living a prosperous life.Whatotherconsiderations?
Optionz Traderz: It’s up toevery option trader to decidehow much risk is too much.The potential reward isalways proportional to theamountofrisk.Atraderwho
hasneverownedApplemightbe more comfortable with aPut Spread, while a traderwho bought shares of Applewhen it was trading at $200might feel more comfortablerisking thosegainsbysellinghis shares at $400 and thenSelling Naked Puts. Optiontradingisveryflexible.
Stock Trader: I agree withyouagain.Ihavetochooseatrade that makes me
comfortable so I won’t betempted to allow myemotions to influence mydecisions.Anyotherideas?
OptionzTraderz:Ihavemetsome traders that sell NakedPuts and Calls at the sametime. Many times, bothoptions expire worthless andtheygetdoubleprofits.
Stock Trader: But aren’tthey taking double theamountofrisk?
Optionz Traderz: At firstglance it might appear thatway.Butinthelongrun,thatriskisoffsetbecausetheyarealso collecting double theamount of premiums.Oneoftheoptionswillalwaysexpireworthless, andover time thatwill eventually offset thelossesontheotheroption.
StockTrader:SohowwouldI manage a trade involvingbothNakedCallsandPuts?
OptionzTraderz:Therewillbetimeswhentheunderlyingprice starts to move againstone of your positions. Inthose cases, you have lots ofchoices to manage the trade.Sometimes it is possible totake the profits on thewinning position and roll thelosing position to a morefavorable strike.Other times,ifthepriceisnottooclosetoovertaking one of the strike
prices, it might be better toturnthewinningpositionintoaSpread.
Let’s sayyousold$350Putsand $450 Calls on Apple,each at $3.00, and the pricesuddenly shot up from $400to $410.You should then beable to buy a $360 Put for$3.00, in effect turning thatsideof the trade intoa ‘free’Put Spread. You’d still have$40 of play before the price
hit your Naked Call strike;but if the price whipsawed,the Put Spread could seesomenicegains.
There are times when thepricewhipsawsenoughthatitis possible to turn both sidesofthetradeintoSpreads.Saythe price moved again, butthis timefellfrom$410backto $390; you would then beabletobuythe$340Callsfor$3.00.Thegoodnews is that
neither Spread would costyou anything because youwould be opening the longposition at a time when thepremium was less than, orequal to, the premium youreceivedontheshortposition.If either Spread realized itsfull potential, you would seeaprofitof$10pershare,andat the veryworst, everythingwouldexpireworthless.
Stock Trader: Those sound
like great ways to managerisk. I guess I would alsohavetheoptionofrollingtheNaked Calls out, if I turnedtheNakedPut intoaVerticalSpread and the underlyingprice continued in a steadyuptrend that placed it indanger of reaching my Callstrike.Anymorethoughts?
Optionz Traderz: Onceagain Iwill reiterate positionsizing.Ifyouarecomfortable
trading no more than 200shares of a stock, then onlysell2contractsofthePutsorCalls short. Do not suddenlystart selling 20 contracts ofNakedPutsjustbecauseyourmarginrequirementsallowit.You would be asking fortrouble when that oneunexpected event occurred,and those events occur moreoften theyyouwouldexpect.Even if youmanage tomakeit ten years without a Black
Swan, ifyourpositionsizeistoolarge,youcouldwipeoutyourentireaccount,includingthose ten years of profits,veryquickly.
Stock Trader: There isnowhere tohidefromcorrectpositionsizing.
Optionz Traderz: Manytraderswhoselloptionsforaliving sell Naked Puts forstocksthattheywanttoown.For example, if a trader
wantedtobelong200sharesof Apple and wanted to buyin at the 200-day movingaverage, he could repeatedlysell 2 contracts of Puts eachmonth.Soifittook6monthsto get the stock put on him,hewouldmakeabout$600amonth selling Puts, and hewould see $3,600 in profitsbeforehefinallygotthestockat the price he wanted. The$3,600 profits would reducethe cost basis of the 200
shares of stock by $18 ashare, and they likely wouldthen go on to make capitalgains in the stock itself, afteritwasputonhimathiswishprice.Eveniftheydidnot,hewouldbe inaposition tousea very generous stop lossorder.
Stock Trader: I guessanother scenario would be ifthe Naked Puts went in-the-money the first month. He
couldrollthemdownandoutto the following month andkeep doing that until therewere no more options withsufficient premiums to coverthe loss on the previousmonth’s Puts, atwhich pointhe could allow the shares tobe put on him at a nicediscount, and then wait forthestocktorebound.
Optionz Traderz: Yes, thatwould be a good choice in
some circumstances, wherethe companywas still strongbut had just hit a soft patch,or when the price was beingweigheddowntemporarilybythebroadermarket.Butothertimes, when chances for theprice to recover are inquestion, it would probablybebettertocutthelossesandmove onto something morepromising.
StockTrader:Great advice,
asalways.
Optionz Traderz: I knowsome traders that also useoptions as an indicator topredictwhether a stock priceisheadedupordown.
Stock Trader: How is thatpossible?Aren’ttheoddsofastock going up or down inpricealwaysequal?
Optionz Traderz: Actually,the odds of a diversified
portfolio of stocksexperiencing upwardmovement are historicallyslightly higher than thechances of prices falling.Even when markets arestagnant, inflation usuallyaddssomeupwardpressure.
StockTrader:O.K.,soevenif prices normally rise overthe long term, how wouldoptionshelpmepredictwhatwas going to happen in the
future?
Optionz Traderz:Well, thestockmarket is efficient, butthe options market is super-efficient.While the prices ofstocks are determined by allofthecombinedsentimentofinvestors and institutions allover the world, they onlyrepresent the value at whichbuyersandsellersarewillingtosettleatasinglemomentintime. In contrast, the
premiumsofoptionstakeintoaccount an extra layer ofinformation, the performanceofthestockoveranextendedperiod of time. Options,because more information isrequiredinordertodeterminea fair price, are much moresensitivetonewsandchangesin the market than stocks;options actually help drivestockprices.
StockTrader:O.K.,Ifollow
yousofar.
Optionz Traderz: So sometraders find ituseful to studya stock’s options before theyactually trade shares of thatstock.Optionsthemselvesarea sort of technical indicator,andtheycanbeusednotonlyto tradestocksbutoptionsaswell. Just as an example, ifthere is a large amount ofopeninterestinCallcontractscompared toPuts, themarket
is indicating a bullishsentimentonthatstock.Iftheunderlyingpricedoesstart tomoveup,thelargenumberofCall options can help give itmomentum. As the pricerises, Call buyers are morelikely to exercise theircontracts, which results inincreasing demand for theunderlying shares. At thesame time, Call sellers aremore likely to buy shares inordertolimittheirlosses.
StockTrader:Wow!Thatisareallygoodobservation.I’massuming it works the samewaywithPuts.Whenthereisamuchlargeramountofopeninterest inPuts, thoseoptionscould actually help reducedemand for the stock if theprice starts to fall, whichwould only exacerbate thedropinprice.IfIamgoingtosell Naked Puts, I shouldprobably check the Put/Callratiofirst,toseeifthemarket
is predicting bearish daysahead.
Optionz Traderz: Exactly!Implied Volatility is anotherindicator that you can use toyour advantage. Volatilitynormally rises fairly quicklywhen prices fall, and thendrops much more slowlywhen they recover. If pricesare rising, you might choosetowaitforvolatilitytofalltoa predetermined level before
you decide to sell NakedPuts, even though you willreceiveasmallerpremium,toensure that you are inagreementwith thesentimentoftherestofthemarket.
Stock Trader: I see whatyou’re saying. If volatilitysuddenly went from 30% to50%,Icouldconsiderholdingoff on selling Naked Puts,evenifthestockwasshowingsigns of strength because the
options market would beproviding evidence of someuncertainty about the pricecontinuingtoclimb.
Optionz Traderz:There areother ways you can useImpliedVolatilitytohelpyoutrade.Youknow thatgraph Isent you that showed aVolatilitySmirk?Well, sometraders have found that thesteeperthesidesof thesmirkare, the worse the stock will
perform. Sometimes this badperformance continues forweeks or even months aftertheseoptionsexpire.
Stock Trader: That soundsconfusing. I thought IunderstoodImpliedVolatilityasbeingasortofmeasureoffear.When volatility is high,it means traders are moreworried that prices will fall.But why would lowervolatility at-the-money be a
predictorofchange?
Optionz Traderz: I haveseen studies showing that apersistent smirk is oftenpresent on many widelytradedoptions,sometimesformonths,beforeaBlackSwanevent.When a normal graphof ImpliedVolatilitystarts totake on a smirk-likeappearance, it could meanthat traders are anticipatingviolent price swings in that
particularstock.
The best stock options topurchaseifyouwanttoprofitfromabigpriceincreaseinastock are deep-in-the-moneyoptions. These options arealready profitable with astrikepricebelowthecurrentmarket price, so they alreadycontain intrinsicvalue.Thesedeep-in-the-money optionsmove closer in value dollarfordollar thanfarout-of-the-
money options since far-out-of-the-money options have alow probability of expiringwith any intrinsic value.Higher than normal demandfor deep in-the-moneyoptions can sometimes be anindicator that speculators areanticipating a major changeinthestockprice.
If far out-of-the-moneyoptions start increasing inpricemore than they should,
based on the Delta of theoption,thisisalsoacluethattraders are anticipating a bigmoveintheunderlyingstock.Just as with deep in-the-money options, speculatorsoften control the demand forfarout-of-the-moneyoptions.
You may want to think ofsuch a smirk as a warningsignthatitmightnotbesucha great environment forselling Naked Options.
Instead you might want toconsider that with at-the-money options beingrelatively cheap compared tothoseatotherstrikes,itmightbeabettertimetouseaLongStraddleorStrangleinstead.
Stock Trader: That isfascinating. You’ve beenreallyhelpful,butIthinkI’mgoingtohaveto takeabreakand digest some of this. Iguess if I can use options to
help me predict the futureprice of a stock, they wouldalso help me choose whatoptionstouseifIamgoingtosellNakedones.
Optionz Traderz: You’vegot it! Studying all of theoptions on a particular stockcan give you additionalinformation you would notget from a traditionalfundamental and technicalanalysis. That additional
information may provehelpful in deciding what andwhen to trade, whether it isstocks or options or both.Speculation is much moreprofitablewithoptionsthanitiswithstocksduetothelargeamount of leverage theyprovide. As a result,speculation often causesoptionpricingtochangelongbefore the stock makes anysignificantmoves.Beforeyouplaceanytrade,youshouldat
least lookupoption tables tofind out what kind ofspeculationisoccurring,evenif it is just for a secondopiniontobackupyourothertechnicalindicators.
Stock Trader: You are fullof good ideas tonight. Well,it’s been nice chatting withyou.I’llneedtostudyNakedCalls a little more to see ifthey will work for me, but Ireally like the idea ofNaked
Puts, ofbeingable to choosethe prices I pay for myfavorite stocks and get paidforbuyingthem.
RookieTrader:Now if thatisnottheHolyGrail,Idonotknowwhatis.Yougetpaidtobuy a stock at your dreamprice?Soyoueitherkeepthepremiums or get the bestpriceforahotstock.Howdoyoulose?
Optionz Traderz: Easy.
Apple continues to fall by50%after it falls through the200-daymovingaverage,justlike itdidback in2009.Youneedtofollowupthatsystemwith a stop loss on the stockitself, after it is put on you,andyouneedtokeepinmindthatitcouldbeputonyouata price that is alreadysignificantly higher than thepriceatwhichitistradingonexpiration day. There are nofree rides in the market, and
once again, no Holy Grails.Anythingcanhappen,soyouhavetoalwaysbeready.
Stock Trader: As always,amazing food for thought.Youmusttradealotorreadalottoknowalot.Youhaveagoodnight.
Optionz Traderz: Optionsaremy business. Good nighttoyoutoo.
Rookie Trader: Finding the
Holy Grail in trading is mybusiness.
PennyPumper:Hey,RookieTrader, I can help you findtheHolyGrail.JustcheckoutEXTO. I read a closelyguarded report this afternoonwhich indicates that somesources are saying there willbe a huge announcementtomorrowmorning thatcouldsendthisstockupover800%.Butifyouwanttogetin,you
should consider doing itearly, before the big-timetraders scoop up theremainingshares.
Rookie Trader: 800%, ofcourse I’m interested. I’ll beup first thing in themorning.Then wait till I show StockTrader and Optionz Traderzhowwellarookiecando!!!
Penny Pumper: If you giveme your email address, I’llsendyouacopyofthereport.
RookieTrader: I’m sendingmy address to you now. Ibetter get to bed, though. Idon’t want to oversleep andmiss out on an opportunitylike this. Thanks for helpingmeout.
Penny Pumper: Great tohear it. I know I’ll bewatching EXTO first thingtomorrow.
Chapter9BUYINGLOTTERYTICKETS:
DEEPOUTOFTHEMONEYOPTIONS
Saturday... Relaxing,peaceful, and B-O-R-I-N-G;whattodo?
Stock Trader foundhimself in his favorite bookstore, perusing the littleinvestingsection.Hewasnotimpressed.
He sat at one of thesmall, sticky tables with hisfavorite energy drink and achart of his favorite stock –his belovedApple. He loved
his iPhone, his iPad, and hisMacintosh, along with themoney the stock had madehimover theyears.Hecouldhave bought a few nice carswithhistradingprofits.
Charts courtesy of
FreeStockCharts.com
Stock Trader liked toview stock charts with theBollinger Bands and movingaverages.
In his stock tradingmethod, the Bandsestablished a logical tradingrange of two standarddeviations with the 20-daymoving average as the meanvalue. The 50-day moving
average was the first stop ofsupport for a hot stock andthe 200-day moving averagewas the final place wherebuyers would come in andbuy a hot stock at a bargain.Thiswashisprimarysystem.Nowthequestionwas:
“How can I use mystock trading methods toprofit the most from tradingoptions?” He felt a sense ofdéjàvu.
Hestaredatthechart;it was making a new run atall-timehighs.Woulditbreakout?Hedidn’tthinkthepricebasewaslongenoughyet,buthe could be wrong. Applewasapowerfulstockthatwasknown to climb up aBollingerbandlikeamonkeyupatree.
Hisnext thoughtwas,ofcourse,howtotradeitwithoptions.
HewroteonapieceofpapernexttohisiPad:
1)At-the-moneyCalls
2) Out-of-the-moneyPuts
He thought the twobest trades would be to buyCallsnow,at-the-money,andif the breakout to all-timehighshappenedandthestockrocketed up to a whole newtrading range, he would do
verywell.HewouldhavehisCalls at what should be thenew support, at the level ofthe price breakout. Howeverifthebreakoutfailedhecouldlosemostorallofhiscapitalas the stock moved back tothe50-daymovingaverage.
Hisotherthoughtwastobet thiswasresistanceandbuyPutsat theprice levelofthe current 50-day movingaverage. The probabilities
weregoodthatifthebreakoutfailed, the price would goback to test that level. Itwould require less capital tobetonaretest.
Apple was trading inat$422.
Dec. $420.00 Callswere$26.00acontract.
Dec. $385.00 Putswere$12.00acontract.
“Wow,”hethought,“Iwould need either a quickmove up or down in eitherdirection, while the optionsstillheldtheirtimevalue,oramove to $446 by DecemberfortheCallstobreakeven,oradownmoveto$373forthePuts to break even. Theseoptions are definitely pricedefficiently to break evenbasedonexpectedmoves.”
Howcouldheget the
oddsbackinhisfavor?
He was deep inthought,watching the baristainthebookstore’scoffeeshopefficiently waiting oncustomers.
Stock Trader wasthinking.
Besides the coffeeshop franchise, the storewasreally empty, customershaving migrated to online
booksellers for reviews andbetter pricing. A couple oftouches to his iPad and hewas looking at the chart forAmazon.com.
Charts courtesy of
FreeStockCharts.com
“I wonder if hotstocks in up trendswould bethe best underlying stock touseforoptionbets.”
Now that I know thedangers of selling lotterytickets, I wonder how I canget on the winning side ofbuying lottery tickets, withtheoddsslightlyinmyfavor.
“IbetbothAppleandAmazon made some optionbuyersbigwinnerswhentheybought out-of-the-moneyCalls, betting that the stockswouldnotrolloveranddieatthe 50-day or 200-daymoving average just becausethe market was in adowntrend. These weremarket leaders, companieswith growing earningsdominatingtheirsectors;theycame backwith a furywhen
the market as a wholereturned to an uptrend,” hethought.
“It is timetosendoutthe signal and call the BatPhone.”
Stock Trader gothome,andasalways,wenttohisdesignatedcomputerspot.He was lucky. Optionz wasonline.
Stock Trader: You may
need to go to SocialNetworkersAnonymous.
Optionz Traderz: Lookwho’s talking, ‘Mr. SocialNetworking at Midnight’himself.
StockTrader:LOL.
Optionz Traderz: What areyouuptotoday?
StockTrader:Ijustgotbackfrom the book store ghost
town.
Optionz Traderz:Tumbleweedsintheaisles?
Stock Trader: Yep, but inthecoffeeshopIwaslookingatafewchartsofmyfavoritestocks, AAPL and AMZN,and wondered what the bestway to buy lottery tickets onthem would be. With thedangers of selling out-of-the-money options in mind, IwonderedhowIcouldflipthe
odds more in my favor if Ibought them. I spend a littleandthesellerrisksalot.Ilikethe risk/reward ratio, just notthe odds. What are yourthoughts?
Optionz Traderz: You justnever stop, do you?You arelike an option vampire,alwaysthirstyformore.LOL.That'sO.K.,though,metoo.
O.K., if you want to buy anout-of-the-money option I
would follow a fewprinciples:
1. The underlying pricenormally remainswithina range of one standarddeviation about two-thirds of the time. Aquickway of estimatingthis range is to look atthestrikepricesofCallswith aDelta near 0.8 or0.2.Anyoptionsoutsideof this range representa
stock price that isoutside of the market’sconsensus of what thatprice will be at theexpiration of thecontract; they truly are‘lottery tickets.’ Whenyou buy a lottery ticket,youareacontrarian,youare betting against theodds. It's O.K. to betagainsttheodds,butyouneedagoodreasontodoso.
2.Donotgo too faroutin price; ideally youwant a price that thestockhasbeentobefore,the all-time high for aCall or the last majorsupport level for a Put.That gives you betterodds of the stockactually getting backthere.
3.Give yourself enoughtime. You may need to
spendtheextramoneytogo at least threemonthsout; the odds are muchbetter foryou ifyougetmore than 60 tradingdays to be right insteadof just 20. The fartherout you go, the morerandompricesbecomeinthefuture,andthebettervalue you get for thetime value of youroptionon the ‘buy’ sidebecause of this
uncertainty.
4. You need to buy theoptions on a stock thathasthepotentialtomakethe big move and getwhereyouarebettingonit going. Of course, theprice premium will behigher if it is volatile;butyouneedastockthathas the potential tomove, not an old tiredblue chip that has its
pricemove as if itweretrudging through mud.Youdon’tneedtoavoidlow-volatility stocksentirely,but the chancesfor a big win are muchbetter with companiesthat have a potential forexplosive earningsgrowth.
StockTrader:Soanoldall-timehighmaybeagoodCalloption tobuywhen thestock
is down at a support level,and an old supportmay be agood place for a Naked Putwhen a stock is at all-timehighs?
Optionz Traderz:Yes, out-of-the-moneyoptionsarebestplayed by being a swingtraderoracontrarian. I thinkit is much more difficult tobetonanewall-timehighorlow, places where the stockpricehasneverbeenbeforeor
at least not in a long time.Investorshavememories,andold levels cause exits andentries from the currentholders of the stock and alsofrom the traders waiting onthesideline.Manytimes,newpricelevelscreatewholenewpatterns that are hard topredict.
StockTrader:O.K.,sorightnowAppleisat$422.Wouldit be a good play to sell a
December$385Put? That isvery close to the 50-daymovingaverageandtheDeltais0.25?
Optionz Traderz: HowmanytimeshasAAPLhitthe50-daymovingaverageinthepastthreemonths?
Stock Trader: Let melook…four times. That lookslikeagoodbet!
OptionzTraderz:Holdyour
horses! What was thedifferenceinthepricelevelofthe50-dayfromthreemonthsagountiltoday?
Stock Trader: The 50-daywas at $338 in July when ittouchedthatlevel,anditwasat $380 in October, the lasttime it bounced mostrecently.
Optionz Traderz: It is amovingtargetwhenthestockis in suchanuptrend.By the
time it touches again, itmaybe at $410; that is what thechartistellingyou.
Stock Trader: Well, thatseemsveryobvious,nowthatyoupointeditout.
Optionz Traderz: If youwere trading the shares, howwouldyoutradethem?
StockTrader:Well,Iwouldbuy them as they eitherbounced at the 50-day
moving average or wentunderitandretookit.Iwouldsell after they broke out andfound support at a newpricelevel, which would likely beatthebreakoutpoint.
OptionzTraderz: Then thatis probably your best optionplay.YousellaCoveredCallwith a strike at the likelybreakout point, when thestockfindssupportat the50-daymovingaverage.
StockTrader: I was hopingto find some way to buyoptions instead of sellingthem andwithout needing topurchase the underlyingshares.
Optionz Traderz: Well, Iwas going to suggest youmight try selling aPut at the50-day moving average andalso a Call at the currentresistancelevel,butifyouareinterested exclusively in
buying options, I think I canhelp.
StockTrader:I’mlistening.
Optionz Traderz: O.K.. Itwould probably be easier tofocus your trade on the all-time high instead of the 50-day moving average. Thehigh is not a moving targetlike the moving average is.BuyingCalls at a strike nearthe all-time high would beone strategy. They are far
enoughout-of-the-moneythatthepremiumsare reasonable,but they are at a strike pricethat the stock has proven ithas the ability to achieve.You may lose on a few ofthese trades, but when thestock breaks out after anearnings announcement or inthe run up to the earnings,youcouldmakeahugereturnonyourcapitalatrisk.Wearetalking 100%-400% or morereturns on out-of-the-money
Callsin3months,withoneofthosewild$75runslikeithasmadeinthepast.
Penny Pumper: Hey,Optionz Traderz and StockTrader, 100% is not enoughof a return! I can help youfind the Holy Grail. Justcheck out EXTO. I read aclosely guarded report thisafternoonwhichindicatesthatsomesourcesaresayingtherewillbeahugeannouncement
tomorrowmorning thatcouldsendthisstockupover800%.Butifyouwanttogetin,youshould consider doing itearly, before the big-timetraders scoop up theremainingshares.
Stock Trader andOptionz Traderzsimultaneously pushed theblock button for PennyPumper and then bothwonderedwhy theydidn’tdo
so sooner; but neither oneknewtheotherhaddoneso.
Stock Trader:But if Appledoesn’tbreakout,Iloseitall.
Optionz Traderz: Notnecessarily. If you weretrading three-month-outoptionsandamonthwentbywithout anypricemovement,you would have alternatives.If you remained confidentabout a breakout and theoptions were liquid enough,
you could roll them to thefollowing month and mightbeable tokeep50%ormoreofyourcapitalintact,aslongas the stock had not movedwildlyagainstyou.Duetotheacceleration of time decay,rolling during the last monthbefore expiration would costyou much more, but youcouldstillbenefitnicelyifthebreakoutfinallyhappened.
Stock Trader: So I would
stillhaveachancetoprofitifthestockdidbreakout,but Iwouldbebuyingmyselfmoretimeforthattooccur?
OptionzTraderz:Yes,anditworks the same way whenyou end up with a winner.Sometimes, if it is the ‘bigwin’ and it is in-the-money,you may want to let it runinto the final month andcapturesomehugeDelta thatwill easily pay for the lost
Theta.
StockTrader:But wouldn’tI be giving up a lot of mypotential profit by allowingTheta to take away some ofthevalue?
Optionz Traderz: LOL,slow down; you’re learningfaster than I can type! I wasjustgettingtothat.Whenyoubuyoptions,itislikeyouarebuying insurance. If you buyautomobile insuranceand the
car subsequently gets totaledin an accident, there is littlereasontocontinuepayingthepremium. You take yourpayment from the insurancecompanyandyoumoveon.
StockTrader:Sooptionsarelikeinsurancepolicies?
Optionz Traderz: You’vegotitexactly.Everybuyerofan option is purchasinginsurance; that’s one reasonwhy the price is called a
premium. Every optionprovides two types ofprotection, one against risingpricesandoneagainstfallingprices.
Stock Trader: Wait, howcould buying a Call protectmefromfallingprices?
Optionz Traderz:Technically, it wouldn’t, butI’mcomparingoptiontradingto stock trading. If you arebuyingCalls,itismostlikely
becauseyouareattemptingtouse options as a replacementfor buying stocks. Socompared to buying stocks,Calls give you insuranceagainst rising prices as wellas fallingprices.Calloptionsdo provide a limiteddownside in that the risk isonly in the price of thecontract, not the full price ofthe100sharesofstock.
Stock Trader: So how do I
know when to cancel thepolicy?
Optionz Traderz: Youcancel itwhenit isnolongernecessary, just like cancelingyourautoinsurancepolicy.Ifyouaredrivingabeat-upoldtruck, there is no reason tokeep paying premiums on apolicy that protects againsttheft.Atsomepointyouneedto accept that all thosepremiums you paid over the
years were wasted; you gotpeaceofmind,butyourtruckwas never stolen. When youfind yourself driving a truckthat nobody in their rightmind would ever steal, it’stime to cancel the theftinsurance.
Stock Trader: O.K., this isgetting a little abstract, butyouranalogieshavenotfailedinthepast,sogoon.
Optionz Traderz: I’m glad
you likemyanalogies. I findthey are the best way tounderstand options. So, let’ssayyouboughtthoseCallsonApple at the all-time high,whenitwastradingatthe50-day average. Then, assumethe price fell through theaverageanddidnotretakeit.Nowyouaredrivingthebeatup old truck. The ‘insurancecompany,’ the Call seller,would love for you to keeppaying the premium for the
lengthofthecontract,buttheinsurance is no longernecessary.The riskyouwereinsuring against, thepossibility that the stockwould surpass its all-timehigh, would be almost non-existent. That is the time tocancel, either by selling theCallsorrollingthem.Ishouldpointoutthatitisnotalwaysnecessary to sell Calls thathave little chance of beingprofitable. It usually makes
sense to do so on a highpriced stock like Apple,wheresellingearlymightcutyourlosssignificantly.Butonlow priced stocks with lowpriced options, it often isn’tworththeeffort.
Stock Trader: I see whatyou’resaying.Butwhataboutwhen the price rises and theoptionsgoin-the-money?
Optionz Traderz: Thatwould be the equivalent of
crashingyourtruck.
Stock Trader: Now I’mconfused. If I buy an out-of-the-money Call and theunderlyingpricesurpassesthestrike,isn’tthatagoodthing?
OptionzTraderz:Ifyoubuyan option and it goes in-the-money, the event for whichyou purchased the insuranceprotection has alreadyoccurred. That is the pointwhere you need to ask
yourself if the insurance isstill necessary. If youboughtthoseCallsonAppleand thestock broke through its all-time high, they would haveserved their purpose. At thattime you would need to re-evaluate the upside potentialoftheshareprice.Ifthestockhadhitresistance,thetruckistotaled; it’s time to take themoney and go buy a newvehicle. If the stockwas stillclimbing, youwould have to
ask yourself whether it wasworthwhile to continuepaying the premium. If theamount of time valueremaining on the Calls wassmall,itmightmakesensetokeep the trade open. But ifthere was a large amount oftimevalueremaining,itcouldmakemore sense to just sellthe Calls and buy theunderlyingshares.
Stock Trader: That makes
perfect sense. Why keeppaying the premium if myindications were that thestockwasheadedup?Icoulddo much better by simplybuyingtheshares.
Optionz Traderz: Exactly.And it works the same waywith Puts. Say you bought astockandalsopurchasedout-of-the-money Puts asprotection. Once the stockfalls through the strike price,
thetradecanonlylosemoneyovertime,aslongasthestocknever rises above that price.At that moment, you wouldeither believe the stock wason itswaybackup, inwhichcasethePutswouldnolongerbenecessary,orthestockwasnot going to retake the levelof the strike price, in whichcase the entire trade shouldprobablybeclosed.
Stock Trader: So I guess
that’s why early exercisedoesn’t make sense. If Ibought a Put for protectionand it went in-the-money, Iwould lose all of theremaining time value if Ichose to exercise it early.And if I held on throughexpiration, I would also loseall of the remaining timevalue.However, if I sold thePutandtheunderlyingsharesas soon as the Put went in-the-money, I would cut my
loss by the amount of timevalueremaining.
Optionz Traderz: Younaileditagain!Earlyexercisealmost never makes sense;theonly reasons todo soareusually associated withcapturingdividendsortoalterthe tax liability. When youbuy anoption and it endsupin-the-money, you need toask yourself, “Would Iexercisethisoptionearly?”If
theanswerisno,youneedtoimmediately considerwhether it makes sense tokeep that trade open. If youbought those Calls on Appleand the shares suddenly hittheirall-timehigh,wouldyouexercisethemearly?
StockTrader:Ofcoursenot,becauseIwouldbelosingallof the remaining time value;and because I had picked awinner,Iwouldbehopingto
letitrun.
Optionz Traderz: But if itreally was a winner and youdid let it run, it wouldperformexactlythesameasifyouhadexerciseditearly.
Stock Trader: I neverthoughtofitthatwaybefore.Whenthestrikepriceishitonanout-of-the-moneyCallthatI own, it really is like a caraccident. The only reason tokeep the Call as insurance
against further upsidemovementisiftheremainingtime premium is low enoughto justify the downsideprotection.
OptionzTraderz:Wheneveryou own an option that endsupin-the-money,youneedtore-evaluate the position sothatyoucanletyourwinnersreach their fullpotential.Thesame concept applies whenyou own an option that ends
up losing money. At somepoint, the cost of theinsurance will often beunjustifiable for the amountofprotectionitprovides.Thatis the time to cancel it, andthat is the basis of allsuccessful trading: increasingyour profits and decreasingyourlosses.
StockTrader:Hmm, lettingwinnersrunandcuttinglosersshortthatsoundsfamiliar.
OptionzTraderz:Tradingistrading,inallitsforms;somerules are universal. And youshould keep an open mindabout selling options as wellasbuying.BuyingCallsattheall-time high onApplewhenthestockishotcouldbeveryprofitable, but that trade isbased only on that particularstockandchart.Withastockin a nasty downtrend, youmay have to reverse it andsell Puts at the all-time low,
whenthestockralliesandhitsresistance at the 50-daymovingaverage.
StockTrader: I reallyneverthought of trading optionslike this. Another interestingsystem for me to thinkabout…
Optionz Traderz: Youshouldn’t limit yourself tojust one strategy. BuyingCallscanworkverywellinabull market, and so can the
selling of Puts. Naked Putsare just another way to putthe odds in your favor – betthat a hot stock is not deadandwill rise again to an all-time high.When you get therare opportunity that one ofthesemonster stocksgoesallthe way to the 200-daymoving average, after thePuts you sold caused you tobuyinattheall-timelow,youcouldmakeakilling.
StockTrader:Aslongasthemarket stays in an overallbullishtrendandthesestocksstayasleaders, thesesystemswillwork.
Optionz Traderz: That istrue.Thesesystemsworkbestinbullmarkets,andthereareotheroptionssystemsthataretailored for every other typeofmarket.
Rookie Trader: If there areoptions systems for every
type of market, that truly istheHolyGrail.
Optionz Traderz:ATTENTION, RookieTrader. This is not the HolyGrail!
RookieTrader:Darn.
OptionzTraderz: I say it isnot the Holy Grail becausethere are hidden risks forevery one of those systems.For example, if you are
buying out-of-the-moneyCalls in a bull market, youshouldkeepinmindthatCalloptions usually becomecheaper as stocks begin totrend upward. As feardissipates from the market,Implied Volatility decreases.The decrease in volatilitycauses all options to losesome of their time value,sometimes to such a degreethat it overshadows theincreasing probability that
theywill end up expiring in-the-money.Whenyoubuyfarout-of-the-money Calls, youneed to be prepared foroccasions when theunderlying price increasessignificantly while thepremium on those optionsactuallydecreases.
StockTrader:SoIguessifIbuyout-of-the-moneyCalls,Ishouldbe looking for returnsonly in intrinsic value,
because Theta and Vega areboth working to take awaymuchoftheirtimevalue.
Optionz Traderz: Correct.The reason that out-of-the-money options are relativelycheap is that they expireworthless most of the time.Even when a trend doesmaterialize, it often takes somuchtimefortheunderlyingto reach the strike price thatTheta removes much of the
time value. When you buyoptions, try to think of thepremiumasthecostofdoingbusiness; whatever amountyou spend will probably betotally lost to Theta andVega. The only money youwill make will likely be inintrinsicvalue.
Stock Trader: That is aninterestingwaytothinkaboutit. Buying out-of-the-moneyoptions really is like buying
lottery tickets; even if I winthe lottery, the seller gets tokeep the original cost of theticket.
Optionz Traderz: Again,that is another reason for theperception that sellers havean advantage over buyers.Even when everything goesright for the buyer, the sellerusuallykeepsmost, if not alloftheoriginalpremium.
Stock Trader: Your
negativity is starting tomakemefeeldepressedagain.
Optionz Traderz: Asalways, I’m being negativefor a reason. You mustunderstand the risks involvedbefore you enter any optiontrade. If you understand therisks, you are much morelikely to be able to protectyourself. Also, when youunderstand the risks youwillbelesslikelytobeinfluenced
by emotion. When a tradedoesnotperformasexpected,itisoftentemptingtocloseitand take the loss. But if youknow what to expectbeforehand, your decision ofwhether or not to close atrade will be based on yourprovensystem,notemotion.
Stock Trader: Point taken.Are there any other risks toconsider?
OptionzTraderz:Well,you
needtoalwaysrememberthatthe options market is moreefficient than the stockmarket. Stock prices onlytake into account theinformation available totradersatasinglemoment intime. Options prices aredetermined not only byinformation that is currentlyavailable, but by historicalinformation, as well aspredictionsabout informationthat will be available in the
future.
Stock Trader: O.K., I’mwithyousofar.
OptionzTraderz:Just as anexample, if you were to buyshares of Apple prior to anexpected announcementregarding sales of its latestiPhone, theywould likely bepricedatalevelthatreflectedthe sales estimates ofanalysts. When analystspredict favorable sales, there
is often a run up in pricebefore theannouncementandoccasionally a sell-offafterwards, even when acompany meets or exceedstheestimates.
Stock Trader: Yes, I haveseen theold ‘Buy the rumor;Sell the news’ effect onstocks. What effect wouldtherebeonoptions?
Optionz Traderz: Optionpremiums are based almost
entirely on time andvolatility. Normally, thatvolatility is a reflection of afear that theunderlyingpricewill fall over time. Butannouncements of sales,earnings,ornewproductscancause a different kind ofvolatility, a ‘fear’ of risingprices.SellersofNakedCallsarevulnerabletoahugerallyoccurring if a companyreports something thatexceeds the market’s
expectations.Asaresult,theydemand higher premiums ascompensation for the addedrisk.
Stock Trader: That makessense.SoifIamgoingtobuyCalls, I should check to seewhether there is anyupcomingnewsthatmightbeinflatingthepremiums.
Optionz Traderz: Exactly.When you trade stocks, it ispossible to profit using a
purely technical analysis ofindicators such as price,volume, and movingaverages.Butwhenyoutradeoptions, you need toremember that there are alsotraders who base their tradeson a fundamental analysis ofa company’s current valueandexpectedfutureearnings.Option premiums reflect thecombinationofbothmethodsoftrading.
StockTrader:Iwouldneverhave thought of that. If Iboughtanoptionbasedonmytechnical analysis alone, Iwould run the risk of thetrademovingunexpectedly ifI didnot pay attention to theway it might be affected byother traderswhowereusinga fundamental analysis. Iguess I’ll have to startlooking at the fundamentalsand payingmore attention tothe news if I am going to
convert my stock tradingsystemtooptions.
Optionz Traderz: That is agood idea when you arebuying options. When yousell options, you don’t reallyneed to do asmuch researchbecause the premium oneveryoptionreflectsallofthecombined sentiment of bothtechnical and fundamentaltraders;youalways receiveafair premium based on the
amountofriskyouaretaking.That’s not to say that buyersaren’talsopayingafairprice;they are. But buyers havefewer alternatives as far asmanaging the trade if itmovesunfavorably,andthoseunfavorable moves could becaused by fundamentaltraders.
StockTrader:Now you arestartingtomakemethinkthatbuying the out-of-the-money
‘lottery tickets’ is not such agoodidea.
Optionz Traderz: Theymightortheymightnot;italldepends on your tradingpersonality.Basically,itboilsdown to this. Option sellershave peace of mind whenthey open a trade becausethey are letting the marketpredict what is going tohappen. Sure, they might dosome analysis beforehand,
but once they open a tradethey know that they havereceived compensation thatwas calculated by themarket’s prediction of theunderlying price’s futuremovement.Then they can sitback and relax and simplyreacttothemarketbycuttingtheir losses when themarket’s prediction wasincorrect.Optionbuyersneedto be able to predict thefuture. When you buy an
option, especially one that isout-of-the-money, it is likeyouaresayingthatyouknowsomethingthemarketdoesn’t– and maybe you do. If youhave a proven system oftechnical trend trading thatworks for you, there’s noreason you can’t apply thatpredictive power to a systemof buying options. You justneedtobecarefulyouarenotignoring those hidden risks Idescribed that might not be
uncovered by a purelytechnicalanalysis.
Stock Trader: That makesmefeelalittlebetter.Iguessitwouldn’t hurt to do a littlebit of extra research after Ihad found a trade that mysystemwas predictingwouldbeprofitable.
OptionzTraderz:You can’tout-wit the options market;themarketwillalmostalwayswin. But there are ways to
make money with options ifyou take the time to informyourself of any hidden risks.Ifyouthinkyouhavefoundagood trade on apharmaceutical company,check for any expectedupcoming regulatory rulingsthat might be driving upImplied Volatility. Likewise,pendingresolutionoflawsuitssuch as those involvingpatents can have the sameeffect. With stocks, such
events usually get slowlybaked into the share price inthe days and weeks leadingup to the expectedannouncement.
With options, the anticipatednewsdoesnotgetbaked intopremiums in the samemanner. All options expiringafter a predictable event willhave premiumswhich reflectthe uncertainty surroundingthat event very soon after it
becomes public. The optionsmarket,becauseitdependsonpredicting the underlyingpriceatafuturedate,doesnothave the luxury of waitingaround.TheeventgetsbakedintoImpliedVolatilityalmostimmediately.
Stock Trader: So that isanother reason to choose theright timeframeformy trade.IfIwantedtobuyCallsonastock in September and the
company was releasing itsearningsreport inNovember,I would be taking on theaddedriskoftheeffectofthatreport if I chose theDecemberexpiration.
OptionzTraderz:Exactly.Ifyou had no other reason tokeep the trade open for thatlength of time, you wouldlikely find much moreattractive premiums on Callsexpiringbeforethereportwas
due.
StockTrader:AnythingelseIshouldwatchoutfor?
Optionz Traderz: There isalways the unpredictable, theBlack Swans, but you can’tdo anything about thoseexcept cut your losses whenyou are able to do so.However anything that hasuncertainty associatedwith itand also a predictabletimeframeisworthnoting.As
we already discussed,earnings, product releases,pending litigation resolution,regulatorydecisions,but alsoupcoming changes in acompany’s leadership andeven political elections andpending legislation cansometimeshaveaneffect.
StockTrader:That’salottothinkabout.
Optionz Traderz: In myopinion,itisnotnecessaryto
study all of these events indepth; theyareall just thingsto consider so you can avoidas many unwanted surprisesas possible. You wouldn’twant tobuyCalls, thenwakeup the day after an electionand be startled to find thatvolatility had evaporated andtaken a lot of their valuealong with it. But if youunderstood that risk goinginto the trade, it wouldn’tcauseyoutolosefaithinyour
system.
Stock Trader: Having faithin my system and feelingcomfortable trading it arevery important. I’m not yetsurewhetherIwouldbemorecomfortable selling optionsand generating income, orspending my money buyingoptions like lottery tickets,lookingforthebigwinners.
Optionz Traderz: Manytraders do both. And you
don’thavetolimityourselftojustbuyingorsellingCallsorPuts. There are manydifferent strategies you canuse that entail combinationsof options, like the StraddlesandStrangleswetalkedabouta while back. There are alsomany,manydifferenttypesofSpreads – everything fromVertical,Calendar, andRatioSpreads to Butterflies andCondors. But we’ll have towait for another time to
discuss those. The pizza IorderedjustgothereandI’mstarving.
Stock Trader: As always,thanks for the advice. Enjoyyourpizza.
StockTraderhadalotto think about. Options weresuch simple things, and yettrading themwas turning outto be utterly complex, notunlike stock trading. Still, heremained confident that
having found a method oftrend trading that allowedhim to conquer thecomplexities of the stockmarket, with help fromOptionz,hewouldbeable toconquertheoptionsmarket.
He now had Theta,Vega, Delta, and all of theother Greeks under his belt,and thatmade him feel a lotmore confident. He also hadCovered Calls, Naked Calls,
Puts, and out-of-the-money‘lottery ticket’ options in histool box, and knew how touse eachone.But therewereso many variables in themarket, and the tools he hadwere mostly designed to beused during very specificmarket conditions. Howwould he deal with range-bound markets, volatilemarkets,andthelike?
MaybeOptionzwould
have answers next time theytalked. Maybe those otherstrategies thatOptionz talkedabout, the Spreads,Butterflies, and Condors,wouldbe theadditional toolshe needed to trade in everymarket.
It was all just toomuch to digest for one day.The same could not be saidfor his stomach. The energydrink he had at the coffee
shop earlier in the day wasnot going to be enough tosustain him now. He neededsomerealfood,likethepizzaOptionz was probablyenjoying. In fact, a pizzasoundedlikeagoodidea.Hequickly tore some leftoverpizza coupons out fromunderneath a magnet on hisrefrigeratorandpickedupthephonetoorderonefordinner.
While hewaswaiting
for his pizza to be delivered,Stock Trader kept thinkingaboutoptions.Itwasdifficultfor him to concentrate, beingso hungry. He felt hisstomach grumbling, but heknewhewouldsurvive.Afterall, the pizza shop hadpromised him that his orderwould be delivered in 30minutes.Theminutesseemedto tickbyeversoslowly.Helookedupat theclockonhismicrowave oven. “Just 10
minutestogo,”hethought.
Maybe it was thehunger, maybe it was thebarrage of analogies thatOptionz had thrown at him,but Stock Trader was nowthinking of his stomach interms of option trading. Heknew hewould not starve todeathinthenexttenminutes.He knew he would soon befull, probably overly-full,afterfinishingoffmorepizza
slices than he should haveeaten. “Ifmy stomachwas astock, it would have foundsupport at the 200-dayaverage and would soon beheadedforall-timehighs,”hethought. “This would be thetime to buy an out-of-the-money Call.” As StockTrader was getting deeperand deeper into thought, thedoorbell rang and broughthimbacktoreality.
“Thepizza!”
“Your total comes to$26.50.”
“O.K., keep thechange.Thanks.Haveagoodnight.”
“$30forapizza?NowI literally am out-of-the-money,” he chuckled outloud.
Chapter10TRENDS
DETERMINEWHOWINS:STRANGLES
ANDSTRADDLES
StockTraderwokeupand glanced at quotes on hisphonebeforeevengettingoutofbed.
TheDowwasupover400points.
“Wow,whatamove!”hethought.
Onceagainhewasonthe sidelines, due to thewildswings in the market and allthe doubt surrounding the
debtproblemsinEurope.
He figured that hecouldnotpredictwhatwouldhappenorevenfollowatrendwith all the uncertainty. Hefigured that the EuropeanUnion would do whatever ittook to avoid a systemicfinancial meltdown.However, anything couldhappen when that manycountries got together toagreeonwhattodo.
The stockmarketwasbeing held hostage bygovernmentdecisions,andhejustdidnotwanttobeonthewrong side. It was apparent,from the magnitude of themove, that the markets gotwhat they wanted overnightinEurope.
“I wish there was away forme to bet on a hugemovebothways,”hethought.
Thenhethoughtabout
the option strategy OptionzTraderzhadusedinthepast.
“Whatwasthatoptionplaywe talkedabout?Was itan option Stripper? No.Striker, Strangle, Straddle;yes, that was it! How did Iforget about that play? Ofcourse, the option strategiesof Strangles and Straddles.Crap!”
“Surely he didn’t usethatagainandwin,whileIsat
herelookingdumbandscaredincash.”
“I wonder if Optionzis online this early in themorning?”hesaidoutloud.
He checked theWinning Traders group onFacebook and found thatOptionz was indeed online,but he was engaged in aconversation with anothertrader. Stock Trader satquietly, watching a very
interesting discussion goingon in the group. He felt hewould be showing poormannersifheinterrupted.
Trend Trader: So you woneven thoughyouhadno ideawhichwayitwouldgo?Howintheworldisthatpossible?
OptionzTraderz: I betbothways.
TrendTrader: Sowere youbullishorbearish?
Optionz Traderz: I was‘trendish.’
TrendTrader:What?!
OptionzTraderz: I believedthenewsoutofEuropewouldcause a sharper thananticipatedmove oneway orthe other. So I bought bothCall and Put options, onestrike out, on theDow JonesIndustrial Average ETF(DIA).
Trend Trader: So didn’ttheyevenout?
OptionzTraders:The thingabout option contracts is thatthey capture the upside andlimit the downside.After the400-point rally, my Calloptions were worth far morethanmyPutoptionshadlost.
Trend Trader: Your Putoptionsstillhadvalue?
OptionzTraderz:Yes,even
though they are now far out-of-the-money, they are notworthless; with the highvolatility in the market theystill have some Theta value.InthepastIhaveevenleftthelosing option side open andthen been able to exit thatside when the market hadanotherstrongreversalmove,afewdayslater.
TrendTrader:Thatiscrazy,I have never heard of that
kind of trading. I focus ontrendidentificationandgoingin the direction of thepredominant trend inwhatever markets I amtrading.
Optionz Traderz: I profitfromoptions.Itradedifferentstrategies based on thecurrentmarketbehavior.
TrendTrader: So you haveoption strategies that allowyou to bet on a trend, not a
direction, just that there willbeatrend?
Optionz Traderz:Yes, theyare called Strangles andStraddles.
Trend Trader: That soundscomplicated.
Optionz Traderz: They arenot really that complicated.Strangles are formed whenyoubuybothaPutandaCallout-of-the-moneyonthesame
equity. A Straddle is createdwhenyoubuybothaCallandaPutat-the-money.Stranglesrequire lesscapitaloutlay, sothereislessriskoflossifyouare wrong. But you need astrong move to bring one ofthem deep enough in-the-money before expiration tomake enough profit to offsetthe cost. A Strangle canexpire 100%worthless whenneithersidemakesitinto-the-money. It can also have a
huge percent return on thecapital at risk by one sidegoingdeepinto-the-money.
TheStraddlecapturesthefullmove of the equity in-the-money. One of the optionswill be in-the-money almostinstantly and will always beworththeamountofthemovein intrinsic value. Also, theoddsare,afterastrongmovethe losing side will still beworth something. However,
althoughtheStraddlerequiresmore capital, it requires asmaller move than an optionStrangle to make enough onthe winner to pay for theloser.
Trend Trader: So duringthis European crisis, I couldhave structureda tradebasedon what I thought was thevelocity of the move eitherway?
OptionzTraderz:Youcould
have also picked whichtrading vehicle would be theone to move – a specificbank, sector, index, maybeeven gold – the one youthought would have beenmostimpacted.
Trend Trader: If I wasbetting on a 200-point DJIAswing, IcouldhaveboughtaStrangle using theETFDIA,out-of-the-money $2 bothways (equivalent to 200
points)andmadeaverygoodpercentagereturn.
Optionz Traderz: Not onlycan you capture that strongmovewithout prediction, butyouwouldown thecompleteupside from that point, withnoadditionalinvestmentuntiltheoptionsexpired.
Trend Trader: How doesthis work? It seems like thelosing side would even outtheprofitonthetrade.
Optionz Traderz: Straddlesare built to capture one sideofanestimatedmoveforasetperiod of time, for apremium.Theyare contracts,not investments, partownerships,orequities.Theyhave limited downside butunlimitedupside.
TrendTrader: Like built-instoplosses?
Optionz Traderz: Sort of.
Youpayabulltosellyouthedownside and a bear to sellyou the upside. Your profitscome when it becomesevident that one of them didnot charge you enough toparticipate in the trend whenit happens. They both tookthe risk of a bigger trendoccurring thanwhat theyhadanticipated.
TrendTrader: So profits inthis strategy come from
biggerthanexpectedtrends?
Optionz Traderz: Yes, likestock trading, sometimes thetrend happens and thenreverses so many times thatyouhave to takeyourprofitswhile you have them. Thevalue of the option reflectsthe probabilities of the valueoftheoptionatexpiration,sotheymay not go up asmuchas you expect because theoptionmay be pricing in the
chance that the trend mayreverse before the option isexercised.
Trend Trader: So whathappens if I bet on a 200-point move, and after theannouncementthereisonlya100-pointmove?
Optionz Traderz: You willlose in the short term. Afterthecatalystpasses,bothsidesof the option strategy losetime value, to reflect the
lower expectations ofvolatility.
Trend Trader: What if itdrops 500 points while I amintheoptionStrangle?
OptionzTraderz:Then youare in-the-money. I haveactually been in one beforewhen that happened andreturned 5% on my wholeaccount inonedaywithonly5% of total equity at risk.That was a 100% return on
myoptionsin24hours.
Trend Trader:Wow, thoseare amazing risk-adjustedreturns. In what other eventswould you use theStrangles/Straddles, besidesnationalcrisisnews?
OptionzTraderz:Onamorenormal basis, when entirenations are not discussingtheir solvency, they can beused for company earningsreports. Unexpected earnings
can spike a stock far morethan is anticipated whenafter-hours traders scrambletogetinorout.Emotionscandriveastockfartherthanwasanticipated when earningscause greed or fear to runwild.
Trend Trader: That is thetruth. There have beenmanymoves that are justunbelievable when a hotstock disappoints or when
everyone piles in after thecompany knocks the coveroff the ball in an earningsreport.
OptionzTraderz: Youwantanepiceventinthemarketorastock.Ifyoufindoutthatacompany has any upcomingnews event that maydetermineitsentirefutureonewayortheother,thatmaybethe time to put on aStrangleorStraddle,tocapitalizeona
trend that could be farstrongerthanisanticipated.
TrendTrader:What are therisks?
Optionz Traderz: There isalways the risk that themarket does not make thesharp move that youanticipated and the value ofvolatility built into theoptions collapses, or themarket only moves farenoughforyoutobreakeven.
Also, like I said, if you holdon and wait for a move thatnever comes, both sides ofyour Strangle expireworthless. Worse yet, youcould have a Straddle thatexpires right at-the-moneywhere you started – a totalloss.
TrendTrader:Howcanyouhelpmanagetheserisks?
OptionzTraderz:Whenyouare wrong, the best thing to
doisjustgetoutearlyandgolook for a new play. Neverhold until expiration unlessyou are just so deep out-of-the-money that the liquidityhas dried up in that contractandyouwouldlosetoomuchinthebid/askspreadtojustifyselling it. Also, sometimes abiggermove thanyouexpectmay be priced-in and theoptionsarejusttooexpensiveto be able to profit. This hashappened tomemany times.
When I buy Straddles, I amlooking for the under-estimation of the seriousnessof an event to move themarket.
Stock Trader did notwant to appear as if he wasrude, but his curiosity wasincreasing. The Dow hadsoaredmore than 400 pointsinoneday,amovethatcouldhave given him thousands ofdollars in profits. But his
trend trading system did notwork efficiently in volatilewhipsawing markets, so hewas on the sidelines,waitingforthemarkettosettledown.Meanwhile, Optionz seemedalmostas ifhewelcomed therecent volatility. It was timetogetsomeanswers.
Stock Trader: Sorry tointerrupt. You are a goodteacher. Did you pull offanotherLongStranglemoney
heist?
Optionz Traderz: Yes, Istarted building a positionwhen all the drama began inEurope. I bought when theoptionsweremoreaffordable,whenvolatilitywaslower.Asvolatility grew and the downtrend deepened, my optionsalsogrewinvalue,withbothincreasing Vega and my Putside going in-the-money. Iclosedoutmyfirstplay,then
openedupanewone,andlostwith the market being rangebound. My latest short termplay on the EU bailoutannouncement worked well,withthe400-pointpopinoneday.
Stock Trader: So what isyourStrangle/Straddlesystemwinrate?
Optionz Traderz: Onlyabout50%.
Stock Trader: Big wins,littlelosses?
Optionz Traderz: Exactly.My wins pay for my lossesandleavemeaprofit.
TrendTrader: So towin inanoptionStrangleorStraddleI have to be right about thetiming of the trend and thevelocity?
Optionz Traderz:Yes, theyareonlyfor timesofmassive
uncertainty, with outcomesthat have the potential tomove violently one way orthe other. You have toovercome the priced-involatility of the options towin.WhenyoubuyStraddlesor Strangles, you are bettingthat volatility will change.Either ImpliedVolatilitywillincrease significantly andstockswillsellofforImpliedVolatility will fallsignificantly and stocks will
surge.
Trend Trader: What aboutexits?
Optionz Traderz: Just likein trend trading, you mightwant to exit on a stop whenthe trend reverses, or youmighthaveatimeexit,whereyou exit after the eventcatalyst has passed and youpresume that the move hasalreadyhappened.
Stock Trader:What is truein stocks is also true inoptions. The only differenceis just a few more movingparts.
TrendTrader:Ineedtolookat some option chains andreallygetthefeelforhowthisworks. I think I have thebasicsnow.
Optionz Traderz: Good foryou.GladIcouldhelp.
Stock Trader: So how doyou decide when to use aStraddle and when to use aStrangle?
OptionzTraderz:Often, theoutcome of both strategies issimilar, especially on morevolatile stocks. If youconsider an at-the-moneyStraddleona stock,Deltaonbothoftheoptionswilllikelybe close to 0.5. That meansthat lowering the strike price
of thePut by$1 should saveyou about 50 cents inpremiums, while increasingthe strike of the Call by $1would do the same. Alltogetheryouwouldsave$1inpremiums, but be entitled to$1 less of any trend thatdeveloped.Inacaselikethat,I would choose the Strangleover the Straddle because Iwould have the samepotential profit with muchlesscapitalatrisk.
Stock Trader: That isinteresting. The Stranglewould cause me to miss outonthefirst$1ofthemoveinthe stock price, but wouldsave me $1 in premiumscomparedtotheStraddle.
Optionz Traderz: Exactly,sowhyputyourselfatriskoflosingtheadditionalpremiumif no move ever occurred?You would lose a lot moremoney on the Straddle, but
have nearly the same profitpotentialasaStrangle.
Stock Trader: So if I wentout$2inpriceonthestrikeofbothoptions,wouldn’t Isave$2inpremiumsandthenmissthe first $2 of any change inthestockprice?
Optionz Traderz: Notnecessarily.Thatmaybetrueon very volatile stocks, butthose with lower volatilityhave Deltas that drop off
considerably with strikeprices that are out-of-the-money. So it is possible thatmoving out both options by$2mightonlysaveyou$1.50orsoinpremiums.Onstockswith very low ImpliedVolatility, you might saveevenless.Butyouarecorrectwhen you are talking aboutStrangles on highly volatilestock.
Just as an example, Trend
TraderhadaskedmeaboutaStrangle on the DIA ETF.With the shares currentlytrading around $116, aStrangleconsistingofa$114Put and $118 Call withNovember expiration wouldhaveacombinedpremiumof$4.31andwouldpickupanymovement of the share pricein excess of $2.00.Meanwhile, a Straddleconsisting of a Call and Put,bothatthe$116strike,would
cost$6.17 andpickupeverypenny ofmovement in eitherdirection. So while theStraddle would have anadditional $2.00 gaincomparedtotheStrangle, theStraddle costs $1.86more toopen; you really aren’tgetting much added benefitfrom a Straddle versus aStrangle, but you are takingonalotofadditionalrisk.
StockTrader:So aStrangle
would be better on volatilestocks. What about lessvolatileones?
Optionz Traderz: That’s achoice you need to makebasedonwhatyourindicatorsare telling you about themarket and how confidentyou are about thatinformation. Straddles arevery expensive, so it takes abigmove tooffset their cost.Strangles are less expensive,
but it actually takes a biggermove in the underlying priceto generate a profit thanwould be necessary with aStraddle.
Stock Trader: That seemsstrange.Iwouldhavethoughta Strangle would performbetter because of the lowerinitialoutlay.
Optionz Traderz: If youconsiderthat thepremiumonan at-the-money option is
equal to approximately 40%of one standard deviation ofthe underlying stock price,based on the amount of timeto expiration, then aStraddlewillgenerallycostyouabout80% of one standarddeviation. So the stock pricewouldneedtomove80%ofastandard deviation just to getto thebreakevenpoint.Thatmight seem like a lot, butstocks generally only staywithin such a tight range
aroundhalfofthetime.
If you compare that to aStrangle,withstrikes thatareout-of-the-moneybyhalfofastandard deviation, they willusually cost about half asmuch as those required forthe Straddle. Because theycost half as much, theircombined premiums areabout 40% of one standarddeviation. So the underlyingpriceneedstomove50%ofa
standard deviation just to getto the strike price, thenanother 40% of a standarddeviation to get to the breakeven point, which wouldlikely be near 90% of onestandard deviation – slightlymore than is required for aStraddle.
Stock Trader: So if I wasconfident that my technicalanalysis was pointing to astrongtrend,aStraddlewould
be a better choice because itwould have a better payout.But if I was less sure of atrend, I could cutmy risk inhalfifIchoseaStranglewithstrikes about half a standarddeviationout-of-the-money.
Optionz Traderz: That istrue. The profit from theStrangle would be slightlylower, butwith about half asmuch capital at risk. Asalways, you need to make
sure theoptionshaveenoughliquidityatthestrikesyouarechoosing.Stranglesaremuchmore vulnerable to liquidityissues thanStraddlesbecauseout-of-the-money optionsalmost always have largerbid/ask spreads, and you areexposed to that risk on bothlegsofthetrade.
Stock Trader: Good point.Anythingelsetoconsider?
OptionzTraderz:Well,you
don’tneedtoconfineyourselfto buying Straddles orStrangles; you can also sellthem.
Stock Trader: That seemsriskier than the Naked Putsweweretalkingabout.
Optionz Traderz:Yes, theydo have risks, but like everyoption strategy, the key ismanagingthatrisk.
StockTrader:Sohowwould
Imanage the risk on a shortStraddleorStrangle?
Optionz Traderz: The firstthing to do is to make sureyou are selling them at theright time, to give yourselfbetter odds. When themarkets are losing value andvolatility is rising quickly,Straddles and Strangles canbeveryrisky.Notonlywouldyou be risking a big loss onthePut side if thedowntrend
worsened, but ImpliedVolatilitywouldprobablyrisetoo, and that would likelyincrease your loss. ShortStraddles and Strangles bothhave a slightly bullish bias;many times they performbetterwhenprices are rising,due toVega causing them tolosesomeoftheirtimevalue.
Stock Trader: So whenpricesare starting to recover,but volatility is still high,
would that be a good time?I’dstillbegettingsomegoodpremiums, but if the uptrendcontinued and volatilitydeclined, I’d be able to cutanylossesontheCallsideofthe trade and take profits onthe Put side, becausevolatility would be workinginmyfavoronboth.
Optionz Traderz: Exactly.Bearmarkets,withincreasingvolatility, are usually more
dangerousforShortStraddlesand Strangles than bullmarkets. So once you havepicked a good time to openthetrade,thenextthingtodois to choose the right strikeprice.Youmight be temptedtosellaStrangle insteadofaStraddle because of a fear ofhaving one of the optionsimmediately being in-the-money.
Stock Trader: Yes, that is
probablywhatIwoulddo.
Optionz Traderz: It isdefinitely unnerving to haveshort option positions thathave intrinsicvalue, even forme, after all these years oftrading.ButIfinditisbesttoavoid letting that fearinfluence my trades. Thestrike prices should be basedon the probability of theentire trade being profitableand whether the premium
receivedisworththerisk.
StockTrader:That’sagoodpoint. I would be tempted tosell a Strangle with strikeprices so far out-of-the-money that there was nochance of either strike pricebeing hit. But the premiumsthat far out are usually tiny.ThehigherpremiumsIwouldgetonaStraddlemightmakeitabettertrade.
Optionz Traderz: Yes, like
wetalkedaboutearlier,someStraddles and Stranglesperform almost identically,especially on very volatilestocks. If the market wasvolatileenoughandtherewassufficient time to expiration,you might be able to collect$1morebysellingaStraddlethanyouwould receive for aStrangle with the strikesmovedoutby$1.Inthatcase,when you planned on sellingoptionsinsteadofbuying,the
Straddle could make moresense. If we use the DIAexample again, you couldcollect $1.86 more on aStraddlethana$2out-of-the-moneyStrangle.
Stock Trader: That makesperfect sense. I would beobligated for an additional$2.00 in intrinsicvaluewhenthe stock price moved, but Iwould receive an extra $1.86inpremiums.SoIwouldonly
betakingonanadditional14centsofriskbutIwouldhaveapotentialadditionalprofitof$1.86 if the ETF’s pricedidn’tmoveatall.
Optionz Traderz: Younailed it! Why leave thatextra money on the tablewhen it isn’t causing you totakeonmuchadditionalrisk?It’sallaboutriskandreward.If it makes sense to buy aStrangleinsteadofaStraddle
because the small amount ofadditional reward does notjustify the riskof a trendnotoccurring, then selling aStraddleinsteadofaStranglecould also make sense. Allyou need to do is weigh therisk against the reward anddecide whether the potentialincreased reward justifies theadditionalrisk.
Stock Trader: That isfascinating. A Straddle can
behave almost the same as aStranglewhen theunderlyingpricemoves,buttheprofitorloss is much different whentheprice remainsflat.So if Icombined the two, say bybuyingaStrangleandsellinga Straddle, wouldn’t thatguaranteethatIwouldmakeaprofitnomatterwhat?
OptionzTraderz:Holdonaminute; you’re learning toofast for me again There is
actually a name for thestrategy you described: anIron Butterfly. But like alloption strategies, it doesn’twinunderallconditions.TheStrangle that you are buyingwill always cost somewhatlessthantheStraddleyouareselling, a net credit trade.WheneveryoutradeStraddlesorStranglesandreceiveanetcredit,youarebettingagainsta trend. The opposite is alsotrue; when you pay a net
debit, you are betting on atrend. You receive a netcreditwhenyouopenanIronButterfly, but if either of theoptionsyousoldexpiredwithintrinsic value greater thanthatcredit,youwouldhavealoss. I’d be happy to explainButterflies to you in detail,but itwouldprobablybe lessconfusing if we got throughStraddlesandStranglesfirst.
Stock Trader: O.K., you’re
theteacher
Optionz Traderz: Whenchoosing strike prices for aStrangle, some traders preferbuyingaPutata strikepricenear a recent support leveland a Call at resistance. Thepremiums are much lowerwith these options being sofarout-of-the-money,sothereis much less capital at risk.The downside is that bothoptions will usually expire
worthless. But when they dopay off, the profits can behuge.
StockTrader:Andthesamewould go for selling aStrangle;aPutatsupportanda Call at resistance wouldprobably both expireworthlessmostofthetime.
Optionz Traderz: Yes,whetheryousellaStraddleora Strangle, you are bettingthatastockorthemarketasa
whole is range bound. Howwide that range is will bedetermined by the strikeprices of your options; thefurther out-of-the-money yougo,thewidertherange.Theremay actually be times, likewhen the Dow waswhipsawing violentlyrecently, that ImpliedVolatility increases toa levelthatmakesitpossibletosellaStraddle and still keep yourrange of profitability in
between support andresistance. Other times youmay have no choice but touseaStrangle,ifyourgoalisto include support andresistance levels within thatrange.
Stock Trader: I think Iunderstand now. BuyingStraddles or Strangles is a‘trendish’strategyandsellingthem is a range boundstrategy. The strike prices
determine how ‘trendish’ orrange bound I am predictingfuturepricestobe.
Optionz Traderz: Correct.So now that you understandwhen to use each strategy,you need to consider thetimeframe of the trade.Option combinations reactmuchmoreslowlytochangesin the underlying price thansingle options. For example,when you open a Straddle,
Deltaon theCall isnormallyclose to0.5andon thePut itis about -0.5; the position isinitially nearly Delta neutral.So even if the underlyingpricedidmove,thecombinedposition wouldn’t change invalue much due to Delta,unless the magnitude of themove was great enough. Inthe meantime, Theta wouldbe eating up some of thevalue.
StockTrader: I guesswe’reback to matching theexpirationdateoftheoptionswith theexpected timeframethat any prediction about astock’spricewouldbevalid.
Optionz Traderz: That isonewaytolookatit.Butyoudon’tneedtolimityourselftothat timeframe. As with alloption strategies, Straddlesand Strangles behave muchdifferentlydependingontheir
expiration date. A Straddlewith a nearmonth expirationwill be much more sensitiveto timedecay thanonea fewmonthsout,butitwillcapturemovesintheunderlyingpricemuchmoreclosely.Also, thenear term Straddle would bemuch less sensitive tochanges in volatility. Youneed to weigh the risksassociatedwitheach.
StockTrader:So if a stock
wasrangeboundandIsoldaStraddle one month out, Iwould benefit much morefromtimedecaythanifIusedoptions two or three monthsout,butIwouldbetakingonmore risk if the stock brokeout.
Optionz Traderz: That istrue, so you may want toadjust your position size tocompensatefortheadditionalrisk.
StockTrader:Goodpoint!IfI am making more profitsfrom faster time decay byselling options with shorterterms, I don’t need to sell asmanycontracts.
Optionz Traderz: You canalsousethefastertimedecayanother way. Let’s say younoticed that one of yourfavorite stocks normallyremained range bound foraboutthreemonthsaftereach
earnings announcement.Perhaps after theannouncementinOctoberyouwere looking to sell tenStrangles with Januaryexpirations. Let’s assumeeach Strangle would get you$2 per share in premiums.Also assume that theywouldlose about 10%of their timevalueinthefirstmonth,iftheunderlying price andvolatility remained stable.How much of a gain would
you have at the end of thefirstmonth?Asalways, thereare 100 shares in one optioncontract.
StockTrader:LOL,anothermathproblem.O.K.$2x10x100 = $2000. 10% of $2000is$200.SoIwouldonlyhavea gain of $200 after the firstmonth?
OptionzTraderz: Youaregetting better at math. Now
assume that the premium onthe November options wasapproximatelyhalfthatoftheJanuary options with thesamestrikeprices.HowmanyNovember Strangles wouldyou need to sell in order toearn$200byexpirationday?
Stock Trader: I think I cando this. EachStranglewouldhaveapremiumofabout$1;so $100 per contract. Thatmeans I could sell two
Strangleswith theNovemberexpiration and potentiallyhave the same $200 profitafter the first 30 days as if Ihad sold ten Strangles withtheJanuaryexpiration.
Optionz Traderz: Exactly.The good news is that if thestock remained range boundand the November optionsexpired worthless, you couldprobably still sell tenStrangles at that point with
theJanuaryexpirationandgetthe remaining $1,800 inpremiumsyouwereoriginallyseeking.
StockTrader:That is reallyinteresting. The profit wouldbethesame,butIwouldhavesubstantially decreased myriskduringthefirst30days.
Optionz Traderz: That’swhat trading is all about,seeking out the best profitswith the least amount of risk
possible.
StockTrader:SohowwouldyousuggestmanagingaShortStraddleorStrangleonce thetradeisopen?
Optionz Traderz: Just treateach leg of the trade as if itwere a singleNakedPut andNaked Call. Cut your losseson the losing side when youare able to do so, and takeyour profits on the winningside when your technical
indicators tell you that thetimeisright.JustaswithanyNaked option, you also havethe choice of rolling thelosing leg to a farther-outexpiration date and a smallernumberofcontractsoramorefavorablestrikeprice.
Stock Trader: I think I’mstartingtoseeathemehere.Itdoesn’tmatterwhatstrategyIam using; the basic rules arethesame.All Ineed todo to
succeed is choose thecorrectstrategy for the currentmarket conditions, increasemyprobability of a profit bychoosing the appropriatestrike prices, limit my lossesby selecting the bestexpirations, manage thetradeswith stop losses or byrolling, and take my profitsoff the table the sameway IwouldifIwastradingstocks.
Optionz Traderz: That is
thereistoit.Whenyoutradeoptions, thecurrentconditionof the market is always aconcern, but never a majorproblem.
Stock Trader: Professionaloption traders reallyhave thegoodlife.
OptionzTraderz:Itcanbeagood life, but it takes somework. My Long Straddle onDIA worked out very wellthisweek,butitcouldjustas
easily resulted in a big loss.Infact, itwassuchabigwinthat my girlfriend and I aregoingoutinmyCadillaclatertodaytocelebrate.
Stock Trader: So youcelebrate all of yourwinningtrades?
OptionzTraderz:Oh,bynomeans. Ihavewinning tradesall the time.But some tradestake a lot of work. I startedworking on my DIA options
tradeweeksagoandenduredsome initial losses. Thereweretimesthatitlookedasifit would be a total loss. Butmy system told me to stickwith it and I did, and theresultwasabigwin. I’mnotgoingouttocelebratethewinitself; I’m going out tocelebrate the success of thesystem.
Stock Trader: I know howyou feel. I like it when my
stocktradingsystemhasabigwin. It makes all of thepreviouslossestolerable.
Optionz Traderz: Yes,losses are part of thebusiness, and they arefrequent.Whenthehardworkfinally pays off and thesystem proves that it works,whynotcelebrate?
StockTrader:Iagree.Enjoyyour night out andcongratulations on a nice
trade…again.
OptionzTraderz:Thanks.
Chapter11THETWINS:
EVERYPOSITIONHASASYNTHETICRELATIVE
Stock Trader wassimply having fun learningfromOptionz online. He feltat times likehewasstudyinga foreign language. Stockoptions contained a lot ofmoving parts and could becombined for a dizzyingamountofdifferentstrategies.
Stock Traderpondered some of the thingshehadlearned.
“Option sellers could
make money from thedeterioration of an asset theysoldshort.”
“Traders could bet onatrendineitherdirection.”
“Traders could makemoneybettingtherewouldbenotrend.”
Catching the fullupside of a move with anautomatic limited downsidewas something he really
liked.
“Withoptions, traderscould be in control of hugeblocks of stock with littlemoneyinvested.”
“Stock trader couldusestockoptionsashedgesorinsurancepolicies.”
Stock Trader justcouldn’t get enough optiontalk.Hewent right back intothefray.
He signed on andwent to thegrouponline thatwas getting to be a regularhangoutforhim.
It appeared a newstudent was being schooled.“Thisshouldbeinterestingtowatch,”hethought.
Income Investor: I heardyouwerethegroup’sresidentguru on stock options. I sellCall options for income onmy investmentportfolio.The
strategyisnotworkingoutaswellasIhadhoped.
OptionzTraderz:Whydon’tyou just sell Naked Puts forincomeinstead?
Income Investor: I wouldneversellaNakedPut;thatisway toomuch risk. Itmakesmy stomach queasy justthinkingaboutit.
Optionz Traderz: Well, Ihave some news for you.
They are the same thing,technically.
Income Investor: What?That is crazy they arecompletelydifferent,CoveredCalls are for income andNakedPutsareawildgamblewithhugerisks.
OptionzTraderz:Howistherisk in aNaked Put differentfromaCoveredCall?
Income Investor: A stock
could crash and you wouldstillhaveitputonyouatasetpricemuch higher than whatit was worth currently at themarketprice.
Optionz Traderz: But youreceiveincomefortheNakedPut.
Income Investor: That is asmall fee for taking on therisk of a stock crashing andpossiblycausingmetobeleftholding the bag. This could
cause me to have to buy astockforwayoverthemarketvalue.
Optionz Traderz: How isthat different from CoveredCalls?
Income Investor: I alreadyownthestockonwhichIamwritingtheCall.Idonothavethe risk of having it put onme.
Optionz Traderz: That is
becauseyoualreadyputitonyourself.
Income Investor: It is aninvestment.
OptionzTraderz:Thenwhywould you not sell NakedPuts on stocks you wouldwanttoown,andiftheywereput on you, it would beinitiatinganinvestment?
Income Investor: I do notlike the idea of offering to
buyastockatasetprice.
Optionz Traderz: With aCoveredCallyouareofferingtoholdastockforasetpriceand risk the entire downside.Whatisthedifference?
Income Investor: I alreadyownthestock.
Optionz Traderz: Correct,you already own thedownside.
Income Investor: I own thedownside? I never reallythoughtofthat.
Optionz Traderz: In aCovered Call you get paid asmall fee to take on thedownward risk of the stockthat you own. In a Short Putyoucollectasmallfeetotakeon the downward risk of astock you must buy at thestrike in the future ifexercised.Itisthesametrade,
samerisk.
Income Investor: O.K., thatmakes my head spin. I can’tbelieve that a Covered Calloption has the same riskprofileasaNakedPut.
Optionz Traderz: Say youown Apple at $385 and yousell aCoveredCall option at$390 and collect $15. Youmake money from $370 andup in price. If you sell aNaked Put at $390 for $15
you make money from $370and up in price.Your risk isto the downside in bothstrategies. The difference isthatyoualreadyputAppleonyourself before you enteredthetradeontheCoveredCall,andintheNakedPutyouwillhaveitputonyoulater.
IncomeInvestor:Iamtakingon the same risk in both ofthesetrades?
Optionz Traderz: Exactly
the same risk; the onlydifference is whether you orthebrokeragefirmisexposedto the downside. I havediscussed this in the group afew times. It is one of thegreatestmisunderstandings inthe option world. The riskembedded in the CoveredCall, the infamous ‘stopgain,’isthesameasaNakedPut,tothetrader.IfyousellaNaked Put and someunforeseen event results in a
loss that is greater than theentire value of yourbrokerage account before amargin call can be executed,it is thebrokerwhoisonthehook.
Income Investor: I reallythought I was an informedinvestor, but that just blewmymind.
Optionz Traderz: Ininvesting and tradingfinancial markets, all we are
doing is trading risk. Eachinstrumenthasanupsideanda downside and generally anequal chance of the trademoving towards or againstour bet when we enter anyposition. The market’scurrentbehaviordeterminesifwewin or lose, not our owngenius.
Income Investor: What elsedo I not understand aboutoptions? I am a stock
investor,notanoptiontrader.
Optionz Traderz: Optionshavetwinsthathavethesameriskprofile.
Income Investor: Really?What isaLongCalloption’stwin?
OptionzTraderz:AMarriedPutisthesameasaLongCalloption. In aMarried Put yougetthefullupsideandprotectthe downside by paying a
small fee. In a Call optionyouget the full upsidewhilethe downside is protected bylimiting losses to the smallfeefortheoption.
Income Investor: Then whywould anyone use aMarriedPut and pay twocommissions?
Optionz Traderz: MarriedPutsareusedforashorttermhedge on a long termposition, sometimes to avoid
thetaxconsequencesofshortterm capital gains. Othertimes they may be used toprotect gains on a stock aninvestoralreadyowns.
IncomeInvestor: Sowhen Isold Covered Calls on thestocks in my portfolio I wasselling the upside of mystocks for the small fee andkeepingthedownsideriskformyself? Is that what you aresaying?
OptionzTraderz: Youwereessentially writing Puts, butthe stock had already beenput on you. Calling a stockfrom you or putting a stockonyouissimplyamanneroftime sequence; they are notdifferentprinciplesentirely.
Income Investor: So thatexplainswhyIlosesobadinbear markets, I have alreadyputthestockonmyself.Istillhavethelossesasifsomeone
had put it on me. I do notknow why I didn’t realizethis.
Stock Trader: Sorry forbutting in, but I'm curious.What other option parallelsexist? I can’t wrapmy brainaround what other optiontwinsareoutthere.
Optionz Traderz: Well, letme think. How aboutSynthetic Stock positions?Buying a Long Call and
selling a Short Put, both at-the-money, will give you aSynthetic Stock. It behavesthesameasifyouownedthestock itself and requires nocapital.Youget theupside ifit goes up due to your LongCall, and lose on thedownside with the Short Putifitgoesdown.Butyouhavelittle to no capital outlaybecausetheshortoptionpaysforthelongoption.
You can also create aSynthetic Short Stockposition, a Long Put andShort Call at-the-money, andit will give you the samereturns and losses as if youwereshortthestockitself.
StockTrader:Iseeyouplaywith options like they are aboxofbuildingblocks.
OptionzTraderz: Only theyaremorecolorfulandfun.
Income Investor: O.K., Ibelieve you guys have gonewayovermyhead.SyntheticStocktrading?Iamout.
Stock Trader: So you aresaying that there is a freetrade. By combining a ShortPut with a Long Call, youwill have a Synthetic Stockpositionthatcostsnothing?
Optionz Traderz: There isalways risk, and don’t forgetcommissions. Also liquidity
riskcanbecomeanissuewithlightlytradedoptionchainsorasyourwinnergoesdeep in-the-money.
Stock Trader: That may bethe coolest thing you havetalked about yet. It is likegoing to a build-a-bearworkshop and getting a freebear built just the way youwantit.
OptionzTraderz: Justmakesure it is not flammable – it
couldburnyourhousedown.
StockTrader:Well, I guessit may be a freebee positionbutaSyntheticStockhas thesame potential of loss as aregularstockwould.
Optionz Traderz: Yes,always remember positionsizing and the risk of ruin ifyouare tempted toplaywiththese building blocks. Tradethe same size as you wouldwith real stock and risk the
sameamountofcapitalbasedonyoursystem,probablylike1%-2% of total equity pertrade. There are also marginrequirements that can besignificantly higher thanthose required for stocks.When you open a SyntheticStock position, a portion ofyour account will be onmargin from the very start.That means you will bepaying interest on thatamount. Depending on the
movementof the stockprice,thatrequirementcanincrease,so it is a good idea to checkyour margin balance whenyoutradeoptions.
Stock Trader: You knowhowtothrowabucketofcoldwater on my head when theadrenal glands get pumpingandmygreedstartsgrowing.
Optionz Traderz: SyntheticStock is good for creatingextra tradeswithout tying up
any additional capital, but itdoes tie up some of yourmargin. And don’t ignoreliquidity. You need to watchthe bid and ask price closelywhen a Synthetic Stockposition has options that aredeep in-the-money and farout-of-the-money. Liquiditycan dry up quickly, and youwouldbe leftwith apositionthatyoucouldnotclose,evenifyouwantedtodoso.Sometradersuseasetlimit,suchas
$0.05 or $0.25, where theywill close the position whenthe bid price reaches thatlevel. Once the bid price ofthe out-of-the-money optiongoes beyond that, youwouldlikely be stuck with theposition until expiration day.Inapositionthatwentinyourfavor,you’dbevulnerable toagapdown that reversed thetrend and wiped out yourgains. Worse yet, in aposition that went against
you,youwouldhavenowaytocutyour losses if theshortoptions went so deep in-the-money that they lost theirliquidity.
Stock Trader: I really likethis idea. I could trade 100sharesofApplebutinsteadoftyingup$28,500totrade100shares I could sell an at-the-money Put contract for $15andthenbuyanat-the-moneyCall contract for $15.Then I
owntheupwardmovementinApple for the cost ofcommission.
Optionz Traderz: And thedownward risk. The Deltarules still apply. No matterwhat the price of the stock,DeltaontheCallminusDeltaon the Put will always equal1.IfthestockpricedropsandDeltaontheCallgoesto0.75thenDeltaon thePutwillbe–0.25.
Stock Trader: I hadn’tthoughtofthat.0.75–(–0.25)=1
Optionz Traderz: So youwill see a full reflection ofvalue at any given moment.Unlikemostoptionstrategies,you don’t need to wait untilexpiration to see the fullvalue because the Theta ispaid for. You sold Theta tobuyTheta,soSyntheticStockpositions do not experience
timedecay.
StockTrader: Selling Thetaand using it to buy Theta,clever. Now I have heard itall.
Optionz Traderz: Sorry todisappoint you, but youhaven’t heard it all yet.Understandingsyntheticswillopen up a whole new set oftoolsforyou.
Stock Trader: So there are
moresynthetics?
Optionz Traderz: Yes, Idon’t usually use formulas,but there isonlyoneformulathatyouneedtoremembertounderstand synthetics. Doyou remember when I gaveRookie Trader that optiontrade that was a guaranteedwinnereverytime?
Rookie Trader: Hey! Areyouguysmakingfunofme?
Optionz Traderz: I’m notmaking fun, but I am usingyourinexperiencetomakeanimportant point. You shouldpayattentionhere;youcouldlearnsomethingimportant.
Stock Trader: So, if Iremembercorrectly,thetradeyou gave him was to sell aCoveredCall and then buy aPutatthesamestrikeprice.
Optionz Traderz: Exactly.Buyingastock,thensellinga
CallandbuyingaPut,yieldsa trade that cannot win orlose. And that will give youthe formula for all syntheticpositions.Here it is:STOCK–CALL+PUT=0.
StockTrader:I’mnotsureIunderstand how to use thatformulathough.
Optionz Traderz: O.K., ittakes a little bit of algebra.Areyouupforsomemath?
StockTrader:LOL,herewego again with the mathproblems.O.K.,goahead.
OptionzTraderz:Well, justleave the equal signwhere itis. What happens if yousubtract a PUT from bothsides?
Stock Trader: Let’s see.STOCK – CALL + PUT –PUT=0–PUT
OptionzTraderz:Youreally
aren’t as bad atmath as youthink. Now consider the leftside of the equation for aminute;youhaveaLongPutand a Short Put, so theycanceleachotherout.Andonthe right side you havenothing, minus a Put, sothat’sjustaShortPut.
StockTrader:So I’dbe leftwith STOCK – CALL = –PUT
Optionz Traderz: You got
it!StockminusaCallequalsa Short Put; a Covered CallequalsaShortPut.
StockTrader:Ineverwouldhave thought of it that way.That’samazing.
Optionz Traderz: It doesn’tend there. If you take theoriginal equation and add aCall to both sides you get:STOCK + PUT = CALL. Ifyou do the math for everypossible combination, you
willendupwiththislist:
POSITION SYNTHETICPOSITION
STOCK = CALL–PUT(LongStock=ALongCall and a Short Put) –STOCK = – CALL +PUT (Short Stock = AShortCallandaLongPut)
CALL=STOCK+
PUT(ALongCall=LongStockandaLongPut)
– CALL = – STOCK –PUT (A Short Call =ShortStockandaShortPut)
PUT = CALL –STOCK (A Long Put = ALongCallandShortStock)
– PUT = – CALL +STOCK (A Short Put = A
ShortCallandLongStock)
StockTrader:Nowthatyouputitthatway,itseemsmuchsimpler.So,thereareonlysixsyntheticpositions?
Optionz Traderz: That’s it.Thosearethebasicsix.
Rookie Trader: I’m gladyou’renotmakingfunofme.I took your advice and wentto an options seminar at ahotel last weekend. I really
learned a lot. So I found theproblem with the CoveredCallsIwastrading;allIneedto do is buy Puts threemonths out, and then sellmonthly Covered Calls threetimestooffsetthepremium.
Optionz Traderz: Howmuchdidyoupaytogetintotheseminar?
RookieTrader:Itwas$150,butitwaswortheverypenny.Now I finally do have the
HolyGrail.
Optionz Traderz: I hate tobreak it to you, but it is notthe Holy Grail. If there wasone,withallofthetradersonEarth, somebodywould havefounditbynow.Icouldhavesaved you the $150. Wereyou paying attention to theformulas for syntheticpositions?
RookieTrader:Yes.
Optionz Traderz: What isthe synthetic position for aCoveredCall?
RookieTrader:AShortPut.
Optionz Traderz: So bysellinganearmonthCoveredCall, you were opening theequivalent of a Short Put. Ifyoucombinethatwiththefarmonth Long Put, you havethe equivalent of a CalendarPutSpread.
Stock Trader: What?There’s actually a name forthetradehedescribed?
Optionz Traderz: Yes,although the exact trade hedescribed doesn’t have anamethatIknowof,whathewould be doing is theequivalent of a CalendarSpread. When you buy anoption with one expirationandsellthesameoptionwitha different expiration, that’s
all there is to a CalendarSpread.Therearetimeswhensuch trades work well, butthey definitely are no HolyGrail.
RookieTrader:Rats!
Stock Trader: I think I’mstarting to see the value inlearningaboutsynthetics.
OptionzTraderz:Yes,manyof these seminars andexpensive black-box trading
systemsdonothingmorethantake simple trades and makethemlookoverlycomplicatedby substituting the positionswith their syntheticequivalents.
StockTrader: I guess that’ssomethingtowatchoutfor ifI see a trading system beingtoutedashavingsome‘secretformula’forsuccess.
OptionzTraderz:Definitely.In the past, I actually made
themistakeofbuyingoneofthose systems. It sounded sosophisticated that it certainlywould be worthwhile. Themethod involved searchingthemarketforstockswiththelowest correlation; when onestockgoesup, theothergoesdown. Once the stocks werechosen,allthatwasnecessarywas to sellCoveredCalls onbothstocks.
Stock Trader: That does
seemlike itwouldbeagoodsystem.Whatwentwrong?
Optionz Traderz: First,there are no stocks that havean exact 0% correlation, sothere were times when bothstocks lost value. Moreimportantly, though, whenone of them hit the strikepriceof theCall, thepriceofthe other was still dropping.Ifthepriceofthelosingstockfell beyond that point, by
more than the amount of thepremiums I received, I lost.The ShortCall causedme togiveupallofthegainsonthewinning stockwhile Iownedthe full downside of thelosingstock.
Stock Trader: So was thisone of those simple tradesthat theyhad justmademorecomplex in order to gettraders to purchase thesystem?
Optionz Traderz: Exactly.The two Covered Calls areequivalent to Naked Puts.And because of the lowcorrelation, one Put behavestheoppositeoftheother,soitis more like a Naked Call.Whenyouput themtogether,it is nothing more than aNaked Call and Put, a ShortStrangle. In fact, I probablywouldhavelostlesscapitalifI had just opened a ShortStrangleinstead.
StockTrader:That’sagoodpoint. These marketing guysreally know what they aredoing to make a profit forthemselves, not theircustomers.
Optionz Traderz: Younailed it. So whenever youare considering opening atrade,itishelpfultoconsiderthesyntheticequivalent.LikewetalkedaboutwithCoveredCalls, before you open one,
askyourselfifaNakedPutatthat strike price would makesense. Ifnot,whyopen it? Ifyou are thinking of buying astock and then using aMarried Put for protection,askyourselfifyouwouldstillopen the trade if you weresimplybuyingaLongCallatthatstrikeprice.
Stock Trader: Now you’vegivenme something to thinkabout. When I own a stock
that has done well, Isometimes buy a Put insteadofusingastoplossifaPutisinexpensive enough, at astrike thatwill getmeout ofthetradewithaprofit.ButifIconsider that buying a Put isthe same as selling the stockand buying a Call, I’dprobablyneverbuyaCallatastrikethatdeepin-the-money.
Optionz Traderz: Asalways, understanding
options is all aboutunderstandingrisk.Youdon’tneed to trade synthetics inorderforthemtohelpyou.Inthe trade you described, Idon’tthinkeitherofuswouldchoose to sell the stock andbuy a deep in-the-moneyCall; the additionalcommissions involved wouldeat up a lot more of theprofitsthanbuyingaPut.Butthinking about the equivalentsyntheticpositionmightmake
you reconsider the risks ofkeepingthetradeopen.
Stock Trader: Any otherthoughts?
OptionzTraderz:Well, as Iwas telling Rookie Trader,just because a trade looksgood on paper doesn’t meanit is. When you think aboutsynthetics, it may help youdecide if the trade you areplanning is correct for thecurrent market conditions.
Some complex trades aredifficult to study; thinkingofthem in simpler terms maymakeiteasier.
Stock Trader: That is true.Rookie’s trade soundedO.K.until you let the air out of itby saying it was just aCalendarSpreadindisguise.
OptionzTraderz:The goodnews is that there areconditions when his tradewould be an appropriate
choice. Even though hisposition was nothing morethan a synthetic version of aCalendar Spread, it wouldworkwellonastockthatwasgoing through someconsolidationinitsprice.
Stock Trader: That’sinteresting. I never wouldhave thought to trade twooptions with differentexpirationdates.
OptionzTraderz:Andthat’s
just one of many ‘Spread’strategies.Thereareplentyofthemtochoosefrom.
Stock Trader: So Rookie’scomments have opened up awhole new toolbox? Now Ireallyhavehearditall.
Optionz Traderz: Oh, weare just getting started in thewonderfulworldofoptions.Iwill let you mentally digestthat until next time. Optionzout.
Stock Trader got upfor an energy drink, but satbackdownat thecomputeraminute later. Optionz wasright;hereallydidhavea lottodigest.Everyoptionhadatwin. Every option, and evenstock positions, could becreatedsynthetically.
To top it all off, justwhenhewasthinkinghewasgetting to know all of theoption strategies he would
need, Optionz goes and saysthat there are many Spreadstrategiestolearn.
Whatwerethey?
He needed to lookthemup.
He did a Googlesearch and quickly found alink to a site that listed awhole host of optionstrategies.
Sure enough, therewastheCalendarSpreadtheyhad talkedabout.Therewerealso Vertical Spreads, RatioSpreads, Butterfly Spreads,and Condors. A Strip and aStrap; what the heck couldthatbe?Guts?Ladder?
“Wow, he was right.We truly are just gettingstarted,”hethought.
Stock Trader waslooking through all of the
strategies when somethingcaught his eye – anadvertisement for a creditcardwithbonusairlinemiles.He suddenly realized that hehad been so busy talking toOptionz over the past monththathehadforgotten tobookthe airline ticket for hisvacation. “Crap. I only getone two-week vacation ayear,” he said out loud. “Ihopetheyaren’tsoldout.”
“Withonlytendaystogo until my vacation starts,evenifIcanfindtickets,theywill be overpriced,” hethought.
Sure enough, therewere still tickets available,but at much higher pricesthanhewouldhavepaidifhehad booked the flight weeksago. “$1,000 for the roundtrip; I guess I don’t have achoice,”he thought. “It’s too
late to get a refund on thehotel room.” He clicked the‘buy’ button, finished hisenergy drink, andwas off todosomeerrands.
Chapter12SPREADS:RATIO,
CALENDAR,DIAGONAL
No alarm this
morning.StockTraderlookedat his cell phone. It was 8
a.m.andhefeltrested.
His morning ritualwas to get quotes on hisphonebeforeheevengotoutof bed, but there were noquotes on Saturdays. It hadbeen an exciting and fast-paced week in the financialmarkets. He had taken shortpositions and done verywellas the market trended lower.Itwasnothisfavoritewaytomake money, but he would
takeit.
Now,with themarketwell beneath its 200-daymovingaverageandeventhebest of stocks at or belowtheir own 200-day movingaverages, the marketappearedtobeperchedontheedge of a cliff ready to rollover into the abyss. Wherewouldthenextsupportforthemarket be, the 350-daymoving average? Would it
fallallthewaytothe600-daymoving average? It waslookingbleak.
He was sure Optionzprobably had on some low-risk high-probability trade hehad built. Learning thesenewest synthetic and Spreadstrategies made him think ofOptionz in a laboratory, likeDr. Frankenstein bringing amonsteralive.
He needed more
option knowledge if he wasgoing tobe able to transitionintooption tradingorat leastdabble in it when stocktrading just wasn’t diverseenough to take on the morecomplicated bets he saw anopportunitytomake.
Would Optionz beconducting class on aSaturdaymorning?
Again Optionz wasonline, and again he was
engaged in a conversationwith Rookie. “I wonder howlong itwillbebeforeRookiementions another HolyGrail?”hethoughttohimself.
Rookie Trader: So aVertical Put Spread is muchsafer?
Optionz Traderz: Yes,CoveredCalls expose you tothe entire downsidemovement of the underlyingstock price; a Vertical Put
Spread only exposes you tothe difference in the strikeprices.
Rookie Trader: So if IwantedtosellaCoveredCallon Caterpillar, I would bebetter off selling a PutSpread?
Optionz Traderz: Notnecessarily better off. Eachstrategyhasitsownrisksandpotential rewards. All I’msuggesting is that a Put
Spread has much less risk.Forexample,withCaterpillartradingat$94,sayyoucouldsellaPutatthe$92.50strikefor$5.90andbuyaPutatthe$90 strike for $4.90.On onecontract of 100 shares, youwouldcollect$1.00pershare,or$100.Aslongas thepricestayed above $92.50 atexpiration, you would keepthe $100, and as long as itstayed above $91.50, youwouldhaveaprofit.
Rookie Trader:Wouldn’t Ilosemoney if the pricewentbelow$91.50?
Optionz Traderz: Yes, youwould, but your loss wouldbe limited by the Long Put.Once the price fell below$90, the Put you bought atthat strikewould pick up theentiremoveinintrinsicvalue.So if that happened, theincrease in intrinsic value oftheLongPutwouldoffsetthe
increase in intrinsic value ofthe Short Put. If the pricestayed below $90 atexpiration, you would buy100 shares of Caterpillar at$92.50andsell100sharesfor$90. You would lose $250,but get to keep the $100credityoureceivedwhenyouopenedthetrade.
Rookie Trader: I see. Themaximum amount I couldlose would be $150. That
reallydoesseembetterthanaCoveredCall.
OptionzTraderz:Iwouldn’tsay it’sbetter, just less risky.If you sold a single CoveredCall at the $90 strike for$8.90, you would collect$890 in premiums, but youwould own the entiredownside risk below $90,with only the premiums youreceivedtooffsetyourloss.
Rookie Trader: So I guess
Vertical Spreads aren’t theHoly Grail either. I couldmake a lot more moneyselling a Covered Call, but Icould lose a lot more thansellingaPutSpread.
StockTrader:2minutesand10 seconds. I think thatmaybeanewrecordforthetimeittook to mention the HolyGrail.
OptionzTraderz:LOL,youweretiminghim?
Stock Trader: Yes, but itlooks like you’re makingprogress in getting him tounderstand a little bit abouthowalloptionsinvolverisk.
Rookie Trader: The two ofyoureallyshouldgetaroom,the way you always gettogether to gang up on me.But thanks for the help withVerticalSpreads.
Optionz Traderz: You are
welcome.However, there aremore Spreads than justVerticals.
StockTrader:That’swhat Iwanted to ask you about.After we talked last time, Ilooked up option Spreadstrategies and there are a lotofthem.
Optionz Traderz: It mightseem like a lot, butmany ofthem have similar behaviorsso it isn’t necessary to
memorize each one. Onceyou learn the basic Spreadstrategies,youwilllikelyalsounderstandthemorecomplexones. Most complex Spreadsare nothing more thanmodifications of basicSpreads.
Stock Trader: So whatSpreads should I concentrateonstudying?
OptionzTraderz:Well, firstthere are three types of
Spreads:netcredit,netdebit,and net even. Every Spreadyou open fits into one ofthese three categories.Spreadsarecreatedwhenyoupurchase one option and selloneoption to create a spreadinpricebetween theoneyousoldand theoneyoubought.Since they differ in pricethree scenarios can occur.Youwill either receivemorepremiums than you arepaying out, ending upwith a
netcredit toyouraccount;oryou will pay out morepremiums than you receive,so your account will have anet debit. You could alsohave an option trade wherethe amount of the premiumswill be equal, a net eventrade.
StockTrader:Wait,howcanIhaveaneteventradeunlessI sell the same option I ambuying?
Optionz Traderz: I think Ican explain. Let’s start withthe simplest Spread, aVertical Spread. A VerticalSpread is just a fancy namefora tradewhereyoubuyanoption at one strike and sellan optionwith another strikeandthesameexpiration.
Stock Trader: That onemakes sense tome. IfAppleis at $375 and I think thepricehasfoundsupport,Ican
buy a $375 Call for $13.00and sell a $390 Call for$6.50, both with Decemberexpiration. Imakeaprofit aslong as the price goes upenough to cover thedifference in premiums, thenetdebit.
Optionz Traderz: O.K., sowhat ifyouboughtone$375Call, but sold two $390Calls?
Stock Trader: I would pay
$13.00for theLongCallandreceive $13.00 for the twoShortCalls.So Iwouldhavea profit as long as the ShortCallstrikewasn’thit?
Optionz Traderz: Actually,the range of profitabilitywouldextendwellbeyondtheShortCallstrike.Ifitwashit,you would have intrinsicvalue in theLongCall, from$375 on up. At prices above$390, the intrinsic value of
oneof theShortCallswouldincrease by the same amountas that of the Long Call.However, you would have$15 of additional intrinsicvalueintheLongCall.
Stock Trader: I see whatyou’re saying. I would onlybe exposed to upside risk ononeoftheShortCalls,sothebreakeven point would be$15 above the $390 strike at$405.
Optionz Traderz: Exactly,and that’s all there is to aRatio Spread. It is nothingmore than a Vertical Spreadusingaratioofoptionsthatisanything other than one-to-one. It doesn’t necessarilyneed to be a net even tradelike the one I described onApple.RatioSpreadscanalsobe net debit or net credittrades.
Stock Trader: I thought
Synthetic Stock was a greatidea, butRatioSpreads seemjustaspromising.IfIboughtone Call at support and soldtwo Calls at resistance, andwas able to open it exactlynet even, I would only losethe commissions if the pricefellthroughsupport.
Optionz Traderz: That isone of the great things aboutRatioBullCallSpreads; theyare very low risk when the
price falls through support.Also, if the price did breakthroughresistance,youcouldbuy the underlying shares.Doing so would turn one oftheShortCallsintoaCoveredCall, and the intrinsic valueof the remaining Short Callwouldgiveyouanicebufferforyourstoploss.
Stock Trader: This seemsliketheultimatewaytotrendtrade. If I thought $390
representedresistanceandtheprice shot through to $395, Icouldbuy100sharesandseta stop loss at $390. If thetrendreversed,Iwouldbeout$500,butstillturnaprofitaslong as the LongCall inmyRatio Spread expired with atleast$5ofintrinsicvalue.
Optionz Traderz: The onlyreal risks with this style ofmanaging aRatio Spread arethat the price gaps up or it
breaksthroughresistanceandthenbeginstowhipsaw.Evenso,withtheunderlyingAppleshares at $390, there wouldstill be$15of intrinsicvaluein the LongCall. Youmightget another chance to bestopped out with a $5 lossand still manage to breakevenonthetradeasawhole.
Stock Trader: So a RatioSpread is like whipsawinsurance?
OptionzTraderz:That’soneway to lookat it.Youwouldalso have the choice ofsimply buying one of theShort Calls if Apple hit the$390 strike. Even if ithappened immediately afteropening the trade, it wouldlikelyonlycostyou$13.00tobuy it back, a $6.50 loss.Whatyouwouldbe leftwithwould be a basic VerticalSpread. However, instead ofpaying a $6.50 net debit to
open the Spread when all ofthe options were out-of-the-money,youwouldbepayingtheequivalentofthesamenetdebit for a Spread that wascompletelyin-the-money.
Stock Trader: I guess itwouldberareforthepricetohit resistance thatquickly, soI would probably pay evenless than $13.00 because inthemeantime therewouldbesome time decay. Plus,
Implied Volatility might belower if the stock wasshowing enough strength toclimb to thatprice level.Thecombination of Theta andVega could cause thepremiumtobemuchlessthan$13.00.
Optionz Traderz: Correct.Also,youdon’tneed to limityourselftoatwo-to-oneratio.Depending on the strikeprices you choose, you can
choose three-to-one, three-to-two,oranyothercombinationthat gives you the debit orcredityouareseeking.
Stock Trader: So how do Ichoose between debit, credit,oreven?
Optionz Traderz: WithRatioDebit Spreads, there isupside risk as well asdownside risk. Lowering thenet debit decreases your riskif the trendgoes theopposite
way you expect, but only byadding risk in the otherdirection. If you lower it allthe way to zero or net even,you eliminate the risk in onedirectionentirely,butonlybyadding it to theother side. Ifyou keep lowering it bymaking it a net credit trade,theriskinonedirectionisnotonly eliminated, but profitpotential is added, again byaddingmorerisk in theotherdirection.
Stock Trader: That makessense. So I need to decidewhether the potential profitand risk in one direction arejustified by the potentialprofit and risk in the otherdirection.
Optionz Traderz:That’s allthere is to it. If the economyisshowingweaknessbutyouhavefoundacompanythatisdoing well in spite of theconditions, a net even or net
credit Ratio Call Spreadwould protect you in theeventyourstockgotweigheddown by a downturn in thebroadermarket.
StockTrader:That’sagoodpoint. I could still make aprofit if the companycontinued to do well, but Iwouldn’tbetakingontheriskof a recession or some otherevent thatwasbadenoughtoaffectallcompanies,eventhe
strongestperformers.
Optionz Traderz: RatioSpreads canbe tailored to fitalmostanymarket.RatioBullCallSpreads, thosewithlongoptionsatalowerstrikeandagreater number of longoptions at a higher strike,tend to work better in bullmarkets as net debit tradesthan those openedwith a netcredit, due to the increasedupside protection. The same
is true of net debit Bear PutSpreadsinabearmarket.
Ratio Bull Call Spreadsopened with a net credit canwork well on stocks that aredoing well when the rest ofthe market is not. If thegeneraldowntrendeventuallybegins to have an effect onthe price of an individualstock, the net credit mightstillresultinaprofit.
Net Even Spreads are good
when there is a high level ofuncertainty in the market. Inthe past, I have used RatioPut Spreads around earnings.Sometimes I buy at-the-money Puts and sell enoughout-of-the-money Puts tobalance the premiums. If theunderlying price takes offafter the report, everythingexpires worthless and I’monly out the commissions.When earnings aredisappointing, I profit from
the Long Put, all the waydown to the strike of theShort Puts.When everythingexpires, I end up buying theunderlying shares andkeeping the profit on theSpread.
StockTrader:Wouldn’tthatalso work if I sold a Put at-the-money and then used thepremium to buy out-of-the-money Puts? It seems like itwould be the same, except I
wouldn’t have any downsiderisk.
Rookie Trader:Now who’slookingfortheHolyGrail?
OptionzTraderz:LOL,he’sgotyou there!There is somedownside risk because theshort option can be in-the-moneywhen it expireswhilethe long options expireworthless. However, if youopen the trade very close tothe earnings report, there
won’tbemuchtimedecay.Ifthe short option ends up in-the-money after earnings,even if the long options didnot have any intrinsic value,they could increase in timevalue. If that was the case,you could close the tradesoon after earnings werereleased and might get outwithasmalllossandpossiblya small profit. It woulddepend on whether theincreaseinfearoverthepoor
report was enough to offsetthe decrease in volatility dueto the disappearance ofuncertaintyaboutthecontentsofthatreport.
StockTrader:So the risk issmall, but there might betimes when I could still beable to get out with a profit,even when the underlyingprice moved to a point thatwouldbealosingscenarioatexpiration. Some might
consider that to be a HolyGrailofsorts.
Optionz Traderz: I guessyou’reright.Thereisanotheruse for Ratio Spreads; theycan help you recover from apoorly performing stocktrade.
Stock Trader: Now this Ihavetosee!AreyousayingIcanowna stock thathas lostvalueandthenuseoptionstoturnaloserintoawinner?
Optionz Traderz:Anything’s possible, but it’smore likely you could cutyour loss enough to breakeven if the conditions wereright.
StockTrader:Goon.
OptionzTraderz:O.K.,let’ssayyoubought100sharesofApple last summer when thepricebroke through the$400resistance level. If you held
them into November, theywouldonlybeworth$375,soyou would have a loss of$2,500 if you sold them.Assumingthepricehadfoundsupport at $375, rather thanhold on and wait for arebound, you could open anet even Ratio Bull CallSpread.Ifyouboughtonein-the-money Call, at the $355strike for $26, and sold twoat-the-money Calls at the$375strikefor$13,bothwith
December expiration, howwouldthetradeplayoutiftheunderlying price remainedjustabovethe$375support?
StockTrader:Letme see…Everything would expire in-the-money, so I would buy100 shares at $355 and sellthem for $375, and I wouldsell the shares I alreadyowned for $375. So I wouldmake a $2,000 profit on thesharesIboughtwiththeLong
Call and lose $2,500 on thesharesIalreadyowned.
Optionz Traderz: Yes, soyourcombinedlosswouldbe$500, still much better thanthe $2,500 loss you wouldhaveneededtotaketogetoutofthetradewithoutusingtheRatioSpread.Thismayseemlike a great way to recoverfrom a big loss, but it onlyworkswhenastockhastrulyfound support. The Ratio
Spread I described would donothing to provide anyprotection if the underlyingprice fell through support. Itonlyworkswhenpriceshavefallenandthenstabilized.
StockTrader:Iwouldneverhave thought to use RatioSpreads on stocks I alreadyown.Greatadvice,asalways!
Optionz Traderz: There isanother form of a RatioSpread called a Ladder. The
onlydifferencewithaLadderis thatallof theoptionshavedifferent strike prices. Forexample,aLongCallLadderwould be opened using aLong in-the-money Call, butrather than selling two Callsat-the-money,onlyonewouldbe. The second Short Callwould have a strike out-of-the-money.Dependingonthestrike prices and ImpliedVolatility,aLongCallladdermightbeanetcredit,debit,or
even trade. Given the higherstrike price of the secondShortCall,itmaybepossibleto reduce someof theupsiderisk when compared to atraditional Ratio Bull CallSpread.YoucanalsocreateaShort Call Ladder by justexchangingthelongandshortpositions.Ladderscanalsobeopened using Puts instead ofCalls.
Stock Trader: That’s
interesting, a Ladder cansometimeswork aswell as aRatioSpread,butwithalittlelessrisk.
Optionz Traderz: It alldepends on the premiums atthe particular strike prices oftheoptionsyouaretrading.Ifyou are considering a RatioSpread, it is often worthcomparing it to a Ladderbefore opening the trade tosee which one is the better
choice. If you do comparethem, don’t forget to includethe additional commissionsandfees inyourcalculations,aswellasslippageduetothebid/askspread.
Stock Trader: Yes. Thosecommissions, fees, andliquidity risks can be silentbutdeadly.
Optionz Traderz: So nowthat you know how to useRatio Spreads, we can move
on toCalendarSpreads.Likewe talked about last time,CalendarSpreadsarenothingmore than trades using twooptions with the same strikeprice and different expirationdates.
Stock Trader: Youmentioned that CalendarSpreadscouldbeusedwhenastock was going through aperiodofconsolidation.
Optionz Traderz: That is
correct. The only way aCalendarSpreadcanresultina loss is if the long optionloses more time value thantheshortoption.Sayyousella near month at-the-moneyCall and buy another Call atthesamestrikeafewmonthsout. If the underlying pricebreaksout,ineitherdirection,thelongoptioncanlosemoretime value than the shortoption.
StockTrader:I’mnotsureIunderstand that. Isn’t Thetathehighestinthefinalmonthof a contract? If the ShortCall expired with intrinsicvalue, I would also have thesame amount of intrinsicvalueontheLongCall,plusIwould still have theremainingtimevalue.
Optionz Traderz: It can beconfusing. So I like to thinkofit thisway.Thereareonly
three major influences thatcan cause an option toexperience a change in timevalue: Implied Volatility,time,andmoneyness.
Stock Trader: O.K., I’mwithyousofar.
Optionz Traderz: Volatilitynormally has a greater effectonthelongertermoptionofaCalendar Spread, but it alsohassomeeffectontheshortertermoption.Theresultisthat
most of the time changes involatility will have minoreffectsonthecombinedvalueofaSpread.
StockTrader:Soweareleftwith time and moneyness asfactors?
OptionzTraderz:Those areusually the two mostimportantinfluences.Youarecorrect that Theta causes thegreatestamountoftimedecayin the final month of a
contract,butthateffectcanbeovershadowed by the changein moneyness of the longerterm option of a CalendarSpread.Ifthatoptionendsupdeepin-the-moneyorfarout-of-the-money it could losemost or all of its time value.Because it had a greateramountoftimevaluethantheshorter term optionwhen thetrade was opened, it is alsopossible for it to lose more.Thelossoftimevalueonthe
longer term option due tochangesinmoneynesscanbegreater than the loss of timevalue of the shorter termoptionduetotimedecay.
Stock Trader: If Iunderstand correctly, theoptions with longer time toexpiration have higherpremiums because there ismore uncertainty about whatthe price of the underlyingwillbewhentheyexpire.But
iftheunderlyingpricemovesviolently in one direction orthe other, they might eitherendup sodeep in-the-moneythattheywillbetradingatparwiththeunderlyingshares,ortheywillbesofarout-of-the-money that they will benearly worthless. In eithercase,theywillhaveverylittletime value. Meanwhile theoptionswithnearerexpirationwill expire with intrinsicvalueonly,having lost100%
of their time value. Theintrinsic values of the longand short options in aCalendar Spread are alwaysthe same, so if I lose moretime value on the longoptions than I gain on theshort options, I willexperiencealossonthetrade.
Optionz Traderz: You’vegot it. You can also do aCalendar Spread trade inreverse – buy a near month
optionandsellafarmonth.Ifthe moneyness of the farmonthoptioncausesittolosemoretimevaluethanthenearmonth option loses due toTheta,youwillhaveaprofit.
StockTrader:SoaCalendarSpread with long options inthenearmonthisbettingthata breakout will causeconsolidation to end, and thesame Spread with the shortoptions in the near month is
bettingthatconsolidationwillcontinue.
Optionz Traderz: Both canwork well if either scenarioplaysout.Butboth strategiesdepend on the same initialsetup; the stock is goingthroughaconsolidationphasewhenthetradeisopened.Ifastock is in a strong trend, aCalendar Spread is usuallynotthebestchoice.
Stock Trader: I think I see
where you are going withthis. If a stock is in a strongtrend,aCalendarSpreadwiththe long options having ashorter term than the shortoptions might result in aprofit, but a Vertical Spreador a Ratio Spread could bemuch more efficient atcapturingthetrend.
Optionz Traderz: As Imentioned earlier, it’s allabout choosing the best tool
forthejob.Whenyouhaveatoolbox full of optionstrategies,itismucheasiertopick the one that will giveyou the best results for thecurrentmarketconditions.
StockTrader:So aVerticalSpread is bestwhen a strongtrend is likely, but there is arisk of loss if the trend goesin the wrong direction. ARatio Spread can be used toprofit froma trendwith little
or no risk if a trend fails todevelop or if it reverses, butthere is a risk of loss if themagnitude of the trend doesnotmeetexpectations.AndaCalendarSpreadisbestwhena stock is going throughconsolidation, but there is arisk of loss if the predictionofwhether or not a breakoutwilloccuriscorrect.
Optionz Traderz: You canalso combine strategies. For
example, you can combine aCalendar Spread and aVerticalSpread to formwhatisknownas aDiagonal. In aDiagonal Spread, you aretrading options with twodifferent expirations at twodifferentstrikeprices.
StockTrader:SoifIboughtNovember Calls on Apple atthe $375 strike and soldDecember Calls at the $390strike, that would be a
DiagonalSpread?
Optionz Traderz: It’s thatsimple.DiagonalSpreadsaremeanttocaptureatrendwithlimited upside and downsiderisk. The difference betweenaregularVerticalSpreadandaDiagonalisthatthefartermoptions have higherpremiums than the near termones.Thatgivesyouachancetoopenthetradeveryclosetonet even, something that is
not possible with either aVerticalSpreadoraCalendarSpread. Just as with a neteven Ratio Spread, if youopen a net even DiagonalSpreadandthetrendgoesthewrong way, your loss isusually limited to thecommissions.
Stock Trader: So whenwouldbeagoodtimetouseaDiagonalSpread?
OptionzTraderz: Iknowof
some traders who useDiagonals as an alternativeforCoveredCallwriting.Bybuying a near month at-the-money Call and selling anout-of-the-moneyCallforthefollowingmonth,theresultisatradethatbehavessimilarlytothatofaCoveredCall,butwithout as much downsiderisk. If the underlying pricefalls considerably, there is achance that both optionscould eventually expire
worthless. If the price risesandthenearmonthLongCallis exercised, the trade trulydoesbecomeaCoveredCall.Theonlydifferenceisthatthestock was purchased in abona fide uptrend, at abargain price that wasdeterminedbythestrikepriceoftheLongCall.
Stock Trader: That seemslike another option strategythatwouldworkwellwithmy
trend trading system. If theLongCall is exercised, I notonly get to keep the fullamount of any move, up tothe strike price of thefollowingmonth’sShortCall,but I also have a cushion onthe downside, having boughtthe shares at the strike priceoftheLongCall.
OptionzTraderz:The goodnewsis thatSpreadsareveryslow to react to changes in
the underlying price. Unlikestock trading, where youraccount changes value withevery tick, Spreads can takedays or weeks to show anyrealmovement.Evenwhenatrade goes against you, theslow pace may give you thetime you need to re-evaluatethetradeandcutyourlosses.
Stock Trader: I really likethe idea of using Spreads aswhipsaw insurance. In my
stock trading system, I oftenget stopped out of anotherwise good trade whenwhipsaw trips my sell order.As disappointing as it is toget stopped out early, mysystemrequiresthatIalways,always,honormystops.Withthe value of a Spread beingmuch more stable than theunderlying stock, I shouldbeable to reduce my whipsawlosses.
Optionz Traderz: Optionstrategies can be tailored toalmostanytradingmethod.Ifcontrollingwhipsaw losses isa major goal, then Spreadscanbeveryhelpful.
Stock Trader: I wish I hadknown about Spreads backwhen the Dow was makinghourly triple digit swings awhile back. I opened severaltrades that week, and everyoneofthemgotstoppedout.
Optionz Traderz: Ouch!That’s something you’llrarely see in the world ofoptions, if you are careful toset up your trades in a waythat minimizes your risk. Ionlykeepahandfulof tradesrunning at any given time,and there are some weekswhen I don’t need to placeanytradesatall.Infact,whenthemarketwasperformingitsrecentstunts,Iwassittingbythe pool, confident that my
option strategies would beunaffected.
Stock Trader: Any otherthoughtsonSpreadtrading?
Optionz Traderz:There aremanySpreadstrategies,butalot of them are just alteredversionsof theoneswehavealready discussed. Therereallyisnoneedtomemorizethem,butitmaybehelpfultosee the wide range of optioncombinations available. Here
areafewofthem:
Guts:Thisstrategyisnothingmore than a Strangle, butwith a Long Call and a Put,both in-the-money, with thesameexpiration.Itwillturnaprofit only when a verystrong trend develops. AShortGutsisjusttheopposite– a Short Call and Put, bothin-the-money. Inmyopinion,aGuts trade isnobetter thana Strangle. The amount of
intrinsic value gained on theCall will be lost on the Putuntil thePutstrikeishit,andviceversa.Profitsdonotstartuntil the underlying pricegoes beyond one of thestrikesbyanamountequaltothecombinedtimepremiums,the same as with a Strangle.The only difference is that aGutstradehasabetterchanceof both options expiring in-the-money, requiringadditional commissions. Just
aswithStrangles,LongGutstrades are trendish strategiesand Short Guts trades arerangeboundstrategies.
Ratio Write: This is one ofthose trades that can besimplifiedusingsynthetics.ARatio Call Write involvesbuying 100 shares of stockand then selling two at-the-moneyCalls.Tosimplifyit,itcan be broken down into aCovered Call and a Short
Call. The synthetic positionforaCoveredCall isaShortPut, so the trade becomesequivalent toaShortPutandShortCall–aShortStraddle.Interestingly, a Ratio PutWrite, which is opened byshorting 100 shares of stockand selling two at-the-moneyPuts, also breaks down to aShort Straddle when thesynthetic positions aresubstituted. Because they areboth equivalent to a Short
Straddle, theybothworkbestontightlyrangeboundstocks.
Variable Ratio Write: For aVariable Ratio Call Write,100 shares of stock arepurchased, followed bysellingonein-the-moneyCalland one out-of-the-moneyCall. The stock combinedwith the in-the-money ShortCall is equivalent to an out-of-the-money Short Put.Combining an out-of-the-
moneyShortPutwiththeout-of-the-money Short Call isthe equivalent of a ShortStrangle. Just as the RatioCall and Put Write areidentical,aVariableRatioPutWrite is the same as aVariable Ratio Call Write.BothareequivalenttoaShortStrangle, and both would beappropriate for a moderatelyrangeboundstock.
Strip: This strategy is a ratio
versionofaStraddle.Usuallyit involves a Long at-the-moneyCallandtwoLongat-the-moneyPuts.Soitbehavesthe same as a Straddle, butwith one-third more risk,which allows it to performbetter in a downturn. Stripsare slightly bearish, strongtrendstrategies.
Strap:AStrap is thesameasa Strip, but with two LongCalls and one Long Put, all
at-the-money. Again, it isslightly riskier than aStraddle, but performs betteriftheunderlyingstockrallies.That makes a Strap a strongtrend strategy with a bullishbias.
Stock Trader: As always,you’ve given me a lot todigest. I think I need sometimetowrapmybrainaroundallofthis.
Optionz Traderz: Don’t let
all of the terminology scareyouawayfromSpreads;thereare no set rules for tradingthem. Just because a Spreadhasanamedoesn’tmean it’sbetter than one you designyourself. Themost importantthing to rememberwhen youtradeSpreads is that youcanmove the risk wherever youwantit.Ifyoudon’twantanydownside risk, choose astrategyandstrikepricesthateliminatethatriskbymoving
it to the upside. If you wantneither upside nor downsiderisk, just move it to thecenter.
Stock Trader: The center?Are you talking about LongStraddlesandStrangles?
Optionz Traderz: Exactly.And there are two moreSpreadswheretheriskcanbemoved to the center:ButterfliesandCondors.
Stock Trader: And howmany more strategies arethere?
Optionz Traderz: JustButterfliesandCondors;afterthat,yourtoolboxwillbefull.
Stock Trader:Well, thanksforthealloftheadviceaboutSpreads. You could write anoption book with all yourknowledge.Goodgrief,Iwillhave to save and read thisconversation thread a few
times to reallyunderstandallthedynamicsofSpreads.Thissoundslikehowthebigboysdoit.
Optionz Traderz: Yes,Spreads done correctly canlead to income with verycontrolled risk. Talk to yousoon.
Stock Trader foundhimself sitting at hiscomputer trying to thinkthrough the option plays that
Optionz had discussed. Theywerealittlemindbending.
Buying an at-the-moneyCallthensellingtwiceas many out-of-the-moneyCalls to pay for the LongCall? A free Call option aslongastheShortCallsdonotgo in-the-money too deeply.This was simply amazing tohim.
Buyinganeartermin-the-moneyCallthensellinga
longertermout-of-the-moneyCall to create a sort ofprecursor to a Covered Callwithmuchlessriskofcapital.
These were so mindbending he felt like he hadtaken the red pill andwokenupfromtheMatrix.
Howcouldcombiningoptions result in completelydifferent option plays thanwhat the individual optionsrepresented? By combining
Longs and Shorts, Puts andCalls you could create whatseemed like endlesslydifferentoptionplays.
Hewasponderingthiswhile sittingathiscomputer,sipping his daily requirementofcaffeineinliquidform.
Hewas lookingathistrading records and thinkingabout different ways to useoptionstoplaytohisbeliefs.
He wrote notes as hethought.
Trading in a rangeboundmarket:ShortStranglesoldatresistanceandsupport.
Ahotstockbreaksouton high volume: At-the-moneyCalloption.
The market bouncesoff support: At-the-moneyCalloption.
Market topping outand reversing on highvolume:At-the-moneyPuts.
Ifaneventisexpectedthatwillmoveastock,sector,orthemarketinonedirectionin a big way: A LongStrangle.
Iwanttoopenatradewithout needing additionalcapital: Create a SyntheticStock position; Call and Putat-the-money, one Long, one
Short, depending on thedirectionbias.
IaminvestedinahotstockIbelievein,butwanttogenerate some income:Covered Calls, write Shortoptions out-of-the-moneyoverandoveragain.
I want to be paid tobuy a stock at the price Iwant:WriteShortPutsat thestrikeprice Iwant topay forthefavoritestocksonmybuy
list.
Volatility isveryhighbutIdon’tbelievethemarketwill really move as much asis priced-in: A Short at-the-moneyStraddle.
He was impressedwith his own list. He hadbeenlistening.
As he thought of thisnew tool box, he looked at aboxofbuildingblocksthathe
keptforhisniecetoplaywithwhen she visited; they weretheinterlockingkindthatyoucouldbuildthingswith.
As he took a few outand put them togetherabsentmindedly, he made alittle dog. He thought for aminute, “When these blockswere lying separately in thebox theywere just individualblocks, but wheninterconnected they became
something different. A smallblockbecameanear,slightlybigger blocks the legs andhead. The blocks did notchange, just how they wereused togetherdid.Theywerethe same exact block as theywere before, but when putinto position with otherblocks they became a smallpartofawholenewthing.”
StockTrader believedthis had to be like option
strategies, combining optionstogethertocreatenewthings.The options themselvesstayed the same but thecombination made them partofanewstrategy.
All this thinking wasstimulating, but at the sametimeexhausting.StockTradersettledontothecouchforanafternoon nap. His tickets toSan Diego, California laynext to him on the coffee
table. As he dozed off,images of blocks, options,and beaches danced throughhishead.
Chapter13THEWIND
BENEATHTHEPRO’SWINGS:BUTTERFLIES
ANDCONDORS
Stock Traderawakened on Sundaymorning, reflecting on thepleasant Saturday he hadpassed. He had done prettymuch nothing but watch alittle television and studychartsof stocksonhiswatchlist.He had also played on afew social network sites.Since he had signed up forthem, they had doubled his‘wasting’ time on theInternet. He did enjoy
connecting with likemindedpeople, although maybe alittlebittoomuch.
Hetrulylovedthefactthat he could talk to peoplearound the world whothoughtthewayhedid.
He would definitelybe keeping his eye on anysocial networking sites thatwent public. He believedsocial networking washeading into the age of
Internet 2.0, with much ofwhat excited investors in thelate nineties coming to passthistimearound.
StockTrader believedeyeballs on the Internetwerebeginning to really have truevalue, similar to thebelief inthego-goInternetboomyearsthatsawtheNASDAQclimbto5,000points.
While stumbling ontoInternet friends, he found it
oddthatsomanytraderswerefreemarket capitalists; manyheldthesamepoliticalbeliefsashedid,evenreadingmanyof the same books andsupporting the same politicalcandidates.
He believed hiscommunications withOptionz Traderz had growninto a true mentoringfriendship,eventhoughsomehad thought they had a
blossoming‘bromance’inthegroup,whateverthatmeant.
With the marketsclosed and Stock Traderbored of surfing the Internet,he thought he had donewelltonotbotherOptionzyet.Butby11 a.m., he could takenomore;itwastimetogetinthemix and learn somethingaboutoptions.
StockTrader saw thatOptionz was online. Not
wanting all of the rest of thegroup to butt in withnonsense, Stock Trader sentOptionz a direct message sothey could chat onlineprivately.
StockTrader:Hey, howareyoudoingtoday?
OptionzTraderz:Iamgreat,just catching up on some e-mailsbeforeIgoforarun.
StockTrader: Do you have
time now or later to runthrough the lastof theoptionstrategies?
OptionzTraderz:Sure,Iaminnohurry.Ihaveallday.
Stock Trader: What werethe last two strategies youteasedmewithyesterday?
Optionz Traderz: CorrectmeifIamwrong,butIthinkthe only two main optionstrategies we have not
discussed are the ButterflyandCondor.
StockTrader:Yes, the birdand the bug; you have notexplainedtheflyingones.
Optionz Traderz: LOL, Ihaveneverthoughtofthemasthe ‘flying ones.’ That isfunny!
StockTrader: Most optionsand strategies have somereasoningbehindtheirnames.
A Call option is so namedbecauseitenablesyoutocallastockawayfromsomeone;aPutoptionallowsyoutoputa stock on someone; aStraddle option play allowsyoutostraddleapriceinbothdirections; creating aSynthetic Stock positionthrough a Long and Shortoptionmimics theunderlyingshares. But why name anoptionsstrategyafterabirdoraflyingbug?
Optionz Traderz:Well, thereason is that these strategieshavea‘body’ofshortoptionsand ‘wings’ of long options.The wings ensure that thelosses are controlled if theoption trader is wrong aboutthe market’s trading range.CondorandButterflySpreadsarejustcombinationsofatwoVertical Spreads. The mostbasic of these, a Long CallButterfly or Long CallCondor, is a Vertical Bull
CallSpreadcombinedwithaVertical Bear Call Spread.I’m sending you diagrams ofthepossibleprofitsandlossesatexpiration.Maybethatwillhelpclearthingsup.
Stock Trader: That looks
simple enough. A Butterflyhas a much narrower rangethan a Condor where it isprofitable, but the potentialprofit is much lower for theCondor.
Optionz Traderz: Asalways,it’sallaboutriskandreward. The higher potentialreward of a Butterfly isbalancedbytheveryhighriskof a small loss. The Condorhasamuchhigherprobability
of turning a small profit, butthat is balanced by a higherpotential loss. The potentialprofitandlossisalsoaffectedby the width of the body.Butterflies and Condors withwide bodies are much morelikely to return a profit, andthe potential profits arehigher than would beexpected from those withsmall bodies. However, thehigher probability and higherpotentialprofitcomeswithan
increaseinthepotentialloss.
Stock Trader: That makessense.Doesitworkthesameway with Puts instead ofCalls? It seems like if Ibought an in-the-money Putand sold two Puts at-the-money and bought anotherPut out-of-the-money, itwould react the same as if IusedCalls.
Optionz Traderz: That iscorrect.Many tradersuse the
term ‘Butterfly’ to refer to aSpread formed entirely fromCall options. Others like touse the term ‘Long CallButterfly’ to distinguish itfrom the one you described,whichisoftencalleda‘LongPutButterfly.’TherearealsoIron versions that combineCalls and Puts. The Ironversions of these are nothingmore than a Short Straddlesurrounded by a LongStrangle as insurance against
beingwrong.
StockTrader: Iron?LikeanIron Butterfly or IronCondor? That soundsridiculous but I think I haveheard of an Iron Condorbefore. I must have lived asheltered stock trading life.With putting Spreads insideofotherSpreadsorStraddlesinsideofStranglesitremindsme of Thanksgiving‘Turducken,’achickeninside
aduck,insideaturkey.
OptionzTraderz:Youcouldsaythat,Iguess.
Stock Trader: It is almostlike a football team, with anoffense being the Short sideand the defense being theLongside.
OptionzTraderz:LOL,youarereallylettingtheanalogiesfly today. I think you areaccurate in your examples
though.
StockTrader:Ithelpsmetograsp your concepts when Iput them in terms I canunderstand.
Optionz Traderz: IronButterflies and Iron Condorsdon’t behave muchdifferently than standardButterflies or Condors. I’msendingyouapayoutdiagramof an Iron Butterfly onBoeingthatyoucancompare
totheLongCallButterfly.
StockTrader:Iseewhatyoumean; the profit and loss onthe Iron Butterfly is almostidentical to that of a regularButterfly. I guess if thepayouts were very close, itwould make more sense touse a regular Butterflybecause it would requirefewer trades and thereforelowercommissions.
Optionz Traderz: It’salways a good idea to
compare and cut yourcommission costs whenpossible.
Stock Trader: Any otherideas?
Optionz Traderz: Youshould also consider thecommissions on the closingtrade. An Iron Butterfly willalways expire with at leastone but no more than twooptions in-the-money,whereas a Long Call
Butterfly can expire with alloptions being completelyworthless,orasmanyasfouroptionsin-the-money.
StockTrader:That’sagoodpoint. Iron Butterflies cost alittlemore incommissionsatthe open, but can be lessexpensivetoclose.
Optionz Traderz: Youshould also check yourbroker’s commissionschedule for exercises and
assignments;oftenthecost ismuch higher than regularoption trades. If you open aLong Call Butterfly and theunderlying price suddenlyshoots way up, the optionsyou traded might lose theirliquidity. In that case, youwouldnotonlybestuckwithalosingtradeuntilexpiration,but also be required to paythe commissions for twoexercises and twoassignments. It could also
come back to haunt you atincome tax time; even if theexercisesandassignmentsdidnotincreaseyourtaxliability,it could be an accountingnightmare.
StockTrader:Thereyougoagain, pouring a bucket ofcoldwateronmejustwhenIwas warming up to the ideaof trading Butterflies andCondors.
Optionz Traderz: Despite
the downfalls, manyprofessionals love thesestrategies as a means ofgenerating consistent returnsin normally functioningmarkets. However, they losemoney in strong sustainedtrends. It has been myexperience that sustainedtrendsoccurabout20%ofthetime. That percentageprovides Butterflies andCondors with a long termwinning probability of about
80%.Theprofitsaremadeinaprice zone,where thepriceof the underlying stock doesnotmoveconsistentlyinonlyone direction. They do verywell in rangeboundmarkets,sometimes giving the falseappearanceoftheHolyGrail.Theycanalsobeprofitableinvolatile markets, as long asthe market keeps swinginganddoesnottakeoffineitherdirection.
StockTrader: Somaximumprofits are made if the stockgoesnowhereandendsupatexpirationtradingatthesamepriceasitwasatthetimethetradewasopened.Theprofitsaretheshortoptionpremiumsminus the long optionpremiums?
Optionz Traderz: Condorshave wider bodies thanButterflies, hence the name.They are both structured to
capture profits in a rangeboundmarketandatthesametime have insurance to avoidany huge losses due tounexpected epic trends ineitherdirection.
Stock Trader: And an IronButterfly or Iron Condor islikeaShortStraddleorShortStrangle,with insurancebothways?
Optionz Traderz: What aButterfly Spread does is
combineaBullandBearCallSpread. This option strategyuses four options at threeconsecutively higher strikeprices. For a Long CallButterfly,thelowertwostrikeprices are used in the BullCall Spread, and the higherstrike price in the Bear CallSpread. As I mentionedearlier, Puts can be usedinstead of Calls and theperformance is usuallysimilar. Either way, a Long
Call Butterfly or Long PutButterfly strategy has limitedriskbutalsolimitedprofit.
StockTrader:Sortofatradeforincome,notbigwins.
Optionz Traderz: Exactly.The Iron Butterfly is alsocreated with four stockoptionsatthreeconsecutivelyhigher strike prices. Thisoption strategy is differentfrom the standard ButterflySpread because it uses both
CallsandPuts,asopposedtoallCallsorallPuts.However,as you observed on thepayout diagrams that I sent,the performance of an IronButterflyisoftenverysimilarto that of a standard LongCallButterfly.
Thetwooptionslocatedatthemiddle strike in the IronButterfly strategy create aShort Straddle – one Calloption and one Put option
withthesamestrikepriceandexpiration date. The stockoptionsatthe‘wings’areaareat higher and lower strikeprices and are created by thepurchase of a Strangle – oneCall and one Put at differentstrike prices, also with thesameexpirationdate.
The Iron Butterfly strategydoes a great job of limitingtheamountofriskandrewardbecause of the insurance the
Long options give to theShort positions. If theunderlyingpricefallsduetoabigdowntrendinthemarket,and the investor holds a ShortStraddle at the center strikeprice,thepositionisprotectedto some extent, thanks to thelowerLongPut.Ontheotherhand,ifthepriceofthestockrises,theinvestorisprotectedbytheupperLongCallactingasinsurance.
Stock Trader: O.K., I amgoing to have to save thatpost and read it again. But Ithink I understand theconcept.TheLongStrangleisthe body guard of the ShortStraddle, and the IronButterfly Spread makesmoney when the underlyingstockisrangebound.
Optionz Traderz: It seemslike you have the basic idea.A Long Call Butterfly
behavesalmostthesameasaLongPutButterflyoranIronButterfly.Theprofit and losspotential on each strategy isnearly identical, and eachstrategyworksbestwhen themarket or a specific stock israngebound.Theonlymajordifference between the threestrategies is the amount ofcommissionsrequiredtoopenandcloseeachtrade.
Stock Trader: If all
Butterflies are almostidentical, how would yousuggest choosing which oneto use in order to limit theamountofcommissions?
Optionz Traderz: That’s agreatquestion.Butterfliescangobble up a lot ofcommissions, sometimesdamaging an otherwise goodtrade. For example, take theButterflyonBoeingCo.thatIincluded in the diagram
earlier. The maximum profitonthat tradeisunder$200.Iknow of one ‘discount’brokerthatchargesabout$10per option trade and $20 forexercisesandassignments.Soassuming you chose a LongCall Butterfly, even if theunderlying price remained apennyabovethecenterstrikeat expiration, youwould pay$30 in commissions to openthethreelegsofthetradeandanother $60 if you allowed
the exercise and assignmentof the in-the-money Calls atexpiration. That $90 wouldeat up a big chunk of yourprofit.
Stock Trader: I see whatyou’re saying. If theunderlying stock closed at apenny over the center strikeprice at expiration, a LongPut Butterfly would result inonly$50incommissions:$30to open the trade and $20 to
exercise the single long Putthatwasin-the-money.That’sstill a lot, but much betterthantheLongCallButterfly.
Optionz Traderz: Yes, sotheLongPutButterflywouldbeabetterchoiceifthestockhad found support butremained range bound,whilethe Long Call Butterflywouldworkbetterforarangebound stock that washovering near a resistance
level. Both strategies wouldperform about the same, butthe commissions could bemuchdifferent.
Stock Trader; I guess Icould also save some of thecommissions if I closed thetradeonexpirationdayratherthanallowingittoexpire.
Optionz Traderz: That’show the pros do it. SinceButterflies produce a limitedamount of profit even when
theyworkperfectly,allowingthemtoexpirecouldresultinunwanted risk that couldquickly erase those profits.Thinkof it thisway.Assumeyou opened that Long CallButterfly on Boeing Co. andallowed it to expire with theunderlying price a pennyabove the center strike. Notonly would you pay theinflated commissions toexercise the Long Call andfor assignment of the two
Short Calls, you would alsobetakingontheaddedriskofthe share price gapping upbefore themarketopened thefollowingweek. Even if youwere lucky enough that theshare price remained steadyordeclinedovertheweekendofexpiration,youwould stillneed an additional trade tocovertheshortstockpositionthat was created when thesecond Short Call wasassigned.
StockTrader:Goodpoint.IfI am only making a $200profitonatrade,whypay$90incommissionswhenIcouldcutthatto$60byclosingthetrade on expiration day? TheaddedbenefitwouldbethatIwouldget tokeepmyprofitswithout risking a loss thatwould occur due to anunfavorable move in thestock price after-hours onFridayorinthepre-marketonthefollowingMonday.
OptionzTraderz:The samereasoning applies to a LongPut Butterfly. Unless all ofthe options expired in-the-moneyorallof themexpiredworthless, youwould end upwith either a Long or Shortposition in the underlyingstock if you didn’t close thetrade before it expired. Thatcanbeagoodthingifyouareusing Butterflies as a meansof entering a stock trade.However, if you are trading
Butterfliessimplyforincome,it usually makes sense toclose themon expiration daywheneverpossible.
Stock Trader: I think IunderstandButterfliesnow.ALong Call Butterfly wouldwork best on a range boundstock that was unlikely topush through resistance. ALong Put Butterflywould bemore appropriate for a rangebound stock thatwas trading
near a strong support level,and an Iron Butterfly wouldalso work well on a rangebound stock, but with fewertrades and commissionsrequiredtoclosethepositionsonexpirationday.
Optionz Traderz: TheCondor option strategy alsohasaBearandaBullSpread,except that all four strikeprices are different.The goalof the Condor Spread is to
trade the higher potentialprofitsofaButterfly for lowersensitivity to small marketmovements, but with aslightlyhigheramountofriskthan a Butterfly. As withButterflies, Condors can becreated using all Calls or allPuts,and themaindifferencebetween the two strategies isthe amount of commissionsrequiredtoclosethetrades.
The Iron Condor is also
created by trading fourdifferent options withdifferentstrikeprices,butitiscomposed of two Calls andtwoPuts. In the IronCondoryou are holding long andshort positions in twodifferent Strangles. Thepotential for profit or loss islimited in this strategybecauseanoffsettingStrangleis positioned around the twooptions that make up theoptionStrangleat themiddle
strikeprices.
This strategy is usedwhen atraderbelieves themovementof the underlying stock willbe range bound within theStranglestrikeprices.AnIronCondor is very similar instructuretoanIronButterfly,but the two options locatednear the center of the optionstrategydonothavethesamestrike prices like they do inthe IronButterfly.Havingan
option Strangle instead of aStraddle at the two middlestrike prices widens the areaforprofit,butatthesametimemakes the potential profitslower.
Stock Trader: These aresome of the most interestingof all the option strategiesyou have shared. Veryfascinating, low risk, andcould generate consistentprofits.
OptionzTraderz: Likewithall option strategies you willhave to be mindful ofliquidity in your options andcommission costs. With fouroptions to buy and then sell,you want to ensure that youstill have profits to make itworth your while afteraccountingfor thelossof thebid/ask spread and possiblypaying eight commissions toenterandexit.Thisstrategyisused best with low
commission costs and tradedwith size thatmakes itworththetrader’stimeandeffort.
Stock Trader: So that’s it.Butterflies and IronButterflies fora tightly rangebound stock, and CondorsandIronCondorsforawiderrange of profitability. I’llhave to read through yourpostsagaintoreallywrapmyhead around these strategies,but I think I have a good
understanding of how theywork now. Thanks for yourhelp.
Optionz Traderz: I don’tmean to scare you, but thereare still six more strategiesforyourtoolbox.
Stock Trader: You’rejoking,right?
OptionzTraderz:LOL, I’mnotjoking.Butthegoodnewsis that they are all related to
the Butterflies and Condorswehavealreadydiscussed,sothey won’t take long toexplain.
Stock Trader: O.K., goahead.
Optionz Traderz: As younoticed, Butterflies andCondors work well on rangeboundstocks.Justaswithallof theotheroptionstrategies,there is an opposite strategythat works well under the
oppositeconditions.
Stock Trader: That makessense. Sowhatwould be theoppositeofaButterfly?
Optionz Traderz: ManytradersrefertosuchastrategyasaReverseButterfly.Thereis also a version called theReverse Iron Butterfly. ThesamegoesforCondors; thereare Reverse Condors andReverseIronCondors.
Stock Trader: I’m guessingby the name ‘Reverse’ thattheyworkbestonstocksthatarenotrangebound.
Optionz Traderz: Exactly.To create the ReverseButterfly or Condor, all thatneedstobedoneisswitchthelong and short positions. Forexample, a Long CallButterfly consists of LongCalls at the wings and ShortCallsinthecenter.AReverse
Butterfly,whichissometimescalled a ShortCallButterfly,is formedwithShortCallsatthe wings and Long Calls inthecenter.
StockTrader:So a ReverseButterfly results inaprofit ifthe underlying stock pricemovesoutsideofaverytightrange?
Optionz Traderz:That’s allthere is to it.WithaReverseButterfly created using all
Calls, it is like selling aCallSpread and buying a slightlyless expensive Call Spread;thetraderesultsinasmallnetcredit. If all of the optionsexpire worthless, the tradergets to keep the net credit,andifalloftheoptionsexpirein-the-money, the trader isleftwith aVerticalBullCallSpread with profits thatexactlycancelthelossontheVertical Bear Call Spread,again keeping the net credit.
TheonlylosingscenarioforaReverse Butterfly occurswhen the underlying priceremains unchanged atexpiration.
Stock Trader: That seemslike a great way to generateincome, so there must be adownside you are about tomention.
Optionz Traderz: Youknowme toowell. In theory,
ReverseButterfliesareagreatwayofgenerating incomenomatterwhichway themarketmoves. However in practice,the income is rarely enoughto offset the commissions. Ifyou look at the Boeing Co.Butterfly diagram again, youwillseethatopeningthetradein reverse would result in amaximum profit of just over$50.That hardly justifies therisk of a maximum loss ofnearly $200, even before
commissions are considered.To turn a profit, the numberofcontractsusedwouldneedto be large enough to offsetthecommissionsandfees.
StockTrader:That diagram
really helps. If I trade aButterfly on Boeing Co., Ihaveachancetomakea$200profit using just four optioncontracts,sothatwouldcoverthe cost of the commissions;but if I trade a ReverseButterfly,the$50profitcouldbe entirely lost tocommissions unless Iincreased the totalnumberofcontracts.
Optionz Traderz: You’ve
got it. It is very important toconsider your position sizewhen trading ReverseButterflies in order to ensurethatcommissionsdonotstealall of your possible profits.Just as with regularButterflies, ReverseButterflies can be createdthree ways. They can beopenedwithallCalls;aShortCall Butterfly, all Puts; aShortPutButterfly,oraLongStraddle surrounded by a
Short Strangle; a ReverseIronButterfly.
Stock Trader: That makessense.Somychoiceofwhichstrategy tousewoulddependon whether I thought thestockpricewasmorelikelytogoupordown.AShortCallButterflycouldhavealloftheoptions expire worthless ifthe stock price dropped, aShort Put Butterfly couldhaveallof theoptionsexpire
worthless if the stock priceclimbed, and a Reverse IronButterfly would guaranteethat nomore than twoof theoptionswouldrequireatradetoclosethematexpiration.
Optionz Traderz: It’s assimple as that. All threestrategies have similarbehaviors, so it is thedifference in commissionsthat sets them apart. Thesame is true of Reverse
Condors. The Short CallCondor requires no closingtrades when the underlyingshares fall below the lowestCall strike, the Short PutCondor expires with alloptions worthless when theunderling price rises abovethehighestPutstrike,andtheReverse Iron Condor alwaysexpires with at least oneoption,butnomorethantworequiringaclosingtrade.
Stock Trader: You wereright; those six strategies arenot that difficult tounderstand.
OptionzTraderz:I’mgladIcould help. ReverseButterflies and Condors canbe particularly useful whenthere is pending newssurroundingacompany,suchas an upcoming earningsreport. Unlike a LongStraddle,whichcancapturea
strongmove that resultsafterearnings are released, aReverse Butterfly or Condorwill not change in valuesignificantly due to thecollapse in volatility thatoften occurs. ImpliedVolatility has an effect onboth the long options andshort options in a ButterflySpread, so even whenvolatility does decrease afteran earnings report, it usuallyhaslittleoveralleffect.
StockTrader:That’sagreatidea, using a ReverseButterfly to capture a movecaused by an earnings reportwithout the volatility risksinvolvedinaLongStraddle.
Optionz Traderz: AnotherniceaspectaboutallSpreads,especially Butterflies andCondors, including theReversevarieties, is that theynormallyreactveryslowlytochanges in the underlying
price. But that’s a topic foranotherday.Iwanttogetoutandenjoythisniceweather.
StockTrader:Gotit.Thanksfor that lastpieceof thepuzzle concerningoptionstrategies.
OptionzTraderz:O.K.,nowit is time for a run on thebeach.IwillseeifIcanbeatmybesttime.
Optionz Traderz is now
offline……
Optionz’s generositynever stoppedamazingStockTrader. He smiled at thethought of Optionz’ beachrun; he himself would soonget to be ocean side on hisupcoming, much-deservedvacation. He was reallylooking forward to enjoyingsome hot weather andmeeting up with his oldcollege roommate, just as he
had donemost every autumnsince graduation. But untilthat day came, it would beback in traffic tomorrowmorning.
“Good grief!” Thevery thoughtof the9-5grindmadehisspiritfall.
Chapter14DEALINGWITHTHE
BEHAVIORALPROBLEMSOFIMMATUREOPTIONS
“71 degreesFahrenheit in Sunny SanDiego,California”iswhathissmart phone said. A smilecameacrosshisface.
“Nice.”
With a week to gobefore he took off, he beganhisannualdaydreamingabouthowgreathisvacationwouldbe.
No more traffic,
bosses, fellow employees, ormonotonous work for twoweeksofblissbytheocean.
Butfornowhehadtofocus.
Stock Trader wascasually looking throughsome option chains thatbaffledhim.
He noticed for thefirsttimehowallthevolume,open interest, and action
started with the nearest dateat-the-money options in bothCallsandPuts,andthefartheraway and out-of-the-moneyhe looked, the more chaotictheybecame.
When he looked upoption chains and comparedoptionswithstrikepricesthatwere$90ormoreout-of-the-money, the options all hadaboutthesamepremiumeventhough they had different
strike prices and the samemonth of expiration. Hefigured the chances that theywould all expire worthlessprobablyplayedabig role inthe price not being an issue.They were just random betswith close to zero odds ofeverhavinganyreal intrinsicvalue.
Hewasamazedtoseethousands of open interestcontracts in strikes$200out-
of-the-money in theupcoming month, no doubtbought by mega bulls longagothatwerenowtrappedinpurgatory with no way ofgetting out. Two cents bidwith 600 contracts of openinterest was like trying tosqueeze a camel through theeyeofaneedlewithonly100contractsadayinvolume.
It was interesting tosee that options deep out-of-
the-money lost all relation toDelta and Theta movementsand became simply pricedbased on demand fromgamblers.Appleoptionsdeepout-of-the-money moreresembled penny stocks fortheir lack of volume andrandomvaluationsbasedonafewrandombuyersthanstockoptionsofoneof theworld’spremiercorporations.
It appeared to Stock
Trader that the at-the-moneyfront month Calls were likethebigcitywithspecificlawsthat were enforced and thefarther away you went fromthiscitythemoreyougotintothe lawless wild west ofgamblersandgunslingers.
You could buyoptions amonth out that hadstrikepriceswithin$90oftheunderlying price and get nomoveinyouroptionfora$50
ormoremoveinthestock.
He wondered whatOptionzhad to say about theweird movements in optionswhen you do not get whatyouexpected.
Bingo, as usualOptionzwasonline.
“He must live at hiscomputer,” thought StockTrader.
StockTrader:Whenwe leftoff the other day, you weretalking about Butterflies andCondors being very slow toreact to changes in theunderlyingprice.
Optionz Traderz: That istrue. One of the mostcommon complaints I hearfrom option traders is thattheir options did not behaveas they expected. Unlikestock trading, it is possible
for the underlying price tomove in a direction that isfavorable to an optionpositionandstill losemoney.Therearealsotimeswhentheshare price canmove againstan option position and resultinaprofit.
StockTrader:Yes, I think Iremember you mentioningthat when you wereexplaining Ratio Spreads. Itseemsa littlecounterintuitive
that options sometimesbehave opposite to the wayonemightexpect.
Optionz Traderz: It can befrustrating,anditmaybeoneof the main reasons thattraders abandon optiontrading. However if youunderstand the behavioralproblems of immatureoptions, it will not only giveyoutheconfidencetosticktoyourprovensystem,butthere
may be times that you cantake advantage of thosebehaviors.
StockTrader:I’mnotsureIunderstand.Howisitpossibleto predict when an optionwon’tbehaveasexpected?
OptionzTraderz:Well, it isnotpossibletopredicthowanoption strategy will behaveunder all circumstances, butthere are some generalguidelinesthatcanbeusedto
makeaneducatedguess.
Stock Trader: O.K., I’mwithyousofar.
Optionz Traderz: First, asyouknow,optionshavemuchless liquidity than stocks.There are almost alwaysfewer option contracts tradedthan sharesof theunderlyingstock.Theresultofthelowerliquidity is that the bid/askspread is normally muchwideronoptionsthanitison
stocks,evenonthosethatareheavilytraded.
StockTrader:Ihave lookedup some option chains and IhavetoadmitIwassurprisedto see that some of thebid/ask spreads were inexcessof$1.00.
OptionzTraderz:Evenonaheavily traded stock such asApple, where the bid/askspread on the shares issometimes5centsorless,the
spread on at-the-moneyoptions can be 25 cents ormore. Generally, the furtherout you go in the expirationdateof anoption, thegreaterthe spread. Also, dependingon the particular stock, someexpirationdatesmaybemorepopular than others. Forexample, there may be highvolumeonoptionsexpiringinoneyearandthoseexpiringinone month, but almost novolume on those expiring in
three months. In thatscenario, it is likely that thebid/ask spread could besignificant on the three-month-outoptions.
Stock Trader: You havementionedmany times that itis very important to considerliquidity when tradingoptions, not only in terms ofvolume, but also the amountof open interest at a specificstrikeprice.
Optionz Traderz: I’m gladyou were paying attentionbecauseliquiditycandriveanoption trader insane if it isignored.Sonowwecanaddasecondbehavioralproblemtothe mix: option premiumschangemuchslower than theunderlyingshareprice.
Stock Trader: O.K. That Iunderstand, thanks to yourexplanationofDelta.IfIbuyaCalloptionwithaDeltaof
0.5, the premium shouldinitially change about half asfastastheunderlyingprice.
Optionz Traderz: Correct.So here is where a lot ofoption traders loseconfidence.When you buy astock and the priceimmediately goes up, thetradewillusuallyshowupasan unrealized gain. Manydiscount brokers also offervery low cost commissions
on stock trades, and somealsooffer free stock trades ifcertain conditions aremet.Astock trade involving a verylow commission might onlyneed to experience a priceincrease of a few pennies toshowaprofit.
With options, most brokerscharge higher commissions,and there are often fees thatadd to those amounts. Theresult is that every option
trade will initially appear asanunrealizedloss,firstduetothewiderbid/askspread,andsecond due to the highercommission. Because theoption premium changesslower than the underlyingshare price, it takes muchmoreof amove to offset theinitialloss.
Stock Trader: So everyoption trade will look like alosswhen I firstopen it, and
that loss will take longer toerasethanitwouldonastocktrade?
Optionz Traderz: Exactly,and as we have discussed inthe past, changes in theunderlying share price canaffect Implied Volatility,which can cause unexpectedchanges in option premiums.This is especially true ofimmature options; thosewiththelongestamountoftimeto
expirationaregenerallymorevulnerable to changes involatility than those nearingexpirationday.
ACalloptionmaynotgainasmuch value as expected,when the underlying pricerises, if themarket perceivestheincreaseinpriceinawaythat causes fear of fallingprices to diminish. ThedecreaseinImpliedVolatilityis reflected in a smaller
increaseinthevalueofaCalldue to the effect of Vega.Likewise, a Call may loselessvaluethananticipatedifadecrease in the underlyingprice creates fear anduncertaintyfortraders.
The opposite is true of Putoptions,whichnormallygainvalue more quickly in adowntrend while also losingvalue more quickly in anuptrend.
Stock Trader: So Puts aremore sensitive to changes inthe underlying price thanCalls?
Optionz Traderz: As ageneral rule they are moresensitive, but there are timeswhen volatility does notmatch the direction of thepricemovement.Itispossiblefor the underlying price torise while Implied Volatilityis increasing and decrease
when volatility is falling. Ibelieve one of the easiestways tounderstand this isbystudying options on aninverse ETF, such as a bearETFthatmimicstheoppositebehavior of the generalmarket. When the marketmakes a strong downturn,Implied Volatility willusually increase, but a bearETF will see its share pricerise in spite of the IncreasedVolatility. The effect of
volatility spreads across themarket like a virus, infectingbull ETFs and bear ETFsalike. The result is that theoptions on bear ETFs maybehave the opposite of whatone might expect, as far aschanges in general marketvolatility.
Stock Trader: I think I seewhere you are going now.Astock or ETF that tends tomove in the opposite
direction as the rest of themarket might have Calloptions that are moresensitivethanPuts.
OptionzTraderz:Theeffectisnotoftenahugeone,butitissomethingtokeepinmind.Inverse ETFs, preciousmetals,andcommoditiessuchas oil can all have pricemovementsthatcontradicttherest of the market, and thatcan have an effect of the
behavior of the associatedoptions.
Stock Trader: Youmentioned that the effect ofvolatility is greatest onimmature options, so I’massumingthatitdisappearsasthe option approachesexpiration.
Optionz Traderz: Correctagain. As options mature,they begin to act their age.When they reach the final
daysleadinguptoexpiration,there are few surprises whenit comes to changes inpremiums. Also, volumetends to increase in the finaldaysoftrading,especiallyonexpiration day itself, astraders roll out, exercise, orclose their positions. Theincreased liquidity cansometimesnarrowthebid/askspread,whichalsomakes theoption premiums morepredictable.
StockTrader:Sothatwouldexplain the increasingpopularityofweeklyoptions.
Optionz Traderz: That andthe increased rate of timedecay makes selling weeklyoptions attractive. At thesame time, the lowerpremiums on weekly optionsmake them desirable forbuyerswhoareattempting tolimit their lossexposure.Thecombination of liquidity and
the relatively small effect ofchangesinvolatilitycausethepremiums of weekly optionstobefairlypredictable.
Stock Trader: Any otherthoughts?
Optionz Traderz: Anotherbehavior problem of alloptions, especially theimmature ones, is that theyliketosleeplate.
StockTrader:LOL,I’mnot
sureIunderstand.
Optionz Traderz: I’m sureyou have noticed that stockstendtohaveveryhightradingvolume right after theopening bell. Normallyvolume drops off as themorning progresses and afinal increase involume thenprecedes the closing bell.Many stocks are also tradedin the pre-market hours aswell as after-market. Not so
withoptions; theyneverstartearlyorstaylate.
But even with shorter hoursthan stocks, options aren’tcontent with a trading daythat is confined to regularmarkethours,sotheytendtosleep late.Mostoptionshavevery little trading volume atthe open, and the effect isusually more pronouncedwith those that have longertimes to expiration. When a
new chain of options is firstintroduced, it can sometimesbe an hour ormore after theopen before a single tradeoccurs. The bid/ask spread,even on heavily tradedoptions, can be significant inthe first hour of each day’strading.
Stock Trader: I would nothave thought of that, but Ibelieveyouare correct. If anoption chain normally
experiences its highestvolumeataparticulartimeofthe trading day, opening orclosing a trade at that timecould help ensure theminimumamountoflossduetothebid/askspread.
Optionz Traderz: Yes, it’sjust another way ofdecreasing liquidity risk. Aswe already discussed,immature options tend tohave lower liquidity than
thosenearertoexpiration.
Stock Trader: O.K., if Iunderstand what you havesaidsofar. Immatureoptionsdon’t always behave asexpected. Trading volume isusuallylowerwhenanoptionhas a lot of time remaininguntilexpiration,whichcausesthe bid/ask spread to widen.In addition, changes involatilitycancause immaturePuts to be more sensitive to
movesintheunderlyingpricethanCalls.
Optionz Traderz: You’vegot it. So let’s move on toimmaturecombinations.
Stock Trader: As inStraddlesandStrangles?
Optionz Traderz: Exactly.In a Straddle or Strangle,volatility tends to lower thesensitivity of the Call andincrease thesensitivityof the
Put. The result is that aStraddle may not behave asexpected in an uptrend. Thelower volatility maysometimes decrease the timevalueofbothoptionsenoughto offset the increase inintrinsic value gained by theCall.Theoppositeistrueinadowntrend, where volatilitymay cause a Straddle toincrease in value faster thananticipated.
Stock Trader: That makessense. So a Long Straddle isactually a slightly bearishstrategy and a Short Straddleisalittlebitbullish?
Optionz Traderz: Straddlesand Strangles are oftendescribed as neutralstrategies, but when theoptions are immature theirbehavior gives them a biasthat makes them performbetter incertainmarkets than
inothers.
Stock Trader: What aboutcombinations of Calls andPuts in Synthetic Stockpositions?Dotheyexperiencethesameeffects?
Optionz Traderz: Yes andno. They are exposed to thesame forces as Straddles andStrangles, but the effect onone option is offset by theeffect on the other. Forexample, inaSyntheticLong
StockpositioncreatedwithaLongCall andShort Put, theCall’s performance will tendto lag in an uptrend, but thedecrease in volatility willincrease the performance ofthe Short Put; they canceleach other out. SyntheticStockpositionsareessentiallyimmunetoallofthebehaviorproblems of options, exceptliquidity.
Stock Trader: So with
Synthetic Stock, I am sellingTheta to buy Theta, sellingexposuretoVegaandbuyingexposuretoVega,andsellingnegative Delta and buyingpositiveDelta.
OptionzTraderz:I’veneverseenitwordedquitethatway,but you are correct.Everythingcancelsoutexceptthat selling negative Delta isequivalent to buying positiveDelta, so you are essentially
buying Delta, twice.Disregarding the loss on thebid/ask spread, the positionshouldbehavethesameasthestock, dollar for dollar, nomatter how much timeremainsuntilexpiration.
Stock Trader: Any otherbehavior problems I shouldknowabout?
Optionz Traderz: Let’ssee… We talked aboutSpreads. Spreads are not
entirely immune to changesin volatility, but the effect isreduced considerably. In aVertical Bull Call Spread, iftheunderlyingpricerises,anydecreaseinImpliedVolatilitythatloweredthetimevalueoftheLongCallwouldalsotendto decrease the value of theShort Call. The effect ofvolatility is not exactly thesame at two different strikeprices, but it is usually closeenough that it does fall into
the ‘bad behavior’ category.Byfar,thebiggestbehavioralproblem with immatureSpreads is that they are lazy.However, as I mentioned afew days ago, you can usethat behavior to youradvantage, cutting losseswhen trades moveunfavorably and holdingwinners until they matureenough to show their truevalue. I’m sending you acharttoshowwhatImean.
Stock Trader: LOL, thanksfor sending this. I can really
see what you are implyingwhen you say immatureoptionsarelazy.TheVerticalSpreadusingmonthlyoptionswas very slow to react, evenwhen the share price was upand down as much as $25.The weekly options weremuchfasteratpickingupthefullvalueoftheSpread.
Optionz Traderz: Theweekly Spread can also losevaluemuchfasterifthetrend
goes against you, so thoseoptions aren’t necessarily abetter choice. It all comesdown to your trading styleandpersonality.Sometraderswould prefer holding themonthly Spread for an extratwo weeks, given that theLong Calls ended the weekmore than $25 deep in-the-money. Other traders wouldrather take on the additionalrisk of the weekly Spreadquickly becoming worthless
in a downtrend, in return forthe faster price discovery inanuptrend.
Stock Trader: So it’s ‘slowand steady,’ or ‘fast andfurious.’
OptionzTraderz:That’soneway of looking at it. Theeffect becomes even moreevident when multipleSpreads are used, such aswithButterfliesorCondors.
StockTrader:SoaButterflySpread will have an evenslowerpricediscoverythanasingleVerticalSpread?
Optionz Traderz: Normallythat is the case.Unless thereis a very strong trend in onedirection or the other, aButterfly will usuallyexperience little change invalue until the week ofexpiration. Even then, mostof the change occurs during
the last few days. There aretimes when the underlyingpricecanmovetoapointthatwouldresultinthemaximumprofitforaButterfly,andthatprofit might not fully revealitselfuntiltheverylastdayofthecontracts.
Stock Trader: That seemsreasonable. If I open a LongCall Butterfly Spread, andDelta is 0.6 on the loweststrike, 0.5 on the middle
strike and 0.4 on the higheststrike, small changes in theunderlying price will havelittle effect. The two LongCallswouldgain60centsand40 cents respectively, forevery dollar increase in thestockprice,andthetwoShortCalls would lose 50 centseach.
Optionz Traderz: AButterflycanbenearlyDeltaneutral when it is initially
opened. The profit from aButterflyisaresultofslightlyfastertimedecayontheShortoptionscompared to the longones. Because the differencein Theta is usually quitesmall,ittakesalotoftimeforaButterflytorealizeaprofit.Even when a Butterfly tradeworks perfectly, if one-month-outoptionsareused,itcantakeaboutthreeweekstoseethefirsthalfoftheprofit.The final half of the time
decay usually occurs in thefinalsevendays.
Stock Trader: I see, so thesame should also be true ofReverse Butterflies andCondors; if the trade is in aposition to experience itsmaximumlossthatlossmightnotappearuntilthefinaldaysoftrading.
Optionz Traderz: Exactly.That makes it very easy totrim losses. However, as we
discussed earlier, Butterfliesand Condors have anadditional behavioralproblem:theyeattoomuch.
Stock Trader: Now thatanalogy I get!With asmanyas eight trades required toopenandcloseaButterflyorCondor, those trades canreally eat up a lot ofcommissions.
Optionz Traderz: I thinkthataboutcoversmostof the
unexpected behaviors youmight experience with thedifferent option strategies.There are a few additionalproblems that can cause alloptions to act in ways thatcancatchyouoffguardifyouaren’t prepared for them,regardlessofthestrategy.
Stock Trader: O.K., I’mready.
OptionzTraderz:Ithinkwehavetalkedaboutthisbefore,
but it bears repeating.Dividends can cause optionsto perform strangely. Optionpremiums are based on theexpected price of theunderlying stock atexpiration. If an ex-dividenddate occurs prior toexpiration, those premiumswill have the expecteddividend-induced decline inthesharepricebaked-in.Putsbecome slightly moreexpensive and Calls a little
cheaper.
Stock Trader: I doremember you mentioningex-dividenddatesinthepast.
OptionzTraderz:Assumingallothermarketforcesremainunchanged,thepassingoftheex-dividenddatewillresultinthe price of the underlyingshares falling by an amountwhich is normally apercentage of the dividenditself.However, thepremium
on the options expiring afterthat date will not usuallychangemuch.Forexample,ifyou sold aCoveredCall andthe stock went ex-dividend,the share price would likelydeclinebut theCallpremiumprobablywouldnot,althoughyou would be entitled toreceive the dividend when itbecamepayable.
Stock Trader: Got it! Anyotherideas?
Optionz Traderz: I hopeyou’re not timing me,because I am about tomentiontheHolyGrailagain.
Stock Trader: It doesn’tsurprise me to see Rookiebringitup,butyou?
Optionz Traderz: I don’tintend to disappoint you, butRookie’s infamous no-losstrade can be helpful inunderstanding the effect of
dividends.
Stock Trader: So we arebacktosellingaCoveredCallandbuyingaPutat thesamestrikeprice.
Optionz Traderz: Exactly.The only difference now isthat instead of beingguaranteednottolosemoneyon the stock, you would beentitled to the dividend. Intheory, the Call should be‘underpriced’ and the Put
“overpriced’ so that openingsuchatradewouldresultinaguaranteed loss equal to theexpected gain from thedividend.
StockTrader:Intheory?
Optionz Traderz: I say ‘intheory’ because optionpricingismoreofanartthanan exact science. There maybe times when such a tradecould result in a loss thatwould be less than the profit
from the dividend, whatmight be called an arbitrageopportunity. However, it hasbeenmy experience that fewstocks have options withenough liquidity to makesuch a trade profitableenoughtoaccountforthelossduetothebid/askspread.
StockTrader:You’llhavetotease Rookie with that onesometime. I’m sure he’d liketofindoutthattheHolyGrail
actuallyexists. It justdoesn’tworkinreallife.
Optionz Traderz: That’sfunny.Butseriously, the trueHoly Grail of option tradingis risk management.Understanding how optionsbehaveandlearninghowthatbehavior can change asoptions mature is one of thekeys to successfullymanagingyourtrades.
Stock Trader: So are there
any other behavioralproblemstoconsider?
Optionz Traderz: In thepast,wehavediscussednewsevents and their effect onoptions.Immatureoptionsaremore likely to be influencedby changes in volatility thanthosenearingexpiration.
Stock Trader: So thecollapseofvolatilityaftertherelease of an earnings reportwould have a greater
influence on longer termoptions?
Optionz Traderz: That isoften the case. However itmight depend on how oftenthat particular companyreported its earnings. Ifanother report was expectedprior to expiration of a longterm option, ImpliedVolatility might remainelevatedon thatoptionwhilesimultaneously evaporating
onaneartermoption.
StockTrader:Ihavealwaysfound it strange that ImpliedVolatility can be differentdepending on the amount oftime to expiration, but thatmakes sense. If there wasincreaseduncertaintyduetoafuture earnings release,Implied Volatility might behigher on long term optionsthanthosewithshorterterms.
Optionz Traderz: Immature
options also have oneadditional behavior issue.They are at a higher risk ofbeingaffectedbyastocksplitorreversesplit.
StockTrader:Whenastocksplitoccurs,aren’ttheoptionsadjusted to reflect thechange?
Optionz Traderz:Yes, theyare. However, it often takestime for theadjustment tobecompleted. During that time,
options are normallyunavailable for trading, andyou could get stuck with abad trade if the blackout ontrading happens to coincidewith some unforeseen eventinthemarket.
StockTrader:That’salottothinkabout,soI’llletyougo,in case you want to takeanother run on the beach.Thanksforallthehelpagain.
Optionz Traderz: As
always, you’re welcome. Iwould go for a run, but mylegs are still tired fromyesterday. I may go for aswimthough;theweatherthisweekhasbeenunusuallyhot,even by Southern Californiastandards.
StockTrader:Thatisfunny.I will be in San Diego in aweek on vacation. Too badCalifornia is such a hugestate. Where do you live, if
youdon’tmindmeasking?
Optionz Traderz: LongBeach.
StockTrader: Oh, where isthat?
OptionzTraderz:Well, youcan get from San Diego toLong Beach in two hourswithno traffic.Ofcoursewehave plenty of traffic inCalifornia,LOL.
StockTrader:Really?Whatdo you say about usmeetingfor a few beers while I amthere?
Optionz Traderz: Howabout I get a martini ormargarita? I really hate beer.Yuck!
StockTrader:O.K., as longasyouletmetalkoptionsandtrading you can drinkwhateveryouwant.
Optionz Traderz: Thatsoundslikeadeal.
StockTrader:Oh,anditwillbe my treat for all yourteachingaboutoptions.
Optionz Traderz: Now thatsoundslikeagooddeal.
StockTrader: Have a greatswim,myfriend.
StockTraderwasveryexcited about the prospect of
meetingOptionz face to facein California. It would begreat to break his normalmonotony of reading booksonthebeachandrelaxingasalonewolf for themajority ofthe time with some qualitytime with his college buddymixedin.
So few people reallyunderstoodhimandhisgoalsand he felt like Optionz wasalready living his dream.
Maybehecouldbeamentor?
Stock Trader thoughtthat a man who didn’t likebeer was just odd, and hepersonally would never getcaught drinking a martini inpublic.
Healsohadthefunnythought that maybe Optionzcould introduce him to somelady friends and they coulddouble date, but how goodcould he be at the dating
game while drinking girlydrinks?
This would no doubtbeatriptoremember.
Chapter15ATRADER’SCHOICES:
INSURANCE,STOPLOSSES,
ORRUIN
Stock Trader awoke
staringattheceiling.
What a wonderfulmorning for him. No alarm,no traffic, no work day. Hedrifted back into a blissfulsleep.
An hour later heawoke with the wonderfulfeeling that one gets on thefirst morning of a longvacation. He wanted thisfeelingtolast.
He had to get going,though, as his plane left inthree hours. He had to leaveplenty of time to be frisked,x-rayed, and groped bysecurity before boarding theplane,orsohehadheard.
“Whattotake?”
He pulled three newtrading books out of hisbookcase that he wascurrently enjoying reading.All of them were about
options, theworldofCollars,Married Puts, Spreads,Synthetics,etc.Hereallywasbeginning to feel moreconfident about tradingoptions with each book heread and each online chatwithOptionz.
“Clothes, check, belt,check…”
“Wait, I need sometrading magazines for theplane; here are some good
ones,” he thought, as heshovedtheminhisbag.
“I also need beachstuff,swimmingtrunks.”
“I am scared to takeanything that will not beallowedon the plane, I thinkliquids are pretty muchbanned. I guess I will justhave tobuy thosewhenIgetthere,”hethought.
He went to his
computerand tweetedoutonhis2ndfavoritesocialnetworksite:
On his main socialnetworking site he posted ashisstatus:
Stock Trader: I am flyingout to San Diego today,planning on having a blastwith my friend John. I amalso planning to meet the
legendary trader and teacher,Optionz Traderz, in personforthefirsttime.
He was finishing uphis packingwhen a commenthit his post a few minuteslater.
Optionz Traderz: I amlookingforwardtoit.
StockTrader:Metoo.
It was time to be off
totheairport.
The security was notnearly as bad as he haddreaded and he was soon ontheplane.
He had a copy of theday’s financial newspaperand read on the front pagethat the airline companyhandling his flight had filedfor bankruptcy that verymorning.
“Wow,” he thought.“That’sjustmyluck.”
The flight went onand on. With no computerandnotevenasmartphonetoplaywith, StockTrader triedtofocusonhismagazinesandbooks, but he really missedthe markets and theinteraction online with othertraders. He truly had apassion for the markets. Heloved nothing more than
catching that big trend andlettingitrunandrun;forhimthatwashappiness.However,hehad todealwith the timeshewaswrongalso.
With each loss hewould think to himself andsometimessayoutloud,
“The market givethand the market taketh away;ifImanagemyriskIwilllivetotradeanotherday.”
While it didn’tremove the pain of losses, ithelped refocus his mind onthenexttrade.
Finally, he could seetheoceanoutofhiswindow.HewasinSanDiegoandtheplanepreparedtoland.
Hefeltalittlewobblyleaving theplaneaftersittingstill for so long.A four-hourflightwasalongtimeforhimto try to sit and entertain
himself.
Hecarriedoffhisbagand finally made his way tothe lobby after weaving hisway through an endlesscrowdofpeople.
StockTradermadehisway to the car rental placeand got his wheels, a redMustang.
“Nice,”hethought.
With his handy smartphoneheupdatedhisstatus.
Stock Trader: Missionaccomplished, the eagle haslanded.
He made his way tothe hotel and checked in.Hewent to his room andimmediately loved the view:water for as far as the eyecould see. It was a differentworld from the land lockedstatehewasusedto.
“Freedom!” he saidoutloud.
“Now where do Ibegin?ShouldIcallgoodoldJohn or the legend ofOptionz? Hmm… collegestories or option and tradingtalk?”
AsmuchashewantedtomeethisFacebook tradingfriendinperson,heknewhisold college buddy would be
awaiting his call. Sure, hewas married now, but Johnwas always up for some funand Stock Trader reallyenjoyed relaxing over a fewbeers and reminiscing aboutsome of the crazy times inwhat now seemed like thedistant past. Besides, hewouldbehere for twowholeweeks,plentyoftimetosharecollege stories and also learnaboutoptions.
A cold beer soundedlike a nice way to unwindafter that long flight.Unfortunately, his phone calltoJohnwenttovoicemail.
He looked out of hishotelwindow at the paradisebelow; the late afternoonDecember sun shining overthe seemingly endlessbeaches, dotted by theoccasional surfer or body-boarder.
Hechangedoutofhiswinter clothes into someshorts, unpacked a tradingbook and smart phone, andwasofftothefrontdesk.
After renting a beachchair and obtaining thehotel’s Wi-Fi password, hewassoonsittingwithhisfeetinthewarmsand,listeningtothesoundofthewaves.
“This is the life,” hesaidtohimself.
But still, he felt theneedtoconnectwithOptionz.
Hetookouthisphoneand sent Optionz a directmessagethroughthesite.
StockTrader: I am in yourneck of the woods; anythoughts on when we canmeet?
About five minuteslater he received his
response.
Optionz Traderz: Howabout a nice Sunday brunchin Long Beach? I will sendyoutheaddressinamessage.Howaboutnoon?
Stock Trader: That soundsgreat.IguessIneedtoadjusttoPacificTimefromCentral,soitwillbelikemy10a.m.
Optionz Traderz: My realname is Terry and I will be
wearing all green, moneygreentobeexact.
StockTrader:Myoff-screenname is Jack. I look forwardtoit,seeyouthen.
“Wow,veryeccentric.Allgreen?”hethought.“Thisshould be very interesting.”He had pictured themmeeting up to leisurelydiscuss options over somesteaks at dinnertime, butbrunchwouldbeO.K. too. It
was probably just as well.Withhisstomachstillsettoadifferent time zone, a heavymeal might not be such agood idea. Still, there wassomething about meeting aman for brunch that madehimfeeluneasy.
A while later Johnreturned Stock Trader’s call,and they spoke for over anhouraboutlife,goals,andthefuture, catching up on old
timesanddreamingaboutthefuture. After an hour, Johngot a business call from animportant client, so theyagreed to pick up theirconversation in person later.John was free after work onTuesday, and that fit nicelyinto Stock Trader’s plans.StockTraderendedupsittingon the balcony of his roomanddrinkingabeerwithlimeandwatchingthesunsetovertheocean.Itwasagreatfirst
day.
The next morning hewoke up early without theassistance of an alarm clock.He felt excited andinvigorated.
“Was it his job thatwas sucking the life out ofhim?”hewondered.
Then guilt rushed in;heshouldbethankfultohavea job in this day and age of
recession.
He checked his GPStosee that the restaurantwasabout two hours away. Soonhe and Optionz would meet;they would be transformedinto Jack and Terry. It waslike being unplugged fromtheMatrix.
The drivewas simplybeautiful. Jack, the stocktrader, dreamed of retiringfromhisjobandmovinghere
into a nice condo by thebeach.ThatwouldbethelifethatOptionzwaslivingnow.
Hegot to thefreewayexitandfelt thebutterflies inhis stomach. He was hopinghecouldhangwithTerry theoptions trader in real life,talkingwithout the pauses ofthinkingandtyping.
He pulled into therestaurant parking lot andthere, inreal life,wasparked
the pink Cadillac he hadlooked at online for so long.He got out of his car andwalked beside it – perfectcondition.
But he couldn’t helpthinking, “What man in theworlddrivesaroundinapinkCadillac,wearingallgreen?”
Ashewalkedintotherestaurant he saw a portlymanwearingagreenfootballjerseyandblue jeanswaiting
tobeseated.Hisspiritsfell.
“Terry?”hesaidwhileholdinghishandouttoshake.
“No buddy,my nameisBilly,”heresponded.
“Oops, sorry, I amwaiting for someone,” hesaid,embarrassed.
“Can I help you?”Jackwasaskedbythesmilingandfriendlyhostess.
“Yes,Iamwaitingonafriend,”hereplied.
“IsyournameJack?”
“Yes.”
“Rightthisway.”
Thehostessledhimtoa tableby thewindowwherea very attractive lady wasseated.
Jackwasdisappointedagain.
“I guess Optionzbrought his girlfriend tobrunch, and she is alsowearing all green. Goodgrief!Henevermentionedhewas bringing his girlfriend!”hethought.
He hid hisdisappointment andintroducedhimself.
“Hello, I am Jack,known as Stock Traderonline,” he said, as he held
outhishandtoshake.
“I am Terry, betterknown as Optionz Traderzwith two ‘Zs,’” sheresponded.
Stock trader Jack hadthat strange moment ofvertigo, when a person is sosurprised theyfeelas ifup isdownanddownisup.Hesatdown at the table unable tohide his surprised look fromTerry.
“What iswrong?Youlooksurprised,”saidTerry.
“I uh, just… uh,pictured you lookingdifferently,”saidJack.
“What does an optiontraderlooklike?”sheasked.
Not wanting tooffend,hetriedtochoosehiswordscarefullyand tactfully,buthewasnotquickenough.
She looked at himsternlyandasked.
“What, you don’tthinkgirlscantradeoptions?”
Jackwas stunned andspeechless, butTerry let himoff the hookby breaking outin laughter. He was relievedthat she was not offended.Suddenly a bunch of thingsmade sense: the margaritas,the pink Cadillac, the pettortoise, the endless patience
with other traders; it seemedobviousinhindsight.
“Itissogreattogettomeetyouinperson.Ifeellikeyou are my option tradingmentor,”Jacksaid.
“I have also enjoyedouronlinechats,”Terrysaid.
“I realized on thedriveupherethatIwantedtobe just likeyouwhen Igrowup,” Jack saidwith a playful
grin.
“It is a great life, ifyou can handle the heat intrading and on the beach,”Terrysaidjokingly.
“Well,Iamnotscaredof the beach, so I guess Ibetterjustmanagetheheatinmy trading,” responded Jackconfidently.
“So, how was thedrive from San Diego?”
askedTerry.
“Not what Iexpected,” answered Jack.“Therewasvery little traffic,and the countryside is sogreen;ithardlylookslikethemiddleofadesert.”
“Yes, December is abeautiful timeofyearhereinsouthern California,” Terryreplied. “And the traffic isn’talways as bad as itsreputation, especially on a
Sundaymorning.That’swhyI suggested meeting forbrunch. Late afternoonSunday traffic can be anightmare.”
The waitress cameandtooktheirordersandtheysoon drifted off into optiontalk,evenfasterthanJackhadexpected, having just metfacetoface.
“I am only able totrade for a living because I
manage all my positionscarefully, first with thecorrect position sizing, thenstop losses, and at timesinsurancewhenneeded,”saidTerry.
“Youhavetouchedonthese before. I am all ears,and this is much easierwithout you having to typeeach response.” Jack relaxedin his chair and gotcomfortable.
“I never risk mylifestyle or net worth on anyone trade.Agood risk is1%to 2% of trading capital onany given trade, for mostsystems. Also, I do notexpose my accounts to morethan 6% of total capital lossat any one time based onmultiple trades. Of coursemarketgaps,liketheoneswehave seen recently, can takemore than you planned; but6%isagoodbasispoint.That
iswhyitisimportanttohaveadequatecapitaltotradewithfor a living. If a 2% gain intotal account capital in youraccount can pay for yourlivingexpenses, thenyouarein business. A $200,000accountwithamonthlyreturnof$4,000isdefinitelydoablewitha robust strategy. Ifyouare risking a total of $2,000pertrade,youonlyhavetoberight a few more times thanyouarewrongtowinforany
given month. Or if you areright much bigger thanwrong, you can do verywell,”explainedTerry.
“So if I risked, say,1% of total capital per tradeinamonth,andhadthreestopoutwith losses for a total of$3,000 and five wins thatmade $5,000, because theywere all equal, then I wouldhavea2%gain thatmonth?”askedJack.
“Exactly, that is howyou trade risk. Of course, inreal life we would hope thewinners were much biggerthan the losers, just as youwould expect with stocks,based on your trend tradingstyle. Trend trading, usingstoplossesortrailingstops,isvery similar to many high-probabilityoptionstrategies.”
“In options you alsohave the benefit of using
insurance as opposed to stoplosses. In a Butterfly andCondor the Long Calls or‘wings’ are insurance for theShort ‘body’ of the optionstrategy against awild trend.In a Married Put or Collar,theLongPut is insuranceforthe stock. Investors at timesmaybuyPutstoprotectgainsin their holdings which forwhatever reason they do notwant to sell. This alternativedoes not exist with stocks;
there you just have to usestop losses and trailingstops,”finishedTerry.
“I think I understandallofthatexcepttheCollar.Idon’t recall you mentioningthat strategy before,” saidJack.
Terry quicklyapologized. “I’m sorry if Ileft that one out during ouronline chats. A Collar issimply the selling of an out-
of-the-moneyCallinordertooffsetsomeofthecostofthepremium of aMarried Put. Ipersonally don’t use Collarsvery often because they canbe simplified usingsynthetics.”
Jack pulled out asmallnotebookhehadtuckedinto his shirt pocket andbegan to flip through thepages.
“I see you’ve been
taking notes,” Terrychuckled,“I’mimpressed.”
“I like to keep ajournalofmytradingideas.Ifind it helps me to avoidrepeating mistakes I havemade.” Jack quickly flippedthrough a few more pages.“Here it is; Iwrotedown theformulas you gave me forsynthetic option positions.Let’s see…AMarriedPut isthesameasaLongCall. If I
add that to a Short Call, itmakesaCollar thesameasaVerticalBullCallSpread?”
Terrysmiledand thenreplied: “You are correct. Iprobably should have talkedabout Collars earlier becausethey can be useful inprotecting gains on a stockyou already own. The Putacts as insurance against thestock price losing value, andselling the Call helps offset
someorallofthecostofthatinsurance.”
Their brunch arrived.French toast, pancakes,bacon, eggs, and hashbrowns; it all lookedgreat toahungrypairoftraders.
“If you want to tradeoptions you have to think ofrisk first and profits second.You have to understand allelementsofriskineachtrade.TheThetathatwillevaporate
on your Long options, thedirectional trendriskonyourShort options, the expirationdate when they will becomeworthless, the percentage ofyour capital that is at risk ineach option play. Withoptions there is the risk thatyouwillhavevolumedryupas you win, with yourpositionendingupsodeepin-the-money that you mighthave to take a big loss tocloseyourwinner.Ifyoujust
wait for it to be exercised atexpiration, then you run theriskofthetradegoingagainstyou. So an exit strategyshould be planned to avoidthis situation, among manyothers,” explained Terry inhercalm,confidentvoice.
“So I take it that riskis by far your number onetheme that you think aboutbefore anything else whileplanning an option trade?”
askedJack.
“You would becorrect. The question is nothowmuchcanImakeifIamright, but how much can Ilose if I amwrong?What ismypossible upside andwhatis my possible downside? Ifmy possible upside is smallandmy possible downside ishuge, then no trade iswarranted. I want a goodreward/risk scenario to make
it worth my trouble,” shesaid.
“That is the sameprinciple I use for tradingstocks,”Jackadded.
“I do trade optionswith the same ideology, butasyouknow, there aremanymore moving parts andpossible outcomes withoption strategies. An optiontrader should carry muchmoreofacashpositionthana
stock trader. You can veryeasily get 30:1 leveragewithoptions, but you really onlyneed1:1leveragewithalargeaccount. So you can keep90%-95% of your capitalsafelyincashandfocusyourattentiononjusttheverybesttrades.Itisverydangeroustogetcarriedawaywithoptionsandhavedollarsigns inyoureyesandjustgoforwhatyouthink is a can’t miss trade –which is all fun and games
until you blow up youraccount with just one bad‘can’t miss’ trade that putsyou out of the game,”cautionedTerry.
“I know what youmean.Ihavetokeepcatchingmyself not fully grasping theleverage of trading 10contractsbecauseitmayonlycost me $3,000. But unlikestockswhere theworstmovemay be 7% or 8%, options
can go down 50% in a fewdaysdue toanadversemovein the underlying. I have toget used to much smallertrades and much biggerpercentagemoves,”saidJack.
“I believe optionshave a tendency to amplifyemotions as they amplifyleverage; it is more difficultto trade with Theta tickingawayeachdayonyourLongsand violent moves against
yourpositiontakingawaybigpercentageswhile liquidity isdryingupandthebidandaskspread is expanding againstyou. It can become intense,andifyouaddtradingtoobigof aposition to theballsyouare already trying to juggle,youmaynotbeable to thinkrationally with all the heat,”cautionedTerry.
“Ihavebeenwarned,”Jackassuredher.
“Define your riskbefore any trade. Whatpercentage of your accountcan you risk? How manylosses can you handle in arow?Ifyouareusingoptionsas insurance,place themasahedgeatapoint thatcontrolsyour total risk in yourposition to less than 1% or2%ofyourtotalcapital.Youhavetogetyourriskdowntoan amount that eliminatesyourriskofruin,theriskthat
youwilleventuallyblowyouraccount up completely byriskingtoomuchpertrade.Itallstartswithapercentageatrisk then a proper positionsize,”shecautionedagain.
“I am familiar withthe risk of ruin; I agreewithyou. If you divide yourcapital into equal incrementsand then risk 1% of yourcapitalpertrade,thenafter10lossesinarowyouaredown
10%;risk10%ofyourcapitalpertradeandafter10straightlossesyouareruined.Thatisrisk of ruin in a nutshell,”Jackassuredher.
“Anyone who hasbeen trading for a while hashad ten straight losses in arow. Some hedge fundsmismanagetheirrisksobadlythatallittakesisonebiglossand they are done,” saidTerry.
“That is sad, butamazinglytrue,”agreedJack.
Terrycontinued,“Itissortof like the traffichere insouthern California. Anyonewho has driven here longenough has been caught inmultipletrafficjams.Anyonewho ignores that eventualityisriskingtheconsequencesofbeinghorriblylatearrivingattheir destination. A hedgefund that mismanages risk is
the equivalent of a jobapplicant taking the freewaytogettoajobinterview.Anyunforeseenevent couldcausehim to miss the interview,and he might never get asecondchance.”
“Youranalogiesareasgood in person as they areover the Internet,” Jackresponded.
WithemptyplatesandJackthoroughlywarnedabout
the dangers of risk and theimportanceofstoplossesandinsurance, they had finishedtheir first hour together. Jackwasfarmorepleasedthanhehad even imagined with thisface to face meeting. Notwhathewasexpecting,buthewasverypleasantlysurprisedwithOptionzTraderz turningout tobethelovely,friendly,andoutgoingTerry.
Jackhopedthiswould
be the first of many face-to-facemeetingswithTerryoverthenexttwoweeks.
“Could Iget adoggiebag for these strawberries?”Terryaskedthehostess.
“She is taking ahandfulofstrawberrieshome;howodd,”thoughtJack.
Seeing the perplexedlook on Jack’s face, Terryexplained: “They’ll make a
nicedinnerformytortoise.”
As they left therestaurant,heopenedthedoorforher and then they chattedfor a minute as she got intoherlegendarypinkCadillac.
As she got into hercar,Terryquicklysaid:“Oh,Ialmost forgot. I haveworkedout the odds for manydifferentoptionstrategiesandIprintedoutacopyforyou.”
“Thanks,” Jackreplied, ashe leafed through,scanningthemanytablesandgraphsshehadprepared.“I’msure these will be as helpfulastherestofyouradvice.”
As she sat in herconvertible with the topdown, he asked her aquestion, somewhatnervously.
“What do you sayaboutmetakingyoutodinner
tomorrownight?”
“What are yourintentions for this dinner?”sheaskedcynically.
He paused, thenlooked right in her eyes andsaid: “I just want to knowmore about whatmy optionsreallyare.”
There was anawkwardpause.Jack thoughtsurely he had missed the
opportunity.
Maybe he was toonervous.
“Did she think I wasnervous?”
“Maybe I didn’tappearconfidentenough.”
“MaybeIsoundedtooconfident.”
He had taken a risk.Butwastheriskjustified?
Then, with a giggleand a smile, Terry broke thesilence.“I’dbehappyto.Justsend me a message onFacebook when you decidewhereyou’dliketogo.”
It was now earlyafternoon and Jack wasfeeling on top of the world.He had a date, not with anyordinary girl, but with hismentor. He felt they had areal connection, not just as
traders but as people.Duringbrunch they had shared notonly option strategies, butalso dreams and goals. It allseemed to be progressing soquickly, perhaps due to theamount of time they hadspent together previously,chatting online over the pastseveralmonths.
Heprogrammedafewlandmarks into his GPS andwas soon cruising the streets
of Los Angeles in his redMustang – his idea of adreamcar.
Los Angeles wascertainlyadeviationfromthedull landscape of hishometown. He stopped for abreakat theLaBreaTarPitsand then continued on pastUniversalStudios, theKodakTheater, and the HollywoodWalkofFame.
He continued to stop
occasionally to snap photoson his phone as vacationsouvenirs.
As he drove deeperinto the HollywoodHills, hefinally found his ultimatedestination, a spot with anunobstructed view of theHollywood Sign. As luckwould have it, some othertourists had also chosen thesame spot and they gladlyoffered to capture a photo of
him on his phone with theSign looming in thebackground,highon thehillsabove. It would make aperfect profile picture for hissocialnetworkingsites.
It was such a niceDecember afternoon, withpeopleoutsideinT-shirtsandshorts. This really was thegoodlife.
As he programmedthe GPS for the trip back to
hishotel,hismindwentbackto something Terry had saidat brunch. On a $200,000account, $4,000 of incomepermonthwasnotoutof thequestion when tradingoptions.
He had neverseriously considered leavinghis hometown before. Butwhatwaskeepinghimthere?Wasithisnine-to-fivejob?Ifhe could earn more trading
options than he could whileworkingfulltime,therereallywas no reason to be tieddown.Hecouldtradeoptionsfrom anywhere. Besides, hisfriend John had offered torecommend him for apositionwithhisemployerinSanDiego ifheeverdecidedto relocate. He had nevertaken John up on the offerbecause itwould havemeanttaking a pay cut from hiscurrent position. But what if
he added the income fromoptiontradingtothemix?
Hewasquickly jarredfrom his daydream by aflashing sign on the side ofthe freeway. It read“SIGALERT.”
“Sigalert, what theheck is that?” he said tohimselfoutloud.
It quickly becameapparent that it meant he
would not be getting back tohishotelanytimesoon;traffichad slowed to a crawl, andthe backup extended as farinto the distance as he couldsee.
An hour later, thetraffic began to thin out alittle.Inthemeantime,hehadmanaged to keep himselfbusylookingatthelandscape,the mansions perched on theedge of hills as if they were
onstilts,andhomelesspeoplewashing the windshields ofcarsastheyslowlymadetheirway down the freeway offramps.Somecarswerefullofgirls in bikinis, probably ontheirwayhomefromadayatthebeach,andothershadskisstrapped to the roof. Thingswere certainly different herethanwhathewasusedto.
Threeandahalfhourslater, he arrived at his hotel.
Terry’s warning about thelate afternoon traffic hadproven to be accurate, justlikeallofherwarningsaboutoptiontrading.
The sun was stillwarm and therewas a gentlebreeze, so he went out ontothe balcony with his phoneand the charts Terry hadgiven him. They truly told astory; every strategy haddifferent risks and different
potential rewards. Itwas onething to talk about a strategylike aVerticalSpread,but tosee the charts showing theodds really made it all somucheasiertocomprehend.
His curiosity wasnagging him.DidTerry onlyaccepthisdinnerinvitationtobe polite? Maybe she hadposted something onFacebook that would givehim a clue to her true
feelings.
Heloggedon.
No newmessages, nonewposts.
He decided to see ifshe was in the WinningTraders group, as she alwaysseemedtobe.
Sure enough, thereshe was, engaged in aconversationwithRookie.He
didn’twantmakeitappearasthoughhewasobsessedwithher, so he sat back andwatchedwithoutinterrupting.
Rookie Trader: I opened aVertical Spread thinking itwould be less risky than aCovered Call, but I lost$1,000 when it expired; thatwas almost half of myaccount.
Optionz Traderz: Howmanycontractsdidyouuse?
Rookie Trader: I sold 10Calls and then bought 10Callstwostrikeshigher.
Optionz Traderz: There’syour problem; you wereriskingtoomuchcapitalonasingletrade.Sure,itprobablylooked great on paper. Youwould have made a heftyprofit if everything expiredworthless.
Rookie Trader: But
shouldn’t my broker havestoppedmefromopeningthetradeifitwastoorisky?
Optionz Traderz: Thatmight be true if you wereusing a full-service broker,where you pay for advice asto whether your trade is inline with your goals.However,whenyoutradeinaself-directed account, it is upto you to manage your risk.Thebroker’s responsibility is
not to guard your accountfrom loss, only to protect itsown funds from loss due totherisksyouaretaking.
Rookie Trader: So whatshould I have donedifferently?Ionlyhaveabout$1,000 left in my account,and I don’twant to lose thattoo.
OptionzTraderz:Inordertoprofitintheworldofoptions,youneedtofollowtherules.
Rookie Trader: The rules?Doyoumeanyourrules?
Optionz Traderz: Yes andno.Therearerules to tradingoptions for income, but I didnot create them; they form asort of ‘natural law’ that isbased upon the properties ofthe options themselves. Justastherearerulestolanguage,there are rules for successfultrading. Some rules areobvious and some are more
obscure.
For example, you need tolearn words in order tocommunicate. However, it isnot enough to simply learnthe vocabulary; there arerules governing the usage ofevery word. Just as societydetermines the rules forsentence structure andgrammar, the marketdetermines the rules foroptions.
Learningoptions is a lot likelearningaforeignlanguage;itis not sufficient to learn thevocabulary of options. Inordertosucceedwithoptions,youneed to learn the correctusage. Still, even afterlearning the vocabulary andproper usage, being able towriteandunderstandthenewlanguage on paper does notguarantee that you will besuccessfulusing it to interactwith others in real time. In
ordertoexcelintheworldofoptions, you need to speakthelanguagefluently.
RookieTrader:Sowhatruledidn’tIfollowcorrectly?
OptionzTraderz:Iwouldn’tsayitwasanyonerule;thereare many. I would suggestthat you read through all ofthepreviousthreadsfromthisgroupwhereIhavediscussedmany of the rules with othertraders. You can’t pick and
choosewhichrulestofollow.Tobesuccessfulasanoptiontrader, you need to followthemall.
Rookie Trader: I willdefinitely read through theprevious posts, but what isthe biggest thing you wouldsayIdidwrong?Idon’twanttorepeatmymistakeandlosethe remaining $1,000 in myaccount.
Optionz Traderz:Well, the
easiestway toavoid losing itis to stop trading altogether.$1,000isn’treallyasufficientamount of capital to tradeoptionsanyway.
But if you are intent oncontinuingtotrade,youmustreduce your position size.You followed one of themajor rules; you usedinsurance when you boughtan option to protect yourselffrom ruin if your short
position moved against you.However, you ignoredanotherrule;youriskedmoreof your capital than youraccount was prepared tohandle. Then you ignored athird rulewhen you failed toeitheruseastoplossorcloseout of the trade when itmovedagainstyou.
RookieTrader:So I shouldonlybetradingfivecontractsinsteadof10?
Optionz Traderz: Actually,you should be trading lessthan that. On the VerticalSpread you mentioned, evenoneShortCallcombinedwithone Long Call at a strike $2higherwouldexposeyoutoaloss of $200. Even if youcollected $100 in netpremiums when you openedthe trade, you would stillhave a possible net loss of$100; that’s 10% of youraccount.
Risking10%ofyouraccounton one trade is asking fortrouble.Infact,afriendandIwerejustdiscussingthisveryissue at brunch today. It isusually a good idea to limityour risk on any single tradeto 1% to 2% of your totalcapital. Unfortunately, youraccounthasbeendrawndowntoalevelthatdoesnotpermitthat, but risking 10% is stillmuch safer than risking100%.
RookieTrader:IguessIseewhat you’re saying. If I risk$100 on each trade, itwouldtake 10 trades to completelywipeoutmyaccount.
OptionzTraderz:Exactly.Itcould happen, but it isunlikely you will have tenlosingtradesinarow.Evenifthat does occur, if it’s anyconsolation, I lost my entireaccount thefirstyearIbegantradingoptions.That’swhy I
nowrisknomorethan2%onasingletrade.
Rookie Trader: So you aresaying that I should not beriskingmore than 2% of mymoney on one trade. 2% of$1,000is$20.Itdoesn’tseemlike I’ll ever get rich doingthat.
Optionz Traderz: Probablynot, unless you increase thesizeofyouraccount,butyouwon’t blow your account up
either.Letmeaskyou,whenyou opened your last trade,could you feel your heartbeating faster as you pressedthe‘trade’button?
Rookie Trader: Actually,yes.Does thathappen toyoutoo?
Optionz Traderz: No, notanymore. In fact, that can beoneofthebestwarningsignsyou will get that you arebreaking the rules. If your
heartstartsracingoryoustartto sweat, it means you don’thave faith in your trade oryou feel you are doingsomething risky. Let me askyouthis:Wouldyouhavefeltthe same way pressing thetrade button if the most youcouldhavelostwas$20?
Rookie Trader: Well, ofcoursenot.Twentydollars isnobigdeal.
Optionz Traderz: And yet
$20 is 2% of your account.Now try to think of it thisway: A trader with a$100,000 account who risks$2,000 on a single tradeshouldfeelthesamewayyoudo risking $20 –nearlyemotionless. Both tradeswould result in a 2%maximum loss. Don’t let thedollar gains and losses ofother traders concern you. Itis the percentages that areimportant.
RookieTrader:But if I amonly getting small profits, Iwillnevergetanywhere.Whytradeoptionsatall?
Optionz Traderz:As I saidearlier, I lost everything myfirstyear.ThenI readbooks,researched options online,and testedsomestrategiesonpaper. After starting overwithanaccountaboutthesizeof yours, Iwas able to growmy capital over time.Asmy
account grew, I was able togradually increase mypositionsize,whichgotmetowhere I am today. But as Iwas rebuilding my accountafter it collapsed, at no timedid I intentionally break therules. When you break therules, themarket will almostalways find a way to punishyou.
Rookie Trader: So the ruleis2%riskoneachtrade?
OptionzTraderz:1%to2%per trade is what worked forme, and I rarely risk morethan 6% on all my tradescombined. But when myaccountwassmall,thereweretimes when it was notpossible to meet thoseguidelines,soIgotascloseasI could. Like I mentionedearlier,10%ofcapitalatriskis not ideal, but it is muchbetterthan100%.
Rookie Trader: So you’vebeenwhereIamnow.IguessI should have asked for youradvice before I opened thetrade, instead of after. Well,thanksforallthehelp.I’llbesearching through yourprevious posts to learn therestoftherules.
Optionz Traderz: You arewelcome.
Seeing that theconversation was over, Jack
logged out of the group. Heplanned to send Terry amessage later, after he hadpicked out a nice restaurantwhere he could take her fordinner.MaybehisfriendJohnwould have some diningsuggestions; after all, hewasalways entertaining clientswithfancymeals.
One part of Terry’sconversation with RookiestuckinJack’smind.Shesaid
shehadbrunchwithafriend.SheconsideredJacktobeherfriend. He felt good aboutthat;heconsideredhertobeafriendtoo,inspiteofthefactthat they had only met oncein real life. They seemed toshare so many similar ideasabout trading, as well as lifeitself. Whether theirfriendship would continuewasunknown,buthethoughttheprobabilitywasgood.
This was reallyturning out to be a nicevacation.
Chapter16
YOURMETHOD,
YOURRULES,YOUREDGE
Jack opened his eyes.
Itwas safe to get out of bedin a relaxed state. He was
safelytuckedawayinahoteland not about to battle thetraffic for the reward ofworkinginhiscubiclecage.
He liked this feelingand wanted to keep it. Howwouldheaccomplishthis?
His cell phone had amessage from his socialnetworkingapp.
Optionz Traderz: I had agreattimeyesterday.Youare
greatcompany.
Jack felt a warmhappiness in his heart whichspread throughout his body.He was having a flood ofmixed-upemotions.Hismindwastryingtocombine‘Terry’that he met yesterday with‘Optionz Traderz’ from theWinningTradersgroup.
Hisphonerang.
“Heybuddy,whatyou
are up to tonight?” askedJohnontheotherend.
“Well, I may betaking my online buddy todinner in Long Beach,”repliedJack.
“Isheassharpandascool as you had imagined?”Johnquestioned.
“Well… she isamazing,” Jack responded inastrangevoice.
“She? Your optionbuddy isawoman?Isn’t thata little odd that she nevermentioned that?” John shotbackverysurprised.
“Not really, I justassumed too much. I shouldhave realized it. I wasfocusingonoptionstrategies,not her gender,” Jack said alittleembarrassed.
“Well,Iguessitreallydoesnotmatter.Atraderisa
trader, right?” Johnresponded.
“The funny thing is, Idonot think theworld’sbestdating site could have foundmeabettermatch,”Jacksaid.
“Goodgrief,Ibetyouhave little heart symbols inyour eyes. Buddy, you needtofocusonoptionsstrategiesbefore you mess that wholething up.Your trading groupisnotadatingservice,” John
counseled.
“You are probablyright. She is probably out ofmyleagueanyway.Iwillcallyou back once I make plansfortonight,”Jackreplied.
As he hung up heponderedwhathisnextmovewould be. He went to thebalcony without his usualearly morning energy drink.He felt invigorated justthinking of Terry and how
great she was. He flippedthrough the option notes thatshe had handed him. It wasverythoughtfulofhertotakethe time to prepare them forhim.
It fascinated him tosee these odds on optionsbeing winners or losers. Hewas sure there would be away to generate cash flowusing these notes. He had toselloptionswithlittleoddsof
winningandbuyoptionswithgreat odds ofmakingmoneybasedonhiscurrentsystems.He had to take on little riskand put the risk on the otherside of the option seller orbuyer. If he was wrong hehadtogetoutof the trade; ifhewasrighthehadtogetoutat the most profitable time.He had to be the casino andlet the other traders be thegamblers. Things werestartingtomakesense.
Hewasreadytomakehis move. He searched steakhousesonlineinLongBeach.
Stock Trader: How about Itreat you to a steak dinnertonight?
His heart raced inanticipation of sending themessage. He no longer feltlike a serious trader going todinner with his mentor.Instead he felt like a teenageboyaskingagirloutonafirst
date – truly a differentrelationshipthantheyhadjustadayago.
Something occurredto him as he paused. It wassomething Terry had said toRookie Trader the previousday.ShehadaskedRookieifhisheartstartedbeatingfasterwhen he pressed the tradebutton.She thenadvisedhimthat his racing heart waswarning him that he was
taking on a disproportionateamount of risk compared tothe faith in his tradingsystem.
Jack thought back tohis own days as a rookietrader, back when tradingmade his heart race like itwascurrently.Hehadbeenarisk taker and the adrenalinerush was poor compensationfor his mounting losses thatnearly wiped out his entire
account.Nowadayshefeltnoemotion when he traded,otherthanthesatisfactionthatcame from watching histrading system slowly growhisaccountovertime.
Today was different.Hewas takinga risk,butnotwithhiscapital.Hefeltlikearookie trader again, gettingreadytopressthetradebuttonforthefirsttime,withoutanyfaith in the outcome.
However, unlike trading, hehad nothing to lose. Theworstcasescenariowouldbearejectionofhisdinneroffer.“This is the proper place foremotions; relationships withpeople, not money,” hethought.
He sent the message.A few moments later therewasareply.
Optionz Traderz: Soundslovely.
Stock Trader: I will sendyoutheaddress.Is7p.m.lateenoughtomisstraffic?
Optionz Traderz: Yes, thatis a great idea. You are aquick learner in other areasbesidesoptions.
Stock Trader: I am a goodstudent.
OptionzTraderz: I will seeyouthen.
The weather was alittle cooler than it had beenthe previous day, but it wasstill sunny. The cooltemperatures and lack oflifeguards did not seem tokeep people out of thewaterthough. As he looked outover the beach from hisbalcony, he noticed a groupof boys with boogie boardsattemptingtoridethewaves.
The three appeared to
bebrothersanditlookedliketheywere having fun –well,two of them, anyway. Theyoungest lookedas ifhewastrying to catch every wavethat washed in. Most of thetime, the waves were toosmallandnomatterhowfasthe paddled, he got nowhere.Afterafewminuteshethrewthe board onto the sand andstomped up the beach to theblanketwhere his parents satwatching.
The middle brotherwas having better luck; hewas more selective in thewaves he chose to ride. Hestood with his back to theocean, looking over his rightshoulder at the wavesapproachingfrombehind.Heignored the waves that weretoo small, butwhen a biggerone came he would jump atthe chance. A few times hemanagedtocatchagoodoneandrideitasfarashecould,
but other times the wavewould crash over his head,sending the boogie boardflying as far as the tether onhisarmwouldallowittogo.
The oldest brotherappeared to be the mostexperienced.He also ignoredthe small waves, but he alsolet some of the bigger onespassbyhimtoo.Jackwasnoexpert,butfromwhathesaw,the key to boogie boarding
lookedasifitwascatchingawave at the precise momentwhenitbegantobreak.Itwasinteresting to watch, and afewtimestheoldestbrother'sstrategy paid off, taking him50 yards or more. Once, hecaughtsuchagoodwavethatitpropelledhimallthewaytoshore.Other timeshis timingwaswrong,butratherthanletthe wave crash over him, hesimply stood up and let itharmlesslypasshimby.
Maybe it was all ofthe analogies that Terry hadshared with him, but Jackbegan to think of boogieboarding in terms of optiontrading.Shetrulywashavinganeffectonhismind.
The youngest brotherwas like an inexperiencedoptiontrader,takingashotatriding every wave he saw,regardless of the probabilityoftheoutcome.Asmanynew
option traders and stocktraders for that matter soonrealize, attempting to tradewithout regard for theprobability of the outcomecan quickly lead tofrustration.
The middle brotherhad an edge.He avoided thefrustration that caused hislittlebrothertoquitbytiminghis entry, just as an optiontrader increases the
probability of success byusing a strategy with a highlikelihood of profiting underthe current conditions of themarket. He didn’t win all ofthe time, but he did wellenough that the few timeshewipedoutwerenotenoughtotakeawayhisenthusiasmandenergy.
The oldest brotherwas like an experiencedoption trader; he timed both
his entry and exit. When herealizedhehadmiscalculatedthe probability of success ofanysinglewave,headmittedhis error and got out early.Other times, when it wasclear that his analysis wascorrect, he rode the waveuntilexpiration.
Unfortunately, apatrolofficeronanall-terrainvehicle put an end to theboogie boarding as he
summoned them out of thewater and proceeded toinstruct the family thatswimmingwas not permittedwhen lifeguards were not onduty.Ofcourse,Jackcouldn’theartheconversation,butthebody languagemade it fairlyeasytodecipher.
Jack returned to hisroom and relaxed for a fewhours, all the while thinkingabout options and his
upcoming dinner with Terry.He was on vacation, histrading accounts safelyprotected in cash positions,andyethewasunabletostopthinking about options. “Is itoptions that have taken overmymind,”he thought, “or isitTerry?”
Laterintheafternoon,after a quick call to John totell him about his plans forthat night, he went
downstairs. Jack started uphis Mustang. He loved theway it sounded and handledon the road. He had spent acasual day looking throughthenotesthatTerryhadgivenhim. He anticipated a verythought-provokingevening.
He pulled up to therestaurant a few minutesearlierthan7p.m.Heparkedrightnext totheCadillac.Hewalked confidently into the
restaurant with his notes inhand. Terry, dressed in allpink, waved him over to hertable.Ashesatdownshehadaglassofwineinfrontofherand had managed to find apink outfit – a pink blouseandapinkskirt.Surprisingly,shelookedsharpandelegant.She seemed to be evenmoreattractive than heremembered from the daybefore.
“I guess your favoritecolorispink?”Jacksaidashesmiled.
“Howdidyouguess?”Terryshotbackwithagrin.
“Even your wine ispink,”Jacksaid.
“Well,Iamagirl,youknow,”Terryrespondedwithaplayfullook.
“Well, my favorite
color was the one you woreyesterday, green, moneygreentobeexact,”Jacksaid.
“I couldn’t care lessaboutmoney itself. It is onlyatooltogetmewhatIreallywant: freedom, time, andmorechoices,”Terrysaid.
“I agree. How is ityou are able to makeconsistent returns withoptions?”Jackinquired.
The waiterapproachedthetable.
“I would like a lightbeer with lime,” Jackrequested.
“Well, Ihave specificrules that I follow that Ibelievegivemeanedgeoverother traders. I manage myriskonevery tradenomatterhowconfidentIamthatIwillbe right. I always want theodds in my favor and the
possible reward to be worththerisk,”Terryexplained.
“Would you give meanexample?”Jackasked.
She whipped out hercomputertabletandpulledupthechartforApple.
Charts courtesy of
FreeStockCharts.com
“For example,currently Apple is trading at$405 a share, its 200-daymovingaverageisat$368.In11of thepast 12months the200-day moving average hasbeen support for this marketleader. 50% of the time the50-daywillholdassupport.Icansell1contractfora$270January Put for $200, the
bid/askspreadisonly3centsandthereare25,000contractscurrently open to bolsterliquidity.
Youcanalsoseehowthe 200-day is slopingupwards due to the overalllong term uptrend in thisstock, so the odds are also ifthe200-dayisbreachedinthenextfewweeksthenitwillbemuch higher than my Putstrikeprice.ThePutbuyer is
bettingthatthismarketleaderwill lose its support line inthenext30days.Iambettingthat even if it does itwill behigher when it happens andthe Put will still expireworthless. That is the key tosellingPutsinanuptrendingstock, even when it retracesto the 200-day, it is muchhigher than a fewweeks agowhen the Put was sold. TheDelta of -.12 reflects exactlythe odds of the buyer being
right. It is a bad bet for thebuyeragoodbetforme,andagreatway topaymyutilitybills.
Nowhereisthefunnypart. I have almost no stressin this trade because I ambullishonAppleandwant toownitatthe200-daymovingaverage. If it goes a fewdollars in-the-money I willallow it to be put onme.Ofcourse, I will buy back the
PutifIstartbeingdownmorethan 1% of my accountequity,” Terry explainedbeforesippingherwine.
“I think you havetalked about this before, sellPuts on the hottest uptrending stocks, undersupportlevels,”Jackreplied.
“Yes, but only whentheleadersareholdingupfarabovetheir50-dayandsafelyinanuptrend.Also,onlyone
month out at a timemaximum; be stingy withgiving option buyers enoughtime to be right,” Terryexplained as the waiterapproached.
Terryorderedthefiletmignon and Jack ordered theporterhouse. Then they gotbacktobusiness.
“Puts can generatesome good steady incomefrom market leaders until
they are no longer leaders;then you buy Puts,” Terrysaid as she pulled up a newchart.
Charts courtesy of
FreeStockCharts.com
“ThischartofNetFlixreally shows how quickly astock can crater with thewrong news.As you can seethough from the chart, I hadtime to get out fromwhere IsoldthePutinJuly,whenthestock was healthy, until thebreach of the 200-day inAugust. While I lost on thistrade, I won for a long time
beforeitcollapsed,sellingmyPuts over and over again atthe 200-day for premiums.Beforethecollapseitstartingfeeling like the Delta shouldhave been zero on the Putsfor thismonster stock. I alsofelt confident buying Calloptions as the price bouncedoff or regained and wentthrough the 50-day movingaverageoverandoverriskingthe Call premium to make a5%moveinprice.Thatwasa
great system until thecollapse. Even then, I onlylostmyCall premium,whileinvestors trading the stockitself lost their shirts andpantstoo.ItispossibletobuyPutsonatopstockthatlosesthe50-daymultipletimesandcover at the 200-day.” Terrygrinned as she took the lastsipfromherwineglass.
The beer that Jackordered sat untouched as he
was completely absorbedwith everything Terry said.Hismindwonderedbackandforth between options andhowtrulyamazingTerrywas.
“Ithinkonethingthatreallyhelpsmewininoptiontrading is the fact that I onlywatch five of the very beststocks and a few leveragedETFs. I try to become anexpert in support andresistance levels and how
their options trade based onmarket volatility. I maketrades based on historicalodds,notguessesorhopesorgambles. If somethingalready traded a certain waythelasttentimes,Ibetthatitwill trade that way again.SometimesIthinkaboutwhatthe dumbest thing an optiontrader could do right nowwould be. Then I do theopposite,” Terry said, thenlaughedoutloud.
“So you are truly anoption trader that tradesoption probabilities?You arenot really a trend trader,swing trader, day trader, orpositiontrader?”Jackasked.
“You are correct. Iwould say I amaprobabilitytrader.ItradewhatIthinktheodds are in favor of. I willtrade anything that I thinkwill be profitable withoptions. I attempt to trade
what the market is saying tome, not what I think willhappen. I do not predict; Ifigure probabilities,” Terryexplained with a look ofauthority.
“Areyouachameleontrader?Selling options abovesupport and resistance whenyou see a range boundmarket? Selling ShortStraddles in quiet marketswhile buying Strangleswhen
you see things possiblygetting very volatile?BuyingCalls on hot stocks at keysupports and selling Puts onmomentum stocks at the lastplace of support? UsingSynthetic Longs or Shorts totake positions you are veryconfident in with little to nocapitaloutlay?Andyoudoallthiswhilekeepingyourmindand emotions clear, studyingcharts,andmakingcalculatedcontrolled risks on each
trade? Is that all there is toit?”Jackaskedexasperated.
“Yes, piece of cake,huh?
“I take my tradingvery seriously. Tortoise’shave to eat, you know!”giggledTerry.
“Optionsare farmorecomplex than my simpletrendfollowingsystems.Iamplayingcheckersandyouare
playing 3D chess. I need atrend.Youjustneedtheoddsin your favor over and overagain. I am looking for theright set up and entry. Youareaskingwhatthemarketistellingyoutodoatanygivenmoment.This is fascinating,”Jacksaid.
Their steaks arrivedjustastheyhadordered.Jackfinally realizedhehadabeerandthat therewerecoldrolls
withbutteronthetable.
Suddenly,Terrybecameserious for amoment, herface stern.She began tospeak in avery serioustone as if towarn and atthesametimemotivateJack
on hisjourney withoptions.
“Themarketsmust bestudied justlikeanyotherprofession orendeavor.That is whyvery fewpeople willever attain
the highestsuccess intrading, justlike very fewpeople everattain thehighest ranksin any otherfield, be itmedicine,sports, music,science, orany other.Emotions
shouldalwaysbe restrainedand shouldplay no partin tradingdecisions.Rather,tradingdecisionsshould bebased ongreatopportunitiesas opposed to
hopefulsituationsanddreams. Totakeadvantage ofthosesituations,successfultraders needto rely onsolid tradingrules insteadof emotions.Stocks act
like humanbeings; theygo throughthe samestages andphases aspeople do,includinginfancy,growth,maturity, anddecline.”
She
continued,“The key intrading is tobe able torecognizewhich stagethe stock andthe market isinandtotakeadvantage ofthatopportunity.Getting adeep
understandingof thepsychology ofthemarketsisveryimportant.Thekeyplaceto be for thebest profits isin the growthstage becausepeople makeprices andbehind prices
are profits,profitstherefore areshaped bypeople. Theactions ofpeople andprofitsultimatelydrive stockprices eitherupordown.”
“I think I understand.
It is not magic. It is work,yearsofdedicationandfocus,then profits,” Jack said withunderstanding andseriousness.
“It is a job like anyother, except the reward isfreedomandtime,alongwithyour own dress code and nocommute. Of course, youhavetomanageanyfearsyouhave of not getting a steadypaycheck and of having to
handle your finances duringthose months when you donotmakeanyprofits or evenlose,”Terrycautioned.
“No doubt, I havebeen warned,” Jack assuredher.
“The biggestdifference between stocktrading and option trading isthatoptionsallowyouamuchwider variety of methods.With stocks, you can only
profitbybuyingandsellingatahigherprice.Thereareonlytwo trading methods withstocks:buyandsellhigher,orshort and buy to coverlower,”explainedTerry.
“That is true,” Jackreplied.“Youhaveshownmeliterally dozens of optionstrategies, but there are onlytwowaystotradestocks.”
Terry’s tone turned alittle sarcastic as she replied,
“Actually there is a third‘method’ for profiting fromstocks: buy and hold. Inreality it is not trading,though, because the stocksare only bought, not sold.”Then she continued in hernormal tone. “But even withthree tradingmethods, stocksare much more limiting thanoptions. I think the singlegreatest characteristic ofoptions is that they are soflexible. When you trade
options, the number oftrading methods is virtuallylimitless.”
Jack nodded inagreementashetookasipofhisbeer.Thenheinquired,“Ilikeknowingthattherearesomany different optionstrategies, but doesn’t thatalsocauseyousomestress?Imean,onceyouopenatrade,don’t you start to secondguess whether that was the
bestmethod,orwhethertherewas another one that mighthaveworkedbetter?”
Terry paused for amomentasshefinishedabiteof her steak, then respondedbyasking,“Doyouhaveanyregrets about ordering theporterhouse?”
Jack quicklyanswered,“No, this isoneofthe best steaks I have evertasted;muchbetterthanwhat
I am used to getting backEast.How’syours?”
“Very tasty. I reallylikethecombinationofspicesandthetextureisperfect.Butseeinghowmuchyouseemtobeenjoyingyourporterhousedoesn’t make me secondguess my choice of filetmignon,” she said with asmile.
Jack laughed a little.“I didn’t realize you were
using our entrées as ananalogytooptions.SoIguesswhatyou’regetting at is thatthere are a lot of differentstrategies for tradingoptions,butthedifferencesaresubtle,like a Straddle being almostthesameasaStrangle.”
“That’s what I likeabout you, you always seemto know what I am sayingwithout me actually sayingthewords,” she said with an
almost affectionate stare.“Whether I’m eating aporterhouse,ahamburgerandfries, or filet mignon andbakedpotato,I’mstillgettingthe samebasicmeal.When Itradeoptions,allIneedtodois choose the strategy thatmeetsmyindividualtaste.”
“And return it for apartial refund if it doesn’tmeetyourexpectations,”Jackadded.
“Exactly.Thestrategyyouuseisdeterminedbyyourtrading method and yourrules.Solet’ssayyouwantedto trade options strictly as atrend trader. Such a methodwould require only that youpick the strategy that wouldbe most likely to produce aprofit if your trend indicatorwas correct.Youcanuse thecharts Igaveyouas aguide.If you were bullish, youwould have your choice of a
Long Call, or a Naked Put,Covered Call, Strangle,Straddle,ReverseButterflyorCondor, to name a few. Thedecision ofwhich one to usewould likelybebasedon theposition you were predictingthe stock to reach during theterm of the contracts. Aprediction of a move to halfofastandarddeviationwouldhave associated strategieswith different probableoutcomes than those related
to a move of two standarddeviations.”
Jack finished the lastfew bites of his steak. “Thechartsyougavemewereveryhelpful in visualizing thedifferent strategies. So if mymethod is to spot trends anduse options to profit fromthose trends, all I need to dois choose the strategy whichmatches both my predictionandmypersonal tastesbased
onriskandreward.”
The waiter returnedwith a dessert menu. Jackwasn’t hungry after finishingoff a 20-ounce steak, but hedidn’t want Terry to feeluncomfortable if she wanteddesert.Helookedthroughthemenu. “The crème brûléelooksgood,maybewithacupof coffee,” he thought tohimself. “I’ll have the crèmebrûlée and a regular coffee,”
said Terry. “Same for me”,added Jack. As the waitertook the empty dinner platesfrom their table, Terrycontinuedtalkingoptions.
“There are a fewdifferentmethodsIhaveusedwhen I trade options. Likeyousaid, it ispossible tousetechnical indicators to lookfor trends and then use thebest strategy to fit the trend.Matchingthestrategytowhat
the indicators are telling youwillgiveyouanedge.Ihavetraded that way in the past;and I still use that methodfrom time to time on thehandful of stocks and ETFsthatIfollow.”
“So are there othermethods?”askedJack.
“I sometimes placetradesonallof the stocksonmy watch list, regardless ofwhethermytechnicalanalysis
ispointingtowardsatrend.Itis a somewhat differentmethod in that it involvesmatching an option strategyto every individual stock,”Terryreplied.
“So thatwouldbe the‘chameleon’ method,” Jackchuckled. “A range boundstrategyonyour range-boundstock, a Strangle on yourstock that was approachingearnings,etcetera,etcetera.”
“That’s funny. ‘TheChameleon Method’ – thatmight be a good name for abook on option trading, if Iever decide to write one.There is alsoanothermethodIusewhenIeitherdon’tfeellike studying the markets orwhenIdon’thavethetime.Isometimes use neutralstrategies. It’s not like I amlivingunderarock,but thereare times when I have betterthings to do than watch the
financial news networks orread the newspapers. Therearemanystrategiestochoosefrom,butoneofmyfavoritesis the Ratio Spread. I oftenopenaRatioBullCallSpreadandBearPutSpread,ascloseasIcangettoneteven.ThenI just manage the trade as itevolves over time. The onlyway it can lose is if theunderlying stock moves bymore than one standarddeviation,soit’safairlysolid
trade despite the lack ofresearchthatgoesintoit.”
“Is there a name forthat trade?” Jack inquired. “Idon’t recall you mentioningthatonebefore.”
Terry quicklyanswered with a grin, “Itdoesn’thaveanofficialnamethatIknowof,soIliketocallit a Bu-Terry-Fly. I alreadycalculatedtheprobabilitiesonit.” She pulled up a diagram
on her tablet and passed itacrossthetabletoJack.
“Now I see what you meantwhen you said optionstrategies with names aren’tnecessarilysuperiortothoseIcan createmyself,” Jack saidwithadmiration.
“I’m glad you like it.There are probably hundredsof possible strategies that donothavenames.But just likeanystrategy,thisoneneedstobemanagedif theunderlyingbeginstoapproachoneofthe
break even points,” addedTerry. She pulled up anotherchart on her tablet, thencontinued, “Like all Spreads,thisoneisverystableaslongas the stock price remainsbetween the break evenpoints.Itonlybeginstoshowa profit when it is close tomaturity. My edge on thistrade comes not from theentry,buttheexit.Ifthetradestarts togoagainstme, I justexititearly.”
“So if my methodinvolves neutral strategies, Iwillnotseemuchprofituntilthe trades are very close toexpiration, but I will also beable to exit the trades withsmall losses, or possiblysmallgains,ifIgetoutwhilethe underlying is in-betweenthebreakevenpoints.Thisisjustamazing,”Jacksaid,witheven more admiration in hisvoice.
They continuedtalking, even as the waiterbrought their desserts to thetable,neverlookingupexcepttosay“Thankyou.”
“So there is a trendtrading option method inwhich you study a stock andonlyopenoptionswhenyourtechnical analysis shows anupcoming trend is likely.Thereisachameleonmethod,in which you open positions
on some or all of the stocksonyourwatchlist,regardlessof any trend, but match theoption strategies to themarket conditions for eachindividual stock. And thenthereistheneutralmethod,inwhich you don’t make aprediction about the stockprice, but open optionpositionswithawiderangeofprofitability, and then simplycut your losses in the rareevent that it becomes
necessary?”askedJackashelookedatTerryintently.
“ThereareafewmoremethodsthatIuse,”answeredTerry as she poured creamandsweetenerintohercoffee,“but not as often as the onesyou mentioned. Sometimes Ijustfeellikepickingthelow-hanging fruit, taking thepremiums on far out-of-the-moneyoptionsthathavelittlechance of ever being worth
something at expiration, likeselling out-of-the-moneyCalls on NetFlix when theprice was falling, ImpliedVolatilitywashigh,andtherewasnosupportinsight.”
“Low-hanging fruit,”saidJack,ashe tookasipofhiscoffee.“Iguessafterallofthe work you put into yourother trading methods, youdeservesomeeasypickings.”
Terry laughed.“Ialso
useasmallpercentageofmyaccount to speculate.Sometimestherearestocksorsectorsthatareinthenewssomuch that it is difficult toignore them. Even thoughthese stocks are not on mywatch list, I sometimes do alittle bit of research on oneand then open an optionposition to capture what themarket consensus seems toindicate.ButIneverriskverymuchonthesetradesbecause
the news reports are rarelyimpartial.”
“I guess each one ofthosemethodswouldgivemeanedge,andasyouhavesaidbefore, with options being azero sum game, any edge,even a small one, willstatistically result in themethod being profitable,”saidJack.
Terry finished hercoffee and looked right into
Jack’seyes.Again,hervoicetook on a serious tone. “I’vereallyenjoyed thedinnerandhaving someone to talk toaboutmycareerinoptions.ItissocomfortingtoknowthatthereareothersouttherethatthinkthesamewaythatIdo.Some traders that I talk tolose interest, but you are thefirst person I have met thatseems sincerely interested.Youhave learnedsoquickly,I’m not sure if there is
anythingelseIcanteachyou.All you need to do to profitfromoptionsishaveanedge.You pick the method thatsuits you best, youmake therules, and you choose theedge that you believe willhelp you themost.That’s allthereistoit.”
“My method, myrules,myedge,”Jackthoughtto himself. As the waiterbegan clearing the dessert
dishes from the table, theyboth relaxed and gotcomfortable in each other’spresence.
“My goal is to tradeoptionslikeyou,foraliving,”Jacksaid.
“It is a worthy goal,nodoubt.Ittakesmanyhoursof study to really understandtheflowofthemarkets,evenmore hours of live tradingand losing to get the
experience needed to be ableto pull the trigger on livetrades.Are you ready to paythatprice?”Terryasked.
“Iam,andIthinkyouhave taken me to a level ofunderstanding where I canbegin to trade options forprofits. I also have yournotes!”Jacksaidconfidently.
“So what are yourplans for the next week ofyour vacation?” Terry
inquired.
“Iamnotsure.IknowwhatIwantthemtobe,andIdo have options,” Jack said,flirting and smiling while helookedintohereyes.
“Show me youroptions,”Terryreplied.
“I would like to havethe option of spending thenext week with you,” Jackreplied.
AppendixARELATIVE
TIMEVALUEOFOPTIONSBASEDON
THETIMETOEXPIRATION
OFTHECONTRACT
The following tables
show the time value ofoptions relative to a contractof exactly one year. Thecolumn,RelativeTimeValue,shows the time value of anoption as a multiple of the
premium on a one yearcontract. A Relative TimeValue of 0.799 means thatcontracts expiring in thespecified number of dayswould have a premiumapproximately0.799 timesasmuchasacontractexpiringinone year. The column,Estimated Premium, showstheapproximatetimevalueasa percentage of theannualizedImpliedVolatility.An Estimated Premium of
40.0% means that optionsexpiring in the specifiednumber of dayswould likelyhave a premium equal toabout 40.0% of the ImpliedVolatility of the underlyingshares.
The tables are basedonat-the-moneyoptionsonly,and the values presented areby no means set in stone.They are offered only as acursory guide to option
premiums, based uponextensive trading experience.Option traders may find thefollowingexamplesoftheuseofthesetableshelpful:
Example 1: A traderbuys an option contractexactly 365 days before itsexpiration date. He wants toknow how extensively timedecaywillaffect thevalueofhis contract over the nextseven days. Looking at the
table, he sees that theRelative Time Value aftersevendays,with358DaystoExpiration, is 0.990. So heshouldexpectthevalueofhiscontract tohave99.0%of itsoriginal value after sevendays, so long as theunderlying price remainsunchanged and there are nochanges in volatility or risk-freeinterestrates.
Example 2: A trader
wantstobuyaProtectivePut,28daysbeforeexpirationandoffset the cost of the Put byselling a Call option, sevendays before expiration.LookingattheRelativeTimeValue of options 28 daysbeforeexpiration,heseesthatthey should cost about 0.277times the premium of a oneyear contract, while theoptions expiring in sevendays are worth 0.138 timestheoneyearpremium.Hecan
then estimate that thepremium he receives on theShortCallwill be about halfof the premium he pays fortheLongPut.
Example 3: A traderwantstobuyaCalloptionona stock that is currentlytrading at $100.00, with anImplied Volatility of 30%,and 127 days until thecontract expires. Looking atthe table, he determines that
the Estimated Premium with127 Days to Expiration is23.59% of annualizedImpliedVolatility.Giventhatthecurrent ImpliedVolatilityis30%of$100.00,or$30.00,he can estimate that thepremiumforanat-the-moneyCall option would be about23.59% of $30.00. Hiscalculations lead him to anestimated premium of $7.08.Having found that tobeveryclose to the ask price in an
option table, he may feelmore confident that he ispayingafairprice.
Example 4: A traderownsastockthatistradingat$100andhasseensignificantgains, and he wants to delayrealizingthosegainsuntilthefollowing tax year. Lookingat the at-the-money Putoptions with an expirationdate 365 days away, henotices that there isvery low
trading volume on thoseoptions, and the bid-askspread is over $1.50. So heconsidersbuyingoptions thatexpirein183daysandrollingthem out another 183 dayswhentheyexpire.Lookingatthetable,heseesthatoptionswith 183 Days to Expirationcost0.708timesthepremiumof those with a one yearexpiration. Realizing that hewould need to purchase twosets of options, each lasting
183 days, to protect hisinvestment fora fullyear,hecalculates the totalcost tobe1.416 times the cost of asingle one-year contract.Looking at the option tablesforthe183dayexpiration,hesees that thecost topurchasethose options, twice, wouldbe greater than the loss hewould experience due to thebid-ask spread on a singlecontract with a one-yearexpiration.
Example 5: A traderwants to buy Call options aweek before expiration andsell them a day beforeexpiration if they are not in-the-money.Hewantstoknowhow much capital he couldsave by selling early. Helooks up the Relative TimeValueforboth,andfindsittobe 0.138 with seven days toexpiration, and 0.052 withone day to expiration. Hiscalculations reveal that a
weekly at-the-money optionwould likely lose about 37%of its time value on the finaldayoftrading.Thisleadshimtoconcludethathecouldsavesignificantamountsofcapitalby closing his losing optiontradesearly.
RelativeTimeValueisshownasamultipleofthe
premiumofa1yearcontract.
EstimatedPremiumsareapercentageofannualized
ImpliedVolatility.Allvaluesareforat-the-
moneyoptions.
AppendixBODDSANDEXPECTEDPAYOUTOFSELECTEDOPTION
STRATEGIES
The following
analysisdepicts thestatisticalprofit and loss potential ofoption strategies. Each ispresentedasa‘lotteryticket.’Rather than present thepossible profit and loss ofeach strategy, the probableprofit and loss is shown. Forexample, the profit potentialof a Long at-the-money Call
is very high at two standarddeviations,buttheoddsoftheunderlyingreachingthatpriceare low. The profit potentialis multiplied by the odds ofthat profit being realized,which then determines thevalues plotted in the graph.For clarity, a traditional‘possibleprofitandloss’plothas been superimposed overeachgraph.
Itshouldbenotedthat
each graph is only anapproximation. Values weredetermined using a modifiedform of a log normaldistribution. The distributionis baseduponhistorical data,andwhileitisnotguaranteedto be accurate for anyparticular stock, it isnevertheless useful as aguide.
The odds of winningare presented as profit and
loss potential based upon theinitial credit or debit to openthe trade. For example, atrade consisting of 10 Longat-the-money Calls at $2.50per share ($2,500 debit)wouldhavea5%chanceofa200% profit, or $5,000.However, the odds shownonly apply to that specificamount of profit. Becausethere are potential profits inexcessof200%,theoddsofaprofit of at least $5,000 are
actuallyabout20%.
Note also that thegraphs and odds weredetermined with theassumption that the range of-3 to +3 standard deviationsdid not include negativevalues for the underlyingprice.Onvolatilestocks, thisassumption may be invalid.Because the price of a stockcannevergobelowzero, theweighted distribution would
be skewed; hence the oddspresented here would not beaccurate. Nevertheless, as ageneral rule, these ‘lotterytickets’ show the predictedbehavior of each strategy atexpiration.
Lastly, these graphsmay provide one additionalbit of insight into options.The sections shaded greenrepresentprofits, the sectionsshaded red represent losses,
and the areas are nearlyequal. Over the long term,given a sufficient number oftrades, every strategy has anequal probability of profit orloss.
AppendixCTHE
RELATIONSHIPBETWEENOPTION
PREMIUMS,DELTAS,
STANDARDDEVIATIONS,ANDPROFIT
PROBABILITIES
The probability of anoption expiring in-the-moneycan generally be determinedby the Delta on that option;
e.g.aCalloptionwithaDeltaof 0.5 can be roughlyestimated to have a 50%chance of expiring in-the-money. However, justbecausealongoptionexpireswith IntrinsicValuedoesnotmean itwill result inaprofitfortheoptionbuyer;IntrinsicValue does not alwaysoutweighvaluelosttoTheta.
The following chartshows not only the
probability of an optionexpiringwithIntrinsicValue,but also the probability of abuyerof thatoptionrealizinga profit and a seller a loss.For added clarity, therelationship between theStandardDeviationandDeltaarealsoshownforeachstrikeprice.
It might not beintuitively obvious to thecasual observer that it is
possible for option buyers tohave similar odds to optionsellers. In general, moreoptions expire with a loss invalue than in a gain, and asignificant percentage ofoptions expire totallyworthless. However, theperception of sellers makinggreater profits than buyersmay be rooted in the actionsofthemarketmakers.
Market makers, many
of whom are engaged in theoption selling business, oftenhedge their short positions.Market makers provideliquidityintheoptionmarket;however they do notnecessarily profit by sellingoptions that expire worthlessor with less Intrinsic Valuethan their original premium.Rather, market makers profitfrom the difference in thebid/ask spread; they selloptionsatthehigheraskprice
andbuythematthelowerbidprice. As a result there is acommon perception amongoption traders that optionsellers, of which a sizeablenumber are market makers,make money while optionbuyerslosemoney.
Noteonthefollowingtable that every option has a50% or lower statisticalprobability of expiring withIntrinsic Value that exceeds
the original premium. It canthen be inferred that a buyerofanoption,anyoption,Callor Put,will always have lessthana50%chanceofmakinga profit on a single trade.Likewise,asellerwillalwayshavebetterthan50%oddsofrealizing a gain. While it istrue that option buyers havelosing tradesmoreoften thansellers, over the long term,buyersmakemore profits ontheirwinningtrades.Inshort,
buyers win more, less often;sellers win less, more often.The chart that follows showshow the odds are stackedagainstthebuyer;however,italso shows the manner inwhich the potential profit tothebuyerbalancestheriskofloss.
The chart has beensimplifiedbydisregardingtheeffects of interest rates,liquidity, kurtosis, skew, and
also the volatility smirk thatmay sometimes occur. It ispresented as an aid tounderstanding optionprobabilities and is notintended to represent exactpricing for all possibleoptions.
The following is anexample of how the chartmaybeapplied:
Example1:Atrader is
seekinginformationontheprobabilitiesofan out-of-the-money Calloption.Looking at theoption chainforaparticularstock,henotesthat at-the-money Callshave a
premium of$10.00 pershare and theCall option heis consideringtrading has apremium of$2.50.
Looking at thechart, alloptionpremiums arereferenced to
an at-the-money optioncosting $1.00.To use thischarteffectively, hewill need tomultiply allpremiumsbyafactor of 10.Call optionswith apremium of$0.25 on the
chart wouldthen have therequired $2.50premium.
Following thecolumns onthe chart, itcan then bedeterminedthat the Calloption with a$2.50premiumhasa
strike that islocated atapproximately1.0 StandardDeviations.Delta on theoption wouldlikely be verynear 0.2; andhe couldestimate theodds of theCall expiringin-the-money
to be 16%.Continuingacross thechart, he canestimate thatthere are 14%odds of theIntrinsicValueat expirationexceeding theoriginalpremium; inother words, a14%chanceof
exceeding thebreak-evenpoint. Giventhose odds,over the longterm, it couldbe expectedthat theaverageIntrinsicValuepresent in thatspecific optionon the rareoccasions
when it didexpire in-the-money wouldbe $15.60, asshown in theleftmostcolumn.
Statistically,given asufficientlylarge numberof trades, suchas1,000, there
would be$2,500 pershare in totalpremiumspaid; 84%, or840 of thetrades wouldexpireworthless and16%,or160ofthose tradeswould expirewith anaverage of
$15.60 inintrinsic valueeach, or$2,496 in totalgains.Statistically,it’s a totalwash.
It may appearconfusing that some strikeshavehigherProbableIntrinsicValuesthanotherswhentheyexpire in-the-money.
However, the differences arenot caused by one optionbeing more profitable thananother over the long term;ratherthisoccursbecauseitisprofitable at a differentfrequency. A far out-of-the-moneyLongCallmightonlybe profitable in one out of100trades,wherealargegainerasestheprevious99losses.Itsaveragegainislarge,butitisarareoccurrence.Deepin-the-money options expire
with Intrinsic Value nearly100% of the time;statistically, half of the timetheywill gain value and halfof the time theywill lose, sothe Probable Intrinsic Valueat expiration is nearly equalto the premium when thetradewasopened.
On a final note, thevalues shown below werecalculated using a slightlydifferent method from that
used in Appendix B. As aresult, there are slightdiscrepancies in theprobabilities obtained. Thosereaders intenton reproducingthe results of theseprobability estimates shouldconsider that the followingtablewas formulated using astandard normal distributionapplied to current optionpremiums for open optioncontracts on an ETF thattracks the S&P 500 index,
whereas the probabilities inAppendixBusedcalculationsinvolving a modified lognormaldistributionand long-termhistoricalpricing.
One might observethat the statistical probabilityof a Long at-the-money Callreturning a profit wasdetermined to be 34% inAppendixBand35%hereinAppendix C. Again, optionpricing is an art, and it is
ultimately thedecisionof thetrader to choose which typeof statistical model fits hisneeds or whether a fewpercentagepointsonewayortheotherwillhaveanyeffectonhistrading.
As in Appendix B,StandardDeviationsshowninthis table are time-weighted.One Standard Deviationreferstotheprobabilityoftheunderlying price reaching a
specific strike price uponexpiration of the contract. Itshould not be confused withthe annualized StandardDeviation of the underlyingshare price, which is oftenstated as annualized ImpliedVolatility. The only optioncontracts for which ImpliedVolatility represents exactlyone Standard Deviation arethosewhichexpireinexactlyone year.A conversion tablefor option contracts expiring
in less thanoneyearmaybefoundinAppendixA.
AppendixDTIME
PROGRESSIONPAYOUT
POTENTIAL
The following graphsshow the differences in
possible profit and loss onselectedoptionstrategiesasafunction of time. For eachstrategy,itisassumedthatthetrade isopened30dayspriorto expiration. Profits andlosses are then plotted baseduponanimmediatechangeintheunderlyingprice,with30days remaining untilexpiration. Additional plotsshow the possible profit orloss with seven days toexpiration,andalsoattheend
ofexpirationday.
There are severalcharacteristics that shouldbecome apparent from astudyoftheseplots.First,theprofits and losses are mostsensitive to time when theunderlying price is near zeroStandard Deviations. As thepriceapproachesoneextremeor theother, theperformanceofeachoptionstrategyislessdependent on the time
remaining to expiration.Theseeffectsaretheresultofa combination of Theta andMoneyness. When optionsare near-the-money, Thetahas its most pronouncedeffect; time value slowlydecreases, lowering thevalueof each option as timeprogresses. When optionsbecomedeepin-the-moneyorfar out-of-the-money, thechange in Moneynessdecreasesthetimevalue.
Second, most optionstrategieshaveprofitandlosspotentials which graduallyapproachtheshapeoftheplotas it would appear onexpirationday.Astimedecayaccelerates, a single optionwillloseabouthalfofitstimevalue during the first threeweeks of a 30-day contract,andtheremaininghalfwillbelost in thefinalweek leadingup to expiration. However,not all strategies are affected
equally by time, namelySpreads. A Vertical Spreadtends to losemuch lessof itscombined time value duringthefirst threeweeks,perhapsonly one-third, thenaccelerates more quickly,losing the remaining two-thirds during the final sevendays of trading. WithButterflies and Condors, theeffect is even morepronounced; withoutsignificant change in the
underlying price, thesestrategies may onlyexperience a combined lossof timevalue of one-tenth inthefirstthreeweeks,withtheremaining90%oftimedecayoccurringinjustsevendays.
Third, the moststrikingexceptiontothetimedecay characteristics are theSyntheticLongandSyntheticShort Stock, both of whichareunaffectedbytime.
AppendixEEXPANDEDTABLEOFSYNTHETICPOSITIONS
Due to the possibility
ofoptionlossesexceedingthe
total value of a trader’saccount, most brokers limittheoptionstrategiesavailableto individual traders.However,manystrategiescanbe created synthetically toyield similar performance tothetraderwithoutaddingrisktothebroker.
One of the simplestexamples of a position thatmight be prohibited by abrokerwouldbeaNakedPut.
A trader seeking theperformance of a Naked Putwill experience similar profitand loss by opening aCovered Call at the samestrike price that would havebeen used in a Naked Putposition.Thepotentialprofitsare not exactly the same forbothpositionsduetothelossof potential gains on thecapital required to open theCovered Call (either throughinterestincomeorgainsfrom
other potential trades);however, the option tradesthemselves are nearlyidentical.
The following tableshows the syntheticequivalent for some of themore common optionstrategies. It should be notedthat some of the syntheticpositions are not exactequivalents;thosethatrequiretheuseofdeep in-the-money
options are merelyapproximations.Forexample,aSyntheticLongpositioncanbe approximatedwith a deepin-the-money Long Call.Such an option would havelittle or no time valueremaining and wouldtherefore behave nearlyidentically to an equivalentlong position in theunderlying shares. Howeverin practice, the optionwouldlikelyhaveverylowliquidity.
Even if it was possible totrade the option, the bid/askspread could be significant.Even so, there are oftenoptions available withsufficient liquidity andMoneyness that theirrelatively small time valuemakes them a viablealternative toSyntheticStockpositions.
AboutSteveBurns
SteveBurnshasbeen an active traderfor over 12 years. Heistheauthorof"HowIMade Money Usingthe Nicolas Darvas
System," published byBN Publishing(available at all majorInternet retailers). Heranksinthetop300ofall reviewers onAmazon.com. He isalso one of the site'stop reviewers forbooks about trading.
He has been featuredas a top DarvasSystem trader onDarvasTrader.comandinterviewed on theMiss Trade YouTubechannel. He has alsobeen a contributor toZenTrader.ca andBusiness Insider. He
livesinNashville,TN,with his wife,Marianne, and theirfive children: Nicole,Michael, Janna, Kelli,Joseph. He has onegranddaughter,Alyssa.
Steve Burns hasnot had a losing yearactively trading in his
main two accountssince 2002. From2003-2007hereturnedanaverageannualgainof22.95%andwenttoa cash position onJanuary 4th, 2008,keeping all of his bullmarketreturnsthroughthe Great Financial
Panic.Histradingbeatthe S&P 500 for sixstraight years and hada cumulative 209.5%return over an eight-year period. Hisreturns doubled themarket returns,averaging 15.7%versus the S&P
returning 7.8% from2003-2010.
Theauthortradesaccounts worth over aquarter of a milliondollars.
ConnectwithSteve:E-Mail:
WebSite/Blog:
www.NewTraderU.com
FacebookPage:
https://www.facebook.com/NewTraderU
Twitter:
@SJosephBurns
AboutChristopher
Ebert
ChristopherEbert has been a realestateinvestorforover24yearsandanactive
stock and optionstrader for over 14years. His formaleducation includesundergraduate studiesin engineering at theState University ofNew York and atRochester Institute ofTechnology. His
option research isfeatured regularly onZentrader.ca where heis a contributor. Helives in Rochester,New York, with hiswife Anita and theirdaughterBreeanna.
ChristopherEbert is a contrarian
trader and as a resultwas able to sidestepthe majority of thedownside of the BearMarket of 2002 andGreat Financial Panicof 2008. He hasoutpaced the S&P in13ofthepast14years.Having gone to all
cash during the finalrunoftheBullMarketduring the spring of2008, and then goneall-in on February 11,2009, he missed themarket bottom by lessthan 30 days, leadingto a gain of over 50%for the year. His real
estate holdings, alsobeing contrarian innature, were mostlyunaffectedby theU.S.Housing Bubble andthe crisis thatfollowed.
Theauthortradesaccounts worth over aquarter of a million
dollars.
Connect withChristopher:E-Mail:
Twitter:
ChristopherEbert@OptionScientist
Contributorto:
Zentrader.ca
References:
www.Dictionary.com (Used withpermission)http://www.optiontradingpedia.com/options_theta.htm
*Quote from chapter 16 byprofessional trader JackMega.
Wehaveabookrecomendation
foryouNewTrader,RichTrader:HowtoMake
MoneyintheStockMarket
BySteveBurns
StockOptions:TheGreatestWealthBuildingToolEverInvented
ByDanielMollat
62RulesUsedByForex,FuturesandStockMarketsTraders
ByJimWyckoff
HowIMadeMoneyUsingtheNicolasDarvasSystem,WhichMadeHim$2,000,000intheStockMarket
BySteveBurns
TheRichestManinBabylon:NowRevisedandUpdatedforthe21st
Century
ByGeorgeS.Clason
TheMasterKeytoWealth
byDr.JosephMurphy
YouCanStillMakeItInTheMarket
byNicolasDarvas
RulesUsedbyProfitableTradersforInvestinginGoldandSilver