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- Are You A Stock Option Dabbler?
- An Option Trader’s Mind
- Why Uncle Sam Likes Index Option Spreads
- Trading LEAP Options
- Rolling out of an OTM Covered Call
- Volatility and Options Trading
- Trading Options with Japanese Candlesticks
- Options and Modern Portfolio Theory
- Fundamental Considerations When Trading Stock Options
- The Sinking U.S. Dollar-an opportunity for Option Traders
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Jan
5
“Option trading hobbyists have the longevity of a fruit fly.”
“ So, you’re a stock option trader?” she asked. “ Not really, I just dabble a little bit”. “ Then here, just open your wallet and give me your money”, she smiled. It might be more productive than being a dabbler”, she laughed coquettishly.
That might be the only luck you’d have being a stock option “dabbler”. If you are a private pilot would you “dabble” when you climb into the cockpit? If so, don’t invite me to go sightseeing with you. No, if you don’t take option trading seriously-no matter how often you trade-you’re probably a masochist looking for someplace to hurt yourself financially. It’s not that trading options is dangerous and ultra risky, it’s just that trading options requires some education beyond a newspaper column or enticing stories of financial conquest. It takes some effort and understanding to trade options and option-trading hobbyists have the longevity of a fruit fly.
To learn how to successfully trade stock options requires some time and dedication to the learning process. Options aren’t that difficult to learn, but the subject is a cut above investing in mutual funds or invest and hold strategies. Stock option trading is not for the hobbyist. If you’re an option trading masochist, go see a Hollywood movie or read the Britney Spears autobiography.
Stock options are pretty amazing investment tools and offer tremendous flexibility for option traders. But they don’t earn their potential rewards by being easy to understand. If you want to trade options, you need to be serious about them. It takes a business-like attitude to trade stock options.
First and foremost, the subject of stock options needs to be studied. Nowadays, with the tremendous advantages of online learning, anybody anywhere can learn about stock options and how to trade them. Would you start a business and invest your money without learning about the business? Of course not.
Once you have learned about the basics of trading stock options, it’s time to assess if option strategies will help meet your investment goals. That suggests some sort of investing plan. Have you made an investment plan? Most
people don’t and this is the first sign of hobbyism and its resulting disappointments.
What is an investment plan? Consider it like a business plan. First, you decide what your goals are and then how to reach those goals. After that, the devil is in the details. Extensive study has shown that doing a business plan first goes a long way to assuring success. Without a road map, you not only can get lost but you also don’t even know where you’re going.
In an investment plan, a trader not only defines goals and ways to measure progress toward those goals, but also operational strategies and procedures to select the proper option trade, what profit margins to expect, stop-loss parameters and how to exit a trade. Almost as important is the rules for money management and what to do if the option trading system is not producing the results expected.
Needless to say, doing an investment plan is a subject in itself. The point is, if you aren’t willing to spend the time to approach options trading with a more than casual level of commitment, your chances of having a positive experience will be nil; only momentary thrills as you toss the dice and cross your fingers. Option traders are not gamblers, they define high probability trades and execute them where they find them. Option traders don’t do things without weighing the odds, and a real option trader would never be a hobbyist. Likewise, a hobbyist will never be a trader.
Jan
4
An Option Trader’s Mind
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“Success is more a matter of proper mental preparation
than having a good trading system”.
Norman Hallett knows. For over twenty years, he was a trader and grew to understand the importance of having the proper trading mentality. As a matter of fact, he realized that proper mind-set is so important for traders that he started up www.directyourmind.com. On his website and course offerings, he teaches traders of all ilk how to “put on a proper trading head”.
Some of the pearls of wisdom he promotes are:
· Successful option traders set goals. Trading and investment goals should be specific, realistic, measurable and attainable. Moreover, trading and investment goals should be tracked and evaluated on a regular basis.
· Successful option traders specialize. It’s better for an option trader to know a few things well than to know a little about a lot. Becoming an “expert” on a few companies, commodities or other investment vehicles really helps a trader understand the small innuendos that can help make the difference between a winning or losing option trade. Many option traders develop several trading systems specific to the stock, option, commodity, etc. For the novice option trader, it’s a splendid idea to focus on just a few types of investment products and strategies and learn everything possible about them.
· Successful option traders take losses in stride: Norman is right when he says that nobody likes to lose but option traders need to under-stand that losing is part of winning. If an option trader is disciplined and pulls the trigger when the system calls for it, the trader will be trading with the head and not the heart. Traders understand it’s a game of probabilities and money management. Losses will happen.
· Successful option traders are prepared and stay focused: A successful option trader is like a well conditioned athlete. They need to be rested, eat well and be sharp every trading day. Many option traders pick a specific time to do their trading. They pounce when their targets are hit, set up stop-loss instructions and walk out the door. Before placing an option trade, “vision” the way it should unfold and when reality follows the vision, be ready to act. Come prepared and have your strategy clearly defined before it happens..
· Successful option traders stay detached: An option trader needs to be totally objective and keep emotions out of trading. That’s the purpose of having a clearly defined option trading process. Establish a system and implement it the same way- every trade. No exceptions.
· Successful option traders are independent thinkers: Norman warns that following the advice of brokers or “experts” can be a mistake. Experienced option traders learn to trust their system. If the system isn’t working right, they stop trading and fix the system.
Too much emphasis is placed on technical information and analysis. Not enough emphasis is given to having the proper mental preparation. In fact, many experienced traders, such as Norman Hallett, strongly believe that success is much more a matter of proper mental preparation than having a good trading system. Option traders and investors need to give this topic serious study; more-over, learning how to stay detached and objective may very well be one of the most important lessons for success in life.
Jan
3
“Gains made on these trades are taxed under a 60/40 rule”
As an option trader, if you don’t consider taxation on gains, you probably think you won’t have any profits to tax. In which case, you should be thinking twice about trading. But for those of you, who know that you’re the real thing, listen up.
Brad Griffin, a CPA and a fixture at Index Spread Options Trader (www. indexoptionstrader.com) talked about options, taxation and the unique status held by index option spreads. First of all, Brad explains that short-term gains from most types of stock and option investing are taxed as ordinary income. If you are in the 31% income bracket, you will pay 31% of your profits as short term gains. If you have a great short term trade, you pay 31% of the profits to the Uncle. If you have a losing trade, Uncle feels bad, but you’re on your own, baby. Nice partnership. Uncle rewards a trader’s patience because if a position is help for more than 12 months, it is considered as long-term and any gains on stock and option investments are normally taxed at 15%. Moreover, if your tax bracket is below 25% then long term gains are taxed only 5%. Uncle is a compassionate fellow but probably wants to know why you have enough money to invest at that tax bracket.
Mr. Griffin goes on to explain that there is some good news because the gains from stock index options trades are taxed differently than gains on individual stock options and stocks. According to Brad, gains on stock index spread trades are considered ITC Section 1256 contracts. This means any gains made on these trades are taxed under a 60/40 rule: gains are treated as 60% long-term capital gain income and 40% short-term capital gain income (ordinary income) regardless of how long the investment was held. At the end of his article, Brad reminds us to not trust what he says as the truth so do your own due diligence. Always good advice.
So what is an index spread option?
As you may know, there are many types of spreads, but the classic definition is: The purchase of one option and the simultaneous sale of a related option, but with different strike prices and/or expiration dates. Index options are traded just like other options with the exception of more favorable taxation. An index is a number which tracks a specific market. For example, some of the markets tracked by an index are:
- NASDQ 100 Index (qqqq)
- NASDAQ (NDX)
- Dax Industrial Index (DJX)
- Dow Jones 30 Index
- S&P 500 Index (SPX)
An example of buying an SPX spread would be the following.
You think that the price of the SPX will rise within a certain time period. You would purchase an SPX call with a certain strike price and expiration month and simultaneously sell an SPX call for the same expiration date but with a different strike price. By selling (writing) a call, we receive a premium which helps reduce the overall cost of the position versus buying just a straight call. Thus, the spread puts less money at risk when assuming a long position. The same concept works for puts when the market is forecast to go down.
Jan
2
Trading LEAP Options
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A LEAP might just be the thing you’re looking for. It’s a normal option on Viagra-it lasts a lot longer. Most people think of options as a speculative tool to be used for short term, repetitive trading. But options are much more. Most don’t think of options as a long term investing strategy. But a LEAP (Long-term Equity Anticipation) takes the flexibility of options into the realm of longer investing and not just short term trading,
A LEAP is an option to exercise the rights of the underlying stock within a certain period- if in-the-money. For a LEAP option, the expiration period can be from one to as much as two and a half years. This gives an investor or trader a method to allow more time for a stock to perform as expected but without having to pay the full stock price of owning the stock. For example, to own 100 shares of a stock priced at $50 would cost $5,000. To own a two year LEAP option contract on the same stock could cost about $1,000; thus, freeing up more investment capital for other uses yet keeping a position in the underlying stock. No matter what the cost of a LEAP option, it will be significantly cheaper than owning the stock outright. Not only that, you can roll a LEAP option forward for an even longer period.
An important consideration when buying LEAP options is the breakeven price. To figure this important price, you need to add the LEAP option premium plus any other transaction costs to the strike price. For instance, if the LEAP option cost $3 per share (a contract is for 100 shares) the stock price would have to rise to the strike price plus the $3. If the strike price were $40, then the break-even price would be $43.
As with all options, the total risk is the premium paid. If you own the underlying stock, the risk can be the total amount of stock owned. For example, if the stock costs $50 and you have 100 shares, your risk exposure is $5,000. If the option premium for the same stock is $2 per share, your total risk is the $200 premium paid.
Returns on LEAPS are much higher than owning the underlying stock.
For example, if 100 shares of a $50 stock appreciate to $60, you will have a gain of $1000 on your investment of $5,000 for a return on investment of 20%. If you had one option contract and it went from the initial premium of $2 to $4 you would have a gain of $200 for the contract. This is a return of 100% on the original premium investment of $2.
Options also can be sold (closed out) if they don’t behave as desired. It’s always advisable to use a mental stop-loss just as in all other trades.
The key benefits of investing in LEAPS over buying the underlying stock is that the risk are lower, the cost of the investment is much less and the return on investment is much larger.
Jan
1
Did you know that you can effectively bypass stock option expiration? Well, maybe that’s a little over the top….but not far. Consider one of the most conservative option strategies: the covered call. It is a strategy that makes money on low volatility. The owner of the underlying stock writes (sells) a call option on the underlying stock. Typically, the option writer writes an out-of the-money call and is hoping that the option will expire worthless and the premium paid for the option can be kept by the writer. This option strategy can be done many times over and over again with the same stock; as long as the call doesn’t go in-the-money and gets called away; it’s like getting high stock dividends on a super regular basis. A refinement on this option strategy is to save transaction costs of constantly writing new calls. It’s called “rolling out” of an OTM convered call.
Let’s say that you have written a covered call option with a stock strike price of $42 on XYZ company with a current stock price of $40. The call option you have written expires in one month. Because of the time decay value of the option premium, the option value is streaking towards zero. You’re happy and you want to write another call option as this one expires. To save transaction costs on writing a new option contract, you decide to “roll out”.
You have several choices:
1). If the stock has remained fairly flat, you can write the new call option for the same $42 strike price to expire at the end of the next month.
2) If the stock price has declined during the existing option call period, you could write a new call option with a lower strike price and try to collect a higher premium for an OTM strike price that is close to being at-the-money (ATM). However, if the underlying stock appears to be continuing in a southerly direction, you might consider getting out of the stock altogether and find another underlying stock. (Most covered call writers look for a stock which is slightly bullish with average to low volatility.)
3) If the stock has moved up closer to the strike price or is at the strike price, you will have made a slight profit on the underlying stock ($2) as well as the option premium collected for writing the call option; however, you don’t want the stock to get called away if it goes into-the-money. In this case, you could buy back the $42 call option and write a new call option for a higher strike price. Or, you could let the stock get called away and you would keep not only the option premium for writing the call but also the appreciation on the underlying stock.
Dec
31
If you want to make money as a trader, you need movement and you need it now. The more the merrier. Most people associate volatility with their high school football coach. Others view it as something to be avoided. And a few-mainly option and commodity traders- see volatility as opportunity.
Volatility is the measure of variance around the mean price. If a stock has low volatility, its band of price movement is limited. On the other hand, a stock with a wide band of price movement is considered volatile. Most investors want to have the value of their investments increase over time. But traders want price to move rapidly and with variation. If a trader can predict the proper direction of movement within a certain time frame, they can make many trades with small profits which will compound over time. Traders want movement and they want it now! To do that, they need investment vehicles with volatility and options can certainly fill the bill.
Types of volatility
There are two types of volatility: implied and historical.
Implied volatility is what the market expects for a stock’s price movement. If implied volatility is high, the market expects the stock price movement to be choppy. Of course, low implied volatility suggests smoother stock price movements within a limited price range.
Implied volatility is, indeed, the same as option value. However, implied volatility can be different for different positions on the same stock. Typically, when volatility on a stock is on the rise, the market is focusing on the stock and something out of the ordinary is happening. If a stock is breaking out, and is not accompanied by volatility, the breakout will probably not be sustained. If volatility builds up along with other technical indicators, a break-out can be significant.
Historical volatility measures the stock price changes in the market and translates this into a statistical measure of variance. We won’t concern ourselves with the math but the result is presented as an annualized percentage. This percentage provides an idea of how far the stock price can vary from its average price. For instance, if a stock has an average price of $40 with a volatility of 50% this means that price could vary between $20 and $60.
An option price is affected by several components: the strike price, days to expiration, current stock price, dividends paid (within the option period), interest rates and implied volatility. Each stock has many options and each will be different mainly due to implied volatility. In general, out-of-the- money (OTM) options have a higher implied volatility because of more risk than at or in-the-money options. Moreover, puts and calls for the same period usually doesn’t have the same implied volatility.
A good option trading strategy using volatility
Covered Call writing is when an owner of the underlying stock sells (writes) an out of the money call. This is a popular strategy and is considered a conservative option trade. According to Ravi Kant Jain in his article “Putting volatility to Work”, a trader should start with a mildly bullish stock. If a trader picks a very bullish stock, it could be akin to shooting oneself in the foot as the trader will lose the potential gains of owning the stock unencumbered by having it called away if n option is exercised. Historical volatility is the next thing to consider. If the historical volatility is high, this demonstrates that the stock moves a lot. That’s good. This means that the stock has a good chance of moving below the strike price as well as above it. Jain recommends that the best candidate is a stock with the biggest difference between implied (option premium) and historical volatility.
Dec
30
Anything that still produces excellent investment results after 400 years must have something to it. Four hundred years ago, Japanese rice traders developed a system to track trading sentiment. Call it the first technical trading system in history. The theory is that as sentiment goes, so goes prices. If market feels that demand for a stock, rice, option, etc, is strong, it will be demonstrated in how price moves over a period of time. If price and buying patterns change, sentiment can also be changing. For example, if a stock price opens at one price and closes at a higher price without going below the opening price for the whole day, demand is strong (Fig 1). If price opens and spikes up but ends the day lower than at the opening, demand may be waning (Fig. 2). If the stock opens then spikes up, spikes down and closes at the opening price, it indicates total confusion as bulls and bears are indecisive. This usually signals a trend reversal (Fig.3). Candlestick figures which show opening, high and low and closing are called Japanese Candlesticks. The color makes it easy to see if a stock is moving up or down. Usually, “up” is green (or clear) and “down” is red (or black). Over the centuries, distinctive patterns have demonstrated a high degree of success in predicting a change in sentiment and resulting price direction.
Fig. 1 Increasing value candlestick Fig 2. Decreasing value
There are over fifty candlestick patters but about thirteen are most common to traders. Most option traders use a candlestick as a primary indicator which points out potential opportunities. Further analysis needs to be done to confirm the sentiment indicator of the candlestick. For example, if a Doji is spotted, the trader will then focus on the stock and do further analysis in accordance with the particular trading system.
The example below demonstrates how one trading system can be employed to confirm a Doji candlestick pattern.
Fig. 4
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Once the Doji appears, further analysis depends on the system. In this case, the trader would look at RSI (relative strength indicator) to see if the stock is over sold or over bought. In this case, the RSI shows the stock in an oversold situation. The trader than checks the 20 day simple moving average (green line). It shows the prices moving back up toward the sma. Next, the trader might want to check to see if the current price levels are abnormal for the stock. One does this by using Bollinger Bands, (upper and lower orange bands. |
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TheBlack line is the median. The prices are well outside the boundry lines. Every indicator in this system seems to confirm the reversal that the Doji indicated. Analysis, fundamentals on issues should be checked to make sure there are no company or industry issues. |
Candlesticks make a good preliminary indicator for a possible option trade but it should be backed up with other indicators and at least three out of four indicators should technically confirm the venerable candlestick. The Doji is only one of many useful candlestick patterns and a trader is well advised to learn about them. Four hundred years speaks volumes.
Dec
29
It’s not surprising. It used to be all the talk amongst the financial egghead group. But now, the dawdling masses are catching on. Not many stock or option investors know about the investment theory that won a Nobel Prize in 1991. Nor do they know about a landmark study that showed that over 90% of the returns on an investment portfolio comes from how- not what- you own in your portfolio.
That’s right. Not the hot picks, top rated or whatever system stock picker gurus use. While most “lay” stock and option investors watch the flash- bang of Wall Street marketing, the buttoned down mathematicians and portfolio managers quietly put the new theory to use. There’s probably a good reason why most investors don’t know about this remarkable study and the importance of Modern Portfolio Theory (MPT). You see, there is a huge industry dedicated to telling you how to invest and what to buy.
MPT is a major tool for professional investment managers and this fact might also be another factor that keeps it mostly invisible to the average retail customer. Up until recently, the sophisticated Nobel Prize winning strategy needed somebody with an MBA or PHD to implement the strategy. But now the tools needed are accessible and easy to use for almost any non-egghead stock or options investor.
Modern Portfolio Theory for dummies
In a nut shell, MPT says that to minimize investment risk and optimize portfolio returns, close attention needs to be paid to the proper balance of asset classes within a portfolio. This is not to be confused with asset diversification. Asset class means types of investments with varying correlations. For example, you don’t want too many investments that move together in sync. That’s O.K when the market is going up and positions are long. But if things turn dicey, closely correlated investments all go down together; eggs in the same basket sort of thing. Investment asset diversification only pretends to give that sort of protection. Having different asset classes with varying correlations in a portfolio does. The important thing is that varying correlation promotes lower overall risk which helps allows an investor to add some kick to the portfolio and boost total returns.
More kick in your portfolio
Listen to this: a study done by the Chicago Mercantile Exchange demonstrated that a portfolio with as much as 20% of investment assets in futures and options yielded up to 50% more than a portfolio limited to low and moderate risk investments.
Options are perfect for the 10-20% of a portfolio balanced for risk reduction. Options offer high leverage so the 10-20% of a portfolio can represent a much larger percentage of assets held. For example, if you have a portfolio with $200,000 in assets, if 10% of the portfolio is in options, the $20,000 alone could provide up to an additional $200,000 or more in rights to stock assets on top of the value of the balance of the portfolio. In this case, 90% of the portfolio would be invested in stocks, bonds and mutual funds and $200,000 in rights to stock through options for a total of $380,000 from which to obtain returns.
Used together with Modern Portfolio Theory, using the flexibility and leverage of options makes for a potent strategy. Consider the important fact that even a slight increase in portfolio returns can make a big difference over time. More investors should take a look at ways to optimize return and reduce risk. MPT and options is a strategy worth investigating.
Dec
28
Fundamental Considerations When Trading Stock Options
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Do the numbers tell it all? When you read something about a company, do you really believe it? How do you make a decision about what makes a good investment opportunity? For most traders, technical analysis takes center stage and some times the fundamentals are pushed to the back or forgotten all together. But there are some important fundamental factors that an option trader should always keep in mind.
1) Every trader or investor should know what is happening within the company and the industry to confirm why the stock or option is behaving as it is or if there are any possible events which could affect the stock or option price. Going to the company website and contacting the Investor Relations department is a good idea before entering into a trade. Its a little time consuming but this step may save you from any surprises and help to confirm your analysis. Of course, consider the source.
2) Investors and traders need to know when a target company comes out with financials such as earnings estimates, quarterly and annual reports and files SEC documents. The SEC regulations are designed to provide investors and traders with transparency. However, if a trader or investor isn’t aware of SEC filings by a company, the trader-investor may overlook important information that is revealed in the required documents. A company could say “it was there for the entire world to see”. It’s caveat emptor, baby.
3) Option traders should be aware of “Triple Witching” dates. This scary sounding day is indeed something to avoid and it happens on every third Friday of expiration months. “Quadruple Witching” day happens when several types of options and other derivatives expire on the same day. This happens on the third Friday in March, June, September and December. Triple or quadruple witching days see volumes and volatility increase, which is largely due to investors “rolling” existing options positions to new expiration months and exercising option contract rights. With the advent of single stock futures (SSF) and improved technology, many feel that the Triple and Quadruple Witching days are no longer quite the chaos they were in the past. However, it’s a good idea for the options trader to be aware of when the witches come out to play.
4) Decide if the stock and its options are overpriced. Look at the last 12 months price range for the stocks and see what the options have been doing in various expiration months. If the price is currently near the top end, consider buying on pullbacks.
5) Check the volatility of the stock. If it is above normal for the stock, there could be some information out there that’s not readily apparent.
6) Check and see if insiders are buying or selling the company stock or exercising or selling options.
7) Review the Annual Report called the 10K or Quarterly Report (10Q) and particularly to the section usually titled “ Management Discussion and Analysis” (usually in the front of the report). This will give a good synopsis of what the company management team feels about the state of the company and what future prospects are.
Check the company Income Statement and Balance sheets. The Income Statement (also called the Operating Statement) shows the profitability and expenses of the company operations and the Balance Sheet shows the financial strength of the company. If you don’t know how to read financial statements, there are plenty of free sources to teach you. 9) Check out the competition in the Industry. How does the target company compare to its competitors? How does the company Price-Earnings ratio compare with that of the industry. The same holds for EBIT (Earnings before Interest and Taxies) profit percentage.
These suggestions should be part of an option trader trading due diligence and incorporated into a checklist from to be checked-off before entering into any trade. Trading strictly on the technicals could miss factors not fully discounted into price. Do both Technical and Fundamental analysis and then make your opinion.
Dec
27
The Sinking U.S. Dollar-an opportunity for Option Traders
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“Oh, my God, the sky is falling in! It could mean the end of the United States as we know it. The strong U.S. dollar-representative of the strongest economy on earth-is crumbling and with it the future”. The alarmists and conspiracy theorists are jumping for joy. “We told you so. And yes, we’re smarter that the lot of you,” they say under their collective breath. Pure, unadulterated hogwash.
The “chicken little” run for the hills thinking offers investors a real opportunity. You see, the U.S. dollar is just making the long sought after correction needed to make U.S. exports much more competitive. From 1995 to 2002, the U.S dollar rose over 35% in relation to other floating currencies, namely the Euro and Canadian dollar. Since 2003, the U.S. dollar has fallen back 35% from what most economists felt was an overvalued U.S. dollar.
While there are problems with the U.S. Federal Budget Deficit and trade deficits, they pose not imminent crisis. No doubt better fiscal policies need to be enacted in Washington but the real pain in a falling dollar lies with our trading partners who hold huge reserve of U.S. dollars. They don’t want to see a large devaluation and they don’t want the dollar to become too competitive either. That’s the real truth. And that is the reason that our trading partners will keep buying U.S. treasuries while more responsible heads try to sober-up the drunken sailor. So, shun the panic and look for the opportunities.
Most of the U.S trading partners in Asia and Latin America have more or less pegged their currencies to the U.S dollar. This means that most of the current devaluation is not exported as price increases to the U.S. As a matter of fact, export opportunities for the U.S. are increasing with each down tick of the dollar against the “floating currency countries”-more specifically Europe. Stocks of U.S. companies who produce and export things such as transportation equipment, computer and electrical products, chemicals and industrial machinery will greatly benefit from a falling dollar. These in-dustries provide 70%-80% of U.S. exports to Europe and Canada. These same industries provide 68% of U.S. exports to China who has recently revalued their currency. As U.S. exports go up, profits go up, employment goes up and tax revenue to help balance the federal deficit go up. On the other hand, in exchange for the benefits of a lower dollar, U.S. travelers going abroad-particularly to Europe and Japan- will find it more expensive overseas. Sounds like a good trade-off.
A good strategy for stock option traders would be to locate solid U.S. ex-porters in the industrial sectors mentioned and consider buying long term out-of-the-money call options or bullish spreads. To many “in the know”, a weaker dollar-even though it sounds bad-is mostly a good thing. The only danger is if trading partners and foreign investors lose confidence in the dollar and flood the currency market with a tidal wave of dollars which could have a disastrous effect but not only the U.S would be hurt but also the World as foreign dollar reserves plunge in value. Moreover, the U.S. dollar is the world’s trading currency. To replace it would require much more crisis management and political investment that it would cause tremendous disruptions. To let the dollar crash would be a foolish mistake.
Traders love it when panic and emotion cloud the thinking of the market place and create real opportunities. Trust in the basic fact that most investors will do what is best for them when they understand what they must do to protect their own interests. This means that there won’t be a run on the dollar. When other investors wake up and act logically and without fear, the window of maximum opportunity usually has already slammed shut.
Dec
26
When you first realize it hits like a ton of bricks. So simple yet so true. About 80% of stocks follow the trend. We all know the “the trend is our friend”. Can you smell a contrarian in the wood pile? Well, if 80% of stocks move with the trend that must mean that only about 20% of stocks or options will move against the trend on a normal day. There must be a way to use those favorable odds. And with options, there is.
An option trader can take advantage of this knowledge and use it to make a profit against the market trend. The trader can write (sell) an out-of-the-money put. This is also called a “naked put” because the writer does not own the underlying stock (it doesn’t mean the option must have been written in a state of undress). If the price of the stock goes up-as is expected-the trader who writes (sells) a put will keeps the writing premium just as long as the price does not go down below the strike price and into-the-money. Given that 80% of stocks move with the trend, the probability of the stock moving against the trend and the writer can be very small. However, to make this sort of trade, the trader needs to have a good understanding of what the short and long term trends are and if there is any possible news (earnings reports, adverse news, etc) that might send the stock reeling backward. This is one of the more risky strategies because if the put goes in-the-money and the option is called, the writer must purchase the underlying stock to place with the option buyer.
A much safer way for an option trader to make money going against the trend is to write a covered call. If the underlying stock is owned by the trader (thus, the put is “covered” in case it is called away), the option call writer is hoping that some other trader believes that the underlying stock will go up in value as will the derivative option. But if the owner knows his stock very well and believes that its usually docile behavior will keep it away from reaching a certain strike price, the call writer will make money when the option expires if it doesn’t get into-the-money and get called away. For example, if the long term trend is up but the shorter term trend is in a correction phase, the trader can write the covered call with an expiration date that will fall within a time frame that should see the correction move back toward the long term trend. Using the promise of a substantial move upwards into the money, the call writer hopes to lure in a trader who doesn’t understand the stock as well as he. Once the option expires, the call writer keeps the premium and if things still look good, (not much upside movement) he prepares to do it again, and again and again. Given that there are option expiration dates for almost every month, the return can be quite impressive over the long term. If a covered call writer is unlucky and his stock gets called away, well he gets to keep the profits and the premium. The only thing he might lose is the opportunity cost of a large move in the underlying stock.
Dec
24
When you learn about options-really learn- you’ll understand why they have become so popular. Don’t let the word derivative scare you. Read on and find out whey options are the way to go. Most importantly, options provide investors with the flexibility to choose from a wide range of strategies. In this short article, we’ll discuss some of the more basic and easy to understand ways to employ stock options.
Long Call
The most basic and easiest to understand is the long call. This is when an option is purchased with the idea that within a certain period of time the value of the option will increase and profits can be made with a much smaller investment than would be needed to purchase the underlying stock. For example, if the underlying stock is currently trading at $30 and you expect the stock to go up to $40, a trader can purchase long call options with a strike price of $ 31 that would expire in some future month. If the option moves past the strike price ($31) the stock option owner can either exercise the option and acquire the underlying stock or hold the option and take advantage of the option premium appreciation.
Long Put
Traders who believe that the future price of a stock may go down in value within a certain period of time can buy the right to sell the stock at a certain price. As in all options, the option holder has the right to sell the stock but not the obligation.
If the market price goes down as anticipated within the time period of the option the premium price will increase and the trader can profit from the difference of the purchase premium and the current premium price. If the price does not increase, the trader can let the contract expire or sell it to someone else.
Short Call ( aka “ Naked call)
When a trader sells (writes) an option, he can either own the underlying stock- which case it is called “covered” writing and or in the case of a “naked” writer, an option is written without actually owning the stock. In the case of writing a naked call, if the market price of the underlying stock decreases, the short call writer will profit by the amount of premium change. If the price of the under lying stock increases, above the strike price of the option contract then the short call will suffer a loss. The short call writer is betting that the stock will not go up. If the short call is exercised then the writer is obligated to buy the underlying stock and honor the option contract specifications. This is perhaps one of the riskiest strategies because of the potential of having to purchase the stock in the open market and then transfer the stock to the short call option holder.
Short Put
If a trader believes that the future price of a stock will increase, they can sell (write) the right to sell the stock at a certain price. If the stock price goes up, the short put position makes a profit on the premium. Conversely, if the price goes down below the strike price, the put writer (same thing as short put) loses money.
To summarize, to be long is to purchase a call or a put. To be short is to sell (or write) a call of put believing that the price will not move in the direction of the call or put. Shorting is a contrarian strategy with a high probability of being correct if going against the prevailing trend as 70% to 80% of stocks move in sync with the strong underlying market trend.
Dec
23
Selling Stock Options
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You can’t believe it’s happening. The stock is starting to move up but the option premium is falling. That’s not supposed to happen, or is it? Stock options are quirky when it comes to time left in the option period. It’s really different than investing in stocks. One of the vital concepts that stock option traders learn about and need to understand is the time value of an option. They learn that as an option contract approaches its expiration date, it loses value because there is less time for the option to move as forecast. The Chicago Mercantile Exchange once did a study that demonstrated that over 80% of all options expire worthless. Does that mean that 80% of option traders lose money? Not really; and in certain cases, expired options are far from worthless. To an option seller, expiring options are all about profits. An option seller under-stands how to make a profit with stock options- even if the market doesn’t move!
When buying an option, the time value works against the buyer as the chart below depicts. The closer to expiration, the more the time value of an option decays until reaching zero at expiration.
The premium value of an option is composed of intrinsic value and time value. Intrinsic value is the in-the-money portion of the option premium. For example, if you buy a call stock option at a strike price of $25 with the underlying stock’s market price at $35, then the intrinsic value of the call option is $10 (in-the-money). If the option contract premium is $12 per share, the additional price component ($2) is the time value-the more time left before expiration date, the higher the time value.
An option seller (also known as the “writer”) wants the option he/she has sold to expire worthless so the premium paid to the writer for the option can be kept. In-the-money or out-of-the money options can be written. If a writer of an option already owns the underlying stock, this strategy is called writing a “covered option”. If the writer doesn’t own the underlying stock, the strategy is called writing a “naked option”. Using this strategy debunks the idea that expiring options are worthless. In fact, option writing is an excellent strategy when you believe the underlying stock is going to move in one direction (or not at all) and you write an option for potential movement in a contrary direction. It’s important to understand that 70% to 80% of stocks move with the trend. For example, if you are bullish, you would sell (write) an out-of- the-money put option. As long as the underlying stock doesn’t go down and into-the-money (hits its strike price) before expiration, you keep the premium paid for the put option. The risk of writing the covered position is having the stock called away if it is in-the-money and the un-covered position is that you might have to purchase the underlying stock if it moves into the money and is called away. In reality, writing a covered option is considered a conservative strategy. Writing uncovered is more risky.
Another nice thing about selling (writing) an option is you don’t have to worry about when to get out. You make money just by not moving into the money. You don’t even have to be correct about the magnitude or direction of movement; just as long as the option doesn’t get into the money. Remember, 80% of options expire worthless. The odds are definitely in your favor if you are going against the trend but that in no way relieves the responsibility of doing the due diligence. The trader needs to not only look at the technicals-particularly Relative Strength Index (RSI) but also fund-amental issues like any potential situations that could cause the stock to reverse direction.
Selling out-of-the-money options can be much less stressful because it only requires an analysis of identifying the high probability of little or no significant movement. The profits are fixed and there is none of the usual conundrum of when to exit a trade. Just ride the time decay curve to the end and ring it up. If you do it successfully enough times, you’ll be a happy camper and probably become a died-in-the-wool contrarian.
Dec
22
The Big Picture: Losing is Part of Winning in Options Trading
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This is what it’s like to be an option trader. You’ve done all the due diligence. You’ve checked the stock and option charts and studied the fundamental issues of the underlying stock. The March out of the money- option looks like a good time interval and strike price to move into-the- money and hit your target price. You decide that it looks like a good option trade and you have three of your four technical indicators supporting your decision. You’re just waiting for the stock price to move through the 20 day simple moving average (SMA). As, you watch the stock price move up to touch the SMA line, you call your stock broker and place a market order for five March 50 strike price call option contracts along with a 7% trailing stop loss. You get a confirmation and you sit back to watch the action. Your heart is beating faster and you move closer to the screen. “Come on, babies, show me the money”, you murmur to yourself.
You’ve told yourself that keeping glued to the scream is something you want to avoid but for some reason you get hypnotized by the promise of seeing the stock and its option price move in your favor. Finally, the option price starts moving up slowly. You feel excitement and a sense of anticipation. You did exactly what your options trading system procedures called for and a surge of confidence brings a smile to your face. You decide to tear yourself away from the screen and go for a walk to enjoy the feeling and relieve the tension.
When you return to the computer, you gasp in horror as you see that the option price has retraced and is nearing your stop-loss. You quickly check the news and the charts for some indication of what’s happening. Nothing. As a matter of fact, you notice that the RSI (relative strength indicator) has moved down. Maybe this is the testing before it really takes off. “But what if I get stopped out before it makes the move back up?” you ask yourself. You quickly call your broker and ask him to move your stop-loss lower to give your position some room to breathe. You know you shouldn’t have done it but you did it anyway.
Within several hours, the price of the underlying stock is starting to move up and you watch with hopeful anticipation for the options to follow suit. But as you watch in horror, the option prices not only blow past your original stop- loss but also scoot right past your adjusted stop. Before the first day is over, you’re out of the game and score some red on the trade. You’re angry and confused. All the study and preparation for what? You should have listened to others and stayed away from options trading. No more options trading for you!
This scenario is too typical and is what separates successful traders from the majority of stock option trader “wannabees”. Listen, losing is part of trading. As a matter of fact, a trader who has an option win-loss ratio over 60% is probably making good profits over the long term. The idea is that if you cut your losing option trades quickly and without second guessing yourself, and let your winners run, you will do well.
The key to becoming a successful options trader is being able to “stay in the game”. Simply put, staying in the game is a matter of setting up a strict policy regarding the amount of trading capital allowed for each trade and religiously “punching out” when a stop loss is hit. Most successful option traders limit their trading capital to about 5-8% of the option trading account on any one trade. If they draw down the option trading account below 30%, most option traders will stop trading and go back to redesigning their trading system or adjusting their heads. Simple rules to trade by, but most new traders don’t go into options trading with these sorts of con-straints in place. And even if they do, many let the emotions take over and will violate their own option trading system to save their egos or try to salvage money they shouldn’t be trading.
In options trading, losing is part of winning. Nobody wins ‘em all, and any trader with a win-loss ratio over chance (50%) is usually doing well because the average losing option trades lose much less than the average winner. For example, if average losers have an 8% loss and the average winner gains 18%, multiply that average margin difference (in this case, 10%) by the number of contracts traded over time and that is what it’s all about. It’s not about hitting home runs, but hitting for average.
Dec
21
If you don’t know much about stock options, wait until you read this! Most investors think that the only way to profit from investing is when the price increases (long position) or when price decreases (short position). However; with stock options, an investor can make money when there is no or little movement in a stock market or individual stock price. Consider the simple strategy of writing a covered call. (The term “covered” means that you own the underlying stock of the derivative stock option).
Writing an out-of-the- money call option
One of the many inviting strategies that can be used when there is little price movement in an underlying stock is to “pledge” the rights of your ownership to others. Some investors in the vast universe of stock option investors might believe that the stock you own may experience an increase in price within a certain time period. In order to position themselves to take advantage of their analysis, they look to purchase a call option(s) contract on the stock.
An option contract is composed of the temporary ownership of the rights to an underlying stock issue. To do this, they pay a premium for each share of stock. For example, a call option for a certain month may cost $2. This means that to borrow the rights for the underlying stock, an investor will pay $2 per share for 100 shares per contract; one contract would cost $200 plus transaction costs. If a stock has a current price of $32, 100 shares would cost about $3200 to purchase. On the other hand, to have the rights for 100 shares of the same stock would cost only $200 for a specific period of time. The cost of the premium depends upon if the option is in- the-money (ITM), out-of-the-money (OTM) and length of time left on the option. Of course, demand for the option is the major determinant.
The owner of a stock can “write” an out-of-the-money covered call whereby he/she pledges the rights to the stock in exchange of a premium payment. In the example above, the owner of the stock would receive the $200 premium for the rights to 100 shares if the stock for the specified time period. If the stock moves from OTM to ITM, the holder of the option may call away the stock and the writer of the call option must pass ownership of the stock to the option holder for the current market price of the stock. However, if the stock option does not move into-the-money, the option can’t be exercised; the premium and the stock stay with the call option writer.
Covered call writers can repeat the process many times over with the same stock and still maintain. For example, if the owner of the stock had paid $3000 for 100 shares of XYZ and then writes 3 covered call contracts per year at the same premium price of $2 per share, the writer of the call options would realize an annual return of 20% including any appreciation which didn’t trigger a call away of the underlying stock. However, the risk of writing covered calls is that if the stock appreciates and the underlying stock is called away, the owner would then lose the opportunity of taking advantage of the underlying stock appreciation.
Writing an in-the-money call
Here is another interesting way to take advantage of the tremendous flexibility of stock options. Instead of paying a broker to sell a stock position, why not make a profit by writing an in-the-money call.
Example:
Suppose the owner of 500 shares of Home Depot (HD) wants to sell the shares… Instead of calling his/her broker and telling the broker to sell the shares, the owner can write an in-the-money call. Keep in mind that ITM calls have higher premiums because of intrinsic and time value.
The owner of the shares discovers that an in-the-money call of the stock costs a premium of $9 per share for an HD-EG-E (May contract month with a strike price of $ 35, which is in the money because the current price of HD is $39.25). For the five contracts (500 shares), the owner would get a premium of $4500 less commissions for writing ITM options for the 500 shares he/she owns. The stock price is currently $39.25 and the calls will probably be exercised and the 500 shares will have to be assigned for the strike price of $35, and, therefore, the owner will lose $4.25 per share ($39.25-$35) for a loss of $2125. But the difference between the premiums ($4500) for the ITM covered calls and the projected loss of $2125 still gives the owner a net profit of $2375 and would give the owner a 12.1% return just on the sale of the underlying stock instead of selling at the current market price of $39.25 and paying commissions to sell the stock. What makes this covered call attractive is the time value of the option.
Dec
20
The Importance of Keeping Score When Trading Stock Options.
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Do you hold yourself accountable for your performance? Does your ego keep you from acknowledging the truth? The basic premise of a successful investing strategy-particularly for short-term investing (trading) - is that by cutting losses as quickly as possible and letting profits run, over time, there will be a pre-ponderance of profits over losses.. Having losing positions will happen, no matter how well the system or the trader. It’s a fact of life. To help keep perspective, a trader must constantly keep in mind that the “name of the game” is to have higher margin winning trades than minimized losses on the losing trades. Losses will happen. Even a 50% win-loss ratio can be a winner over the long term!
When trading options, traders should be constantly aware of: 1) the percentage of profitable option trades they expect to generate, as well as the profit margin of the average profitable option trade compared to the average losing option trade; 2) how many estimated option trades will be made over a specific period. With these two statistics, an option trader can get a sense for the estimated profit potential for trading options over a specified period of time. This estimation can serve as an important, measurable goal and used to help set-up psychologically expectations.
For example, let’s be conservative and say that 50% of your option trades would be winners with an average net profit margin (profits less transaction costs) of 14% and losing option trades to have an average net loss of 8%; the trader can expect a net return before taxes of 6% on 50 % of the total amount invested in total trades. If the trader anticipates making 5 trades per month at an average premium of $1,000, then the trader can expect to make about $150 net profit per month (2 winning trades = $2,500 x .06 = $150). Of course this depends on how long positions are held. Annually, this would translate into $1,800 on an account of let’s say $5,000 (in this example, the trader would have an account of $5,000 but only use an average of $1,000 as a maximum for each trade). This translates into an annual return of 36% on the account capital. If you have a system with a 75% win-loss ratio, then your estimat