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Trader's Corner

Seven Option Trading Mistakes to Avoid

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Getting e-mails from Option Investor subscribers always helps make my day, as I otherwise feel that I'm flying blind about reader interest related to MY choice of topics to write about in these Trader's Corner articles. I got an mail question/comment, sent in after today's important trading session that I'm happy to respond to. The question also gives me a chance to mention a source that I will use in my answer as being from the current issue of "Technical Analysis of Stocks & Commodities" (July, 2007).

** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for my answer or feedback to Click here to email Leigh Stevens support@optioninvestor.com with my name ('Leigh Stevens') in the Subject line.

SUBSCRIBER E-MAIL:
"What do you think are the most common mistakes made in trading options and how do you avoid these mistakes? Any comment on today's action. the S P and Dow held key support you mentioned on the weekend."

I'll take the later part first and show and comment on a couple of key index charts for starters.

CURRENT TECHNICAL CONSIDERATIONS:
Just to comment briefly on the current technical picture for the major market indexes, the most important aspect of today's price action in the S&P 500 (SPX), S&P 100 (OEX) and Dow 30 (INDU) is that prices tested, went below but only slightly, then rebounded well above the prior downswing low; this is highlighted on the OEX chart, which is the same pattern seen with SPX and INDU. As long as a decline does not pierce, on a closing basis, a prior reaction low an uptrend is considered INTACT. Stay tuned on what upside follow through will develop however!

In the case of the Nasdaq, demonstrated by the Nasdaq 100 (NDX) Index chart below, besides the fact that today's (upside) reversal and rebound occurred WELL above the prior (down) swing low at 1876, today's low was a rebound from the area of the internal up trendline dating back to early-March, which maintains a bullish chart. (An 'internal' trendline is one connecting the GREATEST number of highs or lows, rather than simply connecting JUST the lowest lows or highest highs.) Therefore, we can say that technical action in the NDX maintaining itself above this key up trendline is bullish chart/technical action.

OPTION TRADING MISTAKES TO AVOID

I mentioned initially the magazine "Technical Analysis of Stocks and Commodities" (TASC) one of my favorite reads relating to some smart writing on technical analysis techniques and trends. I've had articles published in TASC myself. Anyway, some thoughts from the pages of TA of Stocks and Commodities in the July issue and the following is real BASIC stuff, so if you know all this, skim for reminders of things that you haven't thought of in awhile.

First, a couple of random comments before getting into the seven trading mistakes to avoid as suggested by Ron Ianieri, a professional trader and former market maker in Philly.

VOLATILITY:
A reader said that he/she was taught to sell high volatility and buy low volatility. Someone who specialized in calendar and butterfly spreads and feels that this strategy is far superior to buying puts and calls outright (NOT NECESSARILY!), made the comment that high volatility means there is a 'tornado' in the air. The market is saying that something is going to happen and TRUST the market on this! And, when trading spreads, buy and sell volumes that are in line. If the difference between options is more than 6 points, investigate, or just look elsewhere. Interesting point this.

WEEKEND THETA DROP:
'Public' option traders (retail) sometimes think they'll come in the market on Friday and sell options, picking up two days of theta for free. [Theta or 'time decay' is an estimate of how much the theoretical value of an option decreases when 1 day passes and there is NO move in either the stock price or volatility. Theta is used to estimate how much an option's extrinsic value is whittled away by the always-constant passage of time.] Market makers are onto this strategy or thinking and will typically lower volatilities to cover this factor on Friday mornings.

RISK MANAGEMENT:
I can't emphasize this enough, but thought I would use the words of Dan Sheridan in TASC on this point, as I like to see sometimes how another professional expresses the message that people must get tired of hearing from ME all the time. In answer to the reader question on "the single most important thing to keep in mind when trading options"; the TASC reprinted answer from Sheridan and echoing my own convictions and experiences from a lifetime of trading, is as follows (all-CAPS are MY own emphasis):

The single most important thing to keep in mind when trading options:

"That's easy. Have a risk management plan. Be prepared for the position to move AGAINST you, don't be bushwhacked by it and sit there like a deer in the headlights like Bambi. Know your adjustment points on each and every trade when you put on the trade. Have your contingency orders IN the market immediately AFTER your trade is filled. Make it a BUSINESS, not a speculation. NONE of this: 'I'm going to WATCH it, or I'm going to take the pain.' Do your planning in times of 'peace', not in times of 'war'. If you do that, you'll do well over time."

SEVEN OPTION TRADING MISTAKES TO AVOID

As modified from the TASC July issue 'Trader's Notebook':

1.) Not understanding the independent effects of time and volatility on your option(s)

This is what happened to me big time when I started trading index options after years of trading stock index futures. I bought calls on an index or stock I thought was going to rise, only to have it lose value when it did not go up. Blame time and volatility! An example cited: you think XYZ stock is going to go up from its current price of $47, so you buy a call with a month to expiration. You select the 50 strike calls and buy them for $2.00. The stock moves up to $49 after 3 weeks. However, your calls are now worth only $1.00, a paper loss of 50%.

Unlike stocks, an option's price relies on MULTIPLE variables. Options are sensitive to the passage of time (theta, as noted above) and changes in implied volatility (vega). These variables are independent of each OTHER, the stock price movement and the option's sensitivity to it (delta).

So, in the above example for XYZ stock, its delta made us money as the stock went up, but unfortunately, it was also sensitive to TIME and VOLATILITY. These two variables depleted more value out of the option contract than the delta put into it, creating a loss even with the price of stock rising. Without understanding time and volatility, you of course would not know what happened in this scenario and get discouraged. For sure, we've all been there! Answer: learn more about time and volatility to be better prepared to select the proper option.

The other thing that I found is that it's necessary to work very hard on the TIMING of trade entry. For example, learning to buy calls or sell puts ONLY when the stock or index is into a value area but is out of favor (high bearish sentiment) and 'oversold' technically.

Buy puts or sell calls when the stock or index is probably overvalued as suggested by it being in a key resistance area, 'overbought' according to technical indicators like the RSI, perhaps accompanied by high bullish sentiment and when the stock or index starts to show resistance by topping repeatedly in the same area, especially at a prior high or congestion area and on declining volume.

A TIP: Buy an in-the-money (ITM) option with a delta around 80-85 when you want to use an option in place of buying the underlying stock, for a directional play. The option then will mimic the stock closely. ITM options are much less sensitive to the adverse effects of time and volatility.

2.) Forcing a pre-selected strategy on every opportunity

Those new to options trading especially will learn a particular strategy and then apply it to every stock or index that comes close to fitting the profile. Many different strategies are equally good under the right circumstances, but no strategy works in every condition. This idea of employing the right tool for the right job is also the best course in the field of market analysis, either fundamental or technical.

Let's take the example of the aforementioned strategy of 'selling high volatility and buying low volatility' versus some recent instances when the S&P Index has had 1-2 or a series of intraday spikes below its lower Bollinger Band, which is showing a situation of high volatility. This happened today, on at least a 1-day basis to date, when the intraday S&P 500 low dipped below its lower Bollinger band, indicating a low that was (at that moment) more then two standard deviations below the Index's 20-day moving average or well beyond the norm.

However, on this occasion today (at least on an intraday basis) and on the occasion of a cluster of such dips below the lower Bolli Band in early-June, indicating high downside volatility, this situation signaled a buying opportunity. Adopting a bullish strategy by buying calls for example was the opposite of a trading rule, which is sometimes right, to SELL in situations of high volatility. Of course, selling SPX puts in this example makes the 'sell high volatility' strategy work, but selling puts was another aspect of adopting a bullish trading strategy.

Instead of looking at a chart to see what the market is offering, with fresh eyes as it were, it's easy to force a strategy onto the chart in the way of trying to force a square peg into a round hole.

3.) Not understanding the proper way to use leverage in trading options; comparing apples to oranges

"Leverage" has two applications that apply to option trading. The first is the ability to use the same amount of money to create a larger position. The second definition of leverage is the ability to create the same-size position with less money.

As investors, the latter definition is the one we focus on. Investors would in most instances like to have the same position with less capital outlay, which shows a penchant for good risk management. This might at most mean buying stock on margin. It could mean the use of convertible bonds in certain situations and so on.

Unfortunately, we see the situation often in options trading where we take the same money we would apply to an unleveraged or partially leveraged situation and employ it in options, focusing on the first application of leverage, using the same money to create a LARGER position.

$10,000 invested in XYZ options does not carry the same amount of risk as $10,000 invested in XYZ stock; the option position of course has more risk. Buying 200 shares of XYZ at $75 would mean a total outlay of $15,000. The entire investment would only be lost if the stock traded to zero, a loss of 100% of its value and a very unlikely situation; there are not that many Enron's!

If instead we made the 'mistake' of buying 20 May 70 XYZ calls at $7.50 we would also be laying out the same $15,000, but to control 2,000 shares. Same money, controls far more. Our option position is 10 times greater than the stock position, which may well appeal to the speculative nature of those very bullish on XYZ.

The problem with the latter option leveraged situation is that we would lose our entire investment in call options if XYZ traded down to $70 by that option's expiration, which is only a 6.7% decrease in its price. Such a fluctuation in a stock trading at $75 is fairly commonplace. Obviously the risk scenarios in owning the stock outright, or even on margin, versus taking the same money and controlling 10-20 times that amount of stock by buying XYZ calls, is not at all balanced.

This example applies an incorrect use of leverage if we want to make money over the long haul. We spent the same amount of money to obtain a bigger position in options. Unfortunately, an inordinate amount of risk accompanies that position and gives the entire strategy a very imbalanced risk to reward equation. The example is a use of leverage, but not a balanced one when we apply the same dollars as we would in an UNLEVERAGED situation. Rather, an inverse relationship is what is called for. As risk through leverage goes UP, money committed should go down if we want to balance risk to reward.

OPPS, I'm out of time and I'll pick up on the next 4 basic mistakes in trading options NEXT WEEK.
Meanwhile, have continued....

GOOD TRADING SUCCESS!
 

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