Option Investor
Trader's Corner

Some Option Trading Mistakes to Avoid

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I started on the topic of seven, as in 'lucky' seven or unlucky seven in this case, option trading mistakes to avoid in my last week's Trader's Corner article (Wed., June 27th.); this was in answer to a subscriber question who I gathered was relatively new to options trading. I got through 3 of those 7 rules last week, which were my interpretations of 7 such rules given in the 'Trader's Notebook' section of my latest issue (July) of Technical Analysis of Stocks and Commodities magazine. Hey, my favorite magazine on trading.

Before I launch into completing this topic from last week, I would also make a quick detour into what I make of the technical action of THIS WEEK. I had been leaning to a bearish interpretation of the fact that a possible double top was in place in the S&P and Dow, but without the double top 'confirmation' that comes (only) when the major market indices ALSO pierce, on a closing basis, the last significant downswing low that occurred before there was a top twice in the same area.

Since the S&P has again rebounded from the low end of the recent 1490-1540 trading range in the S&P 500 (SPX) and popped back above its 21-day moving average along WITH the Nasdaq surging to a new high for the current advance, neutral to bullish chart interpretations are intact.


When there is an advance, especially a strong advance, followed by a lengthily sideways trading range (lateral trend or 'line' formation) or what is called a price 'consolidation' phase, the outlook ahead is 'assumed' to be for an eventual bullish breakout and a new up leg. In other words, technical analysis would give the 'benefit of the doubt' to the dominant trend.

The consolidation/sideways/lateral trend after a big leg up calls for a wait and see attitude, which makes for a difficult situation for those holding long options. It is a great situation for those with trading strategies that involved prices remaining in a range and anticipating the erosion of time premiums. The WAIT in terms of trading an outright position is that it's necessary to see either a breakout move ABOVE or a breakdown BELOW the trading range; e.g., to above 1540 or below 1490 in the case of SPX.

Tech is another story as I-phone mania and other factors have finally caused an INDEPENDENT move and strength in Nasdaq.

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.


S&P 500 (SPX)
The longer that the S&P 500 (SPX) trades in a sideways trading range after having the major advance that it had, the greater is the assumed likelihood that the next big move (or 'leg') will also be up and to take prices well above the top end of a temporary sideways trend. The difference between an interpretation for 'building a top', versus a 'bullish consolidation' is only a matter of the DIRECTION of the subsequent breakout above or below the range.

TIME duration is a factor however. The LONGER the duration of the sideways trend the greater is the probability that a lateral move is a consolidation of an intact bullish trend. A top building process can take a long time sometimes, as in 2000, when the market did hang up around its highs for a lengthily period, but more often when a top forms there will be a break sooner rather than later. But, again, the key is the direction of the breakout. Gee and I find it hard to wait!

As I mentioned with the Nasdaq Composite (COMP), the move to a new high for the advance off the last low now suggests upside potential to the high end of the uptrend channel in the 2700 area and a bit above as outlined on the chart below.


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. 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 so to speak, not a speculation. DONT say or think: 'I'm going to WATCH the market or this stock, this index; or, that "I'm going to take the pain." Do your planning in times of peace, not in times of war to use these metaphors. If you do this, you'll tend to do well over time."


The first 3 are brief summaries from last week:

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

An option's price relies on MULTIPLE variables. Options are sensitive to the passage of time (theta) 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). Don't get fixed on just 1-2 of these variables.

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

An example is a strategy of 'selling high volatility and buying low volatility'. Sometimes the reverse will occur and a top is associated with low volatility and you could profit from buying puts. A strategy involving volatility is only one element in a complex ever-changing set of factors that make up the trend of a stock or the market. Therefore, don't get stuck in using the same strategy all the time.

Instead of looking at a chart or situation to see what the market is offering, with fresh eyes, 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

This tends to especially be a mistake made by those new to options trading. They are bullish on a certain stock (e.g., Apple). They were willing to put $10,000 into buying AAPL. Instead they put $10,000 into AAPL calls. Putting the same money into purchasing calls has enormously increased their leverage and at the same time enormously increased their risk of losing most or all invested in options, assuming they hang on to or until close to expiration, even if the stock only drops modestly. Losing all you invested in option happens quickly and commonly, whereas, losing more than 30 percent in the value of stock you own is not that common.

The lesson here is to figure out how much you are willing to risk in owning the stock and make an equivalent bet on the options, where your strategy is to exit an equivalent options stake at the same dollar risk point.

4.) Not fully understanding the building blocks of option theory.

Everyone it seems wants to make a million in the markets, easily and fast even. Many learn one strategy and then they are off trading without understanding how the individual options work. Many courses or tutors overlook three of the most important concepts of option theory: the greeks, synthetic positions and the option pricing model. By the way, I mostly give advice on what I think the market trend or direction will be ahead, but this column today is dedicated to general advice on what should be studied to successfully trade options.

Once you have learned an options strategy, you may of course wonder why knowing the 'greeks' has value. The greeks being a group of statistical reverences that describe and quantify an options position risk relative to the variables that can affect the price of your options. If you don't know what will happen to the value and nature of your options position as movements occur in the stock or index price, volatility and time, you can't accurately assess your risk. As I noted initially, knowing your risk is as important, or in a way MORE important, then knowing how much you could make if a stock or index reached particular objectives.

Synthetic positions are constructed using a tandem of components that mimic another position identically. Synthetic positions show you how options relate to each other mathematically, which in turn tells a trader how to morph from one position from one strategy to another in the most cost efficient way. Add this subject to what you could gain from a studying options.

The option pricing model is to understand the origins of options, which is to understand the instrument itself and is fundamental knowledge and not to be overlooked.

TIP: Avoid courses that rush you into option strategies as they only give you enough knowledge to be dangerous to yourself. Learn from the bottom up if you have determined that you really want to understand and profit from trading options.

5.) Assuming that if an option is cheap or expensive is determined by dollar cost.

However, the strike price is key here. Options with different strike prices have different values. These different option strikes have different deltas associated with them. One of the definitions of delta is that of a percentage chance. Since all of these options have an associated percentage chance of being in-the-money at expiration, they will have different values. This means that options that are already in-the-money have a better chance of finishing in-the-money and are more expensive because of it.

Out-of-the money options are less likely to finish in-the-money by expiration, so they are less expensive. This establishes that dollar cost does NOT dictate how expensive or how cheap an option is; strike price dictates this. The question is how to relate the cost difference between options of different strikes to determine relative cheapness or expensiveness. This is done through implied volatility, which is the only way to determine whether an option is expensive on a relative basis. Although options are separated by different months and strike prices, they are similar under implied volatility.

A higher level of implied volatility means a more expensive option and vice versa. Implied volatility is the unifying factor necessary to use to determine whether any option is truly cheap or expensive.

6.) Overcomplicating otherwise simple strategies.

There are many different strategies in use in options trading. Most are relatively easy. However, some or many traders wind up choosing a strategy that is much more complicated than necessary to take advantage of a given opportunity. Of course, the flexibility of options allows more than one way of doing something, which in and of itself is an advantage of options.

We all know what 'sexy' stocks are; e.g. currently, a stock already mentioned, Apple is one, due to its very 'sexy' cutting edge I-phone product. There are also 'sexy' strategies that get employed just due to being complex and new. I find that this tendency to complicate things is also one of the biggest downfalls in technical analysis methods. You see analysis that is so complex you can't hardly follow it, let along understand WHY this analysis works. Nevertheless, the complexity tends to make us think that there must be something to it. I've followed the advice of others just because I thought that more factors considered made it better. 'Quantity equals quality' is one of the pitfalls of dialectical reasoning.

KISS: 'Keep it Simple, Stupid' is what I try to keep coming back to. Maybe it's just because I am stupid. But I've also been influenced by very successful traders who use fairly simple and straightforward trading strategies and entry and exit rules. This is not to say that there are not complex trading models that ALSO work. But if a simple method works as well, I find it more efficient of my time and energies to use that. Mainly stick to what you really know and can understand.

7.) Not knowing how to pick the correct option for the selected strategy.

When a trader decides to select a strategy to apply to given opportunity, there are several choices to make. Selecting the proper generic strategy is just the first step. Once a strategy is selected, it's necessary to choose the proper month and strike price that will optimize that strategy for the identified opportunity.

Every strategy has certain features that are applicable to different perceived opportunities. The two basic choices are month and strike price. Month selection deals with market timing especially (and what I concentrate on in my Index Trader columns each weekend). Further, a longer-term option of course will not decay as fast as a shorter-term option. This nonlinear rate of premium decay is an important consideration in whether we are best to buy or sell an option in our selected strategy.

Regarding strike price, depending on the strategy and what it needs, we must select an in-the-money, at-the-money (ATM) or out-of-the-money option. An ATM option contains the most extrinsic value of any option in the month. It is also the most sensitive to movements of time and volatility. Consider all such factors when deciding which option will fit best in a given strategy.

As I deem my forte to be market timing or having a reasonably good feel for knowing when a trend may be about to change, I tend to favor ATM or only slightly out-of-the-money index options. But what I do won't work for anyone who is not prescient in timing trend changes. It was also a long hard road to learn market timing, so is probably not the best way to start in options trading. In fact I started by trading the futures markets for a number of years before trading options.


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