If you're new to trading options or are considering trading options on a new underlying, what's the least you need to know?
What exactly is the underlying? Is the underlying an equity, an index, an exchange-traded-fund (ETF), a future contract, or something else? Knowing that the Russell 2000 index, a small-cap index comprised of the bottom 2,000 stocks in the Russell 3000 index, is the underlying security for RUT options becomes important in rising interest-rate environments, for example. We haven't seen a rising interest-rate environment in so long that many subscribers who have traded for several years may still not have traded long enough to know that rising interest rates can impact small-cap companies disproportionately.
Historical RUT Chart with the Oval Depicting the Way the RUT Behaved Leading into the FOMC Meetings at Which the First Rate Hikes Were Expected after a Long Pause:
The impact of rate hikes on small caps isn't always long-lasting, as is obvious, but be aware of how your underlying might react to various challenges.
Knowing your underlying also helps you understanding what some of those challenges might be. Does your underlying offer dividends, and, if so, when are the ex-dividend dates? Those dates impact option values. If your underlying is an pharmaceutical, is it or a direct competitor due to hear soon about an FDA ruling on a drug trial? Is it earnings season and will earnings for your underlying be announced during the expiration period you're trading? Indices and ETFs aren't exempt from these kinds of event risks, either. The SPY offers dividends, for example, and it's not always easy to find the ex-dividend date. In another example of event challenges relating to indices, here's a schedule of the Russell 2000 annual rebalancing for 2015.
2015 Index Reconstitution Schedule, from the Russell Website:
Some upheaval of the impacted Russell indices might be expected around such events. While a frequent trader of a RUT monthly butterfly trade might not avoid trading the RUT during June, a directional day trader might decide to avoid trading the RUT on the dates listed or, conversely, might love the adrenaline of such trades.
Is there anything non-standard about the options you've chosen? If the underlying is an unfamiliar vehicle, take a moment to research its possible peculiarities or those of its options. For example, sometimes traders employ leveraged or inverse exchange-traded funds (ETFs) to capitalize on or protect against an expected move. However, type in "complaints about inverse ETFs" into a search engine and you'll quickly find articles titled "Warning: Leveraged and Inverse ETFs Kill Portfolios" (Justice, Paul. Morningstar) and "SEC-FINRA Investor Alert on Leveraged and Inverse ETFs" (U.S. Securities and Exchange Commission site). When leveraged and inverse ETFs first started showing up, traders greeted their appearance with excitement. Here was the opportunity to buy 2X the protection or experience 2X the gains on a trade. Then traders started noticing that the protection wasn't working as expected or the gains weren't appearing as anticipated. As the SEC site warns, "Leveraged and inverse ETFs typically are designed to achieve their stated performance objectives on a daily basis," with the bold emphasis being mine. They're recalibrated daily, and they often don't perform as expected over the long term. You can read the SEC's warning here. Similarly, options traders find that VIX options often don't perform as expected because the underlying is not the VIX spot price but VIX futures.
When do the options stop trading and when do they expire? Once upon a time, it was easy to memorize when options stopped trading and expired, not always the same day. Now, so many new option types with sometimes non-standard expirations exist that it's difficult or impossible to remember all the schedules. I don't trade weeklies, for example, and couldn't begin to tell you if SPX and RUT weeklies stop trading the same day. Many who traded the VIX options when they were first available years ago were surprised to be hit with non-standard expiration dates, and maybe some traders still are. Go to the exchange that trades the options and look for the information. On this CBOE page, for example, you can find listings for expiration information on options on many types of products.
How is the option settled? If you have a call with a strike price of $85 and your underlying has a final trade of $87, is $87 the settlement price? If so, is settlement achieved by receiving 100 shares of the underlying in your account and being docked $85 x 100 multiplier = $8,500 for that underlying, or are you receiving a cash settlement of $(87-85) x 2 = $200? You'd better know. Many a newbie SPX trader has been startled when the options quit trading on a Thursday afternoon and the settlement value determined the next morning by a calculation based on the opening price of each composite stock (not the opening price of the SPX) is far off from that Thursday afternoon's closing price. Just ask iron condor traders who were trading back in November, 2005, if I'm remembering the date correctly. Ouch. That one hurt.
What hours do these options trade? When I first began trading options, back when we had traditional brokers and called those brokers to place our orders, my broker wouldn't place an order to sell some calls until fifteen minutes after the live markets opened. He was under the impression that options didn't start trading until then. He was wrong, of course, and that delay cost me many thousands. (Hint: if we ever go back to using traditional brokers, don't use one who is a close personal friend and who you would be reluctant to upbraid.) He perhaps had mistaken the fact that options traded for 15 minutes after the live markets closed. However, recently, we've seen a move to extend trading hours for some options, so we may soon have all kinds of hours for trading options. Again, go to the product page under the exchanges that offer those options to get precise information.
Is there enough volume and open interest in the options that I can easily exit the trade, if needed? We don't ever have to enter an options trade, unless we're trying to hedge something, but we do sometimes have to exit and exit quickly to control losses. Good luck if you have a thinly traded vehicle.
You don't have to know everything there is to know about the underlying. For speculative trades, I've run scans and bought or sold spreads with the underlying being companies I didn't know well. (Note that these were speculative trades and were in small lots.) However, this article lists the least of things you just have to know before choosing to enter an options trade.
I wanted to leave you with these ideas about protecting yourself and your trades. I care and have always cared about the subscribers, as do Jim Brown and all the writers and traders he hires for this site. In the last month, a grandchild's health emergency and an elder's death have precipitated a retirement decision for me. Family commitments and a return to my fiction-writing roots will be the focus of the next few years. What a risky step that seems to me to be from this vantage point. May you always take risks, too, but make them appropriate to your risk tolerance, keeping in mind your plan for yourself, your money and your time. Thanks for all your comments through the years, both those that applauded me and those that challenged or disputed me. And thank you, Jim, for replying to my email one day in 2002 and beginning a conversation that ended in an offer to write for OIN.