THE TOP FIVE OPTIONS TRADING MISTAKES (and how to avoid them)

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THE TOP FIVE OPTIONS TRADING MISTAKES (and how
to avoid them)

• Mark S. Longo
• Founder CEO, The Options Insider

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Mark S. Longo

• Former member, CBOE (SPX, INTC)
• Founder, Options Insider Media Group
• www.TheOptionsInsider.com the premier online
  options destination
• The Options Insider Radio Network the worlds
  only options radio network

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Be Prepared

• All option traders have made at least one of
  these mistakes You are not alone! Dont be
  discouraged. The Options Insider is flooded with
  questions about these same mistakes.
• Sooner or later, you will encounter one of these
  scenarios What we discuss today will prepare you
  for that eventuality and perhaps help you avoid a
  costly error.
• Forewarned is forearmed.

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Mistake 5 Writing LEAPS For Income

• This is one of the most common mistakes that we
  see with options traders Its also one of the
  most common email questions that we receive.
• Not limited to novice options traders Its also
  common with financial advisers and other
  professionals who manage a significant number of
  positions.

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Why Do They Do It?

• Convenience Writing long-term options allows
  financial advisers to avoid rolling their
  positions every month.
• Ignorance Many novice options traders simply
  dont understand how options work, which is why
  they choose to write long-term options.

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Why You Shouldnt Do It

• Writing long-term options for income shows a lack
  of understanding of the Greeks

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The Greeks

• Delta Measures an option prices sensitivity to
  movements in the underlying.
• Gamma Measures change in Delta as underlying
  moves.
• Theta (Also known as Time Decay) Measures the
  rate at which an option loses value with the
  passage of time.
• Vega Measures an options sensitivity to changes
  in implied volatility.

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Maximizing Time Decay Is Key

• To generate maximum income, you need to maximize
  the amount of time decay collected.
• Time decay increases exponentially as you
  approach expiration.
• Call writers should concentrate on shorter-term
  options to maximize decay.

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Example Breaking Down Theta

• Theta Example IBM Oct 120 Call w/63 Days to
  Expiration

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Example 2 Breaking Down Theta

• Theta Example IBM Oct 120 Call w/63 Days to
  Expiration

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A Tale of Three Call Writers

• Lets examine the strategies of three covered
  call writers
• Investor A
• Investor B
• Investor C
• All three investors decide to write covered calls
  on Sandisk Corporation (SNDK) when the stock is
  trading at 16.65.

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Investor A Sells Front Month

• On July 23, Investor A buys 100 shares SNDK at
  16.65 and writes an ITM August 16 call for
  1.3435. We will assume his commissions are
  14.95 round trip in stock and option fees.
• Net outlay (with 22 days left to go until August
  expiration) -1,665 (stock) 134.35 (credit
  from option) -14.95 commission 1546

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Investor A Cont.

• Total Income 54.40
• ROI 3.5 over 22 calendar days. Not bad.

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Investor B Sells A LEAP

• Investor B buys 100 shares SNDK _at_ 16.65 sells a
  long-term call (JAN 2011 16 C).
• Investor B receives a credit of 434.41 for the
  LEAPS.
• He will have to hold this investment for 548
  calendar days.

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Investor B Cont.

• Net Income 354.56.
• Overall return 28.4 over 548 days

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Investor C The Ideal Scenario

• Like Investor A, Investor C buys 100 shares of
  SNDK _at_ 16.65 writes the same ITM one-month
  call (Aug 16) for 1.34.
• Unlike Investor A, Investor C continues to write
  the same ITM option for the same relative price
  on the Monday after expiration for the same time
  period as Investor B (approx. 1.5 years).

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Investor C Cont.

• Over the same time period as Investor B, Investor
  C sold 18 ITM calls, generating 979.2 in income
  and earning a 219.91 annualized IRR.

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A Tale of Three Investors Conclusion

• Investor A Total Return 54.40 in 22 days
• Investor B Total Return 354.56 in 548 days
• Investor C Total Return 979.2 in 548 days

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An Ideal Scenario

• Investor C is an ideal scenario In practice, it
  would be nearly impossible to capture the same
  premium level on the same ITM call in perpetuity.
  IV and skew are dynamic and change over time.
• Writing short-term options for income
  dramatically outperforms long-term options.

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The Bottom Of Your List?

• Not Technically An Error Although this is
  perhaps the most common mistake on my list, I
  included it at 5 because it is not technically
  an error. There are a handful of legitimate
  reasons to write long-term options against your
  equity portfolio.

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Reasons To Write LEAPS

• Time Consuming Rolling options every month,
  choosing strikes, etc. May not be feasible for
  busy traders with multiple positions.
• Tax Consequences Writing short-term calls
  generates multiple short-term taxable events over
  your time period vs. one long-term event.
• Term Structure Your product may have a heavily
  skewed term structure that favors the LEAPS. Not
  common

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Quick Tip Get Automated

• If time is an issue then consider an automated
  call writing product BXM, etc.
• These products replicate the returns of a covered
  call portfolio without the hassle.
• For example, BXM replicates the returns of owning
  the SP 500 index and writing front month ATM
  calls against it. It does all of the work for
  you.
• There are many different automated products
  available. Virtually all are preferable to
  writing LEAPS.

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Quick Tip Substitute LEAPS for The Underlying

• More Efficient Use of Capital
• Better Downside Exposure Lower delta more
  leverage Less incentive to panic sell if
  stock moves against you.
• Long Vol Position Losses in the stock will be
  mitigated by an increase in volatility.
• Interest Rate Play Rising rates benefit this
  position

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The Takeaway

• Unless you fall into one of the uncommon
  scenarios listed previously
• It is always preferable to write short-term
  options for income.

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Mistake 4 Getting In Over Your Head

• Option traders frequently dont understand the
  true risk profiles of their positions
• Aka Know Your Synthetics!

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Covered Call Vs. Short Put

• The Covered Call vs. Short Put Dilemma Covered
  calls are considered to be a low-risk strategy
  while short puts, even cash-secured puts, are
  thought to be extremely dangerous.
• This is a common misconception, particularly
  among new options traders.

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Perception vs. Reality

• The Truth
• From a risk standpoint, covered calls and short
  puts puts are essentially identical

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Know Your Risk Step 1 Always Know Your Greeks

• Take a moment to determine values for the
  following position variables
• Delta
• Gamma
• Theta
• Vega
• You dont need an elaborate model If pressed for
  time, even a cursory estimate of The Greeks can
  dramatically improve your understanding of your
  position.

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Greek Breakdown

• This is just a static snapshot, but even this
  quick analysis reveals that these two positions
  are very similar.

Delta may effectively be zero, depending on the
strike of the covered call. .
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Step 2 When In Doubt, Draw

• If you have the time, one of the best ways to
  determine your true risk profile is to draw PL
  graphs for your positions.
• Most brokerage platforms and trading software
  will do this for you.
• However, in a pinch, you can easily create your
  own PL graphs (also know as expiration graphs).

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Covered Call Breakdown
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Short Put Breakdown
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Call vs. Put Side By Side
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Step 3 Parity/Synthetics

• Your position may not be exactly what you think
  it is. Most covered call traders have no idea
  they are actually trading short puts.
• Most new option traders think of calls and puts
  as separate instruments, but they are
  fundamentally linked.
• Most professional traders dont think of calls
  vs. puts, but instead focus solely on strike
  (more on that later)

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Put/Call Parity

• There is an arbitrage relationship between calls
  and puts Put/Call Parity states that the value
  of a call on certain strike implies a fair value
  for the put on that same strike (and vice versa).
  
• This relationship not only helps us find
  opportunities, but also allows us to create
  alternative strategies (aka synthetics) to suit
  our needs.

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What Is A Synthetic Position?

• Synthetic Position A position constructed using
  options and the underlying that mirrors the
  characteristics of another contract (e.g.,
  synthetic long stock, synthetic short put, etc.).
  
• A strong understanding of synthetics allows
  experienced traders to instantly know the true
  risk profiles of their positions.
• Sometimes the best way to trade an option is not
  to trade it at all.

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Basic Synthetics

• The basic synthetic equations for equity options
  are
• Synthetic Long Stock (Long) Call (Short) Put
  (on same strike)
• Synthetic Short Stock (Short) Call (Long) Put
  (on same strike)
• These equations provide the basic framework for
  creating synthetic positions. If you understand
  high school algebra, then you can create your own
  synthetics.

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Basic Synthetics An Example

• A trader is long the XYZ Aug 10 Call and short
  the XYZ Aug 10 Put.
• What happens to this position at expiration?
• Is it even possible to determine without knowing
  the price of XYZ stock at expiration?

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Basic Synthetics An Example

• What is the underlying price? It doesnt matter.
  This position results in the trader buying XYZ
  stock for 10, regardless of the underlying price
  at expiration.
• If XYZ is above 10, then he will exercise his
  call and buy the stock for 10.
• If XYZ is below 10, then the short put will be
  assigned and he will purchase the stock for 10.
• He has created a synthetic long stock position on
  the 10 strike.

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Playing With The Formulas

• Working with this basic formula (Long) Stock
  (Long) Call (Short) Put (on same strike)
• We can explore the relationship between the
  covered call and the short put
• (Long) Stock (Short) Call (Short) Put
• Note When you switch a transaction from one side
  of the equation to the other, it changes from a
  long to a short trade (and vice versa)

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Why Do I Need Synthetics?

• Synthetics also help us develop alternative
  strategies.
• A trader wants to buy XYZ stock. But hes worried
  about downside exposure, so he also decides to
  buy a protective put.
• Thanks to synthetics, he realizes he can save
  money and just buy the call instead Long Stock
  Long Put Long Call
• Synthetics also allow us to determine when prices
  are out of line.

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Know Your Risk The Takeaway

• Familiarize yourself with the true risk profile
  of your positions before entering a trade.
• Know Your Greeks Even a cursory analysis will
  improve your knowledge of your position
• When In Doubt, Draw Be sure to understand the
  PL chart of a position before entering into a
  trade.
• Mind Your Synthetics Sometimes, the best way to
  trade an option is by not trading it at all

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Help With These Steps

• More Information on Steps 1-3 (The Greeks, PL
  graphs and synthetics) can be found on
  www.TheOptionsInsider.com.

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Mistake 3 Paying Too Much

• The first options trade for many new traders
  typically involves purchasing options for
  directional speculation (long call, long put,
  etc).
• Chasing Deltas So obsessed with making a
  leveraged directional bet on a stock that they
  forget about fundamentals (volatility, value,
  etc.)
• Traders typically pay far too much for their
  options.

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Know Your Breakeven Point

• When purchasing options, always know your
  breakeven point.
• It sounds simple, but many new options traders
  are so fixated on direction that they neglect
  simple things like breakeven calculations.
• This leads to the bad habit of purchasing
  ridiculous volatility levels that cant possibly
  break even before expiration.

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Breakeven Primer Long Call

• Buy GOOG Aug 450 Call _at_ 5.80
• Breakeven Strike Price Option price 455.80
• GOOG _at_ 436.24. GOOG must rally 4.5 to 455.80
  in 17 trading days just to break even.

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Watch Your Premium Levels

• Resist the compulsion to buy an option at any
  price.
• Look at the amount you are paying vs. the
  directional exposure you receive (delta).
• Avoid purchasing options at high volatility
  levels unless you have specific insight into the
  stock.
• Rule of thumb Lower premium levels less time
  decay

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Time Is Your Enemy

• Time is your enemy when purchasing options.
• Rule of thumb Avoid buying short-term options
  except for very specific scenarios.

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Watch Out For Earnings

• Earnings announcements are extremely volatile
  periods for options traders, regardless of
  position.
• Avoid The Earnings Trap Dont get suckered into
  buying inflated volatility levels.
• There is no right position for earnings, it
  depends on your trading style.
• For most people, closing the position prior to
  earnings is the best strategy.

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Paying Too Much The Takeaway

• Watch Your Premium Levels Dont buy direction at
  any cost.
• Always Know Your Breakeven Point.
• Have a specific plan if buying short-term options
  (hedging event risk, etc).
• Avoid the earnings trap Dont chase vol into
  earnings, time your trades carefully, study your
  term structure employ spreads for maximum
  effect.

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Mistake 2 Skewed Perception

• The most common question at The Options Insider
  (rivaled only by spread execution questions)
• I own OTM calls on XYZ stock. The stock rallied
  but my calls lost money. Why?
• There are many answers to this question
  (including Mistake 3). But the most important,
  and the most confusing for options traders, is
  volatility skew

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Know Your Skew!

• Volatility skew is one of the most important
  option topics.
• Understanding how this phenomenon impacts real
  world options performance is critical to
  successful trading.
• A solid understanding of volatility skew is often
  what separates professional traders from novices.

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What Is Volatility Skew?

• Most derivatives markets exhibit persistent
  patterns of volatilities varying by strike.
• Volatility skew The variation in implied
  volatility across options with the same
  underlying expiration month but different
  strike prices.
• Note Volatility skew is an intricate subject
  that could easily fill this entire presentation.
  We will only scratch the surface today. Visit
  www.TheOptionsInsider.com for more information on
  volatility skew.

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Skew Has Many Meanings

• In statistics The term skew implies a data
  distribution that is distorted from the normal
  distribution, either toward higher values or
  lower values.
• In the options market Skew has become a
  universal term for the volatility chart of an
  option. Traders will refer to the skew of an
  option even when it doesnt exhibit the
  characteristics of a skewed distribution. We will
  refer to this usage in this presentation.

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Skew vs. Smile
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Many Different Types of Skew

• There are many different types of volatility skew
  in the derivatives markets.
• The type of skew most frequently seen in equity
  index options is called investment skew.

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Investment Skew

• Investment skew Implied volatility decreases as
  the underlying rallies increases as the
  underlying falls
• Why does this happen?

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Investment Skew

• Investment skew derives from the fact that the
  vast majority of traders, funds investors are
  long the market.
• Investment skew is a result of psychological and
  fundamental characteristics of the options
  market.

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Mass Hysteria

• Psychological The market has a strong bias
  toward long positions.
• When the market drops, those long positions lose
  money. As a result, the level of fear and
  uncertainty (aka volatility) in the marketplace
  increases.
• In other markets, such as electricity, volatility
  increases as prices increase. This causes an
  opposite skew to investment skew.

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Hedging Speculation

• Fundamental Investors are primarily long the
  market, so the vast majority of options trades
  are designed to protect and profit from long
  equity positions.
• Investors write millions of OTM calls every day,
  resulting in lower implied volatility levels on
  strikes above the ATM strike.
• They also purchase protective puts, resulting in
  higher implied volatility levels in strikes below
  the ATM strike.

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Skew Underlying Movement

• As the underlying moves, volatility will respond
  accordingly
• Long, slow movements in a single direction will
  follow roughly along the volatility skew curve.
• Sudden, dramatic movements in one direction will
  frequently result in dramatic short-term
  increases in implied volatility, regardless of
  direction.
• Skew estimates become less accurate as you move
  away from the ATM strike.

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Skew Spreads

• The impact of skew will become more noticeable
  when you trade spread positions.
• Particularly important for spreads across wide
  strike intervals (risk reversals, large
  verticals, strangles, etc).

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Skew Order Flow

• Skew is not static. It can be impacted by many
  factors including
• Order flow If an institutional customer sells a
  large number of put options, then implied
  volatilities in the put wing will be depressed.
  The shape of the skew in your product will be
  determined primarily by the order flow of
  institutional customers and the resulting
  positions of the options market makers.
• Example If you trade options on a large, liquid
  stock, you will see more pronounced investment
  skew due to heavy institutional activity.

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Quick Tip Sell ITM Calls

• Heavy call writing activity has depressed IV in
  the call wings of many large cap stocks.
• This has lowered returns for many covered call
  writers who typically write OTM options.
• Many covered call writers have shifted their
  activity to ITM calls in an attempt to capture
  inflated premiums in the put wing.
• In A Tale of Three Call Writers, all three
  investors chose to write ITM calls.

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Volatility Skew The Takeaway

• Why Did My OTM Calls Lose Money?
• Implied volatility of the OTM calls decreased as
  the underlying rallied toward your strike. This
  drop in volatility was greater than the
  directional gains from the underlying.
• You paid too much for that option.
• Skew can negatively impact option positions if
  traders are not prepared.
• Study the order flow in your product to get a
  sense for the skew and how it will impact your
  trading (frequent OTM call sellers may depress
  the skew, etc).

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Mistake 1 Dont Play The Lottery

• Dont Waste Money On Useless OTM Lottery Ticket
  Options By far the biggest problem facing the
  retail options market.
• Brokers, exchanges trading firms spend millions
  combating this lottery ticket problem every
  year.

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A Plague On The Options Market

• Why is it so damaging?
• Thousands of traders enter the options market
  every year looking for cheap leverage. They think
  they cant afford ATM or ITM options, so they
  buy cheaper OTM options.
• These OTM options (low delta, gamma, etc)
  typically expire worthless. The traders lose
  their entire investment and give up on options
  forever, costing the industry yet another
  customer.

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The Greeks Are Against You

• When trading lottery tickets, even the Greeks
  are against you.
• Delta
• Gamma
• Theta
• Vega
• None are in your favor if you are an OTM option
  trader.
• Lets look at a few examples

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Time Is Still Your Enemy

• All options with large amounts of time premium
  suffer badly from time decay.
• OTM options consist ENTIRELY of time premium.
  They have no intrinsic value.
• Barring significant underlying swings, OTM
  options will lose their entire value to time
  decay.
• Tip Buying options with less time premium (ITM)
  will insulate you from some of the damaging
  effects of time decay.
• Tip If you buy short-term far-OTM options, you
  are usually throwing your money away.

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Know Your Probabilities

• Delta of an ATM option 50 50 chance of
  expiring in-the-money.
• Delta of a far OTM option Substantially less
  than 50 chance of expiring in-the-money. Worse
  than a coin flip.
• Entering low probability trades is not a model
  for a successful trading career.
• Note Delta is not a reliable predictor of
  probability beyond ATM

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Many Options Expire Worthless

• A significant percentage of all options expire
  worthless. The exact percentage is hotly debated.
  
• CME study found 76.5 of all their options (held
  to expiry) expired worthless.
• Regardless of the truth, you are stacking the
  odds against yourself by purchasing OTM options.

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Quick Tip Go Vertical

• Vertical Spreads Simple way to move your trade
  to ATM/ITM AND offset costs.
• Long Vertical Spread Buy ITM/ATM, sell OTM
  options.
• Better risk profile than OTM.
• Higher probability trade than naked long OTM.

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Example GOOG_at_437.4, 7/23

• Trade 1 Buy 3 Aug 410 Puts _at_ 3.70, Total Trade
  11.10, Delta 19
• GOOG must move 6.25 to 406.30 to break even.
• Trade 2 Buy 1 Aug 440/410 Put Spread (13.70-
  3.50) _at_ 10.20, Delta33
• GOOG only needs to move 1.7 to 429.80 to break
  even.

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Avoid Reverse Lottery Syndrome

• Dont Let Your Winners Come Back To Haunt You
  Close out any winning short positions that are
  trading at .01 or .05. Claim your winners and
  take needless risk off your books.
• Too many new option traders leave short positions
  open, even at .01 or .05. to avoid extra
  commissions. These open shorts can easily wipe
  out any gains with one adverse move.
• Saving pennies could end up costing dollars.

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A Good Rule of Thumb

• Close It Out If you have a short option position
  that is trading for .10 or below, buy it back.
• Pigs Get Fed, Hogs Get Slaughtered There is no
  reason to leave risk on the table, especially
  when your upside is only a few cents. Close out
  your shorts when they drop below .10.

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Lottery Tickets The Takeaway

• Theta is against you Your entire position can
  decay to zero.
• Delta is against you Your odds are about the
  same as winning the lottery.
• Use Spreads If you cant afford ATM or ITM,
  consider vertical spreads to offset costs.
• Moral of the story You get what you pay for.
  Stop throwing your money away on lottery
  tickets!

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Avoid The Top 5!!

• 5 - Dont Write Long-Term Options For Income
• 4 - Know Your True Risk Profile
• 3 Dont Pay Too Much For Options
• 2 Know Your Skew
• 1 Dont Waste Money on Lottery Tickets

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Dont Get Too Crazy

• Too many new options traders fixate on
  complicated strategies
• Myth Most options volume consists of elaborate
  strategies like iron condor swaps, ratio risk
  reversals, etc.
• Fact The vast majority of options volume stems
  from single leg, single contract transactions
  Even the pros buy calls and puts.

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Dont Get Too Crazy

• This misconception keeps many equity traders from
  entering the options market. Also prompts many
  new options traders to bite off more than they
  can chew.
• Pick a simple strategy or two and stick with
  them. Dont let complexity overwhelm you.

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Dont Be Intimidated

• Directional speculation hedging continues to
  drive options volume Many options traders
  continue to use options as a tool for simple
  directional speculation, while the rest use
  options as a hedge. Only a small percentage
  employ elaborate strategies or use options to
  speculate on volatility.
• Even large institutional customers (pension
  funds, hedge funds, etc) focus primarily on
  simple defensive strategies covered calls,
  protective puts collars.

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What About Smart Money?

• Common question on our website What about the
  Smart Money? What strategies do they employ?
• Smart Money traders with inside information
  on a stock, earnings, etc.
• Primarily simple directional strategies. If they
  know a stock will beat earnings, they load up on
  ATM or near OTM calls immediately prior to the
  close.

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Dont Fixate On Commissions

• Dont fixate on commissions when choosing an
  options broker
• Execution quality, analytical tools and customer
  support are also important.
• Execution quality most important most
  difficult to measure. Either open multiple
  accounts or talk to other users on message
  boards.

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Avoid The Scammers

• Avoid make money in any market condition and
  other straddle scams.
• One of the oldest and most common scams in the
  options market (late night infomercials, etc).