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

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


1
THE TOP FIVE OPTIONS TRADING MISTAKES (and how
to avoid them)
  • Mark S. Longo
  • Founder CEO, The Options Insider

2
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

3
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.

4
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.

5
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.

6
Why You Shouldnt Do It
  • Writing long-term options for income shows a lack
    of understanding of the Greeks

7
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.

8
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.

9
Example Breaking Down Theta
  • Theta Example IBM Oct 120 Call w/63 Days to
    Expiration

10
Example 2 Breaking Down Theta
  • Theta Example IBM Oct 120 Call w/63 Days to
    Expiration

11
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.

12
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

13
Investor A Cont.
  • Total Income 54.40
  • ROI 3.5 over 22 calendar days. Not bad.

14
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.

15
Investor B Cont.
  • Net Income 354.56.
  • Overall return 28.4 over 548 days

16
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).

17
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.

18
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

19
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.

20
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.

21
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

22
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.

23
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

24
The Takeaway
  • Unless you fall into one of the uncommon
    scenarios listed previously
  • It is always preferable to write short-term
    options for income.

25
Mistake 4 Getting In Over Your Head
  • Option traders frequently dont understand the
    true risk profiles of their positions
  • Aka Know Your Synthetics!

26
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.

27
Perception vs. Reality
  • The Truth
  • From a risk standpoint, covered calls and short
    puts puts are essentially identical

28
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.

29
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. .
30
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).

31
Covered Call Breakdown
32
Short Put Breakdown
33
Call vs. Put Side By Side
34
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)

35
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.

36
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.

37
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.

38
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?

39
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.

40
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)

41
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.

42
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

43
Help With These Steps
  • More Information on Steps 1-3 (The Greeks, PL
    graphs and synthetics) can be found on
    www.TheOptionsInsider.com.

44
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.

45
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.

46
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.

47
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

48
Time Is Your Enemy
  • Time is your enemy when purchasing options.
  • Rule of thumb Avoid buying short-term options
    except for very specific scenarios.

49
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.

50
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.

51
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

52
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.

53
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.

54
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.

55
Skew vs. Smile
56
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.

57
Investment Skew
  • Investment skew Implied volatility decreases as
    the underlying rallies increases as the
    underlying falls
  • Why does this happen?

58
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.

59
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.

60
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.

61
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.

62
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).

63
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.

64
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.

65
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).

66
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.

67
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.

68
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

69
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.

70
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

71
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.

72
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.

73
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.

74
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.

75
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.

76
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!

77
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

78
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.

79
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.

80
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.

81
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.

82
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.

83
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).
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