Ten Often Repeated Misconceptions about Option Trading
#1- Options should only be used by professionals
Not true, the use of options has become more widely accepted over the last several years. Today’s modern retail brokerage platforms and tight option spreads put individual investors on the same playing field as the pros. It has been shown in numerous studies that using options can enhance return and lower risk in your portfolio.
#2- Options should only be used in an IRA or tax deferred account
Some people think that due to possible high turnover from using options can create a tax headache. That also is not true. Options can be bought or sold long term and the portfolio turnover is something that can be controlled. Today’s tax reporting software make it very simple to report even if you do have high turnover, like from a strategy of selling covered calls on a monthly basis. The IRS will allow an investor to attach a realized gain/loss statement from a brokerage instead of completing the schedule.
#3- Individual investors get taken advantage of in trade execution
In the old days the market makers controlled the game and the bid ask spreads were wide. Today’s electronic markets are very efficient and competitive. Many issues now trade in penny increments. Investors no longer get taken advantage of by the market makers.
#4- Option trading only works when markets are volatile
Options can help enhance the return on your portfolio regardless of whether the volatility is high or low. There are different strategies that can be used to profit or protect your portfolio when the volatility is rising or when the volatility is falling.
#5- Option trading is not for young investors
Some people say that option trading is good only for highly sophisticated investors with years of experience and a high net worth. That is another misconception that is not true at all. Younger investors with a growth objective may want to purchase long term options on the market or an individual stock to participate in the upside of the market, but limit their downside risk to the amount of the premium paid for the option.
#6- The trades are hard to execute and require experience
Another common falsehood, today’s modern platforms and options chains make it quite simple to enter trades with very little room for trade errors. It only requires a little learning to be able to execute option trades.
#7- Brokerages that are good for options are not suitable for equities or ETFs
Not true, today the main stream brokers all have pretty good option platforms and the firms that specialize in options also have some very good platforms for stocks and ETFs.
#8- You need to spend a lot of time and money on options trading education
That’s another one that may have been true at one time, but does not apply anymore. Most of the brokerages have some good educational materials. The Options industry Council, OIC, has some excellent free education on their website. The Chicago Board Options Exchange, CBOE, also has a wealth of free information. There are many books worth studying as well.
#9- Options traders are greedy short term speculators
Nothing could be further from the truth. Options can be employed by long term investors to reduce risk and produce income. Cash secured puts can be sold to target an entry price on a stock or ETF for a long term hold and the returns can be favorable. Covered calls can be used for income generation in today’s record low interest rate environment.
#10- Options trading popularity will die off
The volume in options trading has been expanding recently. The ETF explosion has led to more and more options volume. The use of options is becoming more widely accepted than ever and will continue to increase.
One of the keys to success in trading options or in using options to enhance return on a portfolio is have some flexibility in your strategy selection so you can adapt to rapidly changing market conditions. I have talked with many traders over the years that have a strategy bias and they get good results for awhile only to eventually experience a period where they have heavy losses and have a substantial drawdown of capital.
What strategy bias means is that is that the trader will learn one strategy and use it on a regular basis regardless of market conditions. A strategy like the iron condor is a good example. People learn about the iron condor, understand that it can have a high probability of success, but may not have much experience with dynamic delta hedging and learn the hard way that iron condors also have a poor risk/reward ratio.
The market goes through cycles knows as “regime changes” where the market moves from a period of relative quiet, through a period of high volatility. Iron condor traders can have losses when the market moves from low volatility to high volatility. In 2008 when the volatility spiked to extreme levels iron condor positions would have hit their maximum loss.
If you are forecasting rising volatility, you’d want to consider trade like a long straddle. Long straddles can be effective when there is a know event approaching that could move the market. On Thursday May 31st the SPY closed at $131.47. The monthly jobs report was released pre-market on Friday June 1st and the SPY opened at $129.41 and hit a low of $128.16. A long straddle bought before the close on Thursday could have produced some nice profits and we knew the jobs report was coming. An iron condor held through that would have had an adverse movement.
To be successful over time, master several different strategies and learn how to employ them in changing market conditions.
The calendar spread is an option strategy that involves
buying an option and selling an option simultaneously with the same strike
price, but different expiration dates. A calendar spread can be long or short. A calendar spread can be constructed with call options, put options or both which is known as a dual calendar spread.
A long calendar spread is done for a net debit and the risk is limited to the
amount of the debit. A short calendar spread is done for a net credit and is known as a credit spread. Investors can use calendar spreads to enter hedged stock or ETF positions. The long put calendar spread can be utilized to enter a long stock position with limited risk. If the investor has a market opinion that the underlying will stay below a certain strike in one month, and then rise the following month, a long put calendar spread may be a good choice, here’s how it works. XYZ stock is at 25, we think it will stay at 25 this month then rise next month with its earnings report. We’re going to sell the near term 26 put and buy a longer term 26 put. The net debit is $1. We’ll get assigned on the near term put, then hold a long stock position with an entry price of $27, but we have the right to sell it for $26 so our maximum loss is $1 and our maximum gain is unlimited. If xyz rises to $30 after the earnings report, we have a gain of $3 and have only risked $1. When there is a volatility skew between the expiration months, we can enter these positions with very tight spreads and very low risk. A volatility skew is defined as different expiration months have higher or lower levels of implied volatility. In the money options will have tighter spreads than at the money options, but will have a lower probability of success. Similarly the long call calendar spread can be used to enter a short underlying position with limited risk when one’s forecast calls for the underlying stock or fund to decline in value in the future. The spreads can be sold for a profit if the spreads widen or employed as a strategy to enter controlled risk positions for certain time periods. Calendar spreads can also be set up as diagonal spreads.
A typical diagonal spread will be long a far dated in the or at the money
option and will sell a near dated out of the money option. A diagonal spread
can be used as a covered call substitute with less risk and less capital outlay
than owning the underlying security. A long dated in the money call can be
purchased with a very long expiration like a LEAP and short dated current month or weekly out of the money options can be sold against the position for income.
The long call option is probably one of the simplest option positions to understand. The purchaser of a call is considered to be long a call option. The long call gives the investor exposure to the upside of the market while the risk is limited to the premium paid for the option. Long calls will have a positive delta and a negative theta. LEAPS or long term equity anticipation securities can be purchased up to three years out. If you are bullish on the market for example, but concerned about global events like
sovereign debt defaults, war or terrorism you could purchase a LEAP on an index like the S&P 500, if the market rises you’ll participate. In the event an unexpected event occurs and the market takes a big hit, your risk is controlled because what you have paid for the option is much less than if you had purchased the index fund outright. Considerations to be made when purchasing a long call include the price of the underlying, the implied volatility of the option, the strike price, expiration, delta and the theta or decay factor of the option. Remember the rate of decay accelerates rapidly in the final weeks prior to expiration. Investors buying call options as a limited risk stock substitute should use longer dated contracts to give the underlying more time to make the anticipated move and to minimize the negative effects of time decay. The options delta is also a primary factor to consider. The at the money call with have a delta near 50 which means that the option will move half of what the underlying does. Out of the money calls have lower deltas as they move out of the money, they also have lower prices which equates to less capital at risk but you also need a larger price movement in the underlying to profit. The delta is roughly equal to the probability of the option being in the money at expiration, so a call with a low delta, say a 25 delta call, will only have a 25% probability of being in the money at expiration. An in the money option will have a higher delta, but will also have a higher price meaning more
capital at risk. An in the money call with a 75 delta will have a 75% chance of being in the money at expiration. If the price of the underlying rises, that call’s delta will change at a rate given by the gamma and will go to 100 if the option goes deeper into the money. Generally tactical option investors buy high delta in the money calls as a stock or ETF substitute that have a high
probability of success. When buying deep in the money calls however, it almost never makes sense to pay more for the call than you would to purchase the underlying on margin or 50% of the price of the underlying.
The Stock Repair Strategy
Have you ever bought a stock and seen it go down? In need of stock repair? One way to try to recover is use the stock repair strategy. It can be used to lower your break-even point. What you do is sell a two by one call ratio spread on the underlying stock to adjust your cost basis lower. The trade can be put on for a small credit or a break even price. For example, our investor buys 200 XYZ at $27.50 for a total investment of $5,500 and it’s now at $20, or worth $4,000. She would sell four $25 calls for $0.50 each and collect $200, then use those funds to buy two $22.50 calls for $1. At no cost, the break-even point is now lowered to $25. If XYZ rises to $25 at expiration, the $22.50 calls would be worth $2.50 each or $500 and the $25 calls would expire worthless. So the 200 XYZ would be worth $5,000 and the two calls would be worth $500 for a total value of $5,500. The breakeven point has been lowered from the initial purchase price of $27.50 to $25.00 at no cost.
The long put option is similar to the long call option in that the
investor has the right but not the obligation to exercise. The purchaser of a
put option has the right to sell the underlying at the strike price on or before the expiration date in the case of an American style option or on the expiration
date if the investor owns a European style option. The owner of a put will
participate in the downside of the market with risk limited to the premium or
price paid for the put contract. Puts can be purchased to profit from a price
decline in a stock, an index or a commodity. For example if you own an all
stock portfolio with 20 holdings and are concerned about a general price
decline in the market, you could purchase a put on a broad based index that
would increase in value if the market declines. The tactical option investor who
purchases a put that is not used to hedge a portfolio against a market decline
is considering a couple of different factors. The first is an analysis of the
underlying to determine if it is overpriced or not. There are a variety of
fundamental research sources that can be used to help determine if a stock or
an index may be overvalued. Once we have determined some overvalued investments to consider, then we study the charts and consider the momentum of the investment. An individual stock or a commodity for example may seem to be overvalued but its price momentum can continue upwards for long periods of time and they can become even more overvalued. The application of some technical analysis can find investments that are overvalued and have some downward price momentum. A moving average crossover can be a good simple tool to apply. The third step is to indentify underpriced put options. You can find an overvalued stock in a downtrend and if you pay too much for the option it may not produce a profit. To locate undervalued options you need to consider the historical volatility of the stock, the implied volatility of the option and study the history of the implied volatility to see where the implied volatility is relative to its long term averages. The difference between a speculator and a
tactical option investor in these types of transactions is that the tactical
option investor will have a fundamental opinion on the underlying investment,
apply some technical analysis to see if the price momentum is favorable and
find a reasonably priced option. The tactical option investor will also buy an
option with sufficient time remaining in the contract for the price movement to
develop. Many option speculators experience failure because they don’t take the time to properly analyze these three steps and they trade in too short of a
time frame. There is much work to be done when taking directional trades with
options, the markets are very efficient and arbitrage opportunities rarely
exist. Using a long put to hedge a portfoliois different because the investor chooses the option contract based on hisunderlying portfolio and is concerned about portfolio protection or insurance. Puts used for portfolio insurance are known as protective puts. Married puts are put options that are tied to a certain number of shares of a specific stock.
Understanding Stock Market Volatility and the New Volatility ETFs.
Volatility in the stock market is what makes investors nervous. Without volatility, though stock prices couldn’t rise. Volatility is defined as the standard deviation of stock returns. It’s the downside volatility of the market that causes fear.
A recent development in the rapidly expanding ETF universe has been the creation of funds that reflect different measures of market volatility. These funds can be an effective hedging tool against portfolio declines when used properly.
The most commonly referred to measure of market volatility is VIX, which is a measure of the implied volatility of option contracts on the S&P 500. The VIX is also known as the “fear index.” The VIX will have a high reading when market participants are fearful and be low when the market is strong and there is a sense of complacency.
There have been numerous academic studies done on using the VIX to hedge equity portfolios. Goldman Sachs did one that concluded that VIX options could be a very effective portfolio management tool for risk reduction.
So how can an individual investor use the VIX for portfolio protection? Not too long ago, an investor would have had to buy and roll call options on the VIX index. This process worked well, but one had to consider the time decay of the options and the term structure. VIX options are based on the VIX futures, so each month’s option series correlates to that month’s futures contract. Some months may be priced higher or lower than another depending on the outlook of market participants. A strategy of rolling call options could be difficult for individual investors to implement effectively.
Today, an investor who wants a hedge and who doesn’t want a short position or an option position with time decay can purchase shares of the volatility ETF, the VXX when it is near the low end of its historical trading range. The VXX can be held indefinitely, just like a mutual fund. Once the VXX position has been purchased, it is held until something happens to the market to increase the volatility. If the market gets spooked by bad earnings reports, poor economic data, or unforeseen global events like natural disasters, war, terrorist attacks, etc, the VIX will spike and profits can be realized from the VXX position which can help to offset declines in a long term portfolio.