Tuesday, February 2, 2010

Options trading 101: How to trade stock options

Stock options are very different than regular shares of stocks, so options trading is also going to require a different understanding and different strategy. If you want to buy a stock you will be entitled to hold however many shares you purchase, and those shares are redeamable for anyone who wants to buy it for as long as those shares and the company with it are still around and trading on the stock exchange. However, if you look to buy call stock options, you are basically getting a contract that is limited in how long it's good for and it may only entitle you the right to trade the option contract itself only for as long as the stock option contract is still valid and there is a buyer willing to take on the risks for you to sell it.

This can get confusing. You are actually buying a device that's related to the stock, but trades independently. However, the option contract MAY entitle you to 100 shares of the stock at the given price.

Stock options are the right but not the obligation to own shares of the underlying stock at a fixed price. In existance are also "index options" or even exchange traded funds options, but these function relatively the same way. So if you were to buy a stock in the SPY an etf for the S&P 500 index, you would buy 100 at the current price, say $130 per share for $13,000. What if however, you thought the market was going to move upwards in a short period of time? You could pay $185 to control the movement of the 100 shares. That's not a typo, however your chances of losing all of that $185 is great.
So if your ETF went from $130 to $120 and you owned the stock, you would lose $1000. If it stayed the same you'd break even, if it went to $140 you'd gain $1000.
If instead you owned the option, you'd lose everything if it was at $120. In fact, if it was at $130 and expired you'd lose everything. However, if it went up to $140, your options would be worth $10 per share. A contract for one option contract is worth 100 shares in almost all cases. So that means that your stock would be worth $1000. Note I did not say you would gain $1000. The reason is because this $185 comes out of your cost. If it were to go up overnight, there would still be plenty of time for it to go up more so people might pay you enough for you to make close to $1000. However your upside is reduced significantly. Your cost is significantly less though. There's a trade off. You give up your overall catestrophic loss total as your loss can never be more than the $185 you spend, while maintaining a similar upside. However the probability of you losing your entire $185 is high and if in 1 month you want to own it longer you will have to buy another contract, or buy one that has more time to begin with and just sell it before expiration.

So you're thinking, wow, this is a great way to get rich, I'll just buy $13000 in options instead of stock, and then I'll have close to $130,000 if I hit it big and the stock/ETF goes up from $130 to $140!

Whoa, slow down cowboy! (or cowgirl)... Although your gains are multiplied, you are taking extremly more risk by doing this.

If you want to become accustom to buying options, you will want to buy options with a LOT of time value on them that are deep in the money because they behave more like stocks. What I mean is they have a lower chance of losing everything, and you can own them longer if you have to, and if you sell them early they maintain a lot of their initial value. On the contrary, out of the money contracts with little time value are more like lotto tickets because your chances of hitting it big are less, and your chance of losing it all are great. They may have better return in the long run than lotto tickets, but if you went out and put all your money on a lotto ticket, you better be prepared to lose it all.

A generally sound strategy is to buy stock options with 3 more months on the contract than you plan to hold it, and sell it before then. This is because people generally won't buy options close to expiration. Meanwhile, people that own options tend to try to panic and sell towards the end when there's not enough buyers. So what happens is, People buy contracts with 1-3 month on it. In order to sell you need a buyer. There are plenty of buyers who will buy your option so there is a lot of demand, so there are a lot of dreamers thinking the stock will continue to go up and that they have plenty of time to sell. However, the closer you get to expiration the more people are waking up saying "there's not much time left!" And all those who own options that are expiring are going to want to sell it because they don't want to be forced to buy 100 shares at th given price otherwise they wouldn't own the option. True they can borrow money buy it and then sell it and some brokerage houses will still redeam the options for even value but the mentality remains the same. Picture it like Christmas shopping... There are plenty of buyers in at the last second, but stores don't want to get caught with too much inventory, or else they will have to mark down items significantly afterwards. After the demand drys up, there are no more buyers, and those looking to sell are in trouble. If you wait until the last minute it will be a hectic frenzy, and if there's any major popular items and sales, they will probably be gone. Avoid the herd mentality... Get in and out early. If you plan months in advance you will generally be glad you did, as there will be a lot of dreamers looking for the high percentage that take on too much risk.

Additionally when you are options trading, start very, very small. Absolutely minute and miniscule. Option trading can be very dangerous because they are derrivatives. Gasoline is less stable than oil because it was derived and refined from oil. Fumes of gas are derrived from gasoline and are even more dangerous. If you light a match near oil, you may be okay, gas, it's dangerous, but it's always the fumes of gasoline that catch fire first.

Put options as opposed to call options allow you to bet against stocks similar to shorting stocks. If you understand how to short stocks this will make more sense. You borrow shares of stock and sell them promising to buy them back, ideally at a lower price. Sell high, buy low. If that's the case, then put options are to shorting stocks what call options are to buying stocks. You have the right to sell stock at a certain price. So if you buy a put option at a strike price of $100 and it is currently $110, you need it to fall below $100 before it expires, or else it has no "intrinsic value". If it stays the same it loses value over time. If it drops to $90 your stock options are worth $10 per share or $1000 per contract(a contract is for 100 shares) plus whatever time value or "extrinsic value" is left on it. Extrinsic value is the potential value... what people pay for the dream of hitting it big. Intrinsic is what it can be directly converted to right now. A call stock option costing $3 for a strike price of $100 when the stock is $102 has intrinsic value of $2 and extrinsic value of $1. In reverse a put option costing $3 for a strike price of $100 when the stock is $98 has an intrinsic value of $2 and extrinsic value of $1. The extrinsic value is what makes options so different, and the key strategy should be to minimize the damage from the loss of extrinsic value while still gaining the benefit of the intrinsic value going up significantly leading to large percentage gains with lower expense.

You can perform "covered calls" which are selling calls against stock you own... This allows you to PROFIT from the extrinsic value decay, however in the process you are renting out your stock. So if a stock goes up while you are selling a covered call, you do not gain from the price appreciation past the strike price. You get the cash immediately and can use it, but if you still have a call option sold after expiration and the stock price is above the strike price, your stock gets "called" away at the strike price. So if you have a $104 stock and you sell a strike price call of $105 for $2 per share and it goes up to $110, you MUST sell it for $105 even though at the open market it's worth $105. However, if it stays at $105 or lower, you keep $2 in your pocket, and can choose to sell another covered call on a monthly basis if you like. The idea is that you are trying to profit from the optomism of call buyers and collect income regularly. You may occasionally get your stock called away and have to buy again if you want your income back... It's tricky because you have to actually know what a stock is worth. If you think it should be valued at $105 with a EPS of $3 and no earnings growth or decay, it should be worth $105 this year, $108 next year, then it would be a good idea to write a covered call for $105 or $110. This way if people do bid it up to $110 or higher, you no longer should be concerned because you planned to sell it at that price anyways. If however the stock drops to $80, you could buy more. If you buy it at $105 with a $3 earnings per share appreciation, you will expect to gain roughly 3% per year just owning the stock as the earnings will add to the company, the company will improve and the value will improve and the shareholders will be more willing to pay more. However, if you regularly yield $2 per share every 2 months for selling the covered call 6 times per year, that's $12 plus the $3 or $15 per year per share or almost 15% If you are able to sell at $110 you lock in a nearly 5% gain which is more than you planned on anyways. That is the idea behind covered calls, lock in a selling price and cap your potential upside, but get paid for it from optomists.

I have a lot more to add and clear up but this was an article that I had to completely rewrite since after I lost this blog and had to try to restore it. The explination needs improvement as I had spent a lot more time figuring out how best to explain it before, but ideally it will improve over time.

Trading Options

As in any trading strategy, when you are trading options there are many important things to keep in mind.
1)exit strategy /protection from large losses
2) position sizing
3)money management

If you want to trade options successfully, you have to have something that works for you. The beginners only focus on 1 method and it's usually #5. Or worse, the beginners methodology is to ask around until they get a hot stock option tip

The exit strategy is important. When put together with good money management, it can make a great overall strategy. By limiting the losses and using other methods to protect yourself from large losses such as proper position size and having the right amount of cash available, you restrict the size of your loss. Your methodology will then only require a small win percentage and upside in order to have a profitable overall system.

Options are very unique though. In the money options function more like stocks and you can actually note the price of the underlying stock. If it drops, your option will drop and you can sell it similar to an exit strategy with a stock. However, out of the money options are different because they are inexpensive, and the difference between the ask and the bid can cause a devastating loss just to buy and sell with a slight movement. Additionally, there is the time value to consider. When you buy a stock option you need to understand the holding period in advance and decide WHEN you will sell given the time, as WELL as the price.

Generally a resonable strategy is to buy a deep in the money stock option with 3 more months than your holding period. So you would perhaps take a method where you have an 8 week holding period (2 months). If that was your plan, you would make sure to buy a stock option that had at LEAST 5 months on the contract. You also will have the possibility that you sell it well before that if the stock drops 8% or so. Additionally, if the stock is up 20% in 8 weeks it's a winner and it has proved itself to be worth holding on to. So you could sell the stock option and replace it with stock by executing your option, or you could roll over your stock option by selling your stock option and buying another option with 5 months or more on the contract so you add at least another 2 more months to the contract. This is very similar to the IBD CANSLIM method of investing only with in the money stock options. This is a very good one to use if you are transfering from a stock buying methodology to an option buying one.

As you become more comfortable with the strategy, you can begin to buy closer and closer to at the money options, or even try buying out of the money option. But the main point you will need to consider before doing this is understanding the risks.

Position sizing is how each individual position size corresponds to the amount of cash you have available. Theoretically you could have a very small position size such as 1%, and still be in danger if they are all call options and the overall market tanks if you do not have a large amount of cash available on the sideline. So position sizing is very closly linked to money management.

Money management encompasses exit strategy, position sizing, overall cash position, win/loss rate as well as the win payout to the loss payout, to form an overall profitable strategy that maximizes your long term growth potential without putting your bankroll at a high risk of ruin. The absolute optimal amount to invest to maximize a positive return is  the "kelly criterion". However, be warned, this makes several assumptions that is not true in the stock market and the biggest one is that your investments or bets are independent. If investors move their money out of the stock market, all stocks will go down, and performance will generally be less for all investments. Because of this, you will have to figure out a safe amount to invest based on your entire average of your portfolio risk. This can get really complicated if you don't already have a good understanding of it already.

The Kelly Criterion is a formula that determines the most you can risk without sacrificing your long term growth potential. For example, if you had a 100% chance of winning you could risk everything and you should because there is no chance of you losing. But what if your chances of winning are 80% and a win doubles your money. For the individual bet, if you bet everything you have, you are maximizing your value for an individual bet, but this is greatly erroneous because if you lose everything you have, there is no chance you can recover. Eventually that will happen. You will lose 1/5 times and win the other 4. . If you bet 80%  this means that if you start with 100 and lose you're down to 20% or 20. You will then bet 16 and win and get to 36 then 28.8 and you win and get to 64.8, then you bet 51.84 and you get to 116.64. Then you will be likely to lose again in the next couple times. Although this is profitable, when you lose again, your losses will be so large, that it will take more work recovering than if you bet less. If you lose twice in a row, you probably won't even get back to even before you lose again. This is bad money management and it actually doesn't produce the ideal results in the long run anyways.

You generally do not want your investment going up too much as you win, or down in size too much as you lose, and you don't want to have too high of a risk of ruin, so a wise decision would be to take 1/4th of the kelly criterion and consider it a flat rate and keep it that way without adjusting it unless the investment size becomes so large that you are investing 1/2 the kelly criterion. The ideal kelly criterion for the above example would be to bet 60%. You can test this by seeing how much you would have after losing once, then winning 4 times in a row.

However, the odds are not known in stock markets. Instead you have odds that vary. Overtime you may be able to conclusively say with 90% confidence that a particular strategy will beat the market over the next 50 years, but you might only be 90% confident that the strategy will win 55-65% of the time, and it could easily be on the low end. Just because you have data that suggests that you will win 60% of the time that has been studied over a long period, doesn't mean it's enough data to use with the kelly criterion. You have to take the low end of the range. If you are a stats major, you can figure this out, but if not, make sure you estimate on the low end of the percentage you will produce a win as markets change and you can't be sure that the past is a measure of future success, you can only be reasonable sure that it will generally fall into that range. Even so, there are studies that suggest there are "black swan events" or rare events that completely shape everything and that are understanding of what's likely may be wrong.

This is why I personally trade high tight flags with options or without, as they have shown to produce a "win" a very high percentage of the time in multiple studies. If it's wrong about hitting it's price target 90% of the time and it only hits it 60%, it can still be a profitable strategy if when you hit the target you win more than you lose. In fact, you can even lose more often than you win, but if you win big and limit your losses you can still be profitable.

If you properly manage the "time decay" that occurs with options, you can put your win ratio even higher. The reason is, an option is a contract for 100 shares that only cost the fraction of what buying 100 shares would. If the stock goes to zero, you are going to lose less owning 1 contract than you will with 100 options. However, if the gain happens overnight, you lose very little time value, and your gain in dollar amount is very close to the same. You lose less when you lose, and make more when you win. If you lose a dollar in the stock, you might lose 60 cents on the dollar by owning the option. If you gain a dollar in the stock, you might still gain 95 cents on the dollar. So if rather than owning 100 shares, you own a single contract, your risk reward is better. If you own the exact dollar amount you would control/own a lot more shares and have a lot more upside, however, you would be leveraged probably too much so and your downside would be significantly more. You will have a greater reward to your risk if you sell the option early. The reason is options decay exponentially. This means that the "extrinsic value" or value in terms of potential decays very little initially, and then begins to lose value at a much faster rate. If you sell the option early you avoid the large part of the decay, and the reward you get is so much greater than the risk that it can be profitable, assuming you have a strategy that is profitable already.

Once you understand all the above, you can consider how leveraged you want to be. If you had a regular strategy that involved buying stock, you can consider using options to add leverage and increase your return on your risk. If you already plan on having options, you can add the position size. You can consider adding even more leverage if you want to buy out of the money options, but they require agreater gain to be profitable and the chances of you using your entire investment are much larger, however you can produce monstrous gains when you win. This is more of a "lotto ticket" strategy because it's losing your investment a few times before producing a win. Once you determine how you are going to leverage, you will then have to go back and run through the first 3 and make sure your strategy is still adequete given the leverage.

Once you have all of this in mind, you can determine your methodology. Your stock selection strategy... Your option selection strategy. So for example you wanted to trade high tight flags. You would take a free screener like Zacks. You would then find stocks that trade options that have gone up 60% in the last 12 weeks. Depending on how many results, you may want to add solid earnings growth, and other things like that. Then you want to manually look at all of your results for a stock that has begun consolidation, or wait until you notice consolidation start to form. Then the high tight flag begins and it's when it breaks out that you can buy the stock option. You may buy multiple positions for multiple high tight flags as long as you keep your cash position large and you don't control too many more shares than you would have, never exceed the kelly criterion. If your win rate is estimated to be 90% assume it to be 75%. If you win 64% in a bull market and 40%in a bear market on average, assume there to be outliers that produce massive games that offset it and assume the market will trade against you and turn into a bear market and assume gaining 30 when you win. If you plan to have a 8% loss, assume a 16% loss as occasionally stocks will drop straight through the stop loss. If you are then told to invest 60% on a single bet, realize that your investments are somewhat dependent and assume you should never bet more than 30% of your whole portfolio and kee 70% cash. Then make 5 investments with that 30% just to be safe since the bets are somewhat dependent, and use in the money options to improve your return on your risk. You will still make plenty to keep your wealth growing, and still be able to get an adequete return. There's no sense in gambling when trading options. Understand now and every day, you are as inexperienced as you ever will be for the rest of your life, so it pays to be extra safe now, and you can always gradually increase the agression as your understanding and experience grows. Then if you go just a little bit too far, you can take it closer until you find that sweet spot where you are protecting your money yet still producing quality returns.

Important Stock Tips For Beginners

When it comes to stock market tips, there are all sorts of people offering you the hot tip of what to buy. However, this teaches you to be gulible and victem to the prey of people who look to exploit inexperienced investors. It's important to avoid a hot stock market tip if all it is is pumping up a stock. Certainly there may be a winner from time to time, but if you really want to become a winning investor, you have to find your own method.

The best advice anyone can give is for you to seek education, learn for yourself, read lots of books, and run the numbers and case studies yourself and see which works for you.

I have a friend that is the most patient man in the world. He would have been a perfect long term investor. But he got convinced that he could make money quickly and that making money quickly even if it was small amounts was the better route. It was so alluring to him that he invested in some training program. Another relative of his who fit that swing trading style perfectly, had success with that system. However my friend joined this system and didn't want to put stop losses. The system taught him to buy the dips when a stock was oversold, and set a stop for money management. He got caught up in the concept that this program taught which was, the more oversold it is, the better purchase it is. He thought, why would I want to sell a stock that's even cheaper? He had the classic value investor mentality, the problem was he wasn't finding value stocks. So instead he ended up spending all of his money on new stock tips and services and started swing trading. He couldn't find any stock to buy that was a good value with this method because this method was technical trading only. So he ended up losing money with this system when a few stocks traded horrendously downward, then bounced but not back to where they were. My friend was patient, but the business had been losing money and it wasn't a good choice for him.

To make a long story not any longer than it already is, he finally discovered value investing, which fit his style and he now makes about 14% per year. Now perhaps he can refine his skills and make more, but he's struggling to get back to where he was because he had such devastating loss trading a style that he's not meant to trade in.

Me personally, I'm a numbers guy. I had a similar problem following my friend into value investing because he had success. I then tried swing trading and lost a lot trading leveraged etfs and inverse ETFs. I like to know the odds of a win, the deviation, how much is safe to bet, what my risk of ruin is, what my win ratio is and all sorts of things like that. So I've finally found a style that works for me. I come from a background of playing poker, knowing money management and odds, so I always thought the transition would be easy. But in order to do treat investing similar to what I'm familiar with, I need concrete numbers. Unfortunately there isn't much information telling you how likely a stock is to win, and it isn't set in stone, unlike poker where there are always 52 cards in a deck and you always know how many cards will be dealt. There's data suggesting that Warren Buffett has made a lot value investing because he finds strong earnings, but how can you put measurements on a "long term competative advantage". You can estimate the return, but it's hard to determine the risk of a company coming along and replicating the success. Buffett is great, but he's just not for me, I can't sit on a stock for 10 years while worried about funding and other companies taking over and I don't know enough about business to do that. I need to measure risk vs reward within a single action.

That begs the question... if a stock pattern makes something that is bullish, is it bullish because when it does produce a "win" it goes up 1000% and it only needs to win once every 10 times and that's if it loses 100% when you're wrong, or once out of 100 times if you have a 10% stop loss? How do you know this? Or is it bullish because it wins 80% of the time but only will go up 5% before going back down again? These are things a number guy needs to know. I'm not intuitive I have no idea what the volume is telling me exactly.

The first step was to identify a book that would teach me plenty of information on chart patterns. It had been backtested to see what the average move upwards was, what the average win ratio was and other useful information. The book was Encyclopedia of Chart Patterns by Thomas N. Bulkowski. He also has a book about candlestick patterns, but candlestick trading isn't my cup of tea because the holding period is too short... I'd rather not spend so much buying and selling and losing fees... I want the system to work for me so I can sit back and let it work. So I read his book, I ran through the numbers, and gave myself a hypothetical investments. I wanted to see based on 1 full "kelly" of risk which gave me the best return with a 7% stop loss(using the kelly criterion). For more information on using this in investing consider this article titled "How much do you make per dollar risked per day?".

So I gained the insight needed to make intelligent investments. I now have a trading system where I trade stocks using high tight flags. Once I identified that I wanted to trade high tight flags I looked at some methods using high tight flags. I needed to read a few more books and one of them was William J O'Neil's "how to make money in stocks - in good times and in bad". That gave me a lot of solid rules but I also needed to make sure I didn't fall into compulsive decisions based on having the wrong mentality. I needed to know I was vulnerable to making mistakes so I read Alexander Edler's "Trading For a Living". That pretty much rounded out my style, but a few other books can still probably help me improve.

My most recent trade involved buying HDY at $3.2. It's now trading over twice that in less than a month over $7. However, with the 25% stoploss in place, if it were to all go south from here, I would still lock in a 82.3% gain assuming it didn't drop below the stop order overnight and sell below it, which can occasionally happen. The other stock I own is up enough where even if it traded below it's 20% trailing stop I would still have a nearly 4% gain so that means there's a very slim chance I will lose in either trade and most likely I stand to make a lot of money. I certainly can't promise you those kinds of gains, and I went through a lot of ups and downs before I found a style that works for me... and it's a constant process. There is still more stock market education that I need to get. However, if you're looking for a stock tip, ignore the noise, decide what style works for you and gain stock market information until you are satisfied and can put it into a system or methodology that works for you.