Tuesday, February 2, 2010

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.


  1. Thanks you friend for explaining all about trading options. I have just stepped in this field in a hope to earn money. In this article you have tried to explain so much trading options that has helped me a lot.
    trade options