Options as a Strategic Investment » Protection

Why Losing Trades Are Good For You

admin — Wed, 30 Dec 2009 21:46:56 +0000

Many people enter trading, whether it be stocks, options, commodities or other markets, after having been very successful in their primary occupation. Many of these new traders are perfectionists by nature and driven to be successful. This often leads to a couple of fatal flaws in trading:

The reality of the trading business is that a large percentage of one’s trades will be losers. Every business has overhead expenses, or costs of simply opening the doors for business. Trading is no different and trading losses are a large part of those overhead expenses. Once one accepts that aspect of trading, it becomes much easier to close losing trades early with minimal emotional attachment.

It is also crucial to post audit your trading every month. I evaluate each trade that lost money and categorize it as a “losing trade” or a “bad trade”. The bad trade is the one where I did not follow my own trading system rules, whereas the losing trade was executed and managed correctly, but simply did not turn out positively – it was part of my overhead.

The precise percentages of losing trades will depend upon the markets being traded and also the particular trading strategy. For example, many successful commodity traders will only have 30-40% winning trades. At first blush, that doesn’t appear to be a viable proposition, but the key is the ratio of gains on the winning trades versus the losses on the losing trades.

For example, let’s assume my trading system’s average winning trade returns $250 but my losing trades average about $500. That doesn’t look like a winning system, but the crucial missing piece of information is the ratio of wins to losses. If I win 10 of the next 12 trades, I will gain $2,500 and lose $1,000 on the two losing trades for a net gain of $1,500. Another trading system might have a different pattern, e.g., winning trades average a $750 gain, but losing trades average losses of $100. This pattern of wins and losses is fine if the probability of success is high enough to make up for the losses. For example, if my probability of success is only 20%, this system will be profitable. Out of the next ten trades, two winners would account for $1,500 while the eight losers would total $800 in losses, for a net gain of $700.

Always understand the risk/reward ratio of your trading strategy. Couple that with the probabilities of success and loss to know the expected value of a series of trades using this system. Depending on the parameters, one system will be profitable with infrequent, but large, winning trades, while another profitable system may be characterized by highly probable, but small, winning trades.

This explains why you often hear a trading guru adamantly insist that you must always trade where the maximum gain is at least three times the maximum loss (a low risk/reward ratio). But then you hear another well known trading coach tell you that the best trading strategies are the ones with probabilities of success greater than 85%, with a high risk/reward ratio. Nether system is superior. But each system has its own pattern of wins and losses and optimal trade management. Which system is most compatible with your trading style and risk tolerance?

Put Time On Your Side

admin — Tue, 29 Dec 2009 22:38:43 +0000

Many conservative income generation trading strategies depend on the time decay inherent in options pricing. When I establish an iron condor well OTM (out of the money), I am selling option spreads and expecting those spreads to slowly lose value as the underlying stock or index trades within a channel. Other traders may use butterfly spreads or place OTM credit spreads on one side only (calls or puts); all of these trades are based on time decay working in the trader’s favor. This is in contrast to the long option position designed to benefit from my prediction of a particular directional move for the underlying index or stock. Those positions lose value over time if the predicted move does not occur, so time is not your friend for those trades.

One of the items on your checklist before making a trade should be a glance at the calendar to see if any exchange holidays are upcoming. When time decay is on your side, exchange holidays are also your friend. If the market isn’t open, it can’t move against your positions, but time decay is still occurring and improving the profitability of your position. I will often establish my OTM credit spread positions before long holiday weekends to add to my edge.Another important factor to keep in mind is the historical seasonality of volatility. Trading activity slows during several of the holidays every year, as traders take time off to be with their families and exchange business tends to slow. March and October have historically displayed the highest volatility for the year, whereas the summer months and the week between Christmas and New Year’s Day are historically slow periods of market activity. An old wall street maxim is “sell in May and go away.” It refers to the tendencies for many market participants to take vacations and long weekends over the summer, resulting in lower trading volumes and lower volatility. This tends to favor strategies like iron condors that benefit from slower moving, sideways markets.Another factor tracked by many traders is which monthly options cycles have 5 weeks and which only have 4 weeks. Option prices will be skewed because of the number of days in an option cycle. If your trading style involves consistently selling premium each option cycle, you should be aware of the five week option months, since the amount of premium income may be affected.Options trading strategies that benefit from the time decay of options prices are attractive for monthly income generation. Pay attention to the calendar and put time on your side.

Have You Insured Your Stocks?

admin — Mon, 28 Dec 2009 22:39:25 +0000

Many people think of options trading as very risky and suitable only for the “high rollers”. In this article we will demonstrate one of the ways options can be used in conservative financial portfolios.The basic definition of a put option is that it gives the owner the right, but not the obligation, to sell 100 shares of the underlying stock at the strike price anytime before expiration. If I buy 100 shares of Apple Computer (AAPL) at $136.50 or $13,650 and buy one contract of the Oct $135 put for $10.50 or $1050, I have a total investment of $14,700. This position is called a married put; we are long the stock and long the put (long means we own the stock or option; short means we have sold it and have an obligation to buy it back). If AAPL goes up in price, my stock will appreciate but my put will expire worthless. On the other hand, if AAPL decreases in price, my put will increase in value and make up for a portion of my loss on the stock price, i.e., the put acts as insurance for my stock.A married put is analogous to your homeowners insurance; you paid $1000 at the beginning of the year for insurance to cover your home in case of damage from fire, storms and so on. At the end of the year, your home was not damaged and you lost the $1000 you paid for insurance. On the other hand, if a storm had caused $20,000 of damage to your home, the insurance company would have paid to have it repaired and you would be glad you had paid that $1000 bill for the insurance.The married put is similar; if the stock price does nothing, our put expires worthless and we did not need our insurance. In this example with Apple, the insurance cost us $1050 (the cost of the put option). But if you are watching the evening news and see Steve Jobs being escorted from his office by FBI agents in handcuffs, you begin to worry. The next morning, APPL opens at $92, but we look at our account online and see a balance of $13,700 – we are only down $1000 or 7% when our stock has collapsed by over 30%; those may not be the exact prices, but you get the idea. Some of our stock price loss has been covered by the put.Let’s use our time machine and travel back to July, 2007. You own 100 shares of Google stock (GOOG) that you bought over a year ago, and have a nice gain in the stock. In June and July of 2007, GOOG was moving up strongly and was trading at about $548 on July 19th. You realize an earnings announcement is coming after the market closes and want to protect your gains, but still be able to take advantage of any gains that might occur after the announcement. To form a married put position with your 100 shares of GOOG, you buy the July $550 put for $14.20 or $1420. GOOG missed the market estimates for its earnings and the stock closed at $520 on July 20, a $2800 loss in one day on your stock position. But the put option you bought for $14.20 is now worth $30, so you gained $1580 on your put option, reducing the $2800 loss on the stock by over 56% to $1220.However, buying puts on each stock would be rather tedious if I want to protect my entire stock portfolio. In that case, using index options that roughly match your portfolio is one answer. If my stocks are large companies in the Standard and Poors 500, then the OEX put options (the S&P 100) might be a good fit; the SPX options (S&P 500) represent a broad range of stocks, including many mid-sized companies. The NDX options (NASDAQ 100) would be a good choice for a high technology portfolio, since this index is made up of the largest 100 companies in the NASDAQ. The best portfolio insurance might be a mixture of SPX and NDX put options, proportioned in accordance with the stock holdings.The essence of the married put strategy is buying insurance on your stock position. If the stock price drops, your gain on the put position offsets much of the loss on the stock. But if the stock trades up in price, you can enjoy all of that gain minus the cost of the put.The married put strategy is conservative, but there is no free lunch in the markets (or anywhere else in a free society). Our downside protection, in the form of the put, costs us a small amount to establish. So, if our stock only moves up a little bit each month, we may only break even after paying for our put. But when the big crash comes, I may feel much more comfortable because my stocks are insured.

Facts and Fallacies About Risk/Reward Ratios

admin — Sun, 27 Dec 2009 22:02:10 +0000

One will commonly hear or read the following “rule of thumb” for trading:Only trade positions with potential profits of at least three times the potential loss.This sounds like a reasonable rule, risking a little to make a lot. However, it ignores the probabilities involved. Buying a lottery ticket for $1 to potentially make one million dollars certainly meets this criterion for a good trade. But we intuitively know that the odds against us winning are astronomical. This paper will define risk/reward ratios, define the concept of expected value, and begin to explore the relevance of these concepts to success in trading strategies.Risk/Reward RatiosIf we are considering an investment where the maximum gain we can expect is $100 and the maximum loss that we may incur is $500, we would compute a risk/reward ratio of 500/100 or 5:1 (five to one) . This is a high risk/reward ratio in that we stand to lose a large amount compared to the maximum gain. The trading rule above of “potential profits of three times the potential losses”, would result in a small risk/reward ratio of 1:3.Expected ValueThe probabilities of the various outcomes of a proposed investment are often overlooked. When someone tells you an investment will return 300%, but doesn’t tell you the probability of success, you are missing critical information necessary to make a decision about that investment. When one accounts for the probability of the profitable outcome, one computes the expected value, sometimes called a risk adjusted return on investment.For example, let’s assume we are considering a covered call on IBM and the called out return is 4% for IBM closing over $90. If we were to determine the probability of IBM closing over $90 is 65%, then we would say that the expected return or risk adjusted return is 2.6% (0.65 x 4%). We can take this analysis one step further by accounting for the probability of loss. Using the same IBM covered call, let’s assume we have a stop loss order entered that we believe will take us out of the trade with a 8% maximum loss. Now our expected return has two terms:Expected Return = (probability of gain) x (maximum gain) – (probability of loss) x (maximum loss), or,Expected Return = (0.65)(4) – (0.35)(8) = (2.6) – (2.8) = -0.2%Therefore, if we were to place this trade many times, our expected return, based on the probabilities of gain or loss, would be a net loss of 0.2%. One could improve this strategy by either improving the probability of success or tightening the stop loss to reduce the maximum loss.High Probability TradesTrading strategies can be positioned in a variety of ways resulting in a broad range of risk/reward ratios. One extreme category may be called the high probability trades, i.e., trades that have probabilities of success of 85-90%. One type of option spread strategy, known as the iron condor, can be positioned in such a way as to have an 85% probability of profit. On the surface, that sounds very attractive. However, the losses for these trades can be quite large, even though their occurrence is unlikely. For example, a typical iron condor might be characterized as having an 85% probability of achieving a 19% return but a 100% loss with a 15% probability of occurrence. The expected return:Expected Return = (0.85)(19) – (0.15)(100) = 1.2%Or the calculation can be done with the dollar amounts. The 19% gain could correspond to a $1,600 gain and a maximum loss of $8,400. The expected return is:Expected Return = (0.85)(1600) – (0.15)(8400) = 1360 – 1260 = $100Therefore, trading this strategy over time and many trades is going to be close to break even, and probably a loser after trading commissions are included. Let’s consider the opposite style of trading and then draw some conclusions.Low Probability TradesLow probability trades are akin to the lottery ticket, i.e., the maximum loss is small, but the probability of success is also extremely small. There is a category of option spread known as “far out of the money vertical spreads”. The basic characteristic of this trade is a small maximum loss, but with a high probability of incurring that loss. An example might be a vertical spread that only cost $130 to establish, but could potentially return $870. Since the maximum loss is $130 with a probability of success of 12.5% and the maximum profit is $870, the potential gain is 669%, so the expected return is:Expected Return = (0.125)(669) – (0.875)(100) = 83.6 – 87.5 = -3.9%or,Expected Return = (0.125)(870) – (0.875)(130) = 109 – 114 = -$5So, the expected values of this low probability strategy result in small losses over time.ConclusionsTrading strategies come in all sizes and shapes to suit anyone’s style and risk preferences. But the reality is that none of these strategies have an inherent advantage. Some trading education firms and authors of trading books will often claim that they have found the holy grail of trading and have the “best” trading strategy. Each trading strategy has its own set of advantages and disadvantages. In addition, if each trading strategy was applied in a blind, “ put it on and let it run” methodology, the net results would be very similar: near break even or a small loser over time. However, the pattern of the results would be quite different. For the examples above, the high probability trading strategy would have many small positive gains throughout the year, but would be expected to have a small number of large losses that wipe out the gains. Whereas the low probability trading strategy would have a small number of large gains, but those gains would be wiped out by a large number of small losses.Therefore, one must manage the trade in such a way as to develop a probabilistic edge. The best analogy is a Las Vegas casino. If you analyze any of the games played in the casino, you will see that the odds favor the casino. The casino has a small probabilistic advantage, so the owners know that over time, they will come out winners. In stock and options trading, one must understand the probabilities and have developed a trading system that gives the trader a positive edge. You want to learn to trade like the casino, not the gambler at the tables.

Squeezing Additional Income From Your Stocks

admin — Sun, 27 Dec 2009 10:14:01 +0000

Many people think of options trading as very risky and suitable only for the “high rollers”. This article briefly surveys how options can be used in conservative financial portfolios to boost the income from your stocks.For the purposes of this article, let’s assume we have a stock portfolio of conservative stocks, e.g., IBM, GE, etc. We may be realizing moderate price appreciation of the order of 5% annually plus dividend yields of 3%, for total portfolio growth of 8 to 10% annually. One easy way to boost our annual gains without increasing our downside risk is to sell call options against our stock holdings. This is known as a Covered Call.A Covered Call is created by selling the appropriate number of call options against stock in our portfolio. Let’s assume we own 500 shares of shares of IBM and IBM closed at $104.69 on May 28, 2009. We are concerned the stock may trade sideways or only slightly upward for the next few weeks. We could sell 5 contracts of the June $105 call options for $2.35, or $235 per contract. This brings $1,175 into our account. If IBM closes at any price less than $105 on June 19, the calls we sold expire worthless and we keep the $1,175 we received and this represents a 2.2% return on our investment in IBM. However, if IBM rallies to any price above $105 by June 19, our stock will be “called away”, i.e., whoever holds those calls that we sold, will exercise them to buy our 500 shares of stock for $105/share. In this case, our account balance will stand at $105,000 plus the $1,175 we received for the calls or $106,175. This represents a gain of 2.5% for about three weeks.There are always trade-offs for any investment strategy and the covered call is no exception. The downside of the covered call strategy, illustrated by this example, is that we gave up any stock price appreciation beyond $105. In return for surrendering that upside potential, we were paid $1,175, or 2.2%. If we are using the covered call strategy with conservative stocks like IBM, it is unlikely that we will see big moves in the stock price very often. Most months will see our call options expire worthless and we will take in additional cash as the stock price moves sideways or slightly upward. Adding one to two per cent income per month to our conservative stock portfolio adds up over the year.Some traders use the covered call to increase the income from a conservative stock portfolio when the market seems a little slow. Others select and buy stocks with the express purpose of selling calls against those positions. In either case, the position should have a stop loss contingency order placed with the broker to protect the downside. The covered call strategy can be expected to yield about 2-3% per month. Of course, every trade will not be a winner, so it would be foolish to project annualized returns of 24-36%, but one can use this strategy to boost the income from a conservative stock portfolio.One forewarning is in order when using covered calls with blue chip, dividend-paying stocks. If the call options you sold are in-the-money, or ITM, as you approach expiration, the calls are rarely exercised early if there is more than $0.05 to $0.10 of time value left in the option premium. However, if the stock is about to go ex-dividend, the call may be exercised early to take advantage of receiving the dividend. The dividend paid to the stockholder may outweigh the time value lost upon exercise.The Covered Call is a conservative strategy for boosting the income of a blue chip stock portfolio. However, the disadvantage of this strategy is the sacrifice of the gains above the price of the call option sold. Selling calls against highly volatile stocks would be a much different strategy than our example with IBM. A Google (GOOG) covered call would be much more aggressive; when GOOG is quiet and trading within a range, we would make a nice return, but when GOOG makes one of its $100 runs within a few weeks, as it did recently, we would be caught with a $10 or $20 return instead of the $100 return. When covered calls are used in conservative stock portfolios, boosted returns of an additional 5% to 10% per year are reasonable expectations, and this can be done without increasing the downside risk.

Trading Options: Good or Evil?

admin — Sat, 05 Dec 2009 23:32:12 +0000

You have probably heard people refer to options as a risky enterprise, akin to gambling. And it is true that options trading can be very risky, especially when engaged in with minimal knowledge and preparation. The average stockbroker or financial planner does not have sufficient options knowledge to guide you in the use of options in your portfolio. But that doesn’t mean options cannot play a role in a conservative portfolio of stocks.The majority of today’s options trading volume derives from institutional money managers who use options to protect their clients’ stock portfolios. They are using options as insurance. Options may also be used to boost the income that may be derived from a conservative stock portfolio.Options written on stocks are referred to as equity options and come in two forms: calls and puts. A call option gives the holder of the option the right to buy the underlying stock at the strike price of the option at any time before expiration. A call option is similar to a grocery store coupon for a five pound bag of flour at an attractive price; but the coupon is only good for 30 days and is limited to the purchase of one five pound bag. Similarly, a call option gives you the right to buy 100 shares of stock at a specific price and it is only good for a particular period of time.Put options are opposite in character to calls and are more like insurance; a put option gives the owner the right to sell the underlying stock at the strike price of the option any time before expiration. Put options are often purchased when one expects a stock to decline in price, or it could be used as a form of insurance if I already own the stock; if my stock declines in price, my put option appreciates and compensates for a portion or all of that loss. An excellent analogy is house insurance; if I pay my insurance premium January 1 and nothing happens to damage my house this year, my insurance expires worthless, just as my put option will expire worthless if my stock just continues to appreciate. But if a hurricane damages my house during the year, my insurance pays for some or all of the repairs. Similarly, if my stock declines in price, my put option will increase in value, replacing some or all of the loss in my portfolio.Equity options expire on the Saturday following the third Friday of each month. It is common to hear or read that equity options expire on that third Friday. While that isn’t technically correct, it is true that Friday is the last opportunity to trade those options. Saturday expiration was established to give the Options Clearing Corporation and the brokerages time to settle their customers’ accounts before the options technically (legally) lose their value.Consider Hewlett Packard (ticker symbol: HPQ) as an example. HPQ closed May 28, 2009 at $34.70; the June $35 call option was quoted at $1.00 at the close. In the options quotations on a site like Yahoo Finance, you will see bid and ask prices posted. The Ask price is the price quoted if I wish to buy the option, while the bid price is what I would have to pay to sell my option. Options are quoted per share of the underlying stock, but are sold as contracts that cover 100 share lots of stock. The HPQ June $35 calls are quoted at an ask price of $1.00. Each contract is priced at $1.00 per share of the underlying stock; since each contract covers 100 shares of stock, the contract costs $100 and five contracts would cost $500. I have the right to exercise my options anytime before they cease trading on Friday, June 19, and buy 500 shares of Hewlett Packard stock at $35 per share or $10,500. Or I could simply sell my call options at the bid price anytime before expiration.Options can be used in several very conservative ways in a stock portfolio. For example, if I own 300 shares of Hewlett Packard (HPQ), but I am concerned this market is softening and may take another dive downward, I could buy three contracts of the June $35 puts at $1.40 to protect my position. This put position would cost me $420 and protect me through June 19. As HPQ drops in price, the puts will increase in price, compensating for some or all of my loss on the stock. This is called a “married put” position. However, there is no free lunch in the market; if HPQ trades sideways or upward, I will lose my $420 of “insurance premium”.Another conservative use of options is the “covered call” strategy. If we continue with our example of HPQ and I think the stock is going to trade sideways or slightly up over the next few weeks, I could sell three contracts of the June $35 calls for $1.00, bringing $300 into my account. If HPQ is trading unchanged at $34.70 on June 19, the $35 call options will expire worthless, and I will have gained $300 or 2.9%. But if HPQ trades upward of $35, my maximum gain is capped at $330, or 3.7%.Options trading can be very risky when used in a speculative manner, but options may also be used in conservative fashion with a stock portfolio, both protecting the downside and also increasing the income from the portfolio.