Why Losing Trades Are Good For You

 Option Trading  No Responses »
Dec 302009
 

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?

 Posted by at 3:46 pm  Tagged with: , , , , , , ,

Put Time On Your Side

 Option Trading  No Responses »
Dec 292009
 

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.

 Posted by at 4:38 pm  Tagged with: , , , , , , ,

Have You Insured Your Stocks?

 Option Trading  No Responses »
Dec 282009
 

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.

 Posted by at 4:39 pm  Tagged with: , , , , , , ,

Facts and Fallacies About Risk/Reward Ratios

 Option Trading  No Responses »
Dec 272009
 

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.

 Posted by at 4:02 pm  Tagged with: , , , , , , ,

Squeezing Additional Income From Your Stocks

 Option Trading  No Responses »
Dec 272009
 

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.

 Posted by at 4:14 am  Tagged with: , , , , , , ,

Trading the Infamous Iron Condor

 Option Trading  No Responses »
Dec 062009
 

Placing iron condor spreads on the broad market indexes is a relatively conservative, non-directional trading strategy that may be used for consistent income generation.  This strategy profits as long as the index trades within the channel formed by the two spread positions.  It is best used during sideways or slowly trending markets.Condor SpreadsA condor spread is a debit spread, established by placing a bear call spread at or above resistance and placing a bull call spread at or below support. The condor may also be established using puts with a bear put spread above and a bull put spread below.  The iron condor is a variation on this trade by using a bear call spread above and a bull put spread below the price of the underlying stock or index.  The iron condor is a credit spread and achieves maximum profitability if the price of the underlying closes between the short options (the strike prices we sold) of the two spreads at expiration.  In that case, all options expire worthless and you achieve the maximum profit, i.e., the credits originally collected.  The profitability of the iron condor is assisted by the fact that the broker only requires margin for one of the credit spreads, effectively doubling the return on investment.Condor spreads are effective when the underlying is expected to trade within the channel defined by the spreads during the life of the options.  The closer one places the spreads to the current price of the underlying, the higher the returns; however, this comes with a higher risk of the price of the underlying stock or index entering one of the spreads and causing a loss on that spread.Trading the stock indexes with condors is effective for several reasons: 1) the indexes generally move slower than most individual stocks, 2) the indexes are less affected by an individual stock’s bad news, 3) the premiums of the index options are generally much higher than individual stock options, 4) index options trade in high volume because large institutional investors use these options to hedge their portfolios; this results in high liquidity, and 5) 60% of the gains with broad index options are taxed at long term capital gains rates, regardless of the length of time in the trade. Money ManagementMoney management refers to the rules used for determining the amount of capital devoted to a trade and spreading risk among strike prices and time. Determine the total dollar value you wish to devote to this strategy.  For this example, we will assume we have a $100,000 account we will exclusively trade using the iron condor strategy.  Take 40% of the total portfolio ($40,000) and divide by $1000 to get 40.  This is the total number of contracts you will trade in this strategy each month (40 contracts total in the bear call spreads and 40 contracts total in the bull put spreads).  This approach lessens your exposure during any particular month and leaves you room in the account to put on next month’s positions before last month’s positions have expired. This also reserves an additional 20% of capital as a safety margin and for possible use in trade adjustments. IMPORTANT: when learning this or any options trading strategy, start very small with one or two contracts and gradually increase your size as your experience and confidence grow.Money management also includes the concept of limiting your losses. Playing iron condors on the indexes as outlined in this paper are conservative, high probability trades. However, the potential loss is quite large, even though the loss has a low probability of occurrence. Therefore, one loss may wipe out several months of profits. Stop loss and adjustment rules and the discipline to strictly follow them are critical to the success of trading iron condors. Those stop loss and adjustment systems are taught in detail in the Advanced Options Trading Strategies course offered by Parkwood Capital, LLC.Timing (Days to Expiration)You can establish your condor position sometime in the range of 40 to 50 days until expiration.  The precise time is not critical.  The trade-offs are as follows: the earlier I put on my spread positions, the more time premium is present in the options and therefore I can receive the minimum credit I am willing to accept farther out from the current levels of the index; therefore, more safety margin is achieved.  However, the more time I use in the spread, the more time that exists for the market to move against me; thus, I am incurring more risk.  As time decay reduces the option premiums, I must move my spreads in closer to achieve a reasonable credit, reducing my safety margin and increasing my risk.  It is also possible to trade the iron condor starting at about 30 days to expiration, but the system rules and adjustments must be adjusted accordingly.Determining Optimal Entry PointsSome traders place the call spreads when the index is hitting resistance and appears to be turning down, and place the put spreads when the index is hitting support and appears to be turning back upward. This will maximize the size of your credits. However, if the index continues to move in that direction, your position could be in trouble quickly and you will not have the compensating spread position helping to hedge your position. For this reason, I generally establish both the call spreads and put spreads on the same day.Choosing the StrikesWe can apply basic statistics to our deciding which strike prices are “far enough” out to be safe. The classic “bell shaped curve” we have seen in various contexts is the mathematical function known as a normal or Gaussian distribution. If we assume that future moves of the index price will be random and similar in frequency and absolute size to previous fluctuations up and down, then we can calculate the probability of the index price being at a particular price on a particular date in the future. I calculate the standard deviation for the index, based upon its level of implied volatility and the time left to expiration. The call spreads are placed just outside one standard deviation above the index price and the put spreads are placed just below one standard deviation below the index price. This results in an iron condor position with a probability of success of approximately 80-85%. The details of this methodology are taught in the Equity and Index Options course offered by Parkwood Capital, LLC.Entering the Order and Getting FilledNow that we have determined the strike prices for our spread, we need to calculate the credit we are going to ask for in our order. Compute the natural price for the credit spread, the natural debit spread price, and the midpoint of the spread (most online brokers calculate this for you).Enter your order at a credit limit at the midpoint and wait to see if the order is filled. After a few minutes, adjust the credit downward by $0.05. Repeat until both spread orders are filled. But do not drop below the lower quartile of the bid/ask spread.Never place an order for less than $0.60 to $0.70 in credit; trading commissions become too large a factor for smaller credits.  My spread credits normally range from $0.60 to $1.05 per spread or about $1.20 to $2.10 per iron condor.Stop Losses and AdjustmentsThe topics of setting stop losses and the variety of adjustment methodologies available are beyond the scope of this paper. An effective, but simple, risk management technique is to monitor the debit spread necessary to close your condor spreads, and when that debit is double the original credit received for that spread, close that side of the condor. This technique will close out positions more frequently, but it will result in very small losses or near breakeven results in the “bad” months when the index moves against you.Index Option SettlementIndex options are cash settled options; there is no underlying instrument like stock shares to be called away or put to you.  You simply lose or gain the dollar value at expiration, e.g., you hold 10 contracts of the $1400 call and the SPX settlement price is $1405; your account will be credited with $5,000 ((1405 – 1400) x 100 x 10). If you were short the $1400 calls, your account would be debited $5,000.Most index options are somewhat unusual in that they cease trading for the month at market close (4:15 pm ET) on the Thursday before expiration, but the settlement price is not that closing price on Thursday or the opening price Friday morning.  Therefore, all final adjustments to positions must be done on Thursday before the close. On Friday morning, the settlement price will be computed based upon the opening prices of each of the stocks that make up that index.  Since each stock may not trade immediately at the open, the settlement value may not be available until later that Friday morning. Since the settlement price may vary several dollars up or down from Thursday’s close, one must be cautious about going into settlement with any spread positions remaining open.Expected ReturnsIf you are placing your spreads for credits of $0.70 or more, then the returns for that iron condor will be about 15% for the month (remember that margin is only charged for one half of the iron condor).  If we are using roughly half of our capital for an iron condor each month, then you can expect to average returns of about 6% to 8% per month.  Of course, you may have to defensively close one of the spreads a few times per year and that will reduce the annualized return of this strategy. SummaryThe iron condor trading strategy is a relatively conservative, non-directional options strategy that may be used for consistent income. However, this strategy is typical of low return strategies with high probabilities of success.  The probability of a loss is small, but one large loss will wipe out several months of profits. Thus, the key to success for trading iron condors is solid risk management rules for entry and exit, stop losses, and adjustments. When deployed conservatively as outlined herein, this strategy should reasonably be expected to return 5% or more per month.

 Posted by at 3:20 am  Tagged with: , , , , , , ,

Trading Options: Good or Evil?

 Option Trading  No Responses »
Dec 052009
 

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.

 Posted by at 5:32 pm  Tagged with: , , , , ,

Why Trading Stock Options is Better in a Recession

 Option Trading  No Responses »
Dec 012009
 

The 2008 recession and stock market crash is the worst financial and economic crisis since the great depression. By Feb 2009, the Dow has dropped almost 50%, erasing all its gains since 1998. In terms of absolute points, the Dow has dropped over 7000 points, which is more than the entire Dow index before 1998. Without doubt, this stock market crash has rendered many traders and investors helpless in search for profit.
Even though profiting during such market condition is a really tough thing to do, traders and investors still bought stocks in hope of a recovery only to be disappointed again and again leaving a bunch of stocks in deep losses in their account. When money is used this way, what it really does is to rob investors and traders of cash for investing when the real recovery starts.
So, is there a way to place those bets with very little money and limit your losses to negligible amounts if your bet is wrong as it had been so many times in this stock market crash so far? Yes, the answer can be found in stock options trading (http://www.optiontradingpedia.com).
Everyone knows that stock options trading is risky and that you could potentially lose all your money. What everyone failed to recognize is the fact that stock options trading is also a risk limited way of trading for big profits while controlling potential losses to negligible amounts!
Stock options (http://www.optiontradingpedia.com/stock_options.htm) are contracts that allow you to buy a stock at a specific price no matter how high the price of that stock is in the future (Call Options (http://www.optiontradingpedia.com/call_options.htm)) or sell the stock at a specific price no matter how low the price of the stock is in the future (Put Options).
By replacing the buying of the stock with buying its call options, you will be able to control the profits on a stock using just a small amount of money. If the stock goes up, you simply sell the call options for the same profit as you would as if you bought the stocks. If the stock goes down, you lose nothing more than the small amount of money you paid for the call option contract. See where I am going with this? If you had bought only the call options of those stocks that you have bought all of last year, you would have lost only a small fraction of the losses that you would already have incurred through buying the stocks.
Let’s look at an example.
John and Peter have $15000 to invest with each and they both decided to buy shares of Apple Inc, AAPL, after it has dropped to $141 in October 2008, expecting a rebound. Peter decided to buy 100 shares with $14,100 and John decided to play it conservative and bought 1 contract of AAPL’s call options with strike price of $140 which was asking at $10.20 for a total price of $1020. 1 contract of call options allows you to control the profit of 100 shares of the underlying stock. In this case, John totally replaced the buying of 100 shares of AAPL with buying 1 contract of its call options. 2 weeks later, AAPL fell all the way to $85 as the recession deepened. Peter lost over $5600 while John lost only the $1020 that he spent buying the call options.
Assuming both Peter and John were right about AAPL and the stock rallies to $200. Peter would have made $5900 in profit while John would have made the same $5900 less the amount of $1020 that he paid for the call options.
See how buying stock options rather than the stock itself in this volatile condition allow you to make a few bets for a rebound without risking all your money? In the above example, Peter would only be able to make one bet once on AAPL with $15,000 while John would have been able to make those same bets more than 10 times at strategic support levels. Who would have a better chance of winning?
By replacing the purchase of stocks with controlling the same number of shares of that stock through its call options, you would definitely have a better chance of survival in this recessionary market condition. Be warned however, that you fully expect to lose the entire amount of money paid on the call options should the stock continue to go down, which is why you NEVER use all your money in a single trade.

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