Trading Options Conservatively

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Posted by hattery at 3:01 pm

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Trading Options Conservatively
Time for you peons to learn a little bit about how to become a man and trade options. Notice while I do think trading options mean becoming a man, that doesn’t mean that it should be done in a macho through all caution to the wind type of way. You are not trading options to look good and feel important, you are doing so to make and keep money. More so in the long run than buying stocks, otherwise you would just purchase the stock
First of all, why would you want to trade options?
Trading options allows you to limit your downside risk significantly, while maintaining most of your potential reward. Your risk is reduced in terms of stock price movement, however you take on the additional risk of time value (or theta) decay. That may seem “greek” to all of you, so read up on the greeks if you must know the terminology and stuff.

Consider GS, which currently could be in the process of making a bear flag along with the rest of financials. It has had a low volume rally after a steep decline which makes it a good stock to buy a put option on. Now first of all, if I short it and I am wrong, my losses are theoretically “infinite”. That’s not a reason to be afraid because you can certainly hedge yourself by shorting while owning an OTM call at your stop loss price to prevent this. Additionally, as long as you are careful and don’t short it before any major announcement, and manage your money properly, leaving money on the side allowing for a loss much larger than your set stop loss price, you’re never going to really get wiped out that badly on a large cap stock as no one instution can cause a stock to move upwards in a huge quantity overnight in a single day.
(Disclaimer: I have bought puts in GS today and I plan to add more on weakness)

No, the more important reason you would want to trade options is because it increases your upside while limiting your downside if done properly. The thing that can make options most costly is the loss of time value. If I wanted to combat the time value decay, I would have to recognize that time decay occurs exponentially. If I bought an option that expired in 2 years, a week’s worth of time value would mean a very small loss. However, if I bought an option that expired in 1 month, a week would be very significant. The advantage of buying an option with less time value is that because the price is less, the rewards are potentially greater. However your cost per unit of time is much greater, and therefore it requires a larger move. Many believe it simply is not safe to trade options without making sure there is significant time value. I would tend to agree. Technically with good money management it can be, however this would require a much smaller investment overall to avoid large unstable swings in your portfolio’s value. In order to receive the same return overall you would need your wins to be significantly higher while maintaining the same amount of cash risked.

Lets take a look at an example. If you want to short GS right now during the month of February at 157 lets say, and it goes down 135 points, I make $20 per share. To short 100 shares you would basically set aside $15,700 or more so that you can buy back the stock later, ideally at a lower price. Now what if I bought a put option instead? I could buy a put option at a strike price of $160 that doesn’t expire until the third week of July, and I would be paying $13.80 per share instead of $157 per share. I wouldn’t ever hold it to July though, I would buy it back probably before the end of April as the last 60 days an option’s intrinsic value is lost very rapidly.
The way this works is the option is currently $3 “in the money” that means that $10.80 of the option is it’s intrinsic value. This value of the option is made up of it’s time value (theta), and it’s premium. I won’t get into the details, but just understand that every $1 the stock goes up, a call option will go up slightly less than $1, because of the premium you are paying and the time value decay. Every $1 a stock goes down, a put option will go up slightly less than $1 for the same reason.
However, if the stock went against you, you could never lose the same amount you would gain. So if the $157 stock went to $300 a share and you had a put option, you would not be entitled to pay the $143 per share. If you owned a call option and the stock went to 0, you would not lose more than you paid for either. For this reason options offer a better risk/reward ratio, provided you can manage theta, or time decay.
This makes options trading fun and profitable, however just because you have $15,700 that you would normally invest does NOT mean you should buy 11 options of GS to match the price investment. This is an almost sure way to lose your wealth as you are multiplying your risk significantly by buying that many. Although you can’t lose more than $13.80 per share, the probability of you doing so is much greater than if you owned a $14 stock because the option is priced on the underlying stock of GS, and GS is priced at over 10 times that amount, making you over 10 times more likely to lose your investment on a dollar per dollar basis.
So rather than own the same dollar amount, you should buy the same number of shares worth as you would. Keep in mind that every option contract is designated towards buying 100 shares. You certainly will be giving up a small edge towards the upside when doing this, however you are protecting so much more on the downside that your losses will not be the same, and you will have a lot more cash available on the side.
Please note that it can be extremely tempting to invest more than you should when you have a have a huge portion of cash on the side… However, to avoid the temptation, I suggest you bet on currency ETFs. In the long run, the dollar isn’t that great anyways, so why own so many dollar denominated assets? It’s much easier to spread your wealth among asset classes when you use options because you free yourself a lot of cash.
So in the above example, you would normally pay $15,700 for a short position. Instead you are paying $1,380… So with the extra $14,320 you might want to buy FXC and EWA to get exposure in the Aussie dollar and Canadian dollar, and maybe a little gold, that way you can still have the same cash position on the side that you’re used to, while still having the liquidity to reinvest into more options, and managing your money correctly.
If you trade options conservatively like mentioned above as an example, you will actually have much smaller losses, often times similar gains, meaning that over time, your overall gains will be much higher. As you become comfortable with option trading, you can then start increasing your positions to be slightly more shares worth than normal, and you can start getting used to having more dollars on the side if you wish. If you want to get real fancy, you can start buying options in currency ETFs and gold ETFs that were previously used (in the example) to reduce the temptation to invest all the excess cash you had. Of course if you do that, you are going to have more excess cash and you just have to get used to it.

As you learn to get more sophisticated with options, you can begin to start doing option spreads. You can set price targets and sell the same option but at a different strike price at you price target. By doing this you miss out on any gains beyond your price target, but you receive the premium from the person betting on an swing beyond your price target, and if it does go beyond, you have simply maxed out your profit, and you will neither lose nor gain any more beyond this price.
Now if you are trading options, stick to the big cap names or index funds. Otherwise you are paying an arm and a leg just through the difference of the bid and ask. Always buy a limit price right between the bid and the ask.
I would advise you stay away from at the money options, and either buy a deep in the money options (and treat it like you are buying the stock). Out of the money options are certainly another viable strategy if you are more experienced trading options, however you have to deal with greater volatility and a lower win rate.