There is a reason for this. You will always lose money trading options without expert advice.  

I am going to teach you how to trade options and win. There are tons of financial websites out there which will tell you about options, but here, I just want to give you some hard and fast tips that we used on the trading floor at Lehman Brothers.

When you buy an option, you are basically buying a seat at the table. You’re making a reservation for 100 shares of stock, and paying a little bit for the privilege. You can either trade on the short side, or the long side, calls and puts respectively. It’s that simple.

When you delve into the options markets, you are up against an army of brilliant traders in offices in Manhattan earning about $1 million a year. Every time you look at the options board, remember who’s setting the prices. There are no safety nets with options, there are very few opportunities to ride them down and hope they come back. Even if you’re trading GE options, which is the most liquid stock on the board, it does not matter.

Options decay faster than a set of teeth bathing in a bottle of Coca-Cola. The underlying company is irrelevant for the actual trade, but a thorough understanding of the company is very important. However, blue-chip companies or not, options have zero relationship to the actual company, only a relationship to the nature of the equity’s performance in the market.

Don’t ever forget this.

I have a rule that has saved me millions trading on Wall Street, and it’s one you should always, without fail, live by. If you’re in a trade that goes against you, get out! Do not take any chances with options. Pay the commission, accept your mistake and get out.

Always live to fight another day. So many people are too proud to be wrong. They start buying more, or buying shares to hedge, or get into ETFs to counter-act their bad options trade. And suddenly a simple position becomes a convoluted hedge for an incorrect decision. Please do not fall into this trap. We all make mistakes, even the best in the business. But what separates us is our ability to get out the second it goes against us.

1. Never chase a rally.

Try to buy calls on days when the stock is down and puts on days when the stock is up. Or simply, buy calls at a time of maximum fear in the stock, and puts at a time of maximum greed.

2. Be guided by technicals, not the media.

If you’re long an option, always exit your position on the news or, even better, just before an expected new event like an earnings report. The day after the earnings report, the price of the option will collapse and often times, even if the stock moves in your favor, you may not make money.

3. Buy or sell puts or calls in the middle of the day.

In the morning, option traders that make the markets for Fidelity, Schwabb or any brokerage firm, keep their spreads wider because they don’t want to get picked off. They want to feel the market come together. Near the close of the trading day you’re also at a disadvantage. If you need to exit a substantial options position, you’re better off not waiting until the close.

The options market maker knows there are people that need liquidity at the end of the day and their markets are not as efficient at those times. At the end of the day, option market makers are wary of getting beaten by savvy traders with inside knowledge.. That’s why they make smaller markets at the end of the day.

4. There’s less decay if you buy “in the money.”

Buy “in the money” puts instead of shorting the stock if the borrow is difficult on the stock. This will also limit the decay factor.

5. Limit orders limit profits.

If you believe in the trade, and it’s time sensitive, don’t mess around with limit orders. Trying to undercut the trader’s market, hoping to buy at a lower price, you’ll end up chasing it like a Bedouin riding toward a mirage. Also, options market makers love making chiselers pay more.

6. Check out the “Open Interest” on the option.

This is what I call the Roach Motel Factor. Beware of buying options where there is little open interest. The less open interest there is in an option contract the more power the market maker has in dictating the price. Generally, the less open interest, the wider the market and the more difficult to get out. It’s like paying a $500 dollar toll to go over the George Washington Bridge to get into Manhattan. Five hundred in, five hundred out is no fun.

7. Understand the volatility price level you are paying for an option.

Before the credit crisis, on the trading desk at Lehman we were buying puts on Washington Mutual (WM). In the spring of 2007 WM was trading like a rock north of $40. The November $30 puts, a full six months out, were ridiculously cheap, something like 60 cents. Today the same trade would cost north of $2.50. The richness or cheapness of what your paying for an option is measured by the vol you are paying. The 40 cent puts we bought were trading at something like a 0.18 vol, today at $2.50 that would represent over 0.70 vol.

8. Know your deltas to the penny!

Every option acts a certain amount like the underlying stock. An option “in the money” will trade with a high delta and an option way “out of the money,” like our Washington Mutual example above, will trade with a low delta.

Let’s say you own 100 of those November 2007 $30 strike puts on Washington Mutual (WM). That means below $30 you are short 10,000 shares of WM. But say it’s May 2007 and the stock is $42. You’re not short 10,000 shares. Most likely the delta on this $30 strike option with the stock at $42 would be 0.15-ish. So 10,000 x 0.15 = 1,500 shares. With the stock at $42, your 100 put contracts will act like a short stock position of 1500 shares. In this example, the lower the stock moves, the higher the delta.

9. Check the borrow on a stock before you buy the option.

If there is no borrow, the option market maker will have a very difficult time hedging his book. Therefore he will keep his spreads very wide. On the trading floor, we used to call this the untradeable market. As a market maker, he’s obligated by the options board to make the market, but if the borrow becomes very difficult, the options market maker will make it senseless to buy or sell the options.

Borrow on a stock can go away and become a hard borrow if a lot of hedge funds and investors have a negative view on the company, and the many outstanding shares are already borrowed.

10. If possible check out the CDS on the underlying company’s debt.

Some of the sharpest knives in the drawer are big players in the credit markets. If the company has a lot of debt this is a must. Often times the CDS spreads will give you an indication as to what direction the company may be heading. In many ways CDS and options are similar. You don’t have to become an expert in CDS to trade options, but it’s nice to know if the CDS is 600 wider in the past three days. That may indicate a good time to buy that put.

The advice in this article is for day trading options. I have not covered hedges or long range out-of-the money trades.

Hope this all helps, and please feel free to leave a comment or any questions!

Only being aware of what you think about the option is not enough, it is prudent to know what others think about the option also. You should talk to people who trade in stock options, read books on that topic and do everything possible to keep your self abreast of all that is related to stock options. Doing this should fairly give you an idea of trading in stock option, to get some practical experience; you could also try “trading on paper”

There is no ground rule to choose the winner stock, you have to do an extensive research on your prospective company and then decide whether it is worth while to invest.

The basic things that you ought to check in the company are; 1. Company’s track record; it is important that you look at the performance of the company in the past few years. 2. Check the price of its stock and its volatility; more often than not after a technical analysis of the stock price you will be able to speculate its price movement. 3. Keep an eye on any current news such as stock split, mergers or accusations or any other investment that the company may be going in to.

In option trading, you can make money either ways. If you expect the stock price to rise, you should buy a call option. A call option is a right that the option holder enjoys, to buy the stocks of the specified company at a specified price. This specified price is called the exercise price. Now, if you buy a call option you will gain if the stock price rises, because you have the right to buy the stock at the exercise price at the expiration of the option. This way you can acquire the stock at a lower cost and sell it in the open market at the market price, there by booking profit. You can also sell the call option if you are expecting the stock price to fall. In this case there is one catch; you are exposed to unlimited loss and limited gain. Your gain is the premium amount that will be paid to you by the buyer of the option, on the other hand if the stock prices rises instead of falling then you will have to buy the stock at a higher price from the market and sell it at the lower exercise price, to the buyer of the call option. This is a naked or an uncovered call option. You can hedge yourself by purchasing a call option with a lower exercise price and a longer maturity. Similarly when you buy a put you are expecting the price to fall and when you sell a put you are expecting the prices to rise.

If you trade correctly and maintain the right balance of risks you can surely emerge a winner in stock option trading.

1. The stock’s past history and movement.

2. Expected earnings reports of the stock’s parent company.

3. Volatility and volume of shares traded daily.

4. Any current news concerning the company’s growth or profitability.

5. The price of the option with respect to how you think the stock will perform. If you do not feel the stock’s movement will handily offset the cost of the option, plus the trading fees, then buying or selling the option would be fruitless.

6. Supply and demand of the underlying stock. (Industry group market action.)

Once you have decided upon which stock to pick, you next need to decide whether you believe the stock’s price is likely to rise or fall. (With stock options you can make money in either direction.)

By purchasing a Call option:

1. You expect the price of the underlying stock to rise, so you can then purchase it at the lower strike price, making a profit in the transaction.

2. You have the right to control 100 shares of stock for a fraction of the cost of purchasing the stock outright.

3. You are managing your risk by limiting the downside to the premium paid for the option. The major downside to buying any option is time decay. Your option expires within a finite period of time. If the underlying stock price behaves as expected, you will not need to be concerned about execution.

Having shown you the benefits of buying Calls over the risks of purchasing the stocks outright, we must emphasize the fact that buying short-term Calls has its associated risks as well. A Call buyer, especially a short-term Call buyer, is severely limited by the time-decay factor. The nearer to the expiration of an option, the less the option is worth, and the less time is remaining for the option to become profitable. Within the leverage used by gambling casinos (the house), the concept of short-term Call buying is completely understood, as well as exploited, as gamblers are considered short-term Call buyers.

Example: Consider your long-term Put, or Call, as a 6 to 8 month license to operate a casino. It allows you to capture short-term premiums; money that gamblers continuously give to you in attempting to beat the odds by speculating they will make profits on very risky bets. They feverishly feed the slot machines, ante up at poker, double-down on blackjack, or spin the roulette wheel. The odds are overwhelmingly against these short-term buyers. You, as the casino owner, continuously capture these short-term premiums, easily offsetting the expense of the license to operate the casino, then earning substantial, clear profits in the following months. They know the odds are with the casino owner, but they still take the enormous gamble on the slim chance they will hit a jackpot. The lottery works in the same manner.

On one side of the position, the transaction is definitely gambling, while on the other, the casino is simply engaging in business. Would you rather bet on the remote chance of a gambler’s rare, limited success, or rake in the steady, routine premiums captured from operating a successful business? Yes, occasionally a gambler does beat the odds to enjoy a limited, windfall return on his bet. For the casino owner, that is simply part of the cost of doing business. But we all know where the true, long-term profits lie. 30%, 40%, 50% and more, are common, and in short periods of time. The odds are with the short-term option seller, not the buyer.

When you choose a stock for short-term Call buying, you not only must carefully consider the proper stock for the type of option you are purchasing, you must also decide which direction the stock will move, then, that movement must occur within a specified, very limited period of time. Many investors have gone broke by attempting to make those same decisions. In short, time is not on the side of the short-term option buyer. It is on the side of the option seller.

Summary: 1. Buying stocks is risky.

2. Buying short-term options is less risky, but still risky.

3. Selling short-term options is the least risky, especially with a hedge, or insurance.

By selling a Call option:

1. You expect the underlying stock price to fall, so the option will not be exercised, but expire, worthless.

2. You can capture the entire premium that was paid to you, as profit. If the underlying stock price rises, you are obligated to sell 100 shares of stock at the lower strike price. If you do not already own those shares, you would then have to buy them at a higher market value, then sell them at the strike price, in order to meet your obligation. This situation is called a “Naked,” or “Uncovered” position, and is extremely dangerous. Anytime you sell a Call option you should consider buying the same option with a slightly lower strike price, and longer expiration date. This will reduce your profit potential, but will also reduce your risk considerably. (Remember the parallel twins, Risk and Reward

- If you want to reduce risk, you must also give up some degree of potential rewards. You may wish to lower your cost basis in the stock, to the extent of the premium received.

By purchasing a Put option:

1. You expect the price of the underlying stock to fall, allowing you to sell stock at the higher strike price, and thereby earning a profit.

2. This option is also used in a combination strategy as a hedge against selling Puts. We will explore that strategy later, in detail.

3. Buying Put options could also be used as a hedge, or insurance, against the possibility of a price drop in stock you already own. Consider the following:

You own 100 shares of ABC stock, and are concerned that the stock price could suddenly fall. You purchase a Put option on the same stock, with a strike price at current market value. If your stock falls in price, you would have the right to exercise your option and sell 100 shares of ABC stock at the higher strike price. The premium you paid for the option could be far less than the loss you would have incurred without that insurance. In this instance buying Puts acted as a hedge against the possibility of a price decrease in the stocks you already own. If the price of the underlying stock increases, your loss is limited to the premium you paid for the option. The option acts as an insurance policy against possible loss.

Selling a Put option without an opposing hedge -”Naked” You expect the price of the underlying stock to increase, causing the Put option you sold to expire worthless. You can then capture the entire premium paid to you, as profit. If the underlying stock price were to fall below the strike price, then you would be obligated to purchase the stock at the strike price, or pay the difference between the strike price and the stock price, if you do not want to own the stock. Your upside is limited to the premium received for selling the option. Your downside is potentially unlimited to the base value of whatever you could sell the stock for on the open market, or to the difference between the strike price and the stock price. This is a “Naked,” or “Uncovered” position, and should never be allowed to occur, unintentionally. Without the implementation of combination strategies, the main objective of the Put seller is to hope the option expires, allowing him to capture the entire option premium as profit. Nearing expiration, if the stock price moves below the strike price, changing the option’s value to ITM, and highly vulnerable to exercise, then the option seller must move quickly to buy back the option, perhaps lessening his profit potential, while also managing his risk. Even so, a small loss would be better than having to buy 100 shares of stock at inflated prices. Also, the loss can be immediately compensated for by simultaneously selling another Put expiring in the following month. We use OPM (Other People’s Money) to buffer downside risks, while buying more time for the stock price to rise.

Stock Option Trading, when done properly, can drastically reduce, or even eliminate, these two stumbling blocks to stock market success. In the first place, A trader of stock options never is not required to own the underlying stock in which an option is based. He or she can design a trade in such a way that downside risk is limited to the cost of the option, which in itself is a fraction of the cost of the stock. We capitalize on traders and speculators greed to get rich who purchase overvalued short term options bid up to inflated levels by an excess of demand over supply, by being the house or casino owner and capturing the inflated premium from the players or buyers. We buy reinsurance at a low cost by purchasing a longer term ( 5 to 6 months) out of the money option to sell the stock at a fixed price no matter how low it may drop. We buy this reinsurance ( puts ) to create a profitable hedge and sell overvalued puts repeatedly, month by month to bring the cost of our hedge down to zero and a credit so that we can enjoy a free ride capturing this inflated premium income. This strategy is known as diagonal put spreads and you do not need to pick a winner to profit.

The financial markets are a similar system. It works best for the investor when trading practices are in balance, and Options Trading is the way to achieving balance for sustained, long-term returns.

If you have invested in the stock market for a while, you are probably pretty frustrated by wrongly guessing a stock’s move more often than not. Psychologically, most investors will bet on an upward move, and there certainly are a lot of researchers and advisors out there who will tell you things like “you can’t miss with this one – the fundamentals are just that good.” The problem is that there are so many things that can happen to a company that are simply not predictable: A product recall, an insider scandal, unexpected regulatory problems – the list goes on. Options trading takes this into account and hedges the bet.

Options trading is similar to a gambler hedging his bets on the roulette table by splitting his money between red and black, odd and even, certain series and other alternatives. Playing in this manner does not result in a sudden huge win, but rather in steady, sustained profits. That’s the difference between a novice and a professional.

The psychology of investing is similar to betting on a crap game. You can win by betting that you’ll win, or by betting that you’ll loose. There are only a few gamblers who bet on the latter, and that is similar to short-selling in the markets, i.e., betting on a stock’s downward move. If you are a more sophisticated investor, you may have tried that. How did that work out for you?

The point is, you are only betting in one direction, and that’s the problem. Options are an exciting alternative and the perfect way of hedging your bets and moving from guessing to safe investing. If you are a beginning investor when it comes to options trading, you would do well to subscribe to a reputable service that will do all the research and give you recommendations as to what moves to make and when.

Options research includes many different elements – not just “the stock will move either up or down”, but scenarios that take into consideration how long the stock may trade in a certain range, whether it will stay low for a few months but rise in the long term, whether it will trade cautiously until earnings are achieved, and then take off or fall dramatically. What’s more, with options you can always adjust your trade and change your strategy to fit the current market trend. What more can you ask for?

Options are like a balanced ecosystem that shield you from the wild up-and-down gyrations of financial markets that are so prevalent right now. If you are interested in more information, visit www.tradegreeks.com and opt in to the TradeGreeks Options Traders Newsletter. Then if you like what you see and want to participate, we invite you to become a member of TradeGreeks.

You are currently reading an article from our article series ‘Covert Life of Investment’.