Thursday, 3 March 2016


I exchanged e-mails with a new trader who wanted to discuss his trading strategy. He uses technical analysis to decide which stocks to buy/sell -- and has been losing money. He asked about using options. The following is a major part of my reply.
Traders tend to ignore the nature of the business and rely only on their ability to predict short-term price movements.
Investing is different. It is based on your ability to understand the basic financial condition of the company, compare it with its peers and make a good evaluation of how well-poised this company is for the future. That's research. When you find a business that is worthy of making an investment, you buy shares and wait for your good judgment to pay off. But you do not wait idly. Investing requires periodic re-evaluation of your holdings because the world changes and you do not want to be married to a poor investment.
Option traders are not investors.
Nor are they very short-term traders. The option markets, with their wide bid-ask spreads, are not designed for day traders.
·         Option buyers require that the stock make a move -- in the right direction -- in a relatively short period of time.
·         Option sellers require time to pass and for the options to decay without the stock moving in the wrong direction.
Option traders also have built-in risk-measuring tools (the Greeks) that make it more efficient to use options than stock. The Greeks include Theta (the risk of holding as time passes), Vega (the risk of holding a position as implied volatility changes) and Delta (the risk of being too long as the market falls; or too short as the market rallies).
These Greeks allow traders to get a good estimate of how much money is at risk -- as well as the potential reward -- that comes with their market prediction.
Why is this important?  Too many traders ignore the following question:  
Even when traders lack proof of any ability to correctly predict direction, they still take bullish and bearish positions with a high expectation of making money.
That is not reasonable. 
Predicting direction is difficult. Most professional money managers cannot consistently beat the market averages. And they are paid big bucks for that inability. Instead of trying to do what they cannot do, why not trade with a much improved chance of success? Options allow you to do just that.
To make money, the trader must have an edge. If you believe that your edge comes from skillfully reading charts, then keep careful records and prove that you can do it.
While waiting to gather evidence, I recommend a basic option strategy: Sell out-of-the-money credit spreads.
Consider getting the details in my book, The Rookies Guide to Options.
Here is a brief outline of how this works, using bullishness as an example:
·         If you buy stock, it must move higher or else you make no money.
·         When buying calls, the stock must move higher just to prevent losing money from Theta.
·         When selling out-of-the money (OTM) put spreads, you can earn good (but limited profits), even when the stock does not move higher.  This improves your chances of earning a profit.
Here is an example, using a stock priced at $68.
Choose an expiration date. Sell the $65 put and buy an equal quantity of the $60 put. That gives you a position that is short the 60/65 put spread. Let's assume that the cash collected is $1 per spread. 
The maximum profit is $100 per spread, and you earn you that profit when the stock moves higher. However, the nice characteristic about credit spreads is that you also earn the maximum possible profit when the stock fails to rally -- as long as it is above the strike price of the short put option. In this example, that is $65 per share.
Yes, this is still a bullish position and you earn money when the stock price moves higher. But in return for accepting a limited profit, you gain wiggle room. You can still earn money on a bullish prediction, even when the stock price does not increase. 
This strategy is not for everyone, but works for the prognosticator who 'almost' gets it right. 


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