# The Seven Deadly Option Trading Sins



## wayneL (13 July 2006)

Not my idea, but a great topic for discussion.

I'll post them without explanation and we can get into some discussion later.

1/ Not understanding the independant effects of time and volatility on your option.

2/ Only ever using one strategy (e.g. covered calls) 

3/ Not understanding the proper use of leverage available

4/ Not understanding the fundamentals of option pricing theory (the greeks  , synthetics, black scholes et al)

5/ Thinking the expensiveness of an option is determined by the dollar cost of the option

6/ Using complicated strategies when simple will achieve the same goal.

7/ Not knowing how to pick the correct option for the selected strategy.

Discuss?

Cheers


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## money tree (13 July 2006)

8. not understanding dividend factors
9. not understanding strike anomolies
10. not constructing payoff diagrams
11. not understanding ACH mechanics
12. not understanding how brokers operate
13. confining yourself to strategies with a name
14. thinking inside the box
15. ignoring taxation consequences
16. not abusing the ex-dividend positive bias
17. not abusing the $5k franking credit rule
18. not constructing your own EXCEL margin statements daily before close

we could go on forever wayne


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## NettAssets (13 July 2006)

Hi Wayne

Think I'll have to disagree with your point two


> 2/ Only ever using one strategy (e.g. covered calls




If it had inappropriatly attached to the end of it then then it may be a little better 

There are some very successful traders who wait for the right opportunity  and strike consistantly and well with one strategy.

Whatever the "market" is doing there is almost always shares trading in a suitable direction.
I guess it depends if you want to look for a share  to suit your trade  or a trade to suit your share.
there would seem to be room for both types of traders.
John


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## mit (13 July 2006)

Wayne,

I have been meaning to write about covered calls. These have been a particular hobbyhorse of yours due to their inappropriate marketing by some gurus as having no downside and being safe etc etc etc. And this for us T/A types this is perfectly true and I can't argue with you about that.

However, think for a moment about the value investors. For them it is probably not a bad strategy for a  cash flow. Think about it -- They would have the underlying share anyway and are planning on holding the share pretty much forever.

So if the share goes down they are in the same boat anyway except they have the premium in the pocket. If the shares go up and they get called they can console themselves that it was overpriced anyway. So for them it's safe as the worse that can happen is that they have forgone some upside on their shares.

Peter Spann uses it in his shares/property seminars and I think for his audience it is appropriate as he is all about the slow accumulation of capital through property and value shares the development of a cash flow is a bonus rather than the prime purpose of the exercise. All this discussion with Realist reminded me of this.


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## wayneL (13 July 2006)

MT,

Yes we could go on, and some of those issues you should be addressed as well. We'll get to those.

OK Netassets,

It is true some traders do that. But it is sub-optimal. The market is everchanging, volatility changes direction changes etc etc. There are always times with one strategy, the odds are piled against you.

As an example, if someone only ever buys calls... if implied volatilities start to become VERY high, and options overvalued, then a call (or put) buyer will have an edge operating *against* them. There are times when it is just silly.

There are over 30 "named" strategies, and as MT pointed out, by thinking outside the box, there are almost infinite possibilities. With options you can customize your market exposure, why not take advantage of that?

In other words, by being flexible, one can take advantage of all market conditions. Isn't that what a *trader* is trying to do?

Mit,

Yes CCs have been a hobby horse of mine. But I have gone to great lengths to point out that they are a most useful strategy under the circumstances you describe. Even so, there are times when the CC is just not appropriate even for a value investor.

Think about it. If you are a value investor, then when you write a call, you want to recieve "value" for your call. I see people come out of these seminars all the time, deluded into thinking CC's are gateway to financial Nirvana, bamboozled with silly catch phrases such as "share renting" and "magic moo-cow" FFS, only to be disappointed by the premium available. These seminar clowns are careful to use times of high implied volatility with their examples.... and they gloss over the risk.

If calls are good value (for writers), and the investor likes the risk profile of the strategy at the time, then yes they are good.

But there are times when writing calls is just not good value for the opportunity risk.

Likewise, I detest initiating CCs for the sake of collecting the premium. Far better risk/reward opportunities lie elsewhere. This has been the crux of my "hobby horse" campaign against CCs.

Now going back to NAs point, a "value" investor, rather than only looking to write calls, could look to further customise their market exposure. There may be times when a bought put is more appropriate, or a ratio spread to contruct the so called "stock repair" strategy, or how about a synthetic straddle? Slingshot hedge? Synthetic Backspread? etc etc etc.

Have a look at the diagram below to see all the payoff diagrams that can be constructed, starting from simple long stock (from Cottle's "Coulda Woulda Shoulda"):







Doesn't it make sense to at least consider other strategies?

Cheers


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## sails (13 July 2006)

While on the subject of covered calls...

About three years ago we were introduced to a group that were trading covered calls - each in their own accounts.  The idea was to use margin lending to the max, buy puts about 20% below the entry price (approx 3-6 months out) and sell mostly at-the-money calls.  Most of them only owned News Corp shares = no diversification   

One couple said they were in the process of selling their house to set this up...

Another trader had apparently sold all his rental properties and was fully leveraged...

Another couple were reportedly leveraged up to $2mil - all on NCP (now NWS)...

These were real people - we met with them on a regular basis.  They generally seemed oblivious to the huge risks they were taking on...  Greeks were rarely mentioned.

To start with we took out a loan on our property and started buying into NCP, but found the risk to reward was terrible and after many anxious nights (NWS is prone to overnight gaps), we decided to close it all out - and so started on the steep learning curve to understanding options and looking for lower risk strategies.

While I agree with those that already own shares can increase their returns by selling OTM calls (there are still traps for the unwary), I really do disagree with the above scenario where people buy shares that they would not otherwise own simply for the purpose of selling calls and subesequently taking on a lot more risk than they realise.  

Just my


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## NettAssets (13 July 2006)

I'm willing to think about that Wayne.

In my short trading career I haven't yet had more than a few days go by when my scanner didn't turn up a trade to consider and sometimes I'd just rather go outside and sit in the sun cause my brain hurts!

I guess from my perspective no 2 and 6 seem to be closely aligned I guess what I was getting at was seeing too many people trying to build big strategies (like the one on leaps you pointed out the other day) and new stratagies every day when cottles diagram also works the other way to simplify things. 
Sometimes the trade offs between the simple and complex seem too small. 
But I guess I am talking from the perspective of a very nice time in the market where just about anything works.
John


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## mit (13 July 2006)

wayneL said:
			
		

> Mit,
> 
> Yes CCs have been a hobby horse of mine. But I have gone to great lengths to point out that they are a most useful strategy under the circumstances you describe. Even so, there are times when the CC is just not appropriate even for a value investor.




Due to work I miss this forum for a week at a time. I only saw the initial discussion of the strategy not the defense of it.



> Think about it. If you are a value investor, then when you write a call, you want to recieve "value" for your call. I see people come out of these seminars all the time, deluded into thinking CC's are gateway to financial Nirvana, bamboozled with silly catch phrases such as "share renting" and "magic moo-cow" FFS, only to be disappointed by the premium available. These seminar clowns are careful to use times of high implied volatility with their examples.... and they gloss over the risk.




What kind of return could somebody get from a moo-cow strategy? These are people who are generally happy to average 12 percent a year from shares from growth+dividends. It wouldn't take much of a premium stream make them happy. Although I take your point that the spruikers should give them some rules about which strike to pick or when the premium is not worth it. 

Again I want to differentiate Option Courses from the Peter Spanns. Peter Spann's audience is not us or most people on this forum. They want simple low risk and long term and are more interested in property. The options courses are different ofcourse and should do much better for what they charge.

 But I have derailed the thread as the people on this forum are more sophisticated and want optimal results. So lead on ...

cheers
MIT


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## mit (13 July 2006)

Sails,

Thats very scary.

MIT


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## wayneL (13 July 2006)

CCs

Check out this chart below:

If this was in the portfolio anyway and you wrote a call over it. You wouldn't be happy, but at least you would be down a little bit less for having written the call.

Now what if someone intitiated this trade specifically to pick up the premium? What if the trade was leveraged to the eyeballs with borrowed money like Margaret was talking about?

That someone would have just commited financial suicide, all for a dollar or two of premium. It does not make sense to do this on a risk/reward basis. It's "picking up pennies in front of a bulldozer" as someone put it.

Cheers


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## zakka (14 July 2006)

I have been writing covered calls on Lihir Gold for 3 months now.  Writing only one month out and all out of the money.  By doing this i have reduced the square even price to $2.60 at this stage and hopefully by years end i would like to think that it would be under $2.00.

if the price remains bouyant then its probably a good way to generate about $4000 a month in premiums by making one phone call a month.

I see the stock holding like buying a house and renting the place out to those who cant afford to buy one.

My premiums btw are used to purchase new 1000 lots of new LHG shares so that they are re-written.  

all strategies have downfalls but as long as you have one and u adhere to some set rules.

Covered call writing is no exception and it is wise to augment this wise buying  of puts and calls in a different series to take advantage of price fluctuations


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## wayneL (14 July 2006)

zakka said:
			
		

> I have been writing covered calls on Lihir Gold for 3 months now.  Writing only one month out and all out of the money.  By doing this i have reduced the square even price to $2.60 at this stage and hopefully by years end i would like to think that it would be under $2.00.
> 
> if the price remains bouyant then its probably a good way to generate about $4000 a month in premiums by making one phone call a month.
> 
> ...




Hi zakka,

Sounds good.

Question:

What was the implied volatility when you sold the last lot of options?
What was the statistical volatility at the same time?
What was your volatility projections?
In your view, were the options fair, over or undervalued.

The reason I ask is that based on todays figures, options are undervalued if realised volatility remains at at least todays levels. If options were sold today the compensation would not be worth the risk, unless you were expecting a drop in volatility.

If you are holding LHG long term, its not much of an issue. If not, the strategy is sub-optimal under the present circumstances.

Cheers


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## NettAssets (14 July 2006)

wayneL said:
			
		

> If you are holding LHG long term, its not much of an issue. If not, the strategy is sub-optimal under the present circumstances.
> Cheers



I nearly choked on that one.

Does that mean that there is  a better strategy to increase the return on this holding or you are better off not to trade options here at all and look for another trade?
John


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## wayneL (14 July 2006)

NettAssets said:
			
		

> I nearly choked on that one.




LOL Big premium does't necessarily mean overpriced. These options could be considered cheap... too cheap for my liking, unless the shares are to be held regardless... and the capped upside is not a concern. hehe



			
				NettAssets said:
			
		

> Does that mean that there is  a better strategy to increase the return on this holding or you are better off not to trade options here at all and look for another trade?
> John




I haven't gone that deep into this particular option chain, but if you just wanted to collect premium with LHG options as a vehicle, then a one of the spreads would offer a much better risk reward... as well as having a rear-gaurd against the fat tail. there are all sorts of possibilities depending if there was any skew etc.

I say, did you get any rain out your way last week?

Cheers


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## zakka (15 July 2006)

wayneL said:
			
		

> Hi zakka,
> 
> Sounds good.
> 
> ...





With respect to the questions you have asked I really cant answer.  

The basis of my strategy is to hold the scrip so I dont have to get back into the market to buy the stock.  If i do that then at night I dont have to worry about things turning against me or a takeover etc.

At current rates and with option sales going into stock purchases so i can write more options then a 40% return per year is not out of the question with very little work on my part.

It may well be sub-optimal but I am not looking to drag every last cent out of it.  

If I can grab 3% per month and do it consistenly for 2 years then borrowing $2m and getting at 2% return per month comes to $40,000 per month.

I also figure that purchasing shares with a dividend reduces my borrowing costs as well as spreading the stock purchases over 2-3 stocks.

Not a sophisticated option strategy and probably not one that will generate the most premiums but one that I can live with and take into account the effect of compounding growth and capital growth on the stocks themselves.



I however will look at other option startegies and learn a bit from this forum.


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## barney (25 August 2006)

Hi Zakka. I know this thread is old but if you read this I was just wondering re your covered calls strategy... (I also thought this type of strategy was a simple way of generating some spare income out of shares) BUT What happens if your shares take a real dive one month (particularly in the early stages ie just after you first purchased them) The value of the covered call you could write for the next month would be way less because the shares had dropped so much. The theory is fine while ever the sp is not fluctuating too much, but if you get one really bad month (sp down say 20% or more; and it does happen) what steps do you take to minimise the downside.  I still think the principal of the theory is fine but I was just wondering if you have a plan in place for a worst case scenario?

PS I guess the simplest way to attack the problem of the sp diving would be to simply buy more stock at the lower price and only write CC on them until the sp rises above your initial buying price.  The moral I suppose is to initially try and buy the shares at a "discount" but the bottom of the market is always hard to pick. Cheers.


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