The idiots way to options riches

[Hopeful]

What's wrong with this simple plan. I'm new at this so be gentle.

Buy stock XYZ for $20 and write a call option with a strike of say $22 (a 10% move will get you exercised). Then, set your stop loss at the current price minus the premium you recieved. So, if the stock drops past BE you exit the whole position without a loss, but if it goes up then you win. It's a "can't lose" trade!

Of course, if the stock opens with a huge gap then you get your arze handed to you. And then there are brokerage fees as well.

What else am I missing? This is a kind of "dorathy dixer" question to elicit some responses, don't panic I'm not going to do this just yet. Cheers. Humor me.

 

[wayneL]

What's wrong with this simple plan. I'm new at this so be gentle.

Buy stock XYZ for $20 and write a call option with a strike of say $22 (a 10% move will get you exercised). Then, set your stop loss at the current price minus the premium you recieved. So, if the stock drops past BE you exit the whole position without a loss, but if it goes up then you win. It's a "can't lose" trade!

Of course, if the stock opens with a huge gap then you get your arze handed to you. And then there are brokerage fees as well.

What else am I missing? This is a kind of "dorathy dixer" question to elicit some responses, don't panic I'm not going to do this just yet. Cheers. Humor me.

Firstly, you will get SFA for the call that far OTM... probably only a few cents, depending on volatility

Secondly, it doesn't work that way anyway. If the stock starts moving down well before expiry, theta will not have had time to deliver you any advantage.

http://www.hoadley.net/options/strategymodel.htm

 

[Hopeful]

Firstly, you will get SFA for the call that far OTM... probably only a few cents, depending on volatility

Secondly, it doesn't work that way anyway. If the stock starts moving down well before expiry, theta will not have had time to deliver you any advantage.

http://www.hoadley.net/options/strategymodel.htm

If it goes down I want to be out anyway. The call premium gives you a little bit of room before BE. So that's the downside - getting stopped out. If the figures were a little more realistic:

RIG (a US stock) is currently trading at 70.45 , Oct calls with a 75 strike are selling for 1.90. So then I hit the bid and short the call then go buy the stock. If it goes down to 70.45 minus 1.90 = 68.55 then I exit with a small loss (brokerage). On the other hand if it ends up anywhere above 68.55 at expiry then I'm laughing (yes, American style means I can get assigned...).

I'm afraid I think I missed your point. I can see two likely results, one positive and one even (I can also see disaster as well, but that would be so without writing a call anyway).

 

[wayneL]

If it goes down I want to be out anyway. The call premium gives you a little bit of room before BE. So that's the downside - getting stopped out. If the figures were a little more realistic:

RIG (a US stock) is currently trading at 70.45 , Oct calls with a 75 strike are selling for 1.90. So then I hit the bid and short the call then go buy the stock. If it goes down to 70.45 minus 1.90 = 68.55 then I exit with a small loss (brokerage). On the other hand if it ends up anywhere above 68.55 at expiry then I'm laughing (yes, American style means I can get assigned...).

I'm afraid I think I missed your point. I can see two likely results, one positive and one even (I can also see disaster as well, but that would be so without writing a call anyway).

OK This is why I bang on and on and on about greeks.

You are analyzing this as if you keep the premium of the short call when you are stopped out.

The only way this is possible is if you stay short the call till expirey *after* you are stopped out on the stock. You can do that, but suddenly you have unlimited risk to the upside and possibly greater than a month to go befor expirey... a very dangerous game.

Firstly, I advise you get a grasp of synthetic positions to understand what you in fact have. What you have with the above position is a synthetic written $75 put.

Secondly, understand that until expiry, your position risk is measured via the greeks. You simply cannot say that if the stock goes down by a 1.90 I'll close out at break even. That is only possible if this happens at expiry.

I think the error comes from looking at the hockey stick graph without understanding that that is the profit/loss AT EXPIRY. Before expiry, the graph is different, and changes every day.

This is why I posted the link to the strategy modeller. This piece of free software will enable you to analyse if-then scenarios before expirey of the option.

Good luck

 

[wayneL]

Viz

 

[dutchie]

G'day Hopeful

WayneL is of course spot on and continually keeps reminding us to learn the "greeks" before thinking about using options.

Don't forget when you sell the shares you still have an open call position that needs to be closed - you need to pay more brokerage plus premium (could be anything - depending on the "greeks").

If you don't close it, thinking it will expire worthless then:
1. Will your broker let you have a naked call open.
2. There will be margin required if he does.
3. You are open to unlimited losses if the stock changes direction (especially if it gaps up the next day!).

Keep plugging away though as you will learn more about options (they can be very versatile).

But I don't think there are too many positions that you are gauranteed to win or break even at the worst (unless of course you have a very good handle on the "greeks") - if there were then everybody would be doing them.



Cheers

Dutchie

 

[bunyip]

Wayne

I know very little about options.
Forgetting for the moment about how options can be used to hedge an open position - considering them purely from the angle of opening and closing trades where your aim is simply to take a position, unload the position some time down the track, and hopefully pull a decent profit or at worst, a small loss.
For the style of trading I've outlined, do options really offer any significant advantage over simply buying or shorting CFD's?

Bunyip

 

[swingstar]

Wayne

I know very little about options.
Forgetting for the moment about how options can be used to hedge an open position - considering them purely from the angle of opening and closing trades where your aim is simply to take a position, unload the position some time down the track, and hopefully pull a decent profit or at worst, a small loss.
For the style of trading I've outlined, do options really offer any significant advantage over simply buying or shorting CFD's?

Bunyip

wayneL will go into specifics as far as better profit potential (volatility increasing etc.), but I think you have a similar style to me (i.e. hold for a few days to weeks), which on the ASX, if you get a lot of opportunities it's probably best to trade CFDs. CFDs usually have much smaller spreads and you don't have to wait half hour into open for a market.

 

[bunyip]

wayneL will go into specifics as far as better profit potential (volatility increasing etc.), but I think you have a similar style to me (i.e. hold for a few days to weeks), which on the ASX, if you get a lot of opportunities it's probably best to trade CFDs. CFDs usually have much smaller spreads and you don't have to wait half hour into open for a market.

I aim to enter from the first entry signal that presents itself after a new trend has become established. I'll stick with the trade as long as the trend continues moving in my favour. This could be weeks, months, or even years in some cases.......depends on the behaviour of the stock.

Bunyip

 

[wayneL]

Wayne

I know very little about options.
Forgetting for the moment about how options can be used to hedge an open position - considering them purely from the angle of opening and closing trades where your aim is simply to take a position, unload the position some time down the track, and hopefully pull a decent profit or at worst, a small loss.
For the style of trading I've outlined, do options really offer any significant advantage over simply buying or shorting CFD's?

Bunyip

It depends on the situation. There are times when I'll just take the straight out stock/future (or CFD in your case)

<add> With more medium/long term trend trades, you can enhance these significantly by using options. But it is a far more pro-active approach. Each position will need to be analysed and a view formed for so-as a strategy can be customized to that view. It won't simpley be a choice of either the option or the share. You will be legging in, legging out, morphing, hedging to get the best advantage.

In the US there are long term options you can use called LEAPS (I don't know if there is an equivalent here) that you can use to simply replace shares, but these still add a layer of analysis to decide if they give you any advantage, because of vega risk for eg.

For instance, if the trade is a day trade or certain other circumstanes, I won't even look at options.

For swing trading, there are advantages and disadvantages of using options. Options will add substantially to the compexity of the trade, because now you have to consider IV, SV, which strategy, which strike(s), which expiry(s) and so on.

In return, you never have to worry about an ELNesque gap that I often post here, wiping out your account.

If you are a busy trader and do several a day, options analysis can become overwhelming in terms of compexity, intensity and time.

So it does depend on a few factors as to whether there is an advantage in options for swing traders. But it also opens up possible new dimensions to your trading.

Cheers

 

[bunyip]

Wayne

Thanks for your reply.
In view of my "THE SIMPLER THE BETTER" approach to trading, I doubt if options and I could ever become friends.
Each to his own I guess.
Thanks for getting back to me.

Cheers
Bunyip

 

[Magdoran]

Wayne

I know very little about options.
Forgetting for the moment about how options can be used to hedge an open position - considering them purely from the angle of opening and closing trades where your aim is simply to take a position, unload the position some time down the track, and hopefully pull a decent profit or at worst, a small loss.
For the style of trading I've outlined, do options really offer any significant advantage over simply buying or shorting CFD's?

Bunyip

I would argue that at their best, options should outperform CFDs hands down when it comes to risk to reward, but to do this, that the options environment needs to satisfy specific conditions, and where these conditions are not met, that other instruments including CFDs may be more appropriate, but not the other way around. What I’m saying is, given a general choice, options should be considered above CFDs.

One key variable though is the capacity and actual knowledge of the individual trader/investor. If you can’t develop a sufficient understanding of options to a level to trade them, then this effectively rules this instrument out of contention. However, in my view, if you can’t figure options out, I would have serious doubt about such a person using any kind of derivative product period. I’d tend to think they’d be better off getting someone else to manage their investments such as considering using a managed fund.

This may sound harsh, but if you don’t have the intellectual capacity to understand derivatives to this level, trying to use related leveraged instruments just doesn’t add up to me – either you’ve got the ability to learn or you don’t. So, I tend to agree with Wayne regarding which instrument to use, it all depends on the situation.

The problem I have is that many CFD traders are not aware of their full exposure to risk, and often are not capable of evaluating the best instrument available to them based on their market view of a potential trade.

I’ve sat down with CFD traders and compared notes looking at the real risk to reward involved with a range of trades comparing CFDs and options and how they performed.

While sometimes good options trades are not available for a stock/index/commodity future/Forex (in which case perhaps using a CFD may be the better alternative in some cases), generally I have found that if you have sufficient options knowledge, options can significantly outperform CFDs in terms of risk to reward, if the appropriate strategy is available (sometimes appropriate options aren’t available maybe due to volatility problems, or liquidity/open interest, etc).

I went through one example with a trader (which was representative of the general findings overall) where the option slightly outperformed the CFD in terms of reward, but was about 5% the exposure - yes, that’s 20 times less exposed - than the CFD position. But each underlying and options market may differ significantly depending on a host of variables, so this comparison can vary widely.

So, I would argue that it is essential to fully understand all the instruments you are considering, and that the trader/investor develops the ability to assess the risk to reward proposition they are considering entering. That’s what using derivatives should be all about, minimising risk in context with maximising reward.

Sometimes a CFD will be the better alternative, but it is having the ability to assess which instrument is best based on the trader/investor’s style that ultimately separates the amateurs from the professionals.

Another issue is that many people using CFDs don’t understand their real exposure. If you’re using a 5% margin for collateral, that means that you are borrowing 95% of the full amount the position is worth.

So, for example, let’s say you enter long $50,000 worth of XYZ stock in CFDs while it is trading around $10, so your margin requirement is $2,500. Let’s say that overnight a major negative news event happens, and the next morning the stock opens at $5.00.

You’ve just lost around $25,000 if your position is closed (which will happen if your account is not big enough to put up the margin required), but thought you were risking $2,500 if you didn’t understand the real nature of the exposure which was $50,000.

Just think about how many people may load up several positions like this thinking all they need to do is leverage $2,500 at a time. What if the market moved significantly against them? It is very easy to be exposed to over $100,000 of risk if you don’t know what you’re doing.

Even though strong moves like this are uncommon, they do happen, and they are a real risk. I know a trader who lost over $100,000 in this way in under a month because he didn’t manage his positions, and didn’t realise his real exposure. All you need is one major loss to wipe out months of good trading… think about it.

Ok, so there are guaranteed stop losses (GSL) available for CFDs which can be used to limit risk, but this is usually set at a maximum 5% loss in the underlying, and often has a fee to establish one, and for some providers a fee to move the stop loss as the underlying moves. This is certainly preferable to being totally exposed, but can still leave the trader/investor exposed to considerable risk. 5% for each large position can add up very quickly.

Another issue about CFDs is the exposure to having your account cleaned out. This happens if a position moves against you, and there are not sufficient funds available to cover the growing margin requirement. I’ve heard of CFD traders having their account cleaned out on an intra day spike, only to see the stock rally up past where it opened and continue on in their direction. But if the account can’t meet the margin requirements at any time, the position is automatically exited at a maximum loss to the account. This is a real problem if it is not managed, and in my view a major disadvantage compared to options.

With options, there are a myriad of ways to control risk that are not available with CFDs. Firstly, even using a simple long call or put, the risk is limited to the initial premium (plus OCH fees and brokerage). You can’t lose more than you paid. Then there are a range of spreads available to cap risk, each with application depending on the market conditions.

Secondly, there are no interest payments required on a long position (or a short one for that matter – although you can receive interest from CFDs for short positions) like there is with CFDs. Certainly, there is time decay, but this can be managed, and ameliorated, or even utilised using various options approaches (sold options suffering time decay are helpful to the seller).

Thirdly, if you buy a put for a bearish position, you don’t owe the dividend at ex div like you would if you were short the underlying with CFDs (Of course if you were short a call that is assigned before ex div, you would owe the dividend).

In addition, options are regulated instruments with significant underwriting, where CFDs are essentially an OTC (over the counter) instrument, and there is a risk that the CFD provider could become insolvent, and part or all of the trader/investors’ funds may be lost in this event.

So, some key issues are based on your view of the market, how long you intend to be in the position, and what the best risk to reward strategy is available balanced against the probability of success.

Add another dimension of a range of other instruments available such as futures, warrants, forwards, swaps, bonds and debt notes, and other instruments such as convertible notes, and you have a smorgasbord of choice. The challenge though is developing the capacity to evaluate all these instruments, and then effectively evaluating the best risk to reward approach with the best probability for success.

While I understand when I hear the response that CFDS are ostensibly simpler than options, I would argue that in the broadest perspective that this is a misconception. CFDs are actually more complex than they seem. Sure they are perhaps less complex than options, but they’re quite dangerous in the wrong hands, and certainly less flexible, and arguably can be much more exposed to risk. Sure, it’s harder to work out an options strategy at first, but if you don’t do the due diligence, you’re really leaving yourself open to potential ruin.

Now, in the particular style of swing trading bunyip is outlining, in my view using liquid options in tradable markets should outperform CFDs significantly because the risk is capped, and can be as good as 20 times less the exposure. This can make a huge difference to the bottom line, but requires a full understanding of the instrument.


Regards


Magdoran

 

[swingstar]

Hi Mag

I've had quite a few 'aha' moments thanks to your posts recently. Wow, was I thinking 'mechanically'...

I am reconsidering CFDs. As I mentioned above, the main advantages for me are smaller spreads and being able to close a position in the morning at open, without having to wait for MMs (it might be different using a full service broker, since I've seen it mentioned that they can contact MMs directly?). I've been stuck with options a few times when there has been no market and hence no way to offload a losing position.

My experience is limited to the ASX though... markets are more liquid in the US and I think I've seen Wayne mention that MMs have to provide a market at open.

Nevertheless I agree (or rather am enlightened, lol) that it obviously depends on the situation. With my style, it would probably be beneficial buying liquid options, and CFDs for stocks with no or thin options. Obviously the more knowledge I gain of options the more uh options I have and strategies I can utilise (and not just relying on directional movement).

Cheers

 

[wayneL]

I went through one example with a trader (which was representative of the general findings overall) where the option slightly outperformed the CFD in terms of reward, but was about 5% the exposure - yes, that’s 20 times less exposed - than the CFD position. But each underlying and options market may differ significantly depending on a host of variables, so this comparison can vary widely.

Great post Mag,

I just wanted to pick up on this point and emphasize it.

I have often made the point that options are an instrument primarily created for the transferance of risk. In the case above, that risk has been primarily tranferred to someone else Combined with a good general trading edge, the other smaller risks assumed by taking on an option position (theta, vega) become de-accentuated.

Superfluous comment I know, but I'm bored ####less on this holiday (in the US) monday.

Cheers

 

[dubiousinfo]

While sometimes good options trades are not available for a stock/index/commodity future/Forex (in which case perhaps using a CFD may be the better alternative in some cases), generally I have found that if you have sufficient options knowledge, options can significantly outperform CFDs in terms of risk to reward, if the appropriate strategy is available (sometimes appropriate options aren’t available maybe due to volatility problems, or liquidity/open interest, etc).

I went through one example with a trader (which was representative of the general findings overall) where the option slightly outperformed the CFD in terms of reward, but was about 5% the exposure - yes, that’s 20 times less exposed - than the CFD position. But each underlying and options market may differ significantly depending on a host of variables, so this comparison can vary widely.

Another issue is that many people using CFDs don’t understand their real exposure. If you’re using a 5% margin for collateral, that means that you are borrowing 95% of the full amount the position is worth.

Another issue about CFDs is the exposure to having your account cleaned out. This happens if a position moves against you, and there are not sufficient funds available to cover the growing margin requirement. I’ve heard of CFD traders having their account cleaned out on an intra day spike, only to see the stock rally up past where it opened and continue on in their direction. But if the account can’t meet the margin requirements at any time, the position is automatically exited at a maximum loss to the account. This is a real problem if it is not managed, and in my view a major disadvantage compared to options.

With options, there are a myriad of ways to control risk that are not available with CFDs. Firstly, even using a simple long call or put, the risk is limited to the initial premium (plus OCH fees and brokerage). You can’t lose more than you paid. Then there are a range of spreads available to cap risk, each with application depending on the market conditions.

In cases where the option was not the best alternative, would there be any reason you could'nt use the CFD & look to reduce the risk by using some options as well. I don't have a particular stratergy in mind, just considering possibilities.

 

[bunyip]

Magdoran

There's a lot of good information in your post.
Thanks for going to so much trouble.
I agree that traders can come unstuck very quickly if they use leverage recklessly.
Thanks again.

Bunyip

 

[ducati916]

et al

While I would certainly concur with the post from Magdoran the following is worthy of a little further discussion;

While I understand when I hear the response that CFDS are ostensibly simpler than options, I would argue that in the broadest perspective that this is a misconception. CFDs are actually more complex than they seem. Sure they are perhaps less complex than options, but they’re quite dangerous in the wrong hands, and certainly less flexible, and arguably can be much more exposed to risk. Sure, it’s harder to work out an options strategy at first, but if you don’t do the due diligence, you’re really leaving yourself open to potential ruin.

The popularity of CFD's undoubtably lies within their constituency of providing enhanced exposure to the market ar very small capital funding requirements.
Their popularity is further enhanced by the direct correlation to the underlying securities price fluctuations.

Options by contrast, are priced on a myriad of contingencies
It is these variables within the pricing, exemplified via the greeks that complicates the true measure of risk being priced.

The outcome, is, the preferrence of novice investor/traders to the more transparent [seemingly] pricing of risk via the CFD. As has already been illustrated by Magdoran this risk is not quite as clear cut as it first appears.

The recognition of risk, the pricing of risk, the assumption of correctly priced risk, the management of assumed risk are the mandatory steps required, and if performed correctly, will result in a positive expectancy of risk adjusted reward.

CFD's are of course in the first instance designed for the gamblers that populate the financial markets, providing the big leveraged moves that get the adreneline flowing for generally small capital.

If your strategy revolves around directional plays, there is no excuse for leverage, prior to consistent returns with common stocks over at least two market cycles [Bull/Bear]

If your strategy is non-directional, then Options would be the preferred instrument, [as Convertible Arbitrage requires large capital to implement successfully for example] but, would require the theoretical knowledge to be in place prior to practical implementation.

jog on
d998

 

[Magdoran]

Hi Mag

I've had quite a few 'aha' moments thanks to your posts recently. Wow, was I thinking 'mechanically'...

I am reconsidering CFDs. As I mentioned above, the main advantages for me are smaller spreads and being able to close a position in the morning at open, without having to wait for MMs (it might be different using a full service broker, since I've seen it mentioned that they can contact MMs directly?). I've been stuck with options a few times when there has been no market and hence no way to offload a losing position.

My experience is limited to the ASX though... markets are more liquid in the US and I think I've seen Wayne mention that MMs have to provide a market at open.

Nevertheless I agree (or rather am enlightened, lol) that it obviously depends on the situation. With my style, it would probably be beneficial buying liquid options, and CFDs for stocks with no or thin options. Obviously the more knowledge I gain of options the more uh options I have and strategies I can utilise (and not just relying on directional movement).

Cheers

Hello Swingstar,


Glad to hear the comments were helpful!

What you’re saying I concur with…

As for which instrument to choose, this gets down to your trading style, including risk profile, and wether you can actually trade illiquid options with your approach or not. To do so though requires a lot of knowledge of the Greeks, particularly volatility, delta and theta.

If you’re trading way OTM positions, you have to accept that heavy losses will occur when you get it wrong, and be comfortable with this (hence considering small positions for single options series).

The alternative is to use CFDs in these situations if you prefer, and it is up to the individual to evaluate which approach to choose based on their style and risk profile. And as you say, you don’t always have to trade directional strategies.

Spreads for any instrument certainly are a factor to be considered as well as the nature of the market maker in any market, I fully agree here, and this is probably where the art comes into trading.

As for the US market, it trades very differently from the ASX, so do be aware of the differences by trading cautiously in new markets to get the hang of them…

Great to hear from you, and hope all is going well!


Regards


Magdoran

 

[Magdoran]

Great post Mag,

I just wanted to pick up on this point and emphasize it.

I have often made the point that options are an instrument primarily created for the transferance of risk. In the case above, that risk has been primarily tranferred to someone else Combined with a good general trading edge, the other smaller risks assumed by taking on an option position (theta, vega) become de-accentuated.

Superfluous comment I know, but I'm bored ####less on this holiday (in the US) monday.

Cheers

Hello Wayne,


So you’re on holidays huh? How is the US – are you back in California? (if so say “hi” to Arnie for me, won’t you – especially since you don’t have to be in your crypt! Hahaha!).

Fully agree with your comment!


Mag

 

[Magdoran]

Magdoran

There's a lot of good information in your post.
Thanks for going to so much trouble.
I agree that traders can come unstuck very quickly if they use leverage recklessly.
Thanks again.

Bunyip

Hello Bunyip,


You’re most welcome, I hope the information is of value.

What I have found is that the precision of T/A styles starts to become important when using options because of the time element involved. You have to take into account the expiry of an option to suit your timeframe, and if you’re swing trading, being able to project support/resistance in time and price starts to become really important – especially if trading OTM single options unhedged along the lines of your current approach.

Being able to read the bar chart and volume, combined with wave structure and understanding how the underlying trends (especially understanding counter trends) I think makes a significant difference when trading options since time is a critical factor in selection of strategy.

Hope this helps!


Warm Regards


Magdoran