10-biggest-mistakes-options-trading.pdf

James DiGeorgia World Renowned Options Expert Gold and Energy Options Trader, LLC

James DiGeorgia

Gold and Energy Options Trader, LLC

CONTENTS

INTRODUCTION ... . ................................ 1

Mistake #1 Not Understanding That Option Purchases Require Direction And Speed To Be Profitable .... ........ 3 How To Correct For Mistake #1 ...... . ........ . ..... . . 8 Mistake #2 Not Buying Enough Time ........................... 11 How To Correct For Mistake #2 ...................... 13 Mistake #3 Only Buying Out-Of-The-Money Options ............... 15 How To Correct For Mistake #3 .. . . .. .. . . . .... .. . ... . 16 Mistake #4 Thinking That You Must Buy Options On Volatile Stocks To Make Money ... . ............... . . . 19 How To Correct For Mistake #4 ...................... 23 Mistake #5 Telling Others What You Are Trading .................. 25 How To Correct For Mistake #5 ...................... 28 Mistake #6 Losing Intrinsic Value At Expiration . ... ..... . . ........ 31 How To Correct For Mistake #6 . . .. .......... ... . . ... 37 Mistake#7 Not Sticking To Your Original Goals ................... 39 How To Correct For Mistake #7 . ...... ............... 42

vi

CONTENTS

Mistake #8 Exercising Call Options Early . .. ...... . .... .. . ....... 45

How To Correct For Mistake #8 . .... ..... ... . .. ... ... 56 Mistake #9 Believing That Covered Calls Are A Conservative Strategy ... . ................. ... ..... 59

How To Correct For Mistake #9 .......... . ........... 70 Mistake #10 Believing That Straddles Make Money In Any Market . ...... .. .... .. . . ..... ... .. ..... .. . 73

How To Correct For Mistake #10 .. . .... . ... .. . ....... 76 EPILOGUE ............................... . ........ 77

1.

Introduction

INTRODUCTION Chances are, the reason you decided to read this book is because you've had some bad experiences trading options. Perhaps you lost money on a call option even though the underlying stock rose. Maybe you expected to take a $300 loss, but ended up with a $3,000 one. How do these mysterious situations arise? It's usually due to a mistake-an error in judgment, understanding, or assumptions. While mistakes are often accepted as part of any learning process, mistakes in option trading can be devastating. While you can only lose the amount you pay for an option, the large leverage and time depreciating qualities of these assets can quickly lead to a catastrophic loss. This Book is a compilation of what we at Gold and Energy Options Trader are the 10 biggest mistakes most often made by option traders. We will identify the mistakes, explain why they happen, and most important, show you how to correct them. Options’ trading is a tough game - really tough. But it is impossible to steadily profit from options if mistakes are made. Hopefully this book will shed some new light into your option trading methods to keep you from encountering - or repeating - these costly errors. Even after reading this book, you will certainly encounter other strange and apparently inexplicable options situations. That's just the nature of options trading - it requires an ongoing educational process in order to understand them well; and the tuitions are not cheap. Oscar Wilde captured this so powerfully when he said, "Experience is one thing you can't get for nothing."

2.

Introduction

However, if you understand the trading mistakes presented in this book, you will expose the culprits that cause the majority of losses for most option traders. Learning to avoid these mistakes will save you money.

Mistake #1 Not Understanding That Option Purchases Require Direction And Speed To Be Profitable The sooner you fall behind, the more time you'll have to catch up. - Steven Wright

While the above quote is comical, it certainly does not apply to buying options. If you buy options, it is imperative to have two conditions occur: 1) A fast move 2) Movement in the right direction If your option trade falls behind, it is often too late to catch up. The time premium erodes, and the position ends up a loser. This is very different from stock trading where the investor only needs to get the direction correct. For example, say you buy a stock for $50 because you think its price will rise. If so, it doesn't really matter when it moves higher. Sure, sooner is better, but the point is that you will always have one point of profit for each point move in the stock regardless of when that move happens. Any gain above $50 is yours to keep. This is not true for options. What makes the options game so difficult is that you need to correctly determine the direction of the stock and how quickly it will get there. For instance, let's assume you want to try your hand at options with that same $50 stock and fmd the following one-month option quotes:

3

4

Mistake #1

Strike

cans

Puts

$40

$11.71

$1.55

$45

$8.38

$3.20

$50

$5.79

$5.59

$55

$3.88

$8.65

$60

$2.54

$12.29

You buy 10 one-month $55 call options for $3.88 and expect to make money if the stock moves higher. After all, you've heard that long calls are bullish assets, so if you guess the direction correctly on the underlying stock you will make money with calls. That is the mistake. The truth is, you need to guess the direction and the speed. Although it may sound like a minor technical complication, it actually makes all the difference in the world; that misunderstanding is the single most common reason so many traders lose with options. Continuing with this example, this $55 call will cost you 10 * 100 * 3.88 = $3,880 plus commissions. Let's assume the stock steadily moves higher and closes at $58 at expiration, which certainly sounds like good news - the stock has risen from $50 to $58 and you own calls. So what's the option worth? It will be worth the intrinsic amount - the difference between the stock price and the $55 strike price, which is $3. That means you paid $3.88 and sold for $3- a 22% loss on the option. How is it that the stock can move up 16% in one month - from $50 to $58 - and still leave you with a loss on a call option? That's because the stock didn't move fast enough. You guessed the direction correctly, but not the speed. If this same stock moved to $58 with significant time remaining on the option, say 10 days or so, there's a good chance that a profit

Not Understanding That Option Purchases Require Direction And Speed To Be Profitable

5

would be made. In other words, the stock price needed more speed and would have needed to rise to $58 sooner. The other alternative is that the stock must move above the breakeven point of $58.88, which is found by adding the original cost of the option to the strike price ($3.88 +$55). Any stock price above $58.88 at expiration would produce profits, although it would have to be somewhat higher than that when you include commissions. The point is that once you buy the option, one of two things must occur in order to make profits: First, you need the stock to move quickly prior to expiration even if it does not rise above the breakeven point. Second, the stock must rise above the breakeven point at expiration. Either outcome requires speed of movement in the underlying stock. Also notice that the percentage of money lost increases quickly below this breakeven point of $58.88. If the stock closes at $56 at expiration, the $55 call is worth $1, which leaves you with a $2.88 loss, or 74%, even though the stock is up 12% (from $50 to $56) from the date you bought the option! If the stock closes at $55, the option will be worth $0 for a 100% loss of principal even though the stock is trading 10% higher.

The following table summarizes these three scenarios: Stock price

$55 call at expiration

%Gain/Loss

$58 (+16%)

$3

-23%

$57 (+14%)

$2

-48%

$55 (+10%)

$0

-100%

Could another option pick have prevented this? Yes. Keep in mind that the stock must be above the strike price at expiration to have any value. If it doesn't, it's worth zero. Think of the options game as a race; the strike price is the finish

6

Mistake #1

line. If you move the finish line closer (lower the strike price for call options), it becomes easier for the stock to cross the strike price and finish with intrinsic value. Let's see what would happen under the same scenarios if the $40 call had been originally chosen instead of the $55 call. Looking at the quotes provided earlier, we can see this would cost $11.71 or $11,710 for 10 contracts. Here's how the $40 call option compares at expiration: Stock Price

%Gain/Loss

$55 call

%Gain/Loss

$40call

$58 (+16%)

$3

-11%

$18

+53%

$57 (+14%)

$2

-41%

$17

+45%

$55 (+10%)

$0

-100%

$15

+28%

It is easy to see that there is no comparison between the $40 call and the $55 call in the above three scenarios. The $55 call produces losses that quickly accelerate as the stock price falls. For instance, with the stock at $58, the $55 call nets an 11% loss, but if the stock closes one point lower at $57, that same call nets a 41% loss. Notice that the $40 call produces gains for all three stock prices and still exhibits impressive leverage. For instance, with the stock up 16% at $58, the $40 call nets a 53% gain. Regardless of where the stock closes, the $40 call can never do worse than the $55 call in terms of total profit (although this may not be the case on a percentage basis). Again, the reason for this is that the stock did not need to move as fast in order to gain intrinsic value. The $40 call option had intrinsic value the day it was purchased and therefore was not exposed to the speed component like the $55 call. We don't need to limit the stock price to just three closing prices to see the differences in performance. That was done

Not Understanding That Option Purchases Require Direction And Speed To Be Profitable

7

to make the charts simple and make the point that a call option can lose even though the underlying stock is up. We can look at a much wider range of stock prices and get similar results: % Dollar profit gain/loss on $40 call

Dollar profit on $55 call

Stock price

$40 call

% gain/loss

$55 call

30

0

-100%

0

-100%

-$3.88

-$11 .71

35

0

-100%

0

-100%

-$3.88

-$11.71

40

0

-100%

0

-100%

-$3.88

-$11 .71

45

5

-57%

0

-100%

$1.12

-$11 .71

50

10

-15%

0

-100%

$6 .12

-$11 .71

55

15

28%

0

-100%

$11 .12

-$11 .71

60

20

71%

5

29%

$16.12

-$6.71

65

25

113%

10

158%

$21.12

-$1 .71

70

30

156%

15

287%

$26.12

$3.29

75

35

199%

20

415%

$31.12

$8.29

80

40

242%

25

544%

$36.12

$13.29

Notice the difference in dollar profits for the two calls as well. In the column labeled "Dollar profit on $40 call" we are simply taking the total dollars gained or lost. For example, the $40 calls cost $3.88, so if the stock closes at $40 or below, the total dollars lost is $3.88. With the stock at $50, the $40 call is worth $10 and produces a gain of $6.12. Even though the percentage gains on the $40 call may be larger in many instances, the total dollars gained is always smaller. There is a lot to be said for owning in-the-money options. Even if you play options for the leverage, don't think there's no reason to buy in-the-money options. We've shown that the $40 call has sizeable leverage and, further, it would take a stock price above $62.43 before the percentage returns are

8

Mistake #1

equal between the $40 and $55 calls. That means, for this example, the stock must move nearly 25% (from $50 to $62.40) before leverage differences even start to show up on a percentage basis. It should be evident that out-of-the-money options are high-risk assets and why the majority of investors lose with them.

How To Correct For Mistake #1: Not Understanding That Option Purchases Require Direction And Speed To Be Profitable The main point you want to learn from this is that you can't just buy a call because you're bullish (or a put because you're bearish). That only works for stocks. With call options, you need to decide just how bullish you are. The next time you want to buy an option, figure out the breakeven point (option cost+ strike price for calls, and strike- option cost for puts) and see if that stock value fits in line with your expectations of the stock. For example, the $55 call in our previous example had a breakeven point of $58.88.1f you do not think the stock has a chance of breaking this point by expiration, you should probably look for another option. It should now be easy to see why this mistake persists with some options traders. If you consistently lose money on options by purchasing too high of a strike price, the last thing you'd want to do is buy a lower strike call for more money. That's exactly what you should be doing, and why it's so easy to routinely make this mistake. And that's why it is number one on our list.

If you're not comfortable putting more money into the option trade, try buying in-the-money options butfewer

Not Understanding That Option Purchases Require Direction And Speed To Be Profitable

9

contracts. Rather than buying 10 contracts of the above $55 call for $3,888, we can instead buy three contracts of the $40 strike for 3 * 100 * 11.71 = $3,513. We can find this easily by taking $3,888 and dividing by the cost of one $40 contract, which is $3,888/$1171 = 3.32 contracts. Because you cannot buy fractional contracts, you must decide if three or four contracts are right for you. No matter how hard it may be, break the thought that a call is a call. They all behave very differently. Remember the need for speed.

10

Mistake #1

Mistake #2 Not Buying Enough Time There is never enough time, unless you're serving it. - Malcolm Forbes

The second biggest mistake in options trading is not buying enough time. This habit stems from the fact that option traders typically don't want to put money at risk. Therefore, they buy options with little time remaining in order to reduce the cost and thereby almost guarantee a loss! Buying time is closely related to our first mistake. Investors who do not understand that options must have the correct direction and speed are easily tempted to buy short-term options. This is compounded by the fact that option traders are attracted to the high leverage provided by options. They reason, "Why pay extra for additional time when you can use that money to buy more contracts?" Again, you must remember that there are differences in the way each option behaves and that all calls are not created equally. They all have different sets of risks and rewards, and it is up to the trader to decide which is best for any given situation. This is not to say that it's never okay to buy short-term options, as there certainly are times when they're the best. However, if you are more often than not losing on your options, buying more time can be an immediate help. Buying time carries some strong benefits. First, obviously, you have more time for the underlying stock to move in the necessary direction. Just in case your prediction is wrong even if it's only a few days off- the added time on the option can bail you out of a losing situation. Remember, you can always close out your option early and receive some time value back, which is a luxury not often provided with short-term options. 11

12

Mistake #2

The following diagram shows the effects on the bell curve when buying longer-term options. Normally, over shorter periods of time, stock prices tend to stay right where they are. However, as time is added the curve flattens out, thus allowing for a wider range of stock prices. This means it is more likely for the stock to move to your anticipated level; this is why investors are willing to pay more for those options.

$45

$50

$55

A second benefit is that longer-term options become increasingly cheaper per unit of time than shorter-term options. For example, it is now January and Microsoft is trading around $68. The January $65 call with five days to expiration is trading for $3.80, and the July $65 call with 187 days to expiration is trading for $9.00. While the July call is more expensive in terms of total dollars, it is cheaper per unit of time. In other words, the January call costs $3.80/5 days= 76 cents per day, and the July costs $9.00/187 days= 4.8 cents per day. This will be true for any option - the more time remaining, the cheaper the option becomes per unit of time. In the real world of trading, it will usually take between three and four times the amount of time in order to double the option's price. A third benefit of buying time is that you increase the responsiveness (called the delta) of out-of-the-money options. If you must buy out-of-the-money options, longer maturities will make the option's price appreciate more than a short-term

Not Buying Enough Time

13

out-of-the-money option. We can look at some out-of-themoney calls on Microsoft to make the point. The January $70 call is $0.90 and the July $70 call is $6.60. These two calls have deltas of 0.36 and 0.53 respectively. This simply means that if Microsoft were to move up $1 over a short period of time, we would expect to see the January call gain 36 cents and the July call gain 53 cents in price. Now some of you are undoubtedly thinking that a 36-cent move on a 90-cent call is a much bigger percentage gain than a 53-cent jump on a call costing $6.60. Once again, percentage changes are not money! They are relative values. A 300% gain on a penny is not the same as a 3% gain on a million. With all else constant, the longer-term options will make more money on that onepoint move. The reason the short-term call has a higher percentage change is due to the fact that it is a riskier option the very same reason that it will likely end up being a loser.

How To Correct For Mistake #2: Not Buying Enough Time The only way you will ever convince yourself to buy more time is to understand the differences between short-term and long-term options. Short-term options behave like lottery tickets and either quickly become valuable or worthless. Longerterm options will almost always have some value to them even if the stock moves in the opposite direction. Please don't think this means that you can't lose a significant amount of principal on longer-term options, because you certainly can. They are, after all, still options. However, the longer expirations typically do not become worthless in the matter of an instant, as is often the case with short-term options. The habit of buying short-term options is hard for many traders to break. That's because once the losses start to mount,

14

Mistake #2

they figure, "Why put out more money on a longer-term option?" In fact, it is this thinking that often makes traders use shorter expirations as well as out-of-the-money options in order to reduce the cost. These are almost surefire ways to ensure a loss.

Mistake #3 Only Buying Out-Of-The-Money Options Most people would rather be certain they're miserable, than risk being happy. -Robert Anthony

The fact that many option traders lose money on options creates a pattern of behavior that only makes the losses more certain. After a few losses, most traders alter their picks in favor of short-term options (mistake #2) and out-of-the-money options (mistake #3) in order to reduce the cost of the option. In doing so, they think the worst that can happen is they lose a couple of bucks, so what's the harm? The harm is that they nearly guarantee a loss on a consistent basis. You can see the web of inaccuracies created by the first three mistakes and why they are so predominant in the business. Buying out-of-the-money options is another surefire way to stack the odds against you. As with buying short-term options, this does not mean that out-of-the-money options should never be used. It's just that they should probably not be used all the time, which is what many traders do. We can graphically show the importance of using in-themoney calls by using a simple chart. If the stock is $50 at expiration, any strike below that will have intrinsic value and any strike above it will be worth zero: value

$0 value

$50 15

Only Buying Out-Of-The-Money Options

17

you may pay more in terms of total dollars for in-the-money options, you will pay less in terms of time premium; and it is the time premium that exposes you to the necessity for speed. The less time premium you pay, the less quickly the option must move in order to tum a profit. For example, let's look at the option quotes presented at the beginning of this book: Strike

Calls

Puts

$40

$11_71

$1.55

$45

$8.38

$3_20

$50

$5.79

$5.59

$55

$3.88

$8.65

$60

$2.54

$12.29

In that example, the stock was trading for $50, the $50 call was $5.79, and the $40 call was $11.71. The $50 call is comprised entirely of time premium (time premium is what remains on an option's price after accounting for intrinsic value). On the other hand, the $40 call is $10 in-the-money and therefore accounts for $10 of its value, which means that $1.71 is time value. While the $40 call is more expensive overall, its time premium component is much lower. The $50 call must have the stock move to $55.79 (strike price+ time premium) in order to break even at expiration, and the $40 call only needs the stock to move to $51.71. Once again, we've shown that the out-of-the-money option needs a more aggressive move in the underlying stock before it becomes profitable. That is simply stacking the odds against you_

1B

Mistake #3

Once you understand the differences between in-the-money and out-of-the-money options, you will not be tempted to buy an OTM just because it's cheaper.

Mistake #4 Thinking That You Must Buy Options On Volatile Stocks To Make Money The more volatile the underlying stock, the higher the likelihood of a big payout. For example, a high-flyer tech stock and a quiet, mature retail company may both be trading for $50. In this case, traders would rather hold the $50 call on the tech stock since it is far more likely to be trading at a higher price at expiration compared to the retail company. With all else constant, the tech company would be the best pick. However, the mistake that investors often fail to realize is that the tech option will be trading for a much higher price, too. This is just a result of simple economics; the tech option has a higher expected payout, so more investors want to own it. The higher demand placed on the tech option relative to the retail option increases its price. We can use some real option quotes to demonstrate. Affymetrix (AFFX) is a biotech company currently trading for $35.32 with a beta of 2, which just means that AFFX is twice as volatile as the S&P 500 index. Walgreen (WAG) is a retail drug store trading for $35.55 with a beta of 0.67, which means that it is about two-thirds (0.67 = 2/3) as volatile as the S&P 500 index. Both stocks are trading for essentially the same price; however, AFFX is far more volatile.

If the February $35 calls for these two stocks were priced the same, there is no doubt that AFFX would be the one to pick. The reason is that if both options cost the same, the amount you have at risk in either option is the same. However, AFFX has a much better chance of being worth more money 19

20

Mistake #4

because it is far more volatile. Any time you can get an asset with a higher expected payoff for the same risk, that is the one to choose. But don't look for that to happen in the financial markets. They will follow that line of reasoning and price each asset according to its risk, which they have done by pricing the WAG February $35 call at $1.30 and the AFFX February $35 call at $3.20. Many option traders make the mistake of believing they must buy options only on volatile stocks because, obviously, they need the stock to move, and the more volatility the better. The mistake is forgetting that the market will take that advantage away by charging a higher price for that option. The higher price raises the breakeven point and makes it that much more difficult to get a profit. If you're not sure how or why that works, we can further demonstrate with two simple gambling games. Say you are given the following two choices for a quick gamble. One, you flip a coin and win $1 if it lands heads. The second, you flip a coin and win if it lands heads. If you win, you get to flip it a second time and win $1 if it lands heads and $2 if it lands tails. Both games cost $1 to play, and the cost of the game is the most you can lose. Which game do you play? Even if you don't have a statistical background, you should be able to reason that your chances are better with the second game because it allows for a potentially higher payoff, yet costs the same and carries the same risk.

In fact, we can show mathematically what the expected outcome of each game is if you were allowed to play them over and over for a very long time. For the first game, we know that half the time you'd win $1 and half the time you'd lose $1, which means on average you could expect to win $0 on each

Thinking That You Must Buy Options On Volatile Stocks To Make Money

21

flip. We can find that by multiplying the individual probabilities by the payoffs and adding them together: 1/2

* (+$1)

+ 1/2 * (-

$1)

= $0 For the second game, the same reasoning shows you could expect to win:

* (+$2) * (+$1) + 1/2 * ( -$1) = + $0.25 1/4 + 1/4

As expected, the second game is the better choice because it results in a positive long-term profit of 25 cents per flip, on average. If these gambles were "traded" on an exchange just like options, you can be sure that investors would compete to play the second game. In doing so, they would drive up the price. Where would they stop buying? Once the price of the bet rises to $1.50, the buying pressure will stop and the net expected outcome will be: 1/4 + 1/4

+ 112

* (+$2) * (+$1)

* ( -$1.50) = $0

This is exactly what happens with all financial assets including options. The assets with higher expected payoffs, with equal risk, are bid up until all are equal in the eyes of the market. As a side note, the markets unfortunately are not this clean and neat to calculate. Corporations get upgraded

22

Mistake #4

and downgraded, announce surprise dividends, beat earnings estimates, and occasionally get bought out. These and other types of surprise information make it difficult to say exactly what any corporation is worth; however, the principle is the same. Assets with equal risk and higher payouts are bid up, and similarly, assets with equal payouts but higher risks are bid down. The important point to understand is that you are not doing yourself any favors by simply purchasing options on high volatility stocks just because they have a higher expected payout - it's already factored into the price. In the above two gambling games, we saw that the second game had a higher payout but also showed it would cost $1.50 rather than $1.00 to play. The reason this is so important to understand is that many investors may be comfortable holding low volatility stocks like General Motors, Walgreen, or Kellogg but they think they must hold highly volatile options. If they do, they are setting themselves up for disappointing trades because they often cannot handle the volatility and end up with huge losses. So a corollary to mistake #4 is to stick with options on stocks you're comfortable holding. If you don't like highly volatile stocks, don't hold their options. And don't think you can't make money on General Motors, Walgreen, or Kellogg options either because you certainly can. Of course, you probably won't make as much as compared to a high-flyer tech stock, but you also won't pay as much - or lose as much - either.

Thinking That You Must Buy Options On Volatile Stocks To Make Money

23

How To Correct For Mistake #4: Thinking That You Must Buy Options On Volatile Stocks To Make Money The first step is to recognize that all options are priced fairly in an efficient market. An option on a volatile stock will carry a higher price than one that is less volatile (assuming all other factors the same). While you stand to make more money with the volatile stocks, you will pay more for their options, which also means you stand to lose more. Before you buy an option, make sure it is on a stock you wouldn't mind owning. This is not to say you can't "take a shot" once in a while and speculate; however, if you do, invest a corresponding amount. If you are more comfortable holding low volatility stocks, stick to your comfort level and buy options on those stocks. You are not necessarily doing yourself any favors by just sticking to the volatile stocks. It is too easy to forget that the luxury of volatility comes with a high price, which makes it equally unlikely to end up with intrinsic value as an option on a low volatility stock.

24

Mistake #4

Mistake #5 Telling Others What You Are Trading The more opinions you have, the less you see. - Wim Wenders

Whether you're new to trading or an experienced trader, it is always tempting to tell other people, especially your close friends, what you are trading. This can be especially tempting when the trade is moving in your favor. However, this is often a big mistake and does not benefit you in any way. Whenever you let others know what you are trading, you automatically open the door for their input and opinions. Many times they will persuade you to alter or exit your position just because it is not in line with their risk tolerances. For example, you may have $3,000 in a high-risk position that you are willing to lose. Your friend, however, may view that as a huge amount of money to have in such a position and may get very nervous if the underlying stock should move in the opposite direction. If this happens, he will do everything in his power to convince you to exit the trade. Notice how there was no discussion with your friend, in this example, as to why you chose the trade in the first place. Your friend just decided to give you an opinion, but it was due to differences in risk tolerances and not on other merits of the position. He didn't know that you were willing to accept a $3,000 loss. He didn't know that a possible payoff might have been $50,000 in a week. He didn't know that you had a hedged position to make money if this trade moved against you. He didn't know, but offered an opinion anyway - because the one thing he did know is that you had the position. If you don't let him know that, there is no way he can cloud your thinking with his opinions. 25

Telling Others What You Are Trading

27

I would have been thrilled to get the shares for $6 but was ecstatic that I got them for $5. I just had to e-mail my friends and inform them of my trade as well as urge them to buy, too. Later that afternoon, I started to get e-mail responses as well as phone calls. "Are you crazy?" they asked. "Don't you know that an airline with no revenue is as good as bankrupt? You should sell your shares now before they're cut in half again." Over and over I heard these words, and they started to cast doubt on my decision. I knew it was a speculative play, but I never really thought about losing the entire $10,000. After all, chances are the government wouldn't allow ValuJet to go bankrupt due to limited competition in the airlines (called an oligopoly) and is the very reason the government bailed out Chrysler around 1980. I really thought the shares would be back to $10 within the next couple of months, and I was more than willing to take the risk of maybe losing a few thousand dollars. But now doubts were there. Thoughts were in my head that didn't exist before. Are they really going bankrupt? Will I really lose the entire investment? By the end of the day, my friends had convinced me that I had made a bad choice and that I should get out. Despite the small rally in the stock near the close, I pressed the button and off went my shares to be sold for a meager $800 profit. The following chart tells the rest of the story. You can see the gap down opening on June 19 and the rally to over $12 per share in less than one month, which was exactly in line with what I thought would happen:

28

Mistake #5

ValuJet (VJET)

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"'

0 0

0

Sl

0

~

0

~ ~

0 0

0

~ ~

0

"'

(0

0

~

0

~ ;:::

0 0

05

;:::

date

I thought it would happen, initiated the trade, yet I wound up with next to nothing. Whose fault was it? It was mine. Had I not told anybody about the trade, I never would have received the outside opinions and comments that influenced me to go against the entire reason I entered the trade in the first place.

How To Correct For Mistake #5: Telling Others What You Are Trading There is nothing wrong with asking for opinions. However, make sure you ask all of your questions before you enter the trade. If you must ask for an opinion after a trade is made, there's no need to let the person know you have a position in that security. It is difficult, if not impossible, for others to objectively view your trades. That's because no two people have exactly the same tolerances for risk or the same regards for money. When you ask for their opinions, their answers are biased in favor of their viewpoint, not yours. If you ask, make sure you frame the question from an objective stance and break any connection between you and the stock or option. For example, it is better to ask, "What do you think will happen to ValuJet now that they're grounded?" rather than "I have 2,000 shares ofValuJet with an $800

Telling Others What You Are Trading

29

profit. What do you think I should do?" When asked objectively, people will answer the same way. They may say, "I think it's going to bounce" or "I think it's going bankrupt," but that's all they will say. Once you tie yourself to the trade, they feel like they must personalize the answer and tell you what you should do. After all, the reason you're asking them must be because you value their opinion and you are looking for their guidance - and they will give it to you. The next time you're tempted to tell your friends about a great trade you're in, think about what you will gain by telling them. You will quickly realize there is nothing to gain and much to lose. After all, if the trade does tum out as expected, you can always tell them after you close it out. And if it doesn't, you won't be embarrassed after the fact. Telling people about a winning existing trade is jumping the gun - after all, those are only unrealized profits. Investing requires patience. Be willing to wait.

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Mistake #5

Mistake #6 Losing Intrinsic Value At Expiration Price is what you pay. Value is what you get. - Warren Buffett

Options have two components to their price: intrinsic value and time value. For calls, intrinsic value is simply the difference between the stock price and the exercise price. Any value remaining is called time value. Assume, for example, a stock is $56 and the $50 call is trading for $8. The call has $6 intrinsic value ($56 stock price - $50 strike) so $2 must be the time value. That's because the $6 intrinsic value only accounted for $6 out of the $8 of the option's value. A call option will only have intrinsic value if the stock price is above the strike price. For put options, the idea is the same except that intrinsic value is found by subtracting the stock price from the strike price. With the stock at $56, the $60 put has $4 intrinsic value. If that put were trading for $5, then $1 would be time premium. Put options will only have intrinsic value if the stock price is below the strike price. It is the time premium of the option that decays with the passage of time. Using the call example above, if the stock was to close at $56 on expiration day, that same $50 call would only be worth $6 and not $8. That's because there is no time remaining on the option, so it must only be worth the intrinsic amount. Many new traders wonder why intrinsic value must exist. The reason is due to arbitrage - a trade that guarantees a profit with no cash outlay and no risk. Assume that, instead, the $50 call is trading for $5, which is $1 below intrinsic value. If so, arbitrageurs would simultaneously sell the stock and 31

32

Mistake #6

buy the call for a credit of $51: Sell stock = +$56 Buy $50 call = - $5 Net credit= $51 Once these two transactions are complete, they will instruct their broker to exercise the call and buy shares of stock for the strike price of $50. This $50 is taken away from their credit balance of $51, which leaves them with a guaranteed profit of $1 -exactly the amount of missing intrinsic value. If a put option is trading below intrinsic value, arbitrageurs will buy the stock, buy the put and then immediately exercise the put. Using the earlier $60 put example, assume it is trading for $3 and is missing $1 of intrinsic value. Arbitrageurs will do the following simultaneous transactions:

Buy stock = -$56 Buy $60 put= -$3 Net debit = -$59 The cost is $59 but the arbitrageur will then exercise the put and receive $60, thus providing for a guaranteed $1 return, which is the amount of missing intrinsic value. So in theory, all options should trade for at least intrinsic value. If they don't, arbitrage opportunities exist. However, if you are an avid options trader, you may have noticed that in-themoney calls and puts will often trade for less than the intrinsic amount on, or near, expiration day. This is especially true for deep-in-the-money options. For example, on February 16, 2001 (option expiration day), Juniper Networks (JNPR) was trading for $83.63. You would think the Feb $70 call would be trading for exactly intrinsic value, also called parity, and be quoted at $13.63.

Losing Intrinsic Value At Expiration

33

However, the $70 call was bidding $12.38, which is $1.25 below intrinsic value. Many investors accept this as normal functioning of the market and will sell their options to close below intrinsic value. For example, say you hold 10 of the above JNPR Feb $70 calls and want to sell them. You could sell at the bid and receive $12.38 * 10 * 100 = $12,380. There is a better way, but it's unknown to most option traders. That's why it makes our list of biggest mistakes. So how do you trade your in-the-money option that is trading below parity? The same way the arbitrageurs would:

Instead of selling your call at the bid, simply place an order to sell the stock, and then immediately exercise the call option. The stock at that time was $83.63 on the bid. You would simply place an order to sell 1,000 shares at $83.63. Now, it doesn't matter if you have the stock or not. Why? Once the sell order is executed, you simply submit exercise instructions to your broker and buy 1,000 shares at $70. This means you received $83.63 but paid $70 to deliver the shares. Your proceeds are $13.63 * 10 * 100 = $13,687 for a difference of $1,312 as compared to selling at the original bid! Your broker will charge you an extra commission to sell the stock, but it can be well worth it. There is one important note to make here. There are people, brokers included, who will tell you to "short" the stock, instead of using a regular sell order, and then exercise the call. However, shorting the stock subjects you to unnecessary risk and can be more costly. If you short the stock you must have an uptick, and that is never guaranteed. So it is possible you may never get the stock sold. Additionally, if you short the stock, you will be subjected to a 50% Reg T charge and may not earn

34

Mistake #6

interest on that amount while waiting for the three-businessday settlement of the exercise. The regulations always allow you to sell shares (without it being a "short sale") that are not held in your account. The reason is that many investors keep certificates in safe deposit boxes and deliver them within the three-day settlement period. This is perfectly acceptable. Now it's possible your firm does not allow shares to be sold that are not in the account. Sometimes the deep-discount brokers have restrictions like this because they spend too much time chasing down people to deliver the shares they promised to deliver and do not generate the commissions to make it worth their while. Further, it costs the firm money to file regulatory extensions in the event the shares are not delivered. However, even if your firm requires the shares to be in the account in order to be sold, let your broker know that your are immediately submitting exercise instructions to purchase the shares. There is no reason they shouldn't allow it since the Options Clearing Corporation (OCC) guarantees delivery of the shares at settlement. Once you sell the stock, immediately submit exercise instructions. It is very important to submit your exercise instructions on the same day, otherwise the sale of stock and purchase from the option exercise will not have matching settlement dates. While this is not a major problem (it won't cause you to lose the sale or anything), it's something your broker does not want to become a habit. I won't go into the details, but as long as you submit your exercise instructions on the same day you sell the stock, you will be fine. The procedures are similar for put options. Assume the JNPR Feb $100 puts are trading for $15.88 on the bid. If you sell 10 contracts, you'll receive $15,880. But with the stock

Losing Intrinsic Value At Expiration

35

trading at $83.75 on the ask, we see they are below intrinsic value and "should" be priced at $100- $83.75 = $16.25. If your put options are trading below intrinsic value,

simply buy the stock and then exercise your put. So you would pay $83.75 to buy the stock and receive $100 from the exercise of the put, leaving you with the intrinsic amount of $16.25 or $16,250- a difference of $370 when compared to the trader who just sold the puts at the bid price of $15.88. Again, the extra commission can be well worth it. For put options, it is not necessary to have the cash in your account to purchase the stock in order to regain intrinsic value. Even if your brokerage firm has a policy that the cash must be in the account for all stock purchases, let them know you are immediately exercising the put and those proceeds will cover the stock purchase within the three-business-day period. In fact, years ago, there used to be an order called "exercise

and cover," meaning that the broker would sell the stock and cover the sale by exercising the call (or buy the stock and exercise the put). With the increased liquidity in the options markets, this order has disappeared although there are certainly times it could still be used. Learning how to recoup intrinsic value with the methods described is a roundabout way to use the exercise and cover order. Why will options trade below intrinsic value? There are a number of reasons, but the primary reason is that the market makers are having a difficult time spreading off the risk with the current liquidity. For example, as discussed earlier, the Feb $70 calls are trading for $12.38 but "should be" trading for $13.63. This is strictly a result of having more sellers than buyers. Everybody

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Mistake #6

wants to sell their calls and nobody wants to buy; the new equilibrium price is $12.38, which is below the theoretical value. You may be wondering why nobody is buying the calls and selling the stock to restore the equilibrium? The answer is, they are. Market makers are buying at $12.38 and then selling the stock. However, there's just not enough volume or interest to bring it to equilibrium. In the meantime, the stock continues to fall, so by the time they short the stock, they may be in for a loss (even though market makers are immune to the "uptick" rule). With a bid at $12.38, they think that is worth the risk while awaiting executions. What about retail investors? Why don't they join in and buy the call and sell the stock? They can; however, they must purchase the call on the ask at $13.63 and sell the stock at the bid of $83.63, leaving zero room for error! If you sell stock at $83.63 and buy the $70 call, you will have a net credit of $13.63, which is exactly what it will cost you to buy the call. Now, you may consider competing with the market makers and try to notch up the bid price a bit. In other words, if you bid $12.63, you will now be the highest bidder and the quote will move to $12.63 on the bid and $13.63 on the ask. If you purchase the call for $12.63, you could certainly sell the stock and make money. But here's the catch: If you bid $12.63, the market makers will bid $12.75 giving them a call option for $0.12! How? Market makers would love to buy the call option below the "fair value" and hold an asset that will behave just like the underlying stock. But if the stock falls, the market maker will sell it back to you at $12.63 and be out 12 cents. In other words, they will use your buy order as a guaranteed stop order for them. If they buy it for $12.75 and it doesn't work out, they know they have a buyer at $12.63- you!

Losing Intrinsic Value At Expiration

37

This is called "leaning on the book" and is a common practice among market makers. Just because the market is offering you a price below the fair value doesn't mean you must accept it. Learn how to capture intrinsic value at expiration and you will conquer one of the biggest - and most costly - mistakes in options trading.

How To Correct For Mistake #6: Losing Intrinsic Value At Expiration First of all, many people dismiss this mistake as something that will never happen to them. They may think they would never hold onto an option that far in-the-money so it would never apply to them. However, we learned from mistake #1 that all options do not behave the same. There may be some times when you wish to hold an option that behaves similarly to the stock. This is especially true if you want to speculate on the direction of the underlying stock but not on the speed. If so, you will need to buy deep-in-the-money shortterm options, which will be relatively expensive because of the large amount of intrinsic value. So while you may never hold onto a relatively cheap option long enough to gain that much intrinsic value, if you want to learn to trade options well, there may be times when you need to buy options with that much intrinsic value. If you do not understand how to regain the full intrinsic value of your options, that lack of knowledge can be the difference between a winning and a losing position. Whenever you are selling an in-the-money option at or near expiration, make sure the bid price represents the full intrinsic value. Remember that intrinsic value represents the amount the option is in-the-money. For call options, that is found by taking the stock price minus the strike price. For puts,

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Mistake #6

it is found by taking the strike price minus the stock price. If the current bid is not at least equal to that intrinsic value, you then must figure out if capturing the shortage is profitable with the added commission. For example, a stock may be trading for $100 at expiration while your $80 call is trading for $19.85. We know the intrinsic amount is $20 and should be the minimum value on the bid. However, the extra commission charged for selling the stock will probably not be worth the 15-cent difference between the current bid and the intrinsic value. In many cases though, as in our actual earlier examples, you will see discrepancies that can save you hundreds or thousands of dollars even after the added commission. In the case of captu.ring intrinsic value with a call option, remember that it is not necessary to have the stock in your account! Again, the reason is that you're going to immediately exercise the call option and will be able to deliver those shares within the three-business-day settlement period. lbis delivery is guaranteed by the OCC. Even if your brokerage firm has a policy that does not allow stock sales without the stock being in the account, let your broker know you're going to immediately exercise the call option. For put options, it is not necessary to have the cash in the account. That's because the cash will become available upon exercise of the put. If you need to use either of the strategies to regain intrinsic value, it is imperative to understand that neither the stock nor the cash needs to be in the account. Explain this to your broker if their first instinct is to tell you it can't be done. Don't be alarmed if they do, as many brokers are unaware of this strategy. There is no reason in the world they should prevent you from doing it.

Mistake #7 Not Sticking To Your Original Goals This one step - choosing a goal and sticking to it - changes everything. - Scott Reed

One of the good things about options is that they are versatile. One of the bad things about options, ironically, is that they are versatile. It is the versatility that allows traders to customize risk profiles that cannot be accomplished by stock trading alone- that's good. It is also the versatility that will make you look at a hundred different ways to get out of a losing situation- that's bad. When we talk about not sticking to your goals as a mistake, we really mean altering your exit points when trades go against you. While there is a lot to be said for sticking to your goals on the profit side as well, it is the lack of discipline to the downside that causes the most trouble. That's because most people are risk-averse and despise losing money. Once losses begin, most people will try altering their strategies to salvage their initial investment - in many cases increasing the risk to do so. This behavior is actually well documented and was really brought to light in 1984 when two researchers, Daniel Khaneman and Amos Tversky, published a remarkable paper in The American Psychologist. In that study, the researchers gave subjects a choice between the following two hypothetical alternatives: A) Take a $500 gain for sure B) 50-50 chance of a $1,000 gain or $0 gain 39

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Mistake #7

Mathematically, either choice results in a $500 expected gain. In other words, if you were to take either choice hundreds of times over, they would both net a $500 gain on average. However, there is some risk involved with the second choice -half of the time you'll gain $1,000, and other half of the time you'll gain nothing. As expected, the overwhelming majority of subjects took the $500 gain for sure, which is probably not too surprising. But the real puzzle didn't start until the researchers posed a mirror image second set of alternatives: A) Take a $500 loss for sure B) 50-50 chance of $1,000 loss or $0 loss With reasoning similar to the first set of choices, the second set encompasses an average loss of $500 regardless of which you choose. It was expected that if subjects displayed a risk avoidance behavior as with the first set of questions, they should still avoid risk and accept a $500 loss for sure. Oddly enough, the researchers found that most subjects accepted the gamble to try and avoid the loss! This means that investors' aversion to loss overcomes their aversion to risk. In fact, Wall Street's adage "Cut your losses short and let your profits run" was created in reference to this effect. Most investors will hold on courageously to a stock that has plummeted and take a gamble of getting out at breakeven rather than take the sure loss. It is not our goal to debate the meaning of an acceptable loss. That is a matter of individual preference, and is up to you to decide. What is important is that once you define that threshold you stick to it. If you don't, you'll fall into one of the most upsetting of all psychological investment traps.

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Not Sticking To Your Original Goals

One of the worst examples of this occurred in 1998 while I was working as a broker. A client sold short 1,000 shares of Amazon.com at $80 (around $13 on a split-adjusted basis) back when the "dot-com" craze was starting. Between February and March, it had quickly risen from about $60 to $80 and the trader "knew" it was way overvalued and would surely fall. The stock continued toward $100 leaving the trader with sizeable losses. Rather than close out the position, the trader shorted another 1,000 shares in late April. It continued to move sideways for a while and the trader was confident that it was now out of steam and about to crash. But then the company split 2:1 in June, which started another rally. The trader was now short 4,000 shares of Amazon.com during its most impressive rally to date - to a high of over $360 - as shown in the following chart:

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Despite continued maintenance calls, the trader kept the position open trying to gamble his way out of the losing situation. The stock kept climbing, leaving a trail of amazement and disbelief in its wake, along with now devastating losses, yet he kept the position open. It became increasingly difficult for the trader to close it out. He thought, "Surely it must fall now, so why close it out?" Had the trader been able to keep the position open indefinitely, he would have regained his money back as Amazon.com

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Mistake #7

is trading for just over $10 as of this writing. The trader was right in thinking that the stock would fall, but he was just off in his timing - by about three years or so. Amazon.com announced a 3:1 split in November '98, which propelled another strong rally through January '99, which was the date it actually split. The trader was not able to meet any more maintenance calls and was forced to buy back all of the shares in a heartfelt defeat. When it was all over, more than half of a one million dollar account was nearly disintegrated by that one position. Why was it so devastating? Accounting for the splits, the trader was short around $13 per share and covered at around $80 or higher on 4,000 shares. But don't forget about the margin account that is required to short stocks; this adds another 2: 1 leverage! I'm sure the trader never intended to let the losses get that far out of control. It's a fair question to ask why he did. The answer lies in our basic human nature to not want to take losses and our willingness to gamble our way out. As you continue to trade options, do not forget about this mistake. It is very easy to make.

How To Correct For Mistake #7: Not Sticking To Your Original Goals Before you enter a trade, make sure you have a plan for all outcomes, especially the losses. It even helps to write it down so you don't subconsciously convince yourself it was something different. It is very easy to slip into that natural behavior of gambling your way out of a losing trade as we saw the trader do in our Amazon.com example. Don't think it can't happen to you. That's what everybody thinks and why the problem still

Not Sticking To Your Original Goals

43

prevails. Make use of stop orders or options as risk management tools to limit losses within your preferences.

If you are using "mental stops" (stops that are not physically placed but that you keep track of in your head), make sure you execute them if that point occurs. It is so easy to want to gamble your way out.

Will there be times when you should have held? Sure, but that doesn't fall under the same description as the mistake we've presented here. Rather, it is a problem with your timing of the market, tolerances for risk, or other aspects that have to do with staying in a position -not getting out of one. Limiting your risk may cause you to miss out on future moves in that position but will also keep you from losing your account. Stick to your goals and don't try to gamble your way out of a losing situation.

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Mistake #7

Mistake #8 Exercising Call Options Early One thing you can't recycle is wasted time. - Anonymous

You did your homework and bought a six-month $40 call when the stock was $45. The stock is now trading for $65 and the analysts are all predicting it will be $200 within the next couple of years. You really want to own this stock long term, so it certainly makes sense to exercise the call now so you can be assured of paying $40 per share. After all, you paid money to buy the $40 call, and you'd hate to lose the right to pay that amount, so you should go ahead and exercise it, right? While this may sound sensible, it is an absolute mistake and one that is made by nearly every investor who has ever exercised a call option. The reason it is not advantageous to exercise a call option early is because there is a built-in put option with it. If the stock should fall below $40, you simply walk away from your call option and let it expire worthless. However, if you owned the stock, you'd be at risk for all stock prices below $40. The hidden put comes from the fact that you cannot lose more than you paid for the call option while the stockowner can. If you buy call options, it will pay to keep the following in the back of your mind:

It is never optimal to exercise a call option early

except to capture a dividend. There are many ways to present why this is true. It is probably best described by a simple situation that happened to me while working on a trade support desk at a large brokerage finn. 45

46

Mistake #8

The trade support desk handles customer trade disputes. If a customer thinks they received a bad fill price, the wrong number of shares, the wrong stock, or any number of possible mistakes that happen on trading floors, the trade support desk reviews the phone call and makes a decision to side with either the customer or the firm. On this particular dispute, the customer claimed that the wrong symbol had been entered, and he was now the owner of a stock he had never heard of. We listened to the recorded phone call to hear the conversation with the broker and, sure enough, the customer was right -the broker transposed two letters, which coincidentally happened to be another stock's trading symbol. We called the customer later that day to inform him of the news. We said we would fix the trade and put the correct shares in the account at the original price (if it was more favorable). As for the unwanted stock, it was trading up about a half point or so from his purchase price of $75 so we gave him two choices: 1) He could keep the stock and sell it for a slight profit. If so, we would waive the commissions for the buy and the sell. 2) If he did not like that choice, we could remove the stock from the account as if the trade had never happened. The customer then thought he may want to keep it and asked, "What exactly does this company do? Do you mind if I research it for five days and get back to you?" It should be apparent that the answer is no. If you are not sure why, think about this. If the stock rises, the customer will call back and say he definitely wants to keep it. However, if it falls, he will call back to have the trade backed out. This puts him in a risk-free situation because he can potentially

Exercising Call Options Early

47

make a lot of money and has no money at stake. But let's add a little twist to the story. Assume we told the customer he could have five days to research the stock and get back to us. Let's say after one day of research he thinks this stock will be bigger than Microsoft and Intel combined and realizes he must have the shares. The big question now is: Should the customer call back the next day to buy the shares? Or should he wait until the end of the fifth day when his time limit is up? Hopefully you realize the answer- he should wait until the end of the fifth day. There are two reasons. First, the brokerage firm is holding the stock, so the firm is the party at risk. If the stock falls, the customer can always back out of the trade. If the stock continues higher, however, the customer is locked into the $75 price, so there is nothing to gain by purchasing the shares early. For instance, the shares could be purchased after the first day, and they could collapse sometime later. It is clearly better for the customer to let the brokerage firm assume the risk for as long as possible. The second reason the customer should wait concerns the time value of money. Because the customer is locked in to the purchase price, he pays the same amount whether he pays today or in five days. As with any payment, you should pay as late as possible to hold on to the money and earn interest. The answer is clear; the investor should wait as long as possible and call the brokerage firm on the fifth day to purchase the stock. The situation we just described is a call option - for no money. Think about your rights with a call option. You have the right, but not the obligation, to buy over a fixed period of time, and that is exactly what the customer was asking for.

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Mistake #8

However, he was not paying for the privilege, which is exactly why we said no. Assuming the customer was given five days to decide, his answer is still the same; he waits as long as possible before committing to the purchase. Any fee paid for this right should only emphasize the need to wait as long as possible. The answer to this example may seem blatantly obvious. But don't laugh; this was a real situation, and many advanced option traders make this same mistake every single day. The situation we just described above is a call option, and many mistaken traders elect to call the shares away early. Traders who exercise early make the mistake of not realizing exactly what is happening in a call option agreement. Often, this is how they view the situation. Say a trader purchases a $100 call option for $15. The stock is now $130 with more than a month left. The option is trading for $32. The trader often feels he does not want to "lose" the value of the call option. He thinks because he paid for the option, he had better go ahead and use it before the market gets the best of him, so he decides to exercise it and walk away the winner. This is wrong for the same reasons as it was for the customer at the trade support desk! Remember that the trader is locked in to the price of $100. The stock can be trading for $200 and may have split twice by expiration, and the stock price is still $100 to the owner of the call option. If he exercises early, however, the stock could completely collapse, so he would have been better off not exercising. Also, by not exercising early, the $100 stays in the money market longer to earn more interest. So what should you do if you feel your option is really high in value and you want to get out before it falls? Sell the call to close. In this example, the trader exercised early and

Exercising Call Options Early

49

received stock worth $130 but paid only $100 for a gain of $30. After subtracting the $15 cost of the call, his net gain is $15. But if he sold the call to close in the market, he would receive $3 2 for a net gain of $17 after subtracting out the $15 cost. In other words, if you exercise your call option, you will receive only the stock in exchange for the strike price; you receive only the intrinsic amount. If you sell the call to close, you will collect the intrinsic amount plus the time premium. You will always be better off selling the call to close if you do not want to continue holding the call option. The last thing you want to hold is the stock; that is the reason you buy the call option in the frrst place. Trading Example

One day a trader called to complain after he viewed his balances on the computer that morning. His net worth on the account was $120,000 and it had been $124,000 the day before; yet all of his stocks were trading at about the same price or a little higher. Mter searching through the transactions, he discovered that he exercised 10 calls the day before. The option was 20 points in-the-money, but the call was selling for $24 the previous day. When he exercised, the four points of time premium were lost, and that is what happened to his $4,000. If he had sold the contracts to close the previous day, his balance would have still been $124,000. If the investor had just said, "sell" instead of "exercise" he would have saved $4,000. Now you might think that had this trader not exercised his call, he would not be holding the stock, which offers certain benefits. If for some reason the investor wanted to own the stock, he still should have sold the calls to close and then

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Mistake #8

purchased the stock in the open market. This would put the shares in the account, just as the early exercise did, but he would also have an additional $4,000. No matter how you look at it, you are better off selling the call to close if there is time premium to be captured. Remember, when you exercise a call, you receive only the difference between the stock price and the exercise price; if you sell the call to close, you receive that same amount plus some time premium.

Covered Calls Cannot Get Around It

If you are still not sure why you should not exercise a call option early, think about this scenario. Say a trader has a covered call position; he has bought stock at $100 per share and has sold a one-year $100 call for $25. If he gets assigned, he will lose the stock but make a 33% profit (effectively buying the stock for $75 and selling it for $100 a year later.) An investor who enters this trade considers the 33% profit a good deal, based on the risk of the stock, for one year's time. What is the best thing that could happen to this trader? He should check his account the next day and see the stock called away. Now he has received 33% in a day instead of a year, which is a much better return (too big to print!). Well, if it is a better deal for the short call position to be called early, it must be an equally bad deal for the long call. This is because options are a zero-sum game, and one trader's gains are exactly the other trader's losses. If you like to write covered calls, do not expect to be assigned early. Because the long call has control, that investor will do what is best for him - he will wait until the very end

Exercising Call Options Early

51

of the year to exercise the call and receive the stock.

Mathematical Models The above illustrations should give you enough understanding to realize that it is never optimal to exercise a call option early on a non-dividend paying stock. However, there are many people who are still not convinced and prefer more concrete mathematical models. I don't generally like these proofs, although formal, because they rarely make sense except to the people who already know to not exercise early. But we'll present one here anyway in case you're not convinced. We definitely don't want you to make this mistake! Consider two portfolios: A and B. Portfolio A: Present value of exercise price in cash + call option Portfolio B: Stock At expiration, the cash in Portfolio A will grow to be worth E, the exercise price. Portfolio A will use this cash to secure the exercise price. If the stock is above the strike price and Portfolio A exercises the call, the investor will receive the value of the stock price minus the exercise price (S - E) plus E from the cash, which can be written: S - E + E = S. So if Portfolio A exercises at expiration, Portfolio A is worth the stock price -· exactly as Portfolio B, which contains only the stock. However, if the stock price falls below the exercise price, E, at expiration, then Portfolio A will lose the value of the call and be worth only E, the cash. Portfolio B will be worth less than Portfolio A because the stock price is below the exercise price. Therefore, Portfolio A is always worth at least as much as Portfolio B.

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Mistake #8

But if Portfolio A exercises early, the portfolio is worth S minus E (from the exercise) minus the present value of E, which must be less than S. Why? Recall that the present value of E must be less than E. If you start with S and subtract E and then add back a number smaller than E (because it is the present value), you must end up with a number smaller than S. This is the only time Portfolio B can dominate Portfolio A, so A should not exercise early. Whichever method works for you, just make sure you leave with the understanding that it is never optimal to exercise a call option early on a non-dividend-paying stock. This knowledge alone will save you money and headaches as an options trader, as it is one of the most widely violated rules of option trading.

Capturing a Dividend We have shown that it is never optimal to exercise a call early, but what about the exception? Why would an investor want to capture a dividend? The main reason is to reduce a loss in the option caused by the dividend being paid on the stock. If the dividend is large enough, you may find it beneficial to exercise the call early to be the owner of the actual stock and therefore receive the dividend. If this is the case, the investor should still wait as long as possible before exercising the call; it should be exercised the day before ex-dividend date. For example, say a stock is trading for $100 and will pay a $1 dollar dividend tomorrow. A trader is holding a $95 call trading for $5 that will expire in a relatively short time. The stock will be trading ex-dividend for $99 tomorrow morning, because the price of the stock is reduced to reflect the dividend payment from the company. What will happen to the call? It will trade for $4 because the stock is down $1,

Exercising Call Options Early

53

so the trader may elect to exercise the call early to reduce the loss. By exercising early, the trader will effectively pay $100 for the stock, because he is paying $95 with the call but discarding the $5 value in the option. The trader now has the $100 stock, which will be worth $99 tomorrow, but he will also gain the $1 dividend to bring the account back up to the $100 value. If he held the call option, he could effectively buy stock for $99 that is worth $99 but would be missing the $1 dividend. Exercising a call early to capture a dividend is therefore more of a loss-reducing strategy than a profit-seeking strategy. One Condition for Exercising Early

Before you exercise a call option early to gain a dividend, make sure the call has no time premium (trading at parity) or a very small amount remaining. If there is significant time premium on the call, you will be better off selling the call to close and then purchasing the stock in the open market. For example, say a $100 call is trading for $11 with the stock at $110. This option is $10 in-the-money and therefore has $1 time premium. If you exercise early, you lose the $11 from the call but gain a $110 stock - effectively paying $111 for it. This is the market "penalty" we talked about earlier. If the stock pays a $1 dividend tomorrow, your stock position will be worth $109, plus the $1 dividend will make your total position worth $110. Because you paid $111, you will lose $1. However, if you sold the call to close, you lose the $11 call but gain $11 cash. If you buy the stock in the open market, you lose $110 cash but receive $110 worth of stock. On a net basis, these transactions are a wash and your account value stays the same. On ex-date, your $110 stock is worth $109, but you also gained the $1 dividend, so your total account value is unchanged.

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Mistake #8

If you decide to exercise early to capture a dividend, there should not be a significant amount of time premium remaining on the option. What is significant? That really requires taking into account the total dollars lost, including commissions, by exercising early versus selling the option to close. For instance, 1/4-point time premium may seem insignificant. However, if you have 30 contracts, it will make a huge difference to sell the call to close and capture the remaining time premium. Likewise, 1/2-point time premium may sound rather significant. But if you have one contract, you may be better off exercising the call early rather than selling it to capture the relatively small amount remaining. The reason is that you will pay only one commission to exercise the call, which is usually the same commission you would be charged to purchase the stock. However, if you sell the call and then purchase the stock, you will be charged two separate commissions. The net effect of these transactions is what determines the time premium's significance.

Even though capturing a dividend is a valid reason for exercising a call early, it is still rarely done. This is because most dividends are relatively small, and most investors find the protective value of the call worth missing the dividend. Just because a stock is paying a dividend does not mean that it is necessarily a good idea to exercise early. You have to weigh the tradeoffs. Is the dividend sizeable? Do you mind holding the stock, even if only for a day, and accepting all of the downside risks? If you are not comfortable holding the stock in exchange for the dividend, you should probably give up the dividend. One Exception for Margin Traders

Here is a great tip you will not see in any books or hear from brokers. It is one exception to the rule about never exercising a call option early on a non-dividend paying stock.

Exercising Call Options Early

55

Say you trade on margin (borrowed funds) and are holding a very deep-in-the-money call, maybe a $30 call with the stock trading for $100. Assume there is some time left on the option; it could be a few days or even months. If you exercise early, you will meet the Fed call for the stock just by exercising! This is because the call is so deepin-the-money. Because you are receiving stock so highly valued relative to the strike, your margin cash available and buying power can explode to the upside. So if you are in a situation where you need to generate margin cash or buying power to take advantage of a certain stock or perhaps to meet a margin call, exercising a deep-in-the-money call option early may be your answer.

The reason you never see this in the textbooks is because, by itself, exercising early gains you nothing in the asset. It is only in other market mechanics of margin trading where you may benefit. Keep that in mind if you're ever lucky enough to have a call option go very deep-in-the-money and need to trade on margin. You should definitely check with your broker for specific details and calculations. Early Exercise with Puts

Early exercise with puts, unlike calls, may be advantageous to the long put holder. This is because put options represent a cash inflow to your account. If the put option is sufficiently deep-in-the-money (technically where delta is equal to one), the put should be exercised. As an example, assume you are holding stock and a $100 put option with three months remaining. The stock is trading at $40 and you see no hope of it coming back above $100 by expiration. If you wait until expiration, you will receive $100 for your stock. If you exercise now, you will receive $100 for your stock. Which do you

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Mistake #8

prefer? As with any cash inflow, it is preferred to have it paid earlier as opposed to later. So we exercise the put and take our $100 now. Although options trading can be used as a tool to buy or sell stock, most options contracts, somewhere in the neighborhood of 95%, are never exercised. This is because most option traders use them as a hedge. For example, say an investor has 100 shares of stock at $50 and also has a $50 put. The stock is trading at $40 on expiration day. Rather than using the put to sell the stock, the option trader will close out the put for a $10 gain and use that to offset the $10 loss in the long position. Because of this fact, most option traders are not very familiar with exercising options. Make sure you become very familiar with the mechanics of exercising, as well as when and why to do it. It has been emphasized that exercising a call option early is never optimal, with the possible exception of capturing a dividend, yet every day, option traders make this costly mistake.

How To Correct For Mistake #8: Exercising Call Options Early Always remember that a call option locks in your purchase price of the stock regardless of how high it may be trading or the number of times it may split. If you do not wish to hold the call option any longer, then sell the call to close. If you wish to exercise early to capture a dividend, check if you are better off buying the stock in the open market and then selling the call to close, making sure to count commissions. For example, say a stock is $60, and you have a $50 call trading for $11 (which is $1 of time premium) and $10,000 cash for a total account value of $11,100.

Exercising Call Options Early

57

If you exercise early, you will pay $5,000 cash and receive $6,000 worth of stock. You will get nothing for the option since you are not selling it- you lose the $1,100 value. Your account value is therefore $5,000 cash and $6,000 worth of stock or $11,000, which is a loss of $100. The $100 is lost because of the $1 time premium on the option that was foregone by exercising the call. Remember, you either get to sell the call or exercise it, but not both.

However, if you sell the call to close, you receive $1,100 and your cash is now $11,100. From that you spend $6,000 to buy the stock in the open market, which leaves $5,100 in cash. You then receive $6,000 worth of stock for a total account value of $11,100, which is unchanged when compared to the beginning balance. Exercising the option early means the time value of the option is lost. In short, if you exercise early, you lose -$5,000 cash and receive +$6,000 in stock and lose an option worth $1,100 for a net difference of -$5,000 + $6,000- $1,100 = -$100, which represents the lost point of time premium. If you sell the option and buy the stock in the open market you lose the $1,100 option but also gain $1,100 in cash from the sale of it. You lose $6,000 cash to buy the stock, but you also receive stock worth $6,000 for a net of -$1,100 + $1,100 - $6,000 + $6,000 = $0, which means that assets are merely switched ·around and no time premium is lost. One asset, the option, is converted to cash (including its time premium) and then some cash is converted to an equal amount of stock.

You will always be better off by the amount of the time premium in the option by not exercising early. In the real world, though, the amount of time premium may not be

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Mistake #8

enough to make a difference commissions.

especially when counting

You can find if it is beneficial fairly quickly by just comparing the commission to purchase the stock with the total dollar value of time premium. For instance, using the above example with $1 time premium, if you had five $50 contracts you have $1 time premium* 5 * 100 = $500 total time value in the option. As long as your commissions to buy the stock do not exceed this amount, you're better off by not exercising.

Mistake #9 Believing That Covered Calls Are A Conservative Strategy It is easier to believe a lie that one has heard a thousand times than to believe a fact that no one has heard before. -Anonymous

You've heard it a thousand times. "If you're new to options trading, start with covered calls because they're the safest." Nearly all seasoned investors - and established brokers, too - believe this. Consequently, it is one of the most popular options strategies. In fact, many brokerage firms only allow covered calls for IRAs (Individual Retirement Accounts) because of this firmly ingrained belief that they are safe. The fact is they are among the riskiest of strategies, depending on basic assumptions and which strike is sold. For many investors, the covered call is their first encounter with options. It is a popular strategy because it generates cash into the account and is relatively simple to understand. Unfortunately, there are many misconceptions about this strategy, which can lead to devastating losses.

What is a covered call? A covered call is a strategy where you buy stock and then sell a call against it. By selling the call, you are giving somebody else the right to buy your stock at a fixed price. The reason this strategy is called "covered" is because you are not at risk if the stock moves higher. This is different from the trader who sells calls "uncovered" or "naked," as that position will continually lose money - theoretically an unlimited 59

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Mistake #9

amount - as the stock moves higher. Because of this risk, naked call writing is among the most dangerous of all option strategies. But with covered writing, this upside risk is removed; you will always be able to deliver the shares no matter how high the stock is trading. The short call is "covered" by the long stock. For example, you may buy 200 shares of JDSU at $102 and you sell two one-month $115 strike calls currently trading for $4.50. Now, for the next month, you may have to sell your shares at a price of $115 regardless of how high the stock may be trading. If the stock is trading at $200 at option expiration, you will sell your shares for $115. Of course, for this right, the person buying the calls paid you $4.50 * 2 * 100 = $900. So, on the surface, it doesn't seem to be a bad deal. It's like getting paid to place a sell limit order at $115. However, there is significant risk to the downside. With our JDSU trade above, you paid $102 for the stock and received $4.50 for the option. The stock could fall $4.50 to $97.50 and you'd still be okay- that's our breakeven point. So that's another small benefit of covered calls; they provide a little downside hedge. In other words, they reduce the cost basis of our long stock position. But if the stock continues downward from there, we get further and further into a losing situation. In fact, the maximum we could lose, theoretically, is the $102 we paid for the stock less the $4.50 we got for the option a total of $97.50. In other words, we are at risk for everything below the breakeven point. Many professionals and even academic journals will tell you that the risk of a covered call position is that you may lose the stock! Nothing could be further from the truth. Risk, for most people, is not defined as missing out on some reward.

Believing That Covered Calls Are A Conservative Strategy

It is defined as loss of principle the position.

61

the amount you spend on

So please understand that the risk of a covered call is that the stock goes down, not up. Believing that your risk in a covered call position is that the stock moves higher is a mistake - and a big one at that. If a professional tells you the risk of a covered call is losing the stock through assignment of the short call, ask him why it's called a covered position? He will likely tell you, "That's because you're not at risk if the stock moves higher- you will always be able to deliver the shares." Think about it... on one hand the broker tells you the risk is that the stock moves higher and on the other they tell you you're not at risk if it moves higher. Which is correct? The answer - the correct answer - is that the risk lies in the downside. If you're not convinced that's the risk, think about this: Say you 're thinking of buying a stock trading at $100 and you ask your broker what the risk of the investment is. He claims, "Well, the risk is that you buy it for $100 and then sell it later at $120, only to watch it trade higher at a later date." If that were really the "risk," the optimal strategy would be to bet the farm and buy all the stock you can. Buying at $100 and selling at $120 certainly doesn't sound like a lot of risk, does it? The same applies to the covered call -you are the one holding the stock. The risk is that the stock goes down. Two Types of Covered Call Writers

This brings us to another critical point of covered call writing. There are two basic categories of call writers; those who use it as an income producing strategy against stock they like and those called "premium seekers."

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Mistake #9

If you write calls against stock you like, then the covered call strategy is arguably one of the most powerful strategies for most investors. After all, you are getting a little downside hedge and getting paid to sell the stock at a price you consider favorable. If it is a stock you like, then you obviously are willing to assume all of the downside risk. You would hold the stock whether options were available or not.

However, there are those who do not understand the downside risk side of covered calls. These are sometimes called the "premium seekers." These investors scan the option quotes, find one that pays a high premium relative to the stock price, and then enter into a covered call. Usually they follow up the trade with a comment to their broker, "By the way, what exactly does this company do?" Investors who trade covered calls this way should be considered speculators. They are not usually willing to assume the downside risk, yet are holding a valuable stock position. However, if you are new to options and don't understand this risk, it is very easy to start buying stock you normally wouldn't own just so you can gain access to the high premium on the calls. Trading Example I remember one investor who bought 7,000 shares of Egghead.com during the "dot-com" craze when it was trading at $55 per share (to make matters worse, it was on margin or borrowed funds). He thought he was going to laugh all the way to the bank when he discovered that a three-week $55 call option was bidding $8. "Wow, that's over 15-fold on your money," he exclaimed. "At that rate, it would take two and a half years to turn $1,000 into $1,000,000."

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63

The trader bought the shares and wrote the calls waiting patiently for his windfall to arrive. At option expiration, the stock was trading at $4. Yes, he did get to keep the entire $8 premium for the calls. I'll let you decide if it was worth it. There was a reason the markets were bidding up the options so high. They wanted someone else to hold the risky stock. The risk is that the stock falls.

A Word Of Caution

Many times you will hear people say that the risk of the stock going down in a covered call position should not be of great concern. They mistakenly believe that you can always write another call after the first call expires and eventually "write your way out of the stock." There is a big danger in believing this. Covered calls realistically only give you one chance over the short term to write the calls. This is not to say that you will never be able to write a second call against your stock. It's just that you may have to wait a long time to do it. For example, say a stock is trading at $100 and you write a $105 call for $5. At expiration, the stock is now $7 5. At this point, you decide to write another call. You'll be lucky if the $105 call is trading for $.05 which, after commissions, will net you zero. How about the $80 call? Yes, you will definitely get some money here and let's assume another $5.1f you write this call and the stock goes up to $80 or higher at expiration, you just locked yourself into a loss. How? Your cost basis is $90 ($100 originally paid for the stock less two calls written for $5 each), and you just gave someone the right to buy your stock for $80, which locks in a $10 loss. Sometimes you will hear people tell you to "roll down" or

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Mistake #9

"roll up" if the stock is moving significantly. However, there are drawbacks with those strategies as well, so let's take a look at each. Please just understand that covered calls do have a sizeable amount of risk and that you may not be able to realistically keep writing calls month after month. Rolldown

We just saw a situation where an investor bought stock for $100 and wrote the $105 call for $5 but would have been locked in to a loss if they wrote the $80 call at expiration. Many investors incorrectly think you can beat the market to the punch by rolling down your strike as the stock falls. A rolldown, for covered calls, is simply a strategy where the investor buys the short call to close and simultaneously sells a lower strike call to open. The new position is a covered call but at a lower strike; the investor has thus "rolled down" their strike price. For example, say the stock is now trading at $100. The above investor could buy the $105 call to close and simultaneously sell the $100 call to open. However, they will receive a credit less than the difference in strikes. So the investor has given someone the right to purchase his or her stock for $5 less than originally anticipated yet has received less than $5 to do so - a net loss. Let's say they roll down for a net credit of $3 and see what happens. Remember, the original trade was buying stock at $100 and selling the $105 call for $3, which gives a cost basis of $97. Once the rolldown is executed, we're assuming the investor receives an additional $3, which gives a new cost basis of $94 for a $6 gain if the stock is called at $100. Keep in mind the original trade had a profit of $8 if called at $105. The reason the investor has reduced his profit margin by $2 is

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65

because that's the net loss on the rolldown. Credits can be deceiving with options. A net loss develops because the investor gave somebody the right to purchase his stock for $5 less yet he only received $3 for it. If you roll down long enough, you will eventually lock in a loss. Be very careful when you're rolling down, and keep track of your effective cost basis. Rollup

The opposite of the rolldown is the rollup. To enter a rollup with covered calls, you buy the call to close and simultaneously sell a higher strike call to open. Let's assume our investor is, instead, faced with the stock trading up to $110 now. If he rolls up, he may, for example, buy the $105 call to close and simultaneously sell the $110 call to open. Again, we'll assume he pays less than the difference in strikes, which will always be true prior to expiration. If the investor rolls up to the $110 strike for a net debit of $3, he has paid $3 to gain $5. On the surface, this doesn't appear to be a bad deal. However, keep in mind that with the original position, the investor is more likely to receive $105 from the exercise of the $105 call. Now he is short the $110 call, which is the same price of the stock, which means there is inherently more risk with the rollup. This does not mean that investors should never roll up a covered call, but rather they should use it sparingly in situations where there is a high level of confidence that the stock's price will not fall too dramatically. Another way to view the additional risk is that, with each rollup, you are raising the cost basis of your long stock position. If you chase a fast rising stock with rollups long enough, you

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will eventually end up holding a long stock position with a relatively high cost basis on a stock that may come crashing down. Most people try to roll up to get themselves out of a "losing" situation. For example, the above investor wrote the $105 call. If the stock is suddenly trading for $120, most investors try to undo the "damage" by rolling up. However, you should always remember your reason for writing the call. If you purchase the stock for $100 and are willing to sell it at $105 for a $5 fee (the option premium), you should probably let the stock go. If you never intended to sell your stock, then you must question why you wrote the original call in the first place. Remember, a short call is an agreement to give someone else the right to purchase your stock. If that's not what you want to do, then writing calls is the wrong strategy. Getting Out of a Covered Call

Many times investors write calls and regret it later when they see the stock trading for a much higher price. If you have a renewed confidence in the stock, you may want to consider closing out the short call. Many investors, however, have trouble with this as they feel they are taking a huge loss. This is absolutely false. Let's take a look at an example and see why. Say an investor has $40,000 cash in the account with no other positions. If he buys 100 shares of stock for $100, he now has $10,000 worth of stock and $30,000 cash. Now assume he writes a $100 call for $3, which gives him $30,300 in cash for a total account value of $40.300. Now assume the stock is $130 at expiration which make the $100 call worth $30. If the investor buys the call to close in order to not lose the stock, he must pay $30. Because he received $3 initially, he thinks he has incurred a loss of $27.

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67

But investors often fail to realize that the stock position is now worth more, too. If he buys the call to close, he will pay $3,000 but now his stock is worth $13,000! That's because he is no longer obligated to sell the stock for $100 once he buys the $100 call to close. The stock is worth $13,000 and the cash is reduced to $27,300 for a total account value of $40.300 -exactly the same as before the closing of the call. If you exit a covered call position by buying the call to close, you're really swapping cash for an unrealized capital gain in the stock. In the above example, the investor lost $3,000 for sure in cash in exchange for an unrealized gain of $3,000 in the stock.

So if you have new information on the stock and decide you want to keep it, buying the call to close is not the worst thing that can happen. You really don't lose anything at the moment you buy back the call - but you may if the stock falls afterward. Buying covered calls to close doesn't really destroy account value; it just changes the values of the assets in the account. If you decide to get out of a covered call position by buying back the call, be sure you are comfortable holding the stock at the current valuations. Profit and Loss Diagram

We can look at profit and loss diagrams to further demonstrate the points that have been made. We'll use the quotes presented earlier:

Mistake #9

68

Strike

cans

Puts

$40

$11.71

$1.55

$45

$8.38

$3.20

$50

$5.79

$5.59

$55

$3.88

$8.65

$60

$2.54

$12.29

In the profit and loss diagram below, we are assuming an investor buys stock at $50 and writes a $60 call for $2.54. You can see the breakeven point has been reduced slightly to $47.46 because he paid $50 for the stock but received $2.54 for the call, giving him an effective cost basis of $47.46. Also, we see that for any stock price above $60 - the strike - the profit is capped at $12.54, which is the maximum gain. The investor makes $12.54 because of a $10 capital gain on the stock (buy at $50 and sell at $60) but also makes $2.54 from the sale of the call for a total profit of $10 + $2.54 = $12.54. Again, you must wonder why many professionals tell you the area in the profit and loss diagram above $60, in this example, is the risk zone. It should be evident from the chart that that area is the maximum profit area, which is exactly where you want to be. The profit and loss chart shows the risk of the covered call is to the downside. Profit and Loss Diagram Long stock for $50 + short $60 call for $2.54 $20

.:!:

~

0 ii

$10 $0

60

·$10 ·$20 -$30 stock price

65

70

75

Believing That Covered Calls Are A Conservative Strategy

69

In fact, we can look at a profit and loss diagram for a naked $60 put sold for $12.29. The trader receives a credit of $12.29, but must purchase the stock for any price below $60. The most this person could make is the $12.29 credit, but he will start to lose profits if the stock falls below $60. If the stock falls below the breakeven point of $60- $12.29 = $47.71, losses will start to accumulate and will increase all the way down to a stock price of $0. Profit and Loss Diagram Naked $60 put for $12.29 $20

.,

$10

~

$0

15

-$10

s

a.

60

65

70

75

-$20 -$30 stock price

Notice the shapes of the profit and loss diagrams of the two above charts look exactly the same. This is because a naked put is the same thing - from a profit and loss standpoint as a covered call. Positions that behave the same way as another from a profit and loss standpoint are called synthetic equivalents. It's rather ironic that a trader can synthetically create a "conservative" covered call position with a "high risk" naked call position. You may notice that the profits don't exactly match up in the two charts. For instance, the maximum profit for the covered call is $12.54, while it is $12.29 for the naked put. That's because the covered call must buy the stock to complete the trade. In doing so, the trader misses out on the interest he could have earned had he not bought the stock. The markets are simply compensating that investor for the lost interest. If we overlaid the two charts, you would not be able to distinguish

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Mistake #9

one from the other. Do not be fooled by someone who tells you that covered calls are always a conservative strategy. That is a mistaken belief. If you make decisions based upon that mistaken belief, you may learn the hard way that you are taking the same risk as a naked put seller. Covered calls are a very useful strategy if used properly, especially if you are selling calls against stock you would hold regardless. If you wouldn't hold the stock and choose to enter the covered call, treat the position as highly speculative and invest accordingly.

How To Correct For Mistake #9: Believing That Covered Calls Are A Conservative Strategy Before you enter into a covered call position, calculate the breakeven point and see if you are comfortable holding the stock at those levels -just in case you need to. To fmd the breakeven point, simply subtract the cost of the call option from the stock price. For instance, if the stock is $40 and you write a $2 call, your breakeven point is $40- $2 = $38. If the stock falls below this level, you will start to incur losses, and those losses will grow all the way down to a stock price of $0. In other words, you have effectively invested $38, and that is the most you can lose. Keep in mind this cost basis will continually fall every time you write a call against the same stock. If a $40 call is written for $1.50 the following month, the cost basis would be $40- $2- $1.50 = $36.50. Also understand how to calculate your maximum gain. This is simply the strike price minus the cost basis. In the above example, the most that can be made is $40 strike- $38 cost basis = $2. After the second month, it would be $40 - $36.50 = $3.50.

Believing That Covered Calls Are A Conservative Strategy

71

Next, ask yourself if those limits, the breakeven and max gain - are acceptable to you. If they are not, you need to reconsider whether or not that is the proper strategy for you at that time. Also ask yourself if you would be willing to give up the stock if it's trading above the strike price and appears that it will be called at expiration. If not, you will likely spend a lot of time and money trying to undo the position, which often leads to bigger losses.

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Mistake #9

Mistake #10 Believing That Straddles Make Money In Any Market It's not the bulls and bears you need to avoid it's the bum steers. - Chuck Hillis

It's not hard to find ads that tout an option strategy that makes money regardless of the direction of the market. If you see such an ad, the service is undoubtedly talking about straddles - a strategy where the trader buys a call and buys a put with the same strike prices. For instance, if you buy a $50 call and a $50 put, you are long a $50 straddle. While it is true that the straddle will produce intrinsic value regardless of the direction of the underlying stock, it is an entirely different story as to whether it will be profitable. For instance, assume the underlying stock is trading for $50. Using the earlier quotes, a trader could buy the $50 call for $5.79 and the $50 put for $5.59 for a total cost of $11.38. The good news is that one of the positions - either the call or put- will gain intrinsic value (assuming the stock doesn't close exactly at $50). The bad news is that the other one will lose time value. However, if the underlying stock moves far enough in one direction or the other, the total straddle will become profitable. Straddles have two breakeven points, which are found by adding and subtracting the total cost of the two positions to the strike price. In this example, the lower breakeven would be $50 strike - $11.38 = $38.62 and the upper breakeven would be $50 strike + $11.38 = $61.38. Looking at it another way, the straddle will result in some sort of loss for any stock price

73

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Mistake #10

between $38.62 and $61.38 at expiration, which is a very big range. From a profit and loss standpoint, the above straddle looks like this: Profit and Loss Diagram Long $50 straddle for $11 .38 $10

.:g

$5

a.

·$5

s '5

$0

·$10 ·$15 stock price

As we said earlier, either the call or put will produce intrinsic value iLthe stock makes any kind of a move. So while either is "making money" intrinsically, it is only offsetting the cost until the breakeven points are reached. This can be seen by looking at the profit and loss chart for the straddle. Notice the lowest point of the "V" shape is at the maximum loss of $11.38 and occurs exactly at the $50 strike. If the stock makes any move, up or down, from $50, the intrinsic value offsets the $11.38 cost and is the reason the profit and loss diagram starts to move upward from that low point on the "V" shape. But also notice that even though the revenues are increasing, the position does not make a profit until it breaks through the breakeven points. The mistaken belief with the straddle is that any stock move produces profits. It doesn't. It produces revenues, which may or may not be enough to produce profits. In fact, in most cases, straddles produce losses because

Believing That Straddles Make Money In Any Market

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stocks rarely make this kind of a move prior to expiration. This is not to say you should never trade straddles, as they can be great strategies under the right conditions. The point is that it is a mistake to believe they are profitable regardless of what happens to the underlying stock. As a corollary, this does not mean that short straddles are the optimal strategy since long straddles most often lose. All strategies carry their own unique sets of risks and rewards, and no single strategy is superior to another. If someone tells you about the "best" strategy, it is usually due to a bias toward a particular risk and reward profile, which may not be in line with yours. Short straddles may be excellent for some traders, but they come with a high degree of risk. While it is true, in most cases, that the short straddle seller will make money more often than not, when they lose, they can lose big. This can be demonstrated with a simple example. Say you are offered a gamble to draw from a deck of five cards four black and one red. You pay $1 and draw a card. If you draw a black card, you win $500. However, if you draw the red card, you lose $10,000. In this hypothetical game, chances are you will win; in fact, you would expect to win four out of five times or 80% of the time. But few would take the bet because of the looming danger of the large potential loss. In other words, while the odds are you will win, few people will play since the expected value is a loss of $1,600 per play (found by 0.80 * $500 + 0.20 * -$10,000). It is this asymmetrical payoff that would cause most people to avoid the gamble even though you should win 80% of the time. Keep this in mind, as this is the same idea behind naked straddles. You should win the majority of the time. But if the naked straddle goes against you, it can go hard. Be sure you're prepared to withstand the losses before entering into the trade.

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Mistake #10

How To Correct For Mistake #10: Believing That Straddles Make Money In Any Market Understand that straddles must make a significant move up or down before a profit is made. To find the breakeven points at expiration, simply add and subtract the total cost of the straddle to the strike price. For example, if you buy a $100 call and a $100 put for a total of $8, the stock must either move above $108 or below $92 at expiration before a profit is made. This does not mean that a profit cannot be made if the stock does not move above or below these points. Prior to expiration, it is certainly possible that changes in implied volatility and minor movements in the stock would push the straddle to profitable levels. However, it would require a fairly rapid move and should not be relied upon. Look for the stock to break through these points at expiration before entering the straddle. It is also important to understand, as we've mentioned, that no strategy is superior to another and no strategy can guarantee a win (if it does, you will win the risk-free rate of interest). If somebody touts a "high payoff" strategy with little or no risk- think twice. The market will always compensate you in relation to the risk you took. You will certainly come across people or ads that tout straddles as a way to make money regardless of whether it's a bull or bear market. Don't give any merit to their claim and definitely don't put in any money. It's a bum steer.

EPILOGUE The only real mistake is the one from which we learn nothing. - John Powell

The best experience often comes through making mistakes. When you're dealing with options, though, the money can dry up long before the necessary experience is gained to profitably trade options. This book is a compilation of the 10 biggest mistakes and misconceptions I have seen option traders make. These are the same mistakes that are made over and over, year after year, and they will continue to be made by each new group of option traders and investors that enters the market. These mistakes persist because they are easy to believe. They are so easy to make. If you trade options or are just thinking about it, make sure you understand the mistakes presented in this book and how to avoid them. There is nothing better or more profitable - than learning from others' mistakes.

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