My name is Anders Bøgebeck. My mission is to help you become a better investor and trader. Why is this important? We are not only helping ourselves by becoming financially free. Along the way we help society by either allocating capital the right places or creating better products and services. That's why I want to help you achieve the life you desire!
In this post, I will talk about, how you can use options in your trading plan in the best way possible. First, we must understand what options are. A stock option or index option is the right but not the coercion to buy (call option) or sell (put option) shares of the underlying asset at a predetermined price called the strike price. I will not go into details on how these work, you can get that on Investopedia: https://www.investopedia.com/terms/o/option.asp. Rather, the post will be about, how you can avoid all the pitfalls and use options as they are intended to be used. This is the structure of the post:
1. The importance of market risk
When constructing your portfolio, you must first ask yourself whether the broader market is in an uptrend or a downtrend. If it's in an uptrend you want to have a portfolio of 6-10 great long bets, which are bought at a key support level. It is important to find good entries for your bets. Let's say you risk 1% of your account size on every bet you make. If the broader market moves in your favor significantly, you could be up on average by 1-2% on your positions. Your stop loss is still placed below the key support level. This means, that you have a significant downside risk in your portfolio compared to your entry prices. There is also good probability, that the broader market may experience a correction soon. In order not to loose everything you are up, a put option comes in handy. Let's say you allocate 1% of your account size on put option(s). Now two things can happen: Either the market continues in your direction and you loose 1% on the put option(s) or the market experiences a quick correction. In the first scenario, you could be up 4-5% on your portfolio and you would have been 1% more up, if you did not buy the put option. However, in the second scenario your portfolio could easily be down 4-5% in a day or two, if you did not buy the put option. The put option could easily be worth as much as you are down on your long bets, and net you loose nothing!
Furthermore, you must reduce what is called tail risk in your portfolio. That is right, crazy unexpected events in the stock market. At any time some ugly news could come out and turn weeks of good trades into garbage. However, by owning put options, unexpected downside risk tends to be very profitable and net you could be a little down or even up in your portfolio.
2. A gambler thinks about profits - a trader thinks about losses
As a trader you must always think: "what can go wrong?". In the long run, you will make more money by focusing on reducing your downside risk as opposed to increasing your upside risk. Ultimately, your goal should be 0% downside risk. That is why you use options to hedge your positions. A hedge is simply betting in the other direction to reduce exposure to market risk. Options are designed to expire worthless and there is a good reason behind that. It is an insurance contract for your portfolio. Think about your house insurance: you would not save some bucks on insurance, if it happened that your house was on fire! The trick is to buy options when they are cheap - just like stocks. A good entry to be long a put option is on a market up day. That is, when nobody else than you are interested in buying it.
3. Why a pure option bet typically is an uphill battle
So why not trade options only, they seem to be very profitable when they work? As a technical trader, you only care about the price pattern and entry and exit prices for your positions. Creative option strategies will not make you better off. Let's say you bought a call option instead of a long stock position. Firstly, if you were right, you would get horrible spreads, as options tend to be very illiquid bets. Secondly, you have to be right within a certain date. Thirdly, volatility is usually already priced into the option making it harder for you to profit.
4. Why you never sell options
It is a very dangerous practice to sell naked options and your broker knows that. That's why you must put up huge amounts of margin for opening a naked short option position. Indeed, it is like picking up pennies on a railroad track. A real insurance company is different than YOU playing insurance company in the stock market. They operate with percentage probabilities, which are much more likely to happen, than the greek term "delta" of an option. Delta is like a predictor of the proability that the option will expire in the money. Delta is very imprecise and changes constantly! You cannot count on that for a long term strategy. If you still are not convinced about the practice of selling options, check out picture 1 below. The price of that SPY put option went from $0.57 to $77.59 in a month. If you sold it for 1% of your account, you would have been wiped out completely!
An option is a great instrument to hedge against market and tail risks. Options should be used as an insurance contract. Just like stocks, they must be bought cheap. That is, you could buy a put option on a market up day. Your goal as a trader is to have 0% downside exposure. That strategy works best in the long run and helps you sleep at night! It's very hard to profit on an option bet alone, because time and big spreads are against you. Furthermore, it is very dangerous to sell options and that practice should be avoided altogether.
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