Truly Understanding Options Trading

• stevenplace
• August 22nd, 2011

Volatility breeds opportunity.

But it’s never that simple.

As equity markets come back to retest the lows, there is a possibility of a bounce. It’s not a clear trade by any means, but if you’re leaning contrary to the market right now, this is where the options market really shines.

Provided you have the right mindset.

Some Context

Barry is out with a mention of an expectation that if we do get a 10% rally, it should be sold into. We also have a very high implied volatility environment.

So if you have limited upside expectations, but are leaning bullish stock and bearish volatility, you can structure your risk in the markets.

The simplest setup out there is the “covered call,” where you have a short call that is covered by stock. It has limited reward, unlimited risk, and can get you in a stock at a better basis.

Steven Sears says that this is definitely an idea to consider, along with risk-reversals.

And I tend to agree. In fact, I put out a few ideas with respect to put sales for longer term investors, albeit poorly timed. Cash-secured put sales have the exact same risk profile as covered calls, except for the fact that you don’t yet own the stock.

A “Simple” Setup

Let’s take an example from that post, where I looked at selling puts in $POT, specifically selling the Sep 50 put.

POT is currently trading at 50.65, so if you got assigned now you would be profitable.

But here’s where it trips up many new option traders.

Sure the stock can be above your stock price, but remember there are other components to an option price besides its relationship to the stock price. There’s also time risk, vol risk, and interest rate risk. So even if your option is profitable “at expiration,” it will still be at a loss on your books.

It’s All In Your Head

This is where we get into dangerous territory, because you know if you hold onto the option for another few weeks, it will be back in the black.

With that mindset, it brings about a magnified version of prospect theory and anchoring bias. Those are very, very bad things to have as an investor.

It gets worse with options because the option contract already has defined what number to focus on, even if there isn’t a true market structure around that area.

Why do people not succeed in the option market? It’s not just about educating them about how a call spread works. It’s also understanding how options differ from stock in investor psychology.

And that’s why it’s not so simple.

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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