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10 Biggest Mistakes Options Trading PDF
10 Biggest Mistakes Options Trading PDF
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
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
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.
3
4 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:
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:
equal between the $40 and $55 calls. That means, for this ex-
ample, the stock must move nearly 25% (from $50 to $62.40)
before leverage differences even start to show up on a percent-
age basis. It should be evident that out-of-the-money options
are high-risk assets and why the majority of investors lose
with them.
11
12 Mistake #2
value $0 value
$50
15
Only Buying Out-Of-The-Money Options 17
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
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 advan-
tage 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 be-
cause 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
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 bank-
rupt due to limited competition in the airlines (called an oligop-
oly) 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)
0 0 0 0 0 0 0 0 0
~
~ ~ ~
0
~
~
0 0
0 0 05
~
Sl ~ "'
(0 ~ ;::: ;:::
"'
date
31
32 Mistake #6
wants to sell their calls and nobody wants to buy; the new equi-
librium 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
One of the good things about options is that they are versa-
tile. 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
40 Mistake #7
IAmazon.com I
Ql
f~l I I
2: 1split
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6--J +=
3, 1split
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CX) CX) CX) CX) CX) CX)
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date
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 an-
nounced 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.
45
46 Mistake #8
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 previ-
ous 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
50 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.
Mathematical Models
The above illustrations should give you enough under-
standing 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.
52 Mistake #8
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 dis-
carding 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.
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 fore-
gone 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
58 Mistake #8
59
60 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 will-
ing 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 down-
side 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 con-
sidered 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."
Believing That Covered Calls Are A Conservative Strategy 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
64 Mistake #9
because that's the net loss on the rolldown. Credits can be de-
ceiving 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 differ-
ence 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. How-
ever, 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
66 Mistake #9
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 demon-
strate the points that have been made. We'll use the quotes
presented earlier:
68 Mistake #9
$20
.:!: $10
$0
~ 60 65 70 75
0 ·$10
ii
·$20
-$30
stock price
Believing That Covered Calls Are A Conservative Strategy 69
$20
$10
.,
~ $0
s 60 65 70 75
15 -$10
a.
-$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 "con-
servative" 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
70 Mistake #9
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
74 Mistake #10
$10
.:g $5
$0
s
'5 ·$5
a.
·$10
·$15
stock price
77