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Options can be risky, even very risky, but they don't have to be. Today I'm starting a series of articles about options trading. I will show you how options can be less risky or more risky, depending on your risk tolerance. I will show you that there is more than one way to make money with options. I will expose some of the myths and misconceptions about options trading.

So let's begin our journey.

Myth: the only profitable way to trade options is buying calls or puts.

In a recent Seeking Alpha article, my fellow contributor Allan Harris wrote:

Spreads, credit spreads, butterflies, reverse butterflies, writing calls, protective calls, writing puts, protective puts, bums, thumbs, thumbs up your...well, you get what I mean. All of these are designed to be risk averse, limit losses, limit gains, generate high win rates and tiny profits. Give me a break, that's not why I buy options.

Well, Mr. Harris, I have a quiz for you.

Let's pretend we are now before Apple's (AAPL) earnings. Apple is trading around $427. Let's assume that you think Apple will reach a price of $450 after earnings. Assuming you are right, what would be the best way to play it?

  1. Buy the 430 weekly calls.

  2. Buy the 440 weekly calls.

  3. Buy the 450 weekly calls.

  4. Buy the 445/450 weekly call debit spread (buy 445 call/sell 450 call).

As I showed here, the correct answer is "Buy the 445/450 spread." That trade would produce a whopping 316% gain, compared to 80-100% gains in the first two trades and 100% loss in the third trade.

Myth: you should aim for at least 100% gain in each option trade, otherwise it is not worth the risk.

Mr. Harris continues his theory:

Sure, you can make 25%, maybe even 50% if you were lucky, but why waste your time and money? If I can't make 100% or better on an option opportunity, I'm passing.

Some questions to Mr. Harris:

  1. In order to make the 100%, how much do you risk?
  2. How much of your capital do you allocate for those positions?

  3. How much time do you give the trade to develop?

The first two questions are directly related to position sizing.

Consider the 2% rule described in Dr. Alexander Elder's excellent book "Come Into My Trading Room". The 2% rule is to protect traders from any single terrible loss that can damage their accounts. With this rule traders risk only 2% of their capital on any single trades. This is for limiting loss to a small fraction of accounts.

If you adapt the 2% rule and the risk in your trade is 50%, then you can allocate 4% of your account for that trade. If your risk is only 20%, then you can allocate 10% to that trade.

So here is another quiz:

Which one is better - one 100% winner which risked 50% and took one week to achieve or seven 10% winners which risked 20% and took one day each?

If you followed the 2% rule and allocated 4% of your account to the first trade, it contributed 4% to your account. But you could allocate 10% to each of the seven 10% winners, so they contributed a full 7% to your account during the same week.

Myth: you can have many failed trades but few big winners will cover those failed trades.

Here is another Mr. Harris quote:

On any one option trade the maximum gain is theoretically unlimited. A handful of 100%, 200%, 300%, 400% and 500% (and up) gains covers a lot of failed option trades.

Well, it might be right, and it might work for some traders. But do you know in advance what will be your winning ratio? You might have five 50% losers before you have that big 500% winner. If you allocated 10% to each trade, your account just had a 50% haircut before you had a chance to enjoy that 500% winner. And if someone tells you that he never had five straight losers, he is either not enough time in this business or not telling the truth.

Yes, the maximum gain is theoretically unlimited. But to achieve those occasional 500% gains, you might need a lot of time and especially luck, and it might not happen for months or even years, which brings us to the next myth.

Myth: you need a lot of luck to be successful in options trading.

Here is another one of Mr. Harris's gems:

I thought that sometime between July and December there was a high likelihood of the market falling 10% which would have resulted in a least a 100% gain in VXX and a 400-500% gain in the VXX calls. I got lucky, the market dropped 15% in about two months. You read the results above, 550%.

When I trade options, I treat is like a business plan. Luck is not part of that plan. You thought that the market is going to fall 10%? What if you were wrong? How much would that trade lose? In another words, we are back to the previous question: How much did you risk to achieve that 550% gain? How often does it happen? Do you rely on luck to get those gains or do you have a plan?

My trading strategy is based on consistent and steady 10-15% gains with holding period of 2-5 days. Check out, for example, how this strategy made 20% in two trading days on Amazon (AMZN) while the stock was unchanged. Other examples include 14% gains in Google (GOOG) trade and Baidu (BIDU) trade. Cisco (CSCO) Iron Condor trade made 22% in three weeks. Those are not Home Runs, but most of those trades had very low risk, hence you could allocate 10-15% of your account to each trade. Make ten such trades each month with average return of 10% per trade, and your account is up 10% per month.

Here are some conclusions:

  1. There is more than one way to trade options.

  2. Position sizing is one of the most important elements of trading, especially options trading.

  3. Few small winners achieved with low risk might be better that one big winner achieved with higher risk.

What is really important is not an occasional 500% winner, but an overall trading plan. What really matters is the return on the overall account. Next time someone tells you how he made 500% in an options trade, please ask him the following questions:

  1. How many trades you make every month on average?

  2. How much do you allocate per trade?

  3. How much do you risk per trade?

  4. How many trades do you have open on any given time?

  5. What is the average duration of the trades?

  6. What is your winning ratio and average return per trade?

  7. What is an average monthly return on the whole account using your strategy?

If you learn to ask the right questions, you can avoid the hype and properly evaluate an options strategy in context of the overall portfolio return.

Source: Myths And Misconceptions Of Options Trading