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10 Options Tips Used By Wall Street Traders

What’s an Option?

If stocks can be compared to five-speed automobiles, stock options are F-16 fighter jets. In order to qualify for an options account, you have to state your level of experience, candidly reveal your level of liquidity, and pretty much accept that it’s your fault if you go bankrupt.

There is a reason for this. You will always lose money trading options without expert advice.  

I am going to teach you how to trade options and win. There are tons of financial websites out there which will tell you about options, but here, I just want to give you some hard and fast tips that we used on the trading floor at Lehman Brothers.

What Am I Really Buying?

When you buy an option, you are basically buying a seat at the table. You’re making a reservation for 100 shares of stock, and paying a little bit for the privilege. You can either trade on the short side, or the long side, calls and puts respectively. It’s that simple.

What Are My Chances Of Success?

When you delve into the options markets, you are up against an army of brilliant traders in offices in Manhattan earning about $1 million a year. Every time you look at the options board, remember who’s setting the prices. There are no safety nets with options, there are very few opportunities to ride them down and hope they come back. Even if you’re trading GE options, which is the most liquid stock on the board, it does not matter.

Options decay faster than a set of teeth bathing in a bottle of Coca-Cola. The underlying company is irrelevant for the actual trade, but a thorough understanding of the company is very important. However, blue-chip companies or not, options have zero relationship to the actual company, only a relationship to the nature of the equity’s performance in the market.

Don’t ever forget this.

What If I Get It Wrong?

I have a rule that has saved me millions trading on Wall Street, and it’s one you should always, without fail, live by. If you’re in a trade that goes against you, get out! Do not take any chances with options. Pay the commission, accept your mistake and get out.

Always live to fight another day. So many people are too proud to be wrong. They start buying more, or buying shares to hedge, or get into ETFs to counter-act their bad options trade. And suddenly a simple position becomes a convoluted hedge for an incorrect decision. Please do not fall into this trap. We all make mistakes, even the best in the business. But what separates us is our ability to get out the second it goes against us.

10 Expert Tips On Making Money With Options

1. Never chase a rally.

Try to buy calls on days when the stock is down and puts on days when the stock is up. Or simply, buy calls at a time of maximum fear in the stock, and puts at a time of maximum greed.

2. Be guided by technicals, not the media.

If you’re long an option, always exit your position on the news or, even better, just before an expected new event like an earnings report. The day after the earnings report, the price of the option will collapse and often times, even if the stock moves in your favor, you may not make money.

3. Buy or sell puts or calls in the middle of the day.

In the morning, option traders that make the markets for Fidelity, Schwabb or any brokerage firm, keep their spreads wider because they don’t want to get picked off. They want to feel the market come together. Near the close of the trading day you’re also at a disadvantage. If you need to exit a substantial options position, you’re better off not waiting until the close.

The options market maker knows there are people that need liquidity at the end of the day and their markets are not as efficient at those times. At the end of the day, option market makers are wary of getting beaten by savvy traders with inside knowledge.. That’s why they make smaller markets at the end of the day.

4. There’s less decay if you buy “in the money.”

Buy “in the money” puts instead of shorting the stock if the borrow is difficult on the stock. This will also limit the decay factor.

5. Limit orders limit profits.

If you believe in the trade, and it’s time sensitive, don’t mess around with limit orders. Trying to undercut the trader’s market, hoping to buy at a lower price, you’ll end up chasing it like a Bedouin riding toward a mirage. Also, options market makers love making chiselers pay more.

6. Check out the “Open Interest” on the option.

This is what I call the Roach Motel Factor. Beware of buying options where there is little open interest. The less open interest there is in an option contract the more power the market maker has in dictating the price. Generally, the less open interest, the wider the market and the more difficult to get out. It’s like paying a $500 dollar toll to go over the George Washington Bridge to get into Manhattan. Five hundred in, five hundred out is no fun.

7. Understand the volatility price level you are paying for an option.

Before the credit crisis, on the trading desk at Lehman we were buying puts on Washington Mutual (NYSE:WM). In the spring of 2007 WM was trading like a rock north of $40. The November $30 puts, a full six months out, were ridiculously cheap, something like 60 cents. Today the same trade would cost north of $2.50. The richness or cheapness of what your paying for an option is measured by the vol you are paying. The 40 cent puts we bought were trading at something like a 0.18 vol, today at $2.50 that would represent over 0.70 vol.

8. Know your deltas to the penny!

Every option acts a certain amount like the underlying stock. An option “in the money” will trade with a high delta and an option way “out of the money,” like our Washington Mutual example above, will trade with a low delta.

Let’s say you own 100 of those November 2007 $30 strike puts on Washington Mutual (WM). That means below $30 you are short 10,000 shares of WM. But say it’s May 2007 and the stock is $42. You’re not short 10,000 shares. Most likely the delta on this $30 strike option with the stock at $42 would be 0.15-ish. So 10,000 x 0.15 = 1,500 shares. With the stock at $42, your 100 put contracts will act like a short stock position of 1500 shares. In this example, the lower the stock moves, the higher the delta.

9. Check the borrow on a stock before you buy the option.

If there is no borrow, the option market maker will have a very difficult time hedging his book. Therefore he will keep his spreads very wide. On the trading floor, we used to call this the untradeable market. As a market maker, he’s obligated by the options board to make the market, but if the borrow becomes very difficult, the options market maker will make it senseless to buy or sell the options.

Borrow on a stock can go away and become a hard borrow if a lot of hedge funds and investors have a negative view on the company, and the many outstanding shares are already borrowed.

10. If possible check out the CDS on the underlying company’s debt.

Some of the sharpest knives in the drawer are big players in the credit markets. If the company has a lot of debt this is a must. Often times the CDS spreads will give you an indication as to what direction the company may be heading. In many ways CDS and options are similar. You don’t have to become an expert in CDS to trade options, but it’s nice to know if the CDS is 600 wider in the past three days. That may indicate a good time to buy that put.

The advice in this article is for day trading options. I have not covered hedges or long range out-of-the money trades.