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Answers to Some of Your Options Questions ...

By Chris Rowe November 9, 2006 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

I read through your comments that we allow you to enter at the bottom of each Tycoon Report (by clicking on the link allowing you to rate the article.) 

I’m telling you, I really get a kick out of reading what you all write.  Most of it is motivating, some is funny, some is obscene (which is usually funny to me.)  Last week (Thursday) I wrote an article  titled "Sometimes Greed is Good - But Not With Options."

I talked about how easy it is to get greedy with making money on options, and how I was once in an “abusive” relationship with the out-of-the money, short-term call option.   

I got some great feedback and questions relating to last week's article, and although I can’t answer most of them, I will answer a few that seem to be popular. 

(By the way, sometimes people choose to leave their name, and sometimes they choose not to.  I decided that I will only post the first name.) 

Let’s start with this one: 

A good word of caution that I needed to hear. What about selling the options since most expire worthless? 

ANSWER:  

Actually, while many people believe that 90% of options expire worthless, this is a  myth.  According to the Chicago Board Options Exchange: 

  • About 30% of options expire worthless in each monthly cycle.
  • Only about 10% of options are exercised during each monthly cycle, usually in the final week before expiration.  
  • Over 60% of all options are traded out in the marketplace. This means that
     buyers sell their options in the market, and writers buy their positions back to close. 

But in answer to your question, here’s what I think about selling options: 

When buying an option, the one thing that can work in your favor, is that the underlying stock moves in the direction that you predicted it would move in. 

But there is always something working against you at the same time, and that is that time is always tick-tick-ticking away, causing your option to lose some of its value. 

You can compare buying an option that ends up profitable to being a great swimmer and swimming against the current, or upstream.  Sure, you might be able to do it, but the force of the water (or time) is always working against you. 

Selling options is a great strategy, because you have time working in your favor.  As time passes, options lose part of their value.  This is a positive since you have first sold something which then goes down in value (which in this case is a profitable trade.) 

Selling (shorting) an option contract is like swimming with the current, or downstream.  You will move with the water, and if you swim with it (or if the stock also happens to move in the right direction,) then you (or your option contract) will move in the right direction twice as easily.  You don’t even have to make any effort whatsoever, and the water can actually carry you to where you want to be.  Just like if you sell an option, and the stock trades flat (you would still make money as the option lost some value due to time decay.) 

If you are the seller of an option, I believe (and most would agree with me) that you should be covered with either the underlying stock, or another option as a hedge. 

Here’s a funny one: 

Why can’t you make a short summary at the beginning or end? Such a paper would never be accepted in a scientific journal. ~ BC. 

ANSWER: 

Yes, thank you.  And I will be sure to remember that for the next time that I submit my article to a scientific journal!  To tell you the truth, I’m a good trader.  But I feel lucky when I write three paragraphs without one spelling or grammar error! 

Here’s a very good question, but I need your help with this one:  

Do you have any suggestions on good sources for learning better trade discipline?

ANSWER: 

If any of you readers have suggestions of any good places that help teach discipline, please leave a message by clicking below on “rate this article here.” 

I personally learned my discipline through trial and error over several years.  I do write in The Tycoon Report from time to time about ways to keep your cool.  But although many of the books that I have read over the years talk about discipline, it is hard to obtain from reading a book. 

I suggest starting by learning about technical analysis which takes much of the emotion out of trading and investing.  I also suggest checking back next week in this section to see what our readers recommend.  And you can also read this article that I wrote on August 3, 2006 titled “How not to jump the gun on the trade”  for some of my suggested exercises for learning discipline. 

QUESTION: 

Hello Chris,  

I read your articles with a great deal of interest - I usually learn something from them. I am a beginner in options trading so I'd like to venture a question if I may.  

In August I bought my first option - a put option expiring in January 2007. After some research, I'd identified a company which seemed to have all the makings of another Enron - a complex business which no-one understood, it is under investigation by the SEC and it was due to restate its earnings for the past 5 years.

I bought an ITM put at a $30 premium - however the stock rose since then, and the put price has fallen to $10.  In retrospect I should have known better since the stock was heavily shorted and this rise in price could be due to short covering. 

 My question is - do you have suggestions on how to repair this trade? Since the option expires in January, should I wait until October end (3 months before expiry) to exit this position? I realize this is a very specific question but I expect one you would be able to answer easily, given your expertise and experience.  

Regards, Tanaji  

ANSWER: 

Yes, this is a very specific question.  I will have to speak very generally in this answer however, because there are so many possible variables that it would be impossible for me to give an accurate answer to this specific question. 

But generally speaking, I wouldn’t say that you could exactly “repair” most trades which go in the wrong direction by too far.  But one strategy that I have used on many occasions to reduce my exposure to a loss, is to sell covered short-term options against my long option position to collect a premium, and reduce my cost basis. 

For instance: Let’s say that General Motors (GM-NYSE) stock is at $31.00 and I open an options trade by purchasing a put option expiring in March, which allows me to sell GM stock at $35.00 (4 points higher than were GM is actually trading.)   The put costs me $5.60. 

GM Stock 

March35 put 

GM Trades    UP 

GM Stock 

March35 put 

$31.00 

$5.60 

 

$33.50

$4.50 

My goal would be for GM to trade lower so that my put would trade higher.  But instead, GM trades up from $31.00 to $32.50 causing my put that I just purchased to trade from $5.60 to $4.50. 

Well one strategy that I could use would be to open an additional trade by selling a short-term put with a lower strike price.  That means that while I still own my March 35 put, I will be selling someone the right to sell me their GM stock at a strike price that is lower than $35.00.  In other words, I’m committing to someone that I will buy GM from them at a particular price (30)upon their request in exchange for $1.00 (or $100.00/option contract.) 

Now, so far I have committed $5.60 to the trade by purchasing the March 35 put. 

GM has traded to $32.50. 

If I were to sell out of my March 35 put at this point, I would only get $4.50. 

I could now open the additional trade to sell the November 30 put for $1.00.  (I get to keep that dollar no matter what happens.)  I would sell the same number of (November) put options that I have purchased (for March.)  I will have then sold someone the right to sell me GM at $30.00 upon request until expiration day in November. 

By doing this I have essentially reduced my cost on GM March 35 puts from $5.60 to $4.60 (by collecting that $1.00 premium.)   

Now if GM trades flat, or even trades lower, but not lower than $30.00 before the third Friday in November (options expiration day,) then the put which I have sold (Nov. 30 put) will expire worthless since it is out-of-the-money.   

Once the put that I sold expires, I could repeat the process with the next month out (December) and continue to collect premium after premium. 

HERE’S THE OTHER POSSIBILITY: 

What if GM trades below $30.00 before November options expiration, and I am now required to buy GM at $30.00? 

The answer is that this would be okay with me.  Why? Pay close attention here – this is Key. Because, if you recall, I still own that GM March 35 put which gives me the right to sell GM at $35.00. 

So if I am required to buy GM at $30.00 because someone is exercising the November 30 put which I sold for $1.00, I would have my broker buy that person’s GM stock at $30.00 and then simultaneously sell the GM stock at $35.00, by using the March 35 put option that I own, which gives me the right to do so. 

My net sale price is $5.00, or the spread, or difference between my $30.00 purchase price, and the $35.00 sale price.  Do you remember what my purchase price is?   

Well it started out being $5.60, but we reduced it to $4.60 when we sold the put for $1.00.  So although I paid $5.60, and essentially sold for $5.00, I am still profitable by 40 cents because I sold that put option for $1.00. 

The two important things to remember here are these: 

  1. If you want to unwind that position or if you want to sell your GM March 35 put (which is your “long put,”) then you must FIRST buy back your “short put” which in this case is the November 30 put.  You don’t want to be short an option unless you are covered with stock, or another option. 
  2. You should understand, and be prepared to accept the consequences if your options are exercised.  Here the consequence was a net sale price of $5.00.  Calculate that first.  Then make the decision. 

I Hope that this helps. 

LAST QUESTION: 

Hey, Chris, the first part was hysterical.  Good job. But, ironically, now I am thinking about how to use more straddles etc.  Is there a "hedging your options/positions made easy" article anywhere? 

ANSWER: 

The short answer is yes.  There are lessons and articles all over the internet on hedging your positions.  But if you are asking about that because you know that I wrote a free report titled “Options,” and you want to know if I am doing more, the answer is yes, in the future you will have more reports from me on this subject.  But since I am running The Trend Rider service, it is hard to tackle everything at once. 

I will be writing a lot more about different options strategies in The Tycoon Report on Thursdays, and I am considering asking an old friend who is an options expert to be a guest contributor.  This would help, too, to further our goals here at The Tycoon Report which is to empower the individual investor.   

Well, everyone, I hope that I have helped you somehow today, and if you know someone who may benefit from this, then forward the article to them. 

I have never answered your questions in The Tycoon Report before, so please let me know what you thought about me this week by clicking the link below. 

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