This paper was originally published on the MoneyShow web site on 8/18/17.
Many conservative income generation trading strategies depend on the time decay inherent in options pricing for their profits. When I establish an iron condor well OTM (out of the money), I am selling option spreads and expecting those spreads to slowly lose value as the underlying stock or index trades within a channel. Other traders may use butterfly spreads or place OTM credit spreads on one side only (calls or puts); all of these trades are based on time decay working in the trader’s favor. This is in contrast to long option positions that lose value over time if the predicted move does not occur, so time is not your friend for those trades.
It is common to see web site banners or other advertisements similar to the title of this article, touting the benefits of options trades with probabilities of success of 85-90%. Technically, these trades indeed have a high probability of success. But when the improbable loss occurs, it will be huge - so what can we do about that?
Many people think of options trading as very risky and suitable only for the “high rollers”. This article briefly surveys how options can be used in conservative financial portfolios to boost the income from your stocks.
Beginning options traders often make costly mistakes due to either a lack of knowledge or misinformation about the basic characteristics of options and their exercise. Examples of common errors include being surprised that one is unable to close an index option position on the Friday before expiration, or being surprised by an unhedged option exercise during expiration. This paper covers some of the basic concepts surrounding option expiration and how options are exercised. Be sure you understand the settlement, exercise, and expiration characteristics of the options you trade.
One will commonly hear or read the following “rule of thumb” for trading:
Only trade positions with potential profits of at least three times the potential loss.
This sounds like a reasonable rule, risking a little to make a lot. However, it ignores the probabilities involved. Buying a lottery ticket for $1 to potentially make one million dollars certainly meets this criterion for a good trade. But we intuitively know that the odds against us winning are astronomical. This paper will define risk/reward ratios, define the concept of expected value, and begin to explore the relevance of these concepts to success in trading strategies.
We all have a tendency to believe that someone out there has the secret formula or inside track to making money in stocks and options trading, and if we could just find that secret, we would be making lots of money with minimal effort. Of course, that simply isn't true. There is no free lunch.
Beginning options traders often are confused about the organization of option chains. This paper covers the basic concepts surrounding which options are available at any given point in time, and how that may affect the options you trade.
You have probably heard people refer to options as a risky enterprise, akin to gambling. And it is true that options trading can be very risky, especially when engaged in with minimal knowledge and preparation. The average stockbroker or financial planner does not have sufficient options knowledge to guide you in the use of options in your portfolio. But that doesn’t mean options cannot play a role in a conservative portfolio of stocks.
One will commonly hear or read the following “rule of thumb” for options spread trading:
When implied volatility is high, sell credit spreads and when implied volatility is low, buy debit spreads.
Unfortunately, this is simply not true. The credit spread and its corresponding debit spread at the same strike prices will always have virtually identical returns on investment (ROI). This paper addresses the role of implied volatility in the vertical spread, both at initiation and over the course of the trade.
Placing iron condor spreads on the broad market indexes is a relatively conservative, non-directional trading strategy that may be used for consistent income generation. This strategy profits as long as the index trades within the channel formed by the two spread positions. It is best used during sideways or slowly trending markets. However, the potential losses are huge, so judicious trade management, timely adjustments, and contingent stop loss orders are essential.
The reality of the trading business is that a large percentage of one’s trades will be losers. Every business has overhead expenses, or costs of simply opening the doors for business. Trading is no different and trading losses are a large part of those overhead expenses. Once one accepts that aspect of trading, it becomes much easier to close losing trades early with minimal emotional attachment.
The Married Put strategy can be used to help you sleep better at night when you are concerned about the market's direction. Buying put options is effectively a form of insurance for your stocks.
Two emotions, fear and greed, can be lethal to your financial success. Developing an unemotional, systematic approach to your trading and investments is crucial for success. This paper will present five guidelines to help you control your emotions and improve your trading results.
Unfortunately, there are many “snake oil salesmen” operating in options education. They are busy selling the dream of instantaneous riches without effort.