The key to successful options trading is faith, an abiding conviction in fundamental truths. No, I am not speaking of religion, but of the rules governing options pricing.
Options prices increase with increasing volatility and decrease over time if the price of the underlying stays the same. Of course an increase in the price of the underlying will, if significant enough, increase the value of calls and decrease that of puts, while a decrease in the stock price will do the opposite. However, those who focus on stocks are seeing only the proverbial “tip of the iceberg”. What lies beneath the surface is both more difficult to see and far, far more important.
Very often, a price swing will increase both put and call prices. The tendency to change in price is knows as volatility, the so-called “fear factor” in the market. Frightened little stock traders use purchased options as a rather pitiful attempt to hedge their bets. Rather than buying a stock that might go down, a trader may choose to buy a call. If the stock goes up, as he thinks it will, he will make a profit, and if it goes down, as he fears it might, he will lose only what he spent on the call.
People who own stocks often purchase puts to ensure they can sell the stock for no less than a certain value no matter how far it falls. Puts are, quite simply, “stock insurance”, and calls are best thought of as “savings coupons”. By purchasing a coupon book for a local business, you ensure that you can buy a certain thing at a certain price. However, it only helps you if the price doesn’t fall below the price on your coupon. A call will simply give you the right to purchase a stock at the strike price, and if the stock falls and stays below the strike, exercising the call will be unwise.
Because of their use as a risk management tool for stock traders, options are at a premium when volatility is high. Better yet, because stock traders always over react to changes in the market, options prices easily become over inflated, which is why the mental skills to be a “retail options trader” are comparable with the brains required to be, say, a Labrador retriever. That might be a bit unfair; my Lab has to fetch sticks. I just click on things with the mouse.
It is fascinating to me that the “advice” given to potential traders is always something about not being emotional about trades. Clearly, stock traders as a group do not ascribe to this philosophy no matter what they may say to the contrary. So I won’t lecture you on how to make decisions; it’s so much simpler than that! All one has to do is take advantage of all the silly traders out there who preach about rationality even as they furiously scramble to purchase options.
Of course diversity is key; having several different underlyings, preferably in several different sectors, is ideal if you can manage to find such a diverse group of underlyings worth having. There are many successful trading strategies. Iron condors are ideal of high priced underlyings, while strangles are best for low priced stocks. Note that both spreads are market neutral, meaning that you are not betting, as would a stock trader, on the direction of the prices changes, merely on the fact that, in general, options prices will decrease as expiry approaches.
You will lose fairly often, and it is key to be able to cut a loss, however, I mention this last because the vast, vast majority of those who give trading advice overemphasize this greatly! The greatest mistakes made by traders are not errors made in stubbornness, arrogance, or greed, but rather actions resulting from self-doubt and a belief that it is possible to make emotional decisions.
I know this from hard, costly experience. I’ve paid more than my share of tuition in the school of hard knocks. Yesterday, I analyzed the difference between my real trade account and my paper trade account. The paper trade account is far more profitable, even though I overcorrected for any bugs in the paper trade software by buying and selling virtual options at hideous prices.
So I asked myself, “What’s the difference? Why I am so darn successful at paper trading, while I have made so many mistakes in my real trades?”
The answer is simple; in my paper trade account, I have worked under the assumption that all of my decisions are entirely reasonable. I have traded every virtual product as if I were physically incapable of emotional weakness. I have acted with sincere faith in myself and in the mathematics I know to be true.
In my real account, I have listened to the remembered advice of all those who say, “Don’t be emotional! You need to cut your losses! Don’t take too many risks!”
I like to use the following metaphor for a lot of things in life:
In the old Warner Brothers’ cartoons, a character would sometimes be faced with a dilemma and have a little angel on one shoulder telling him the right thing to do, and a little devil on the other shoulder telling him to do something destructive. In real life, it can be hard to tell the two apart.
But I think my experience have proven beyond a shadow of a doubt that it is the little angel saying, “You know what you’re doing; it’s trivial!” and the little devil that whispers, “You’re being emotional, don’t take risks.”
I’m very tired of that little devil, and although we all have both an inner voice of reason and a corrosive demon of self-doubt, I will no longer allow the latter to affect my decisions.
The secret to success in trading is the same as the secret to success in any endeavor. Figure out which voice is the angel on your shoulder, and never doubt that voice. Other than making a killing with retail options trading, my goal in life is to share what I know so that your little angel has more firepower when the devil starts spouting his drivel.
After all, if you can’t trade without fear, you shouldn’t be trading.