Welcome to the Coaches Corner. It’s a great place to tap into a wealth of knowledge in each monthly newsletter. Our experienced coaches have decades of options trading experience and will share their thoughts, strategies and trading ideas in this section each month..
You’re sure to benefit from the thoughts and insights you’ll find in each issue of Coaches Corner, provided by some of the sharpest and most experienced option traders around. We plan to discuss issues ranging from specific strategies and trades to general market analysis and tips and tricks to help improve your trading—information you’re sure to find priceless.
Allow me to introduce myself. My name is Mike Curtis and I have been an active option trader for eight years now. I have personally coached and worked with hundreds of traders just like you, focused on helping them find a successful system that they can implement over and again.
Throughout years of trading successes, having personally paid some “market tuition,” and working with all types of traders to help them find their pathway to successful trading, I’ve found there’s ONE common mistake most traders make. I know sharing this bit of information can help any trader, whether you are a beginner just getting started or a seasoned veteran with years of experience.
Most traders entering into the world of option trading usually start out as option buyers— especially call options—as this closely simulates buying shares of stock, which most traders can relate to. Buying a call option gives you the right, without any obligation, to buy shares of stock at a specified price, called the strike price. For example, if you buy a 50 strike price call, you have the right to buy shares at 50. If the stock goes higher, the value of your call option will increase since you maintain the right to buy the stock at 50.
Sometimes your gains can be exponential when you buy a call option and catch a large move up in the stock. A 50 strike price call expiring a few months out in time might only cost a couple hundred dollars. If the underlying stock moves five to 10 percent, you could see your option contract almost double in price in some cases! (This is a generic example and there are several variables to consider, but it illustrates the profit potential)
Buying calls (or puts) can be slightly addictive mainly because of the high rates of return that can be achieved. You can see a couple-thousand dollar investment double or triple if the stock makes a decent move in your direction.
I have seen MANY traders narrow their focus and try to implement a trading plan consisting of 100percent call option buying. This is a path to a very short trading career in most cases. The problem with buying options is that options have an expiration date and depreciate. You determine before buying which expiration period you want to trade, but as that expiration date approaches the option will start to lose value. Imagine buying a new car for $50,000; after a few years that car will have depreciated by maybe 50percent or more. Ten years later that $50,000 car is only worth a few thousand dollars. Options depreciate at a similarly rapid rate, but on a shorter time frame. A portion of their value is ‘time value” and that time value will decay rapidly, especially on options expiring in just a month or two.
In my experience of working with hundreds of traders, purchasing a call option is one of the hardest ways to make money in option trading. The time decay working against you proves difficult to overcome. You could buy a call option, have the stock climb slightly higher, and still lose money. The stock could trend sideways or not move much at all, but the time decay can still cost you dearly. If the stock were to drop, you take an even bigger loss as the option loses value.
Options are fairly cheap compared to the stock price, so they are appealing in that sense as well, but that cheap cost can also lead to being reckless at times. It is not uncommon for me to see people take a 100percent loss on an option purchased that expires with no value. Luckily, people don’t usually invest as much into an option contract as they would into a stock position. That said, even with a cheaper option contract, the losses can really start to add up.
So how can we stack the odds more in our favor? How can we avoid falling into some of these tough situations that can occur when buying options? Let me clarify, we still buy options… once in awhile. It is a small piece of our overall trading plan and we always control our positions sizes. However, the bulk of our trading focuses on taking the other side of the option contract. We can really put the probabilities in our favor by being option sellers, so let’s talk about how this can really help improve your trading.
By selling options and taking the other side of the option contract, you flip the time decay on your side. Now as time decays you profit from it instead of the decay hurting your position. Why is this so important? Well, we ALWAYS know time will pass. It is really the only true constant in the market. Also, whether the stock moves in the direction you are hoping or if it just stays flat, you can still profit.
Here’s an example:
If a stock is trading at 101 and we sell a 100 strike put for $2.00, the stock could go up and the put would expire worthless. We’d keep the full $2.00 per share as profit, or $200 per contract. The stock could stay at 101 or drop a bit to 100 and we could still keep the full $2.00. In fact, we don’t start losing money (at expiration) until the stock drops below 98 per share, in which case we would need to buy back the sold put and close the position. That in itself gives us a statistical edge. The stock could move up, stay flat or move slightly down and we can still make money.
(Note – selling a put is a bullish/neutral trade while buying a put is a bearish trade. It is easy to get confused when thinking about selling options until you gain experience)
Next, we layer on a high probability setup (compelling news, strong reaction to earnings, a pre- announcement, etc.) where we know a stock is likely to behave in a certain way and now we’ve really stacked the probabilities in our favor!
Selling the option is only part of what we usually do. It’s crucial to add protection to your
positions when selling your options. If selling a put, you add protection by simply buying a put contract as well. This turns the trade into an option spread. If you sell an option without buying a position to cover (a naked position), your broker will most likely hold a large margin requirement for the position. Let’s look at another example:
Following the previous example, if the stock is trading at 101 and we sell a 100 strike price put for $2.00, we would then go out and BUY a protective put at the 95 strike price or lower. Now your broker will recognize your obligation to buy stock at 100, but you’ve covered the position by buying the right to sell at 95, capping your risk at $5 per share, or $500 per contract. Adding the protection covers you from substantial loss if the stock really falls apart, but if the stock still goes up, sideways or down slightly we can still generate a phenomenal profit with limited risk.
If you have never sold options before or traded option spreads in the past, I would recommend trying it in a virtual/paper account first. It is always helpful to get some practice to ensure you avoid silly mistakes before putting your hard-earned capital at risk.
The next time you see a stock that you feel is likely to move higher, consider utilizing this high probability strategy to take advantage of the move instead of simply buying the call. If you start incorporating more option selling and spreads into your trading plan, I think you’ll find yourself winning on more trades, being more consistent and experiencing fewer big drawdowns in your account equity curve.
Mike Curtis has been an active trader in the derivatives markets for 8 years. He has mastered the world of equity and index options along with spread trades, futures and foreign currency. He loves teaching and has personally coached over 500 individual investors needing help learning to apply a consistent trading method. Through his mentoring, he has helped hundreds of people change their financial situation through trading in the financial markets. He is a husband and father of 4 young children currently lives in Salt Lake City, Utah.