Options have a winning combination of controlling risk and high leverage. They provide tools to extract value from the market with the ability to limit and define your risk.
You can limit your capital’s exposure with options since their risk is confined to the option’s premium. This means that in a nightmare scenario where the market goes completely against you, your total exposure is the price you paid for the option; no more, no less.
Also, you control up to 100 shares of stock per option. For a few hundred dollars, give or take, you control a large block of shares with the potential to reap large returns. And, in a perfect world, options would be all that traders would need in order to outperform the market. But, in the real world, options have serious disadvantages that at times outweigh their apparent advantages.
the real world
Adding to how expensive options can be, if you’re a buyer, you’re at an immediate disadvantage. Why? Options have a limited shelf life, so timing is even more critical than when trading underlying stocks. If the big move that you were anticipating doesn’t pan out, then you’re at risk of having time decay eat away at your option’s premium.
As option expiry approaches, even if your big move arrives, there’s a good chance that it will be too late. This is because time decay has eroded the option’s premium to such a degree that it simply can’t deliver a return. An option’s delta — the mathematical representation of how a derivative moves in step with the underlying security’s price — is simply too eroded by time decay to deliver a decent return.
To get an edge, you have to know the pros and cons of options trading and avoid overconfidence, because with options there is always more to learn. The exponential permutations of risk in options is a minefield of potential obstacles.
If you think you’ve got enough experience to maneuver between the danger zones, think again.
Having some experience with options gives you an understanding of the difficulties. But, what about the not so obvious difficulties? There are three other obstacles that you may not have considered. They are: Options trading doesn’t lend itself well to trend trading, the risk of ruin and the hidden tax of execution costs.
Sure, there are some profits to be made simply by trading in the direction of the trend but there are a couple of problems to be aware of. One is that, generally, trends tend to trade rather slowly. This slow-moving action puts you at odds with “theta”-- the time decay mentioned earlier.
Two, this also causes your risk/reward ratio to work against you over the long run. This is because you may make a series of easy small profits over time, but one bad trade can erase all that progress in one fell swoop, which brings us to risk of ruin.
Risk of ruin is the professional trader’s primary consideration when sizing a trade’s potential and making an effective decision. Risk too much of your capital and you put yourself in danger of crippling your ability to go on, like a buzzard waiting for you to do something stupid and expire.
To avoid this, you need to trade large enough to come out a net winner, but not so big that you can’t go on if a trade, or series of trades, goes against you. The more you trade, however, the greater your fees and slippage. The bid/ask spread is typically in favor of the market maker, not the trader.
Bid/ask spreads of 5¢ to $10¢ are common when trading options. If you’re a buyer, you’ll pay the higher of the bid/ask, and if you’re a seller, you’ll sell at the lower end of the bid/ask. This leads to an extra $5 to $10 per option that gets added as an additional trading expense.
There isn’t really anything you can do about it since you don’t control the deal flow like the market maker. Now, if you’ve calculated all these potential problems with options and you’re still reading, then here is the good news: there is a strategy to help you sidestep these issues in large part.
the lead-cinch trade
There is nothing certain in trading, but you can tighten the odds in your favor. With options trading, you want to reduce the inherent weaknesses of derivatives to contain risk like a lead-cinch clamp.
This takes a combination of the long-term view combined with intermediate-term counter-move trade. Hedge fund guru Paul Tudor Jones said of counter-move trading: “The very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well, for 12 years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.”
The lead-cinch option trade (LCOT) was designed to do that by pinpointing the precise points where profit potential is high but avoiding the land mines detailed earlier.
We will demonstrate this with a setup with energy firm Conoco Phillips (COP) after it entered a “death cross” in late 2014 (see “Market turns,” below).
The rules for the trade are:
- Keep trades small. No more than 2% to 3% of your total trade capital.
- Bullish trades are set up when the market is above the 40-week simple moving average; bearish trades when the market is below the 40-week SMA. Trade in the direction of the overall trend as defined by the 40-week SMA, which acts as the trend filter.
- Watch the weekly chart for intermediate counter-moves along support and/or resistance for intermediate bullish periods or bearish periods. When an underlying security has an intermediate-term reversal — in the form of a weekly price bar up or down sequence from a high or a low — the odds of the intermediate trend having changed are very high (see “Opportunity knocks,” below). As you can see, COP begins an intermediate-term correction from its bear move creating an opportunity to go short.
- Buy the strike — put or call depending on the setup — that is at or slightly in-the-money (ITM) with no less than 45 days left untill expiration.
The strategy is designed to define the counter move to catch the meat of the move as the predominant trend resumes (see “Trap is set,” Below). Since the entry was signaled in early November, you would want to buy the December strike or further out with the $51 put. COP fell to a low of $44.56 in December, allowing for a $6 gain in premium. If you bought out to February of 2016, then COP fell to $31.05 for an even greater gain.
It helps to be mindful of what field you’re playing on with this strategy. If the market is quiet, then using 2% to 3% of your total capital per LCOT position is sound, but if there is more volatility, you may want to be more conservative.
the final bell
The short-term explosive potential combined with the rapid expansion of option volatility and premium value can yield sizable returns. But, for all its potential, it’s worth repeating that everything comes down to risk control. Tightly defined risk parameters have to be respected or your losses can quickly mount up, increasing the risk of ruin.
The LCOT is not inherently an options strategy but it works well with options because, as with our example in COP the existing sharp downward move tends to increase premiums available. And by designing a strategy that profits from a resumption in an existing trend, there is less time to wait for confirmation and have your premium fritter away due to Theta. You have the clock ticking against you as a buyer with time decay. The LCOT’s strength is that it catches the market right as it snaps back in the direction of the primary trend. This spikes option volatility and value in your favor and minimizes the effects of time decay.
The most important thing is that you avoid risk of ruin so you can survive to trade another day. Don’t get too involved with one loss or a series of losses because that can wear you down mentally and emotionally causing a breakdown in discipline that can cause you to act impulsively. When that happens, your chances of ruin are almost inevitable.