The Option Trader Handbook E-Book

George Jabbour

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Trading Series
• Sprache: Englisch

Seitenzahl: 755

Veröffentlichungsjahr: 2009

Beschreibung

Strategies, tools, and solutions for minimizing risk and volatility in option trading An intermediate level trading book, The Option Trader Handbook, Second Edition provides serious traders with strategies for managing and adjusting their market positions. This Second Edition features new material on implied volatility; Delta and Theta, and how these measures can be used to make better trading decisions. The book presents the art of making trade adjustments in a logical sequence, starting with long and short stock positions; moving on to basic put and call positions; and finally discussing option spreads and combinations. * Covers different types of underlying positions and discusses all the possible adjustments that can be made to that position * Offers important insights into more complex option spreads and combinations * A timely book for today's volatile markets Intended for both stock and option traders, this book will help you improve your overall trading skills and performance.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Preface to the First Edition

Preface to the Second Edition

CHAPTER 1 - Trade and Risk Management

INTRODUCTION

THE PHILOSOPHY OF RISK

TRUTH ABOUT REWARD

RISK MANAGEMENT

TRADE MANAGEMENT

TRADING AS A BUSINESS

SCORE—THE FORMULA FOR TRADING SUCCESS

CHAPTER 2 - Tools of the Trader

INTRODUCTION

OPTION VALUE

OPTION PRICING

OPTION GREEKS AND RISK MANAGEMENT

TIME DECAY

DELTA/GAMMA

IMPLIED VOLATILITY

SYNTHETIC POSITIONS

BASIC STRATEGIES

BASIC SPREADS AND COMBINATIONS

ADVANCED SPREADS

THE GREEKS AND SPREAD TRADES

VALUABLE DERIVATIVE TRADERS PROGRAM

INTRODUCTION TO TRADE ADJUSTMENTS

CHAPTER 3 - Long Stock

INTRODUCTION

PROTECTIVE PUT

CALL REPLACEMENT

SELL COVERED CALLS

COLLARS

RATIO WRITE

SHORT STRADDLE/SHORT STRANGLE

CALL RATIO SPREAD

CALL CALENDAR SPREAD

CHAPTER 4 - Short Stock

INTRODUCTION

PROTECTIVE CALL—INSURANCE

PUT REPLACEMENT

COVERED PUTS

SHORT COLLARS

PUT RATIO WRITE

PUT RATIO SPREAD

CHAPTER 5 - Calls and Puts

INTRODUCTION

LONG CALL

SHORT CALL

LONG PUT

SHORT PUT

CHAPTER 6 - Spreads

INTRODUCTION

BULL CALL SPREADS/BEAR PUT SPREADS

BEAR CALL SPREADS/BULL PUT SPREADS

CALENDAR SPREADS

CHAPTER 7 - Combinations

INTRODUCTION

LONG STRADDLE

LONG STRANGLE

SHORT STRADDLE/SHORT STRANGLE

Index

Copyright © 2010 by George M. Jabbour and Philip H. Budwick. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data:

Jabbour, George (George Moussa)

eISBN : 978-0-470-57998-5

1. Options (Finance) 2. Options (Finance)-Prices. 3. Stock options. I. Budwick, Philip. II. Title.

HG6024.A3J32 2010 332.64’53-dc22

2009041414

To our families: Thank you for all your love and support.

Preface to the First Edition

Option trading is both an art and a science. The science of option trading is very straightforward and mechanical and involves the specific steps in establishing a position, pricing, and understanding how movements in the underlying stock affect your trades. The art of trading, on the other hand, involves the use of your imagination and ingenuity. The market is your canvass and you coordinate different strategies and adjustments to create a unique painting, which is your portfolio. As mechanical as option trading seems, to be truly successful you will need to apply your own artistic style with respect to developing strategies and making trade adjustments. This book is about the art of making trade adjustments.

Making an adjustment to a stock or option position is one of the most overlooked and underutilized skills in trading. Moreover, it is one area where your personal style and imagination are valued over any other quantitative trading skill. Options give you the flexibility to trade markets in any direction, or with no direction at all, and for as long or as short a time period as you want. Just as eight simple musical notes can be combined to make an infinite number of symphonies and songs, calls and puts also can be combined in a number of ways, using different expiration dates and strike prices, to create an almost infinite number of positions and follow-up adjustments.

Using the right trade adjustment can hedge or even boost your profits, limit your losses, and create risk-free trades. Trade adjustments can also be used to repair losing positions. Whether you invest using only stocks, only options, or both, the information in this book is intended to give you the tools you need to improve your trading skills and performance.

The material in this book presents the art of trade adjustments in a logical sequential order. First, we discuss the most important aspect of investing—risk and trade management. Trade adjustments are tools used to implement trade and risk management. Therefore, you cannot understand how to use the tools if you are not aware of the theory behind them. That is why in the first chapter we present the guiding principles of risk and trade management and describe how to apply them to manage your portfolio. We discuss investment and portfolio themes and how to develop a professional approach to your trading. Finally, we detail our formula for trading success, known as SCORE, which not only teaches you how to incorporate our principles of risk and trade management into your daily trading, but also lays out a complete step-by-step trading and portfolio management system.

After you have learned the theory, you need to know the right tools for effectively putting the theory into practice. Chapter 2 provides an overview of the tools you will need to control your risk, take advantage of the benefits of options, and make adjustments to your positions. This book is not meant for the pure beginner in options; we assume that the reader has a minimal understanding of how options work and a familiarity with the basic strategies. Nonetheless, we provide a quick overview of the most important characteristics of options and various strategies to remind the reader of the terms and strategies that are used throughout the book. The trade adjustments discussed range from basic to quite complex. Therefore, a general background in option strategies is required and presented in Chapter 2. We also discuss implied volatility and time decay, two often overlooked option characteristics, which, if used effectively, can reduce many common mistakes made by most traders.

Once you have learned the theory and the tools to put that theory into practice, you are ready to learn the art of trade adjustments. The remaining chapters discuss how to adjust various trading positions to lock in a profit, hedge against a loss, or boost an overall profit. Each chapter covers a different type of underlying position and all the possible adjustments that can be made to that position, whether the underlying stock moves higher or lower, or even if it moves sideways. We start with long and short stock positions and the various adjustments you can make using options. We also deal with basic and advanced call and put positions and cover adjustments to more advanced strategies such as spreads and combinations.

The strategies and adjustments in the book continually build on information presented in previous chapters. Therefore, you are encouraged to read the book straight through because the strategies and adjustments become more complex and follow a natural progression. However, most traders will probably use the text as a reference handbook and go directly to the chapter or strategy they are interested in reading about. In later chapters you may find references to earlier chapters or find short summaries of position analysis where the relevant background to a specific strategy was presented earlier in the handbook.

We tried whenever possible to make it easy for the handbook users to read up on the specific strategy they are interested in and find all the information they need in one place. However, you will find that all the strategies and adjustments complement each other and you will gain a better understanding of the art of trading by first reading the chapters in order. Thereafter, you can keep the handbook at your side and use it as a trading reference.

Within each chapter, we use numerous examples to demonstrate the different trade adjustments using real stocks. The stocks used as examples are merely for illustrative purposes and in no way are to be construed as an investment opinion on whether to buy or sell such securities. Whenever we quote stock or option prices or specific strategy costs, we are estimating the premiums on the given options based on market prices at the time of writing for purposes of illustrating the given strategies and adjustments. The prices quoted for each option are the assumed prices you would hypothetically buy or sell those options for in each example and we ignore bid/ask spreads.

When calculating the profit and loss for each strategy or adjustment as well as for the risk/reward profile charts contained in each chapter, we assume that the relevant options are at expiration and worth only their intrinsic value, if any. The positions can be terminated at any time prior to expiration either by closing the position or exercising the options. However, the only time we know the exact value of the option is on its expiration day, so we assume all positions are held to expiration. For simplicity, the profit calculations also exclude commissions, taxes, and other transaction costs as well as the effect of the time value of money.

When discussing option pricing in Chapter 2, we present the Black- Scholes option pricing model merely for purposes of explaining the different option pricing factors and how they affect the price of the option. Although the formula assumes that the options are European style, we apply the price sensitivity factors in the Black-Scholes model to American-style equity options discussed in the handbook—to simplify the explanation of how each pricing factor can affect the value of a call or a put.

The number of possible trade adjustments to the positions we cover in the handbook is almost infinite and we could not possibly cover every single trading scenario or contingency. We try to present the best possible trade adjustments given the movement of the underlying stock and even present some adjustments that we do not recommend, for the sake of being as complete as possible. The number of possible adjustments that can be made is limited only by your imagination, so feel free to take what you read one step further whenever practical.

Moreover, there are some strategies to which we did not cover trade adjustments. Because most complex option positions can be broken down into more familiar simple strategies already covered in this handbook, you can easily take the adjustments covered here and apply them to any option strategy. However, you should never overtrade your position or make too many adjustments. Sometimes the best adjustment is closing out a profitable trade to realize your gain or closing out a losing position to limit your loss. Therefore, the handbook is meant to teach you to make appropriate trade adjustments and not overtrade positions by making as many adjustments as possible.

This book is intended to be a tool for both stock and option traders. Whatever strategy you are using, you can find numerous trade adjustments for most situations. Making the right adjustment to your position at the right time can improve your trading skills and performance. However, all skills take time to learn and the same is true with the art of trade adjustments. Let your imagination be your guide, and this handbook will become one of the most valuable assets in your portfolio.

Preface to the Second Edition

The key to being a successful trader is to always improve your skills and never assume you know everything about the markets and the products you are trading. Moreover, you can improve your knowledge by simply reviewing in greater detail what you already know and look at it in a different way. We are always striving to improve ourselves with respect to option trading, and in the years since the first edition of The Option Trader Handbook, we have delved deeper into the mechanics of option pricing and trade adjustments to gain a new perspective on the art of option trading. As a result of our efforts, we are proud to present the second edition of The Option Trader Handbook with even more tools and tips to improve your understanding of how options work and how to make better trading decisions.

The largest addition to the new edition is in Chapter 2, “Tools of the Trader.” We have added a new section dedicated to the option Greeks and risk management. Most people have a general understanding of the different factors that affect the pricing of an option but very little understanding of what the Greeks are and how to read and understand them. More important, how can you use this information to make better trading decisions and avoid making some common mistakes? We focus on the most significant pricing factors, which are time to expiration, stock price, and volatility, and discuss the Greek values used to measure changes in these factors. In addition, we describe their general characteristics to better understand how options move with changes in these pricing factors and what risk we are exposed to in our positions. Finally, after highlighting the key principles of each of these pricing factors, we discuss how to apply these principles to improve your risk management and make better trading decisions.

Specifically, we look at Delta and how sensitive options are to changes in the price of the underlying stock and how those sensitivities change whether you are in the money, at the money, or out of the money. We then look at time to expiration and time decay and understand how fast options can shrink to nothing and ways to reduce those risks. We also discuss implied volatility, its unique characteristics, and how changes in volatility have significant effects on the prices of options. We also discuss the VIX, or market implied volatility index.

To better illustrate the Greeks and their application in trading, we added a Greek profile description under each option strategy. We describe the basic Greek characteristics of each option strategy, as well as the specific risks. Understanding the Greek profile of each strategy will help you to choose the right strategies for different situations.

To show the practical application of the Greeks, we highlight our step-by-step approach to using the Greeks together to make better trading decisions and avoid many common mistakes. We highlight this approach in our Valuable Derivative Traders program, where we develop a three-step approach to analyzing implied volatility, strike selection, and time to expiration to arrive at the most appropriate option strategy and risk management approach. Finally, we provide our detailed theory of trade adjustments and explain why we choose a risk/reward approach to trade adjustments versus looking solely at the Greek values.

In the subsequent chapters, we add some detail to some of the adjustments already discussed. We also add information on credit spreads, butterflies, and short straddles. Our goal is to provide the reader with as much additional detail as possible on the tools of the trader and risk management techniques to ensure a better understanding of how to trade options smarter and with increased awareness of how to manage the risk. You will be able to take better advantage of the adjustments discussed if you are better prepared before you even enter into a trade.

Like the first edition, this book is meant to be a tool that provides you with the necessary skills to improve your trading decisions. We worked to add additional material to ensure that you never stop improving your knowledge about options. Moreover, even if you are familiar with the Greeks, we presented a program to help you see the Greeks in a more practical way so that you can directly apply that knowledge to your trading.

We want to thank our families for putting up with us while we wrote both editions of this book and for their nonstop love and support, not only for us but of our passion for options. More important, we are thankful for this book for giving us a new perspective on options and the opportunity to strengthen our friendship and share our enjoyment of trading options. Finally, we want to thank all of the editorial and production staff at John Wiley & Sons for their support, guidance, and patience during this long process and for all the time they put in to get our book completed.

CHAPTER 1

Trade and Risk Management

INTRODUCTION

When novices begin to learn martial arts or boxing, they invariably want to start by learning how to punch or strike their opponent. To them, that is the most exciting part of learning martial arts, and they are in a rush to learn to attack. However, the trainer or coach will usually start by teaching them how to defend themselves or block an attack. If you cannot defend yourself from getting hit, then you will not last long enough to attack your opponent. Most novices fail to see the importance of defensive techniques. In sports, the motto is that defense wins championships. After all, even if you score points, you cannot win if you let your opponent score more points against you.

The importance of defense is also true in option trading. Beginners and advanced traders alike want to focus on trading strategies and making money. They usually overlook the importance of defense. Of course when trading options, we are not at risk of getting punched or attacked, but the money we invest is under constant attack. We are competing with thousands of traders and investors who want to “take” our money. Investors and traders need to learn to defend their capital against losses just like boxers need to protect their bodies and heads. Allowing too many losses, or “attacks,” to your trading capital will leave you with no money, and you will be out of the trading game. Therefore, option investors must also first focus on defense before jumping into the offense of making trades or establishing positions.

The defensive skills that should be studied by any investor before focusing on trading strategies are risk and trade management. Learning how to control and manage the risk of each and every trade, as well as your portfolio on the whole, is vital to protecting your capital. Many investors have had the experience of making money on a series of trades only to see one or two bad trades wipe out all their hard-fought gains. Imagine working hard the first six rounds of a boxing match to weaken and hurt your opponent, only to come out in round seven with your hands at your sides and allow your opponent to knock you out. Ignoring risk and trade management is just like walking into a boxing ring with your hands stuck to your sides, leaving your whole body and face exposed.

We believe that the difference between a good investor and a bad investor comes down to the proper use of trade and risk management. This is not to say that stock picking, market timing, and analytical skills do not play a part in the success of traders. However, it is trade and risk management that allows such qualified investors to keep the fruits of their labor and not give back all their profits. We all have heard many stories of day-trading millionaires in the tech boom of the late 1990s when all it took was going long in anything with .com in the company name to make money. However, most of those millionaires walked into the year 2000 with their gloves at their sides and were systematically knocked out one by one, with many of them losing all of their gains. Again, these traders focused on the techniques of trading without worrying about a good defense—risk and trade management.

Therefore, our first step before learning trading strategies is to review the principles of good risk management. As with any skill, you will not pick it up simply by reading this chapter once. You need to study the principles and practice applying them as you trade. It takes time before it becomes ingrained into your trading style. As human beings, we are susceptible to the emotional stress, anxiety, and excitement that come with trading and making or losing money. The principles of risk and trade management help remove much of the emotion from trading and go a long way toward helping you as much as possible to avoid making costly mistakes.

THE PHILOSOPHY OF RISK

The most misunderstood concept in investments and finance is the concept of risk. However, risk is what investing is all about. Remember the old cliché: It takes money to make money. What this really means is that to make money you need to risk money. You must put some of your capital at risk in order to receive a reward. It is the incentive of the reward that encourages you to take on the risk. Because you must risk money to receive your reward, the science of finance is all about pricing and quantifying that risk to determine whether the reward is worth the risk.

Assume that a 5-year U.S. treasury note is paying 4% interest per year. We often refer to U.S. treasuries as risk-free securities because the odds of the U.S. government defaulting on the note are so infinitesimally small; you are practically guaranteed to receive your interest throughout the life of the note, as well as the return of your principal at the end of the 5 years. Assume that a private corporation is also offering a 5-year note. This corporation is a very strong business entity but there is a small risk that the business could go under and you will not get your principal back. If the corporation is offering to pay 4% interest per year, would you consider purchasing the corporation’s note over that of the U.S. government?

Naturally, the answer is no. Why should you purchase a risky security that is paying the same interest, or reward, as a security that technically has no risk? There is no incentive at all to take on the risk of the corporation defaulting and losing your money. The basic theoretical concept of risk/reward is that you should be compensated for taking on additional risk by receiving a higher reward (return). Of course, the theory of risk/reward is more complicated than our simplification, but for our purposes of understanding risk management, it is sufficient to state that investors require higher returns in order to take on increased risk. Therefore, in order for the corporation to induce you to purchase their security, they need to offer you a better reward to compensate you for taking on the additional risk over the risk-free security. Assume that the corporation and the investors decide that, using complex financial models that are beyond the scope of this book, offering an additional 2% interest per year on the note is enough of an additional reward to compensate for the greater risk that exists in the corporation’s note. In other words, 6% per year in interest is perceived by the market to be a sufficient reward to encourage investors to purchase that corporation’s note.

This example summarizes the basis for all investment decisions. We want to know the risk of the investment and the reward we receive for assuming such a risk. If we have two investment alternatives, the way to select the best choice for our money is to compare the risk and reward of each investment to determine which one gives us the best reward for the amount of risk we must assume. Therefore, before every trade, you should always determine and quantify the risk and reward of the investment.

With respect to options, the quantification of risk and reward is very straightforward and is covered in our first and most basic principle of risk management:

KEY PRINCIPLE

You must be able to determine and quantify the maximum risk (loss) and maximum reward, as well as the breakeven points, of a position before committing any money to that investment.

This principle requires that you calculate the maximum risk, the maximum reward, and the breakeven points for every trade you are considering. Even if you fail to make these determinations prior to entering a trade, you should be able to look at any existing trade and immediately determine the maximum risk, maximum reward, and breakeven points. Deriving these three factors should become second nature. We cannot emphasize enough how important it is for every investor to understand and be able to derive these three factors before entering into any position.

We strongly recommend that you calculate these three factors in the same order as we stated them; that is, first calculate your maximum risk, then your maximum reward, and finally your breakeven points. The reason is that for you to be truly successful, you must understand the next principle of risk management:

KEY PRINCIPLE

You are a risk manager first and an investor or trader second.

Most traders immediately start by thinking of the maximum reward because they are only focused on how much money they could make. They forget that to make that money, they first need to risk something. Greed makes you focus on your reward first and clouds your judgment regarding risk, which leads to costly mistakes. For example, many investors become enamored with the idea of selling options to take in premium because they immediately get a credit. They focus first on how much money they receive and pay little attention to the enormous risk that comes with selling naked options. Unfortunately, the time they eventually learn about that risk is when they have suffered huge losses and are forced out of the game altogether.

Always focus first on how much money you could lose. Focusing on how much money you could lose puts you in the frame of mind of a risk manager. Once you have understood and accepted the amount of money you could lose, you can make a clearer decision on whether you are willing to proceed with the analysis and possibly proceed with the trade. You will begin to make decisions based on how to quantify, control, and limit your risk.

We caution the reader to not take lightly the extent of the maximum risk derived for any trade. For example, some option strategies have unlimited risk. Most traders take the words “unlimited risk” too lightly at times because ego and pride makes them feel that it really is improbable to have unlimited risk. They say things such as, “I will get out of the position if it moves against me long before I suffer any major losses.” However, the market can prove us wrong in very costly ways, as the following story demonstrates.

Nick Leeson, a 28-year-old derivatives trader, worked for the 200-year-old Barings Bank out of its Singapore office. In November and December 1994, he began selling naked options on the Nikkei index (Japanese stock market), expecting the Nikkei to trade sideways over the next couple of months. As long as the Nikkei stayed in a tight trading range, Leeson would profit from his naked option positions. On January 17, 1995, an earthquake hit Kobe, Japan, and as a result of the economic aftermath, the Nikkei started to fall sharply. Instead of closing out his positions to cut his losses, Leeson began purchasing futures on the Nikkei index to stop its fall and try to reverse the declining market. The more the Nikkei fell, the more futures Leeson purchased to try to overcome his growing losses.

More and more margin was required for the naked options and growing futures position Leeson amassed until the margin calls became too much for Barings to cover. The magnitude of the losses totaled around $1.3 billion. Leeson was arrested and put in prison because he hid the size of his trades from Barings, which was forced into bankruptcy. The Dutch bank ING stepped in and bought Barings, a 200-year-old bank, for $1.00. Next time you see an advertisement for ING, remember how one trader ignored maximum risk and good principles of risk management and brought down an entire bank.

TRUTH ABOUT REWARD

Before proceeding further with risk and trade management, we clarify some myths related to the rewards of option trading. Breaking down some of the misconceptions of the potential rewards of trading options is imperative for traders to truly understand and appreciate the risk involved. The following principle seems obvious enough, but we find too many traders, both novices and experienced investors, fall prey to this greatest misconception of all:

KEY PRINCIPLE

Options are not a get-rich-quick scheme.

The potential rewards of option trading are significant, but in no way should it be seen as a get rich quick scheme. Traders looking for quick cash end up trading more on emotion and greed than detailed analysis and proper risk management. The desire for money forces investors to look desperately for the next trade. They are more likely to take unnecessary risks to get their return, and those additional risks usually lead to large losses. It is even worse if they happen to have some positive results early. If investors have a string of successful trades, they develop a false sense of invincibility and ego and begin to increase the stakes in their already risky trades until they lose everything very fast.

KEY PRINCIPLE

Investing is a long marathon, not a fast sprint.

The honest truth about rewards is that they take time and effort. It is unrealistic to assume that everyone can start trading options and turn $5,000 into $100,000 in 1 year. You should therefore have a realistic plan about the type of rewards you can earn and in what time frame. Making money in options requires a lot of commitment and discipline. Investing in options is like starting a business. In the beginning, most investors lose money, and it takes a lot of effort, research, experience, and even some luck to be successful and start producing results. Therefore, the beginning stages might be quite frustrating, and you may even feel like the market is out to get you. However, the path to the rewards of investing can be a profitable one if you have the discipline, patience, and determination to do the work.

RISK MANAGEMENT

Risk

Once you have an appreciation and respect for the risks involved in trading and the hard work required to reap the rewards, you can begin to understand how to use risk management to improve your trading performance. First, the whole point of using options to trade is that they are an excellent tool for controlling and limiting risk. Therefore, your first step is to always trade with the intent to limit or control risk. Once you have a handle on the risk, you can prevent any one trade from significantly reducing your trading capital.

The first step we have already emphasized is to know exactly what your risk is before entering a specific trade. Once you have quantified that risk, that is, say, $400 or $4,000, you need to determine what your plan is if the trade goes against you. It is nice to think that every position you enter into will make money, but you always have to consider what will happen if you are wrong. You need an exit strategy based on the price of the underlying stock or the percentage loss at which you decide to close out the position to prevent any further loss. Thus, the following is an important principle in risk management:

KEY PRINCIPLE

For each and every trade, you must determine your exit strategy for when the trade goes against you.

Assume you purchase 100 shares of ENRON at $70 for a cost of $7,000. You expect ENRON to move higher and therefore are bullish on the stock. However, before you purchase ENRON, you need to develop an exit strategy to decide when you will get out of the trade if the stock moves lower instead of higher. If you develop the exit strategy ahead of time, then you can make the decision before your capital is at risk. By developing your exit plan before your money is at risk, you can make a clear, emotionless decision as to how much loss you are willing to absorb before you decide to close the position. If you wait until the stock starts dropping in price, you may begin to panic, get frustrated, and even freeze up and fail to pull the trigger and close the trade when you should.

You may even utter the words that are the kiss of death in risk management: “The stock has to recover and move back higher; it cannot just keep falling forever!” The reason we call this the kiss of death is because as soon as you utter this phrase, you are practically giving in to the position and letting it control you. You are refusing to close out and limit your loss because of a false hope that the position will recover. So you end up waiting and doing nothing and losing even more money. That phrase is an indication of “trade freeze” where you are unwilling to make a move to limit your risk. We used ENRON as an example because we can bet that many traders held onto ENRON the whole way down until it was worth $0.10, crying the whole way that the stock just has to move back higher. The stock is under no legal obligation to move back higher simply because you are holding 100 shares. Such thinking violates the following principle:

KEY PRINCIPLE

The market will tell you which way the stock is moving; you cannot tell the market where you want the stock to move.

When the stock is falling, you are in the heat of a battle and it could be too late to try to make a logical decision concerning your risk. Your perception is skewed and becomes biased because you are losing money, and you will look for things that are not there. For example, you will be so desperate for the stock to recover that you will look for any signs of life and hang your hopes on those faint signals.

If the market is telling you that the stock is moving lower, then your desire to not lose money will make you ignore the obvious signs. Therefore, we cannot stress enough that you must make an exit plan before the trade so that if the stock drops in price, you will not freeze up or panic but simply stick to your risk management plan and close out the position. This way, you will prevent any one position from wiping out your other gains or your trading capital. However, establishing a predetermined exit strategy works only if you follow the next principle:

KEY PRINCIPLE

You should have the discipline to stick with your exit strategy plan to cut your losses no matter what happens. Any decision to stray from your exit strategy should be based on sound analysis or as a result of a change in circumstances of the underlying security.

Your exit strategy is based on your personal risk tolerance. It is better to establish a specific exit strategy than a generalized plan to maybe get out of the trade if it moves against you. Assume you did purchase 100 shares of ENRON at $70. You could have decided that you would close out your position if it loses 15%. You could have used a monetary value and decided to close out the trade if it is down by more than $1,000. If you used technical analysis, you may have developed an exit strategy based on the stock price and a technical indicator you found in the price chart of ENRON. For example, if you found that ENRON has support at $67, you could have decided that you will close out the bullish position if ENRON breaks through support at $67 and continues to move lower.

There is no one right answer in developing an exit strategy. Each person has a different risk or loss tolerance or a different assumption of where the stock will move to. Therefore, we recommend that you develop an exit strategy that is comfortable for you. If you put $7,000 of your $200,000 portfolio into ENRON, you may be willing to absorb more of a loss before closing the position than someone who had $7,000 worth of ENRON in a $10,000 portfolio. As long as you are comfortable with the basis for selecting your exit strategy, then your only real concern is that you stick with your plan and act immediately when the stock hits your loss target, whether it is a specific stock price, loss percentage, or loss amount.

This approach is also applicable when trading options, because the underlying security is a stock. For example, if we bought a $70 Call on ENRON instead of 100 shares of stock, we could use the same criteria for determining when to close out our option position, with one notable exception—time. Because options have expiration dates, time affects the value of our long options as well as our short options. Therefore, we may also have an exit strategy based on time. For example, we may determine that we expect ENRON to move higher in the next 30 days or so and purchase a 2-month call. Our exit strategy could be that we close the long call if ENRON has not moved higher in 30 days because that was the time period in which we expected a move.

Therefore, the first part of risk management is determining what our maximum risk is before entering a position and then developing an exit strategy to close out the position if the trade moves against us. You will never have a perfect record when trading; you will have losing positions no matter what you do. However, if you have 10 trades and 9 move against you, you can still have an overall positive return if you practice good risk management by closing out the 9 losing trades before they produce significant losses. Always know the full risk before entering into any investment and always have a plan to get out if you start to lose money.

Reward

We do not just recommend developing an approach for handling the risk of a trade, we also advocate dealing with the reward portion as well. Most investors enter into a trade expecting to make money. They do not really develop clear reasons why they expect to make money except for such standard analysis as “I expect the stock to go up.” In addition to understanding the risk involved in a trade, investors should understand the reward they hope to receive as well. Why do you expect the stock to move higher? Do you have an idea of how high you expect it to move? When will you close the position? How long do you expect to hold the stock? Most traders gloss over these types of questions and simply place their money into the trade. However, if you do not consider these questions, how will you know the right time to get out of the trade and pocket your return? How do you prevent trade paralysis, where you watch a winning position turn into a loss right before your eyes because you failed to close it out when you had an unrealized gain?

The tendency by most investors is to simply buy and hold a stock without any clear plan as to when to get out if they have an unrealized profit. For the long-term buy-and-hold investor, this is the right thing to do. The long-term investor (e.g., someone investing for an individual retirement account, pension plan, or college fund) is buying for the long haul, and the strategy is to hold on for years and let the stock move higher over time. However, for all other investors and traders, risk management also involves properly managing rewards based on the following principle:

KEY PRINCIPLE

You should always have an exit strategy for closing out your profitable position.

Most investors ignore this tenet of risk management because they feel that if they are making money, why do they need an exit strategy? Failure to have some sort of profitable exit strategy usually indicates that you do not have a vision going into the trade. You expect the stock or option to go up in price and make money, but stocks and options do not just go up indefinitely. If you have no logical reason for the trade, then you will never know the right time to get out. What usually happens is that you end up cutting profits short or letting winners run too long until they reverse and produce losses. Therefore, you need to manage your gains as much as you need to manage your losses.

Before entering a trade, you need to develop a plan as to what your profit target is. Once that profit target is reached, you can close out the trade and pocket your returns. You do not need to be as strict with profit exit strategies as we recommend you be with exit strategies when the position is losing money. The profit in the position provides additional room to breathe, and therefore you can give the position more time as long as the stock or option continues to show strength in moving in the expected direction. For example, you could close out the position if it earns 25% or if the stock hits a certain price or resistance point. Maybe you have a predetermined dollar value you are looking to make. Another option is to close out half your position when the trade doubles in value (e.g., for option trades) to take your cost off the table and play with “house money.”

In addition to an exit strategy, you should also plan potential trade adjustments to enhance the performance of your position. The goal of the subsequent chapters is to teach you various trading adjustments to make to your trading position. Many of these adjustments are meant to reduce your risk, lock in a profit, or hedge against a loss. Making plans on how to adjust a position in the middle of the trade could lead to a rushed decision that is not that well thought out. If the market begins to move quickly, it may cause you to rush into making an adjustment that is inappropriate for your position. Therefore, we recommend that before you enter into a position, you also plan what potential adjustments you can make. You can study the various adjustment strategies covered in this book and become familiar with the ones that best fit your trading style and risk tolerance. Managing risk and reward after you open your position through trade adjustments is just as important as managing your risk and reward before you enter into the position.

Breakeven Points

Every position you enter into may have one or more breakeven points at which you either recover the costs of the position or suffer no profit or loss. When you establish a position for a net debit, the breakeven point is very significant because it tells you how far the underlying security has to move before you recover the cost of your trade. If you establish a net credit trade, the breakeven point tells you at what point you will begin to lose money on the position. Therefore, the breakeven point is a significant part of risk and reward. You should be able to calculate the breakeven point of any trade before you enter the position, as well as the new breakeven point created from any adjustments to the trade.

TRADE MANAGEMENT

Trading Theme

In the previous section we covered risk management and recommended that before every trade you should determine your maximum risk, maximum reward, and breakeven points, and also determine an exit strategy if the position is making or losing money. Taking such steps before the trade is entered into is a way for you to examine the risk, quantify it, and develop a plan on how to control it. The subject of trade management also focuses on dealing with risk in your trades and portfolio as a whole as well as your overall approach to trading.

The best way to teach the lesson of trade management is to use the analogy of chess. When learning chess, the first step you take in improving your game is to learn opening strategies, that is, specific sets of moves made in the beginning of a chess game to establish a certain attack or defensive pattern. Beginners study the moves and memorize the patterns. They learn different variations of the openings so that they can adapt in case the moves occur in a different order than the memorized pattern. Chess openings usually cover the first 10 moves or so but set the stage for the entire game. If you can establish a good position through proper use of an opening strategy, then you will have a strong defensive position from which to attack and gain the advantage.

The problem is that most novice chess players merely focus on memorizing the moves. They look at the picture of where the pieces are supposed to be at the end of the opening stage and work on getting their pieces into the same position. They study the mechanics only and therefore move mechanically without thought. Their analysis is only move to move, and they do not see the bigger picture. Chess is a game of strategy and concentration and is unlike checkers, where both players simply react from one move to the other. What the beginner fails to realize is that every opening strategy has its own theme. For example, one opening has a theme of establishing a strong offensive position in the center of the board while another is focused on establishing a strong defensive position.

Each opening is not just a series of mechanical moves. To have success in executing each opening strategy, you must understand what the theme of the opening is. What is the opening trying to accomplish? Understanding the theme will allow you to move away from simple mechanical moves and force you to play with a goal in mind. As long as you have the overall theme mastered, you can execute your plan no matter what your opponent does. Even if your opponent reacts in an unexpected manner, you can still stick with your overall plan and adjust with no problem. Each move will be made within the context of the opening strategy, and you will be able to calmly execute your plan.

How is this relevant to option trading and trade management? Like chess novices, many new traders focus only on the mechanics of trading. They study the option strategies and concentrate on how to open and close positions; that is, they become mechanical traders. However, every trade has a theme behind it. When you select a stock to invest in, there is an overriding theme to your investment. You have conducted research and analysis on the security and have made a prediction or assumption about the direction you expect the stock to move and how long you think it will take to make such a move.

Another mistake novice chess players make with respect to selecting an appropriate opening strategy is that they fail to choose the strategy that best represents their playing style. For example, players with an attacking style should not choose a passive defensive opening strategy. If they do, then they will attempt to make attacking moves from a position that was not intended for such attacks and will end up weakening their position and opening themselves up for severe counterattacks. This mistake is often made because the players ignore matching the theme or overall strategy of the opening they choose with their playing style and simply focus on the mechanical moves. The difference between chess players and chess experts in this respect is that experts understand the theme and the strengths and weaknesses of the opening they select as well as the strengths and weaknesses of their playing style and focus all their moves on executing that strategy.

Assume you have analyzed and researched the stock of XYZ and have decided that the stock will move higher over the next few months. Your reasons could be based on technical analysis or fundamental analysis or a combination of the two. You have established a theme for your investment in XYZ. Your theme is that you are bullish on XYZ for specific reasons and you wish to make an investment that will profit from the impending rise in price of XYZ over the next few months. In other words, you have developed a plan of attack on XYZ. Most investors do not see trading as developing themes and plans for attack, but investing without any plan or theme is simply throwing money around like a gambler would do at Las Vegas, moving from table to table. Therefore, like expert chess players who select an overall theme to their opening strategy and move each piece in furtherance of this plan of attack, the option trader must also develop a trading plan for each position.

To develop a trading plan or theme, you need to decide what your trading objectives are. Most investors simply say that their objective is to make money. However, this is too vague of an objective and is akin to the chess players simply saying they want to win the game. The more specific objective is focused on how you want to make your money. Do you want to make money buying stock, shorting stock, purchasing calls and puts, selling options, using spreads, using nondirectional strategies, using high-risk or low-risk strategies, picking specific stocks or sectors, trading volatility, picking only one strategy or various strategies, only focusing on indexes (but which ones?), and so on? As you can see, the question of how you want to make your money has numerous answers and can be quite overwhelming to a trader with so many investment choices to choose from.

When chess players are researching openings, they are encouraged to select the openings that best fit their playing style. With an almost infinite list of opening strategies, you can easily find a strategy that best fits your playing style: conservative, aggressive, offensive, defensive, direct attacking, flank attacking, slow development, quick development, and so on. The same process is required of investors. Traders need to determine what their trading style is and their level of risk tolerance.

This self-assessment process is the most important step in developing an effective trade management system. In The Art of War, the classic treatise on strategy, Sun Tzu wrote, “If you know the enemy and know yourself, you need not fear the result of a hundred battles.” With respect to investments, the enemy is the uncertainty of the market and every trade is a battle. Knowing yourself means that you must put in the effort to classify your trading style. Are you a conservative or an aggressive investor? Is your time frame short term or long term? Do you prefer focusing on a wide array of sectors or indexes or just a few select stocks? If you study and research the market and you know your own trading style, then you need not fear the result of a hundred battles (trades). You will be able to match your trading style with the right investment choices. Although you will not win every battle, your wins will outnumber your losses as long as you always trade within your style.

If you do not know your trading style, then you will simply follow the crowd and invest blindly. You will trade without conviction and be easily swayed by the volatility of the market. Worst of all, you will look for guidance from any source to find trading ideas instead of developing them on your own. This usually results in following the wrong advice. You will never understand what is causing your losing trades to fail and your winning trades to make money, and your luck, because no skill is involved when trading blindly, will run out.

Once you have determined your trading style, you can develop the appropriate trading theme to match your style, just as chess masters select the appropriate opening theme to match their playing style. Then it will be easier to know what trading opportunities to look for. For example, if you are a long-term conservative investor, you will look for stocks of well-established companies with a history of sustained growth. You would then be inclined to select more appropriate option strategies for this type of stock—such as Long-term Equity AnticiPation Securities (LEAPS), covered calls, long calls, and bull spreads. Understanding your trading theme will narrow your focus and make it easier to research investment alternatives.

The Theme of Your Portfolio

Developing your trading theme will assist you greatly in developing a portfolio of investments that are all focused on furthering your goal of positive returns. As much as you need an overall theme for your investment strategy, you need a theme of trade and risk management for your portfolio. For example, if you have a conservative, long-term investment theme, then your portfolio should reflect this theme in your risk and trade management. You will not allow any position to make up a significant portion of your portfolio and thus expose you to too much risk. You might keep a certain amount of cash in reserve so that you always have capital in case a good trading opportunity comes along. Finally, you might decide that because you are a long-term investor, you will not trade your portfolio frequently. Your investment theme will therefore affect the way you balance your portfolio and manage your risk.

If you are aware of your investment theme, you should be able to glance at your portfolio and see that theme reflected in your trades and the structure of your portfolio. To truly understand this principle, let us look at the most basic example, which is prevalent in mutual funds. Assume that you are a fund manager of a small-cap value fund. The investment theme of the fund is to find stocks with small market capitalizations (i.e., $500 million or less) that are relatively cheap based on some criteria such as price-to-book and price-to-sales ratios. You will only investigate and invest in small companies that meet your thematic criteria and select the companies that best represent your trading theme. Of course, you will also be concerned with future growth prospects, earnings, and capital appreciation. If we were to look at the stocks listed in your fund, we should be able to notice that all the stocks you are invested in appear to be small companies; that is, we will not find GE, MSFT, or IBM. Thus, a basic principle of your trading theme will be obvious in your overall portfolio.

You should conduct the same exercise on your portfolio. Do all your trades appear to represent a particular trading theme or are they a hodgepodge of different, unrelated strategies with one thing in common—your capital at risk? If that is the case, then you lack a portfolio theme. This makes it difficult to follow your investment decisions and keep track of why you made each trade, because each position will most likely have its own independent justification.

If you do not have clear guidance on why you entered into each trade, then you most certainly will not be following predetermined exit strategies. Therefore, you will also be ignoring the principles of risk management; when you fail to control your risk, your risk will control you! Investing with this kind of “trade blindness” is akin to gambling in Las Vegas, and remember the old adage in gambling, “The House always wins.” If you have never gambled, let us clarify that you are not the House, and eventually you will lose everything when your luck runs out. Therefore, following your investment theme in your portfolio will keep your trades focused and allow you to better manage and control your risk.

Diversification and Flexibility

All the strategies within your portfolio need not be identical simply because they are established under the same trading theme. Diversification is highly recommended in all aspects of investing, including the selection of option strategies. A portfolio theme, for example, does not envision having a portfolio made up entirely of covered calls or credit spreads. There are various option strategies that share common investment themes. Each strategy may work better under certain conditions, and therefore we need to understand the best environment for each one. Golfers have more than 10 clubs to choose from each time they hit the ball, and to be successful they must understand which club is best to use in different situations. The same is true with option strategies.

Avoid falling in love with any one strategy. If the market conditions change, a particular strategy may be inappropriate. As a result, you must be flexible in choosing a more appropriate strategy. Therefore, not only must you diversify your strategy selections, but you must also be flexible and adapt to changes in the market to switch to strategies that are more appropriate. You must adapt to the markets; the markets will not adapt to you.

TRADING AS A BUSINESS

The best way to incorporate all the principles of risk and trade management into your investments is to treat your trading as a new business. Your business is trading, and you are the president and chief financial officer of the company. This is a professional endeavor and not to be taken lightly or treated as a game or hobby—you are risking real money. You should think of trading as a career, and your job is to run the company that controls your investments. The employees of your business are your trading positions, and their jobs are to make you money. Whether you are an investor who merely trades on the side or a professional money manager or trader, you should have the same professional approach to your trading.

Start-Up Phase

At the start-up phase of a new business, there are many sunk costs and expenses required to get the business started as well as much preparation and hard work. As the owner of the new company, you need a detailed business plan, which outlines the purpose of the business and how it will get started and conduct its daily operations and also provides guidance on budgeting issues so that the company can manage its revenues and expenses. You will need to acquire assets to start the business and hire employees. The start-up phase, which usually covers the first year, is the most important and difficult part of starting a new business. Most new businesses take some time to be profitable, and therefore you, as the owner, have to be able to bear the losses until your company can begin turning a profit.

Option trading also has a start-up phase. You will need to invest time and money to learn about options and study the market before you begin to trade. Most traders begin working hard after they start trading and fail to prepare ahead of time. Learning on the run, that is, learning while you trade and lose money, is a very expensive form of education. Of course, you will constantly be learning as you trade, but before you invest the first dollar in your new business, you need to commit yourself to learning everything you can about options.