Option Trades: Option Illusions

Looking at the Big Picture

Optical Illusion
Wikipedia.org

When we enter into an option trade, most of the time the trades are straightforward, and even the novice trader understands the trade results; i.e., just how much money was earned or lost. One obvious example occurs when buying or selling an option. It is easy to determine when the trade has made/lost money.

However, there are situations in which a trader may believe that he/she has lost money when in reality, the trader should understand that the trade resulted in a profit.

All that is required to fully grasp the process is a logical way of thinking.

Here Are Some Examples

1) Writing covered calls.
Let's say that you buy stock at $38 per share and write a 2-month call option whose strike price is $40, collecting a $1 premium. If time passes, expiration arrives, and the stock is then priced at $44 per share, the owner of the call option will elect to exercise his/her rights to buy your stock at $40 per share, and you will be. That notice informs you that you sold your shares at $40, per the conditions of the option contract.

This is a wonderful result because you bought stock at $38, sold it at $40, and also get to keep the $100 option premium (price at which you sold the option). At the time that you decided to write the call option, the possibility of achieving this result appealed to you - and why wouldn't it? The idea of earning $300 on an investment of $3,700 (8.1%) in only two months is very attractive - especially when you don't have any expectation that the stock price could rise all the way to $44.

The unsophisticated option trader may feel that he/she lost money of the trade because the stock could have been sold @ $44 per share, and he/she collected (counting the option premium) only $41 per share. This is a way of thinking (a mindset) that must be avoided if you have any hope of becoming a long-term successful trader.

Sure it is nice to collect the maximum possible profit from every trade (or even from a single trade), but I urge you not to analyze your trade results according to what you "woulda, coulda, or shoulda" done.

You did not have to buy this stock, but you did, and it turned out to be a good decision. You did not have to write the call option, but you did, and it contributed extra $100 to your total profit. How can that have resulted in "lost money?"

Please remember one thing about selling options: The option seller is not competing with the option buyer. It is not a case where one wins and the other loses. The buyer and seller each have their own reasons for making the trade, and each can win by using the option to achieve a specific investment objective. In this example, you "won" by collecting the premium and being able to sell the stock at your original target price (the strike price). Remember, that if you DO NOT want to sell stock, then do not write covered calls.

When trading, if you are capable of making good decisions - at the time when trade decisions are made -then you will be a winner. If you regret decisions and keep kicking yourself for earning less than the maximum possible sum, then you will spend far too much time feeling sorry for yourself, and not enough time congratulating yourself of yet another winning trade.

2) Selling naked put options -- and selling put spreads.
NOTE: The identical principles apply when selling naked calls, but puts are the preferred choice among traders. One reason for that is because most brokers forbid the sale of naked call options.

One of the conservative option strategies for investors is the sale of naked put options. It tends to work well because either of the two possible results is acceptable to the trader: a) The option expires worthless and the trader earns a profit equal to the premium collected when writing the option; or b) The stock price declines, the trader is assigned an exercise notice and buys stock at the strike price, minus the option premium. Because an investor is willing to own shares when the price is right, this is a decent strategy for investors.

Traders tend not want to own shares, and their purpose when entering into the trade is to earn a short-term profit.

And that goal must be kept in mind at all times. That may seem trite, but careless traders make lots of bad decisions.

For example, you decide to sell an OTM SPX 10-point put spread and collect $1.25. The position expires in four weeks and this is your very first sale of a put spread.

Time passes, the market doesn't have any big down days and the spread can be covered (i.e., you can buy to close) by paying $0.10. The options are still far enough OTM for your comfort zone, and there does not appear to be the apparent urgency to "waste" $10, plus commissions, to exit the trade.

However, despite your inexperience as a trader, you read about the sad experience of other traders who chose to never waste money by covering these "safe" positions. Based on your reading, you decide to go ahead and lock in the profit ($1.15, less commissions) now, instead of holding out for another week and hoping that the options expire worthless.

Although I do not recommend the practice of looking back to see what would have happened to an investment -- once you elected to exit -- it is human nature to do so. Sure enough, one week later the market declined by a small amount, and the options that had been part of your spread expired worthless. 

It is quite tempting to believe that you lost $10 (plus commissions) per spread. A much more effective and rewarding way to think about what happened is:

  • You bought inexpensive insurance that allowed you to protect your profit and be certain that the position did not turn into a loss.
  • You earned a good profit in three weeks -- an average of $38 per week for those three weeks. Exiting one week early cost only $10 for one week of safety. All in all, this is an intelligent way for traders to manage position risk.
  • Please do not think of the $10 as wasted money or cash that you threw away. That $10 did a lot of good for your long-term success.

Warning: After you successfully complete some trades similar to this example; after you get out of the position at a low price while there are still a few days before expiration arrives; and especially after it turns out that the options would have expired worthless had you not covered; I promise that is is going to be very tempting to stop "wasting" or "losing" money for no reason. It is going to be tempting to hold positions all the way through expiration.

All I can do is to warn you that stock markets do unexpected things at unexpected times. All it takes is a terrible earnings report from an important company (think GOOG, AAPL); or an election result (think Brexit), or a big terrorist attack or assassination. In this world, I urge you not to take such chances.

3) Buying Protective Puts.

Let's say that you own 300 shares of a stock priced near $200 per share and you like the prospects for the company. However, you fear that there is a good chance that the stock price may be unstable for a short period of time. Rather than sell the shares (which you prefer not to do for income tax reasons), you decide to buy a 2-month put option with a strike price of $190. That put costs $8 per share.

You acknowledge that $8 is a lot of money (4% of the stock price), but you want that protection.

So what happens if the next two months pass quietly and despite your fears for the worst, the price of your stock moves higher, to $206, as the puts expire worthless. There are two basic methods that you can look at what happened.

The first is to write the truth in your final trade report. And the truth is that your fears were overblown and, in retrospect, it turned out that owning insurance was an unnecessary expense.  However, it is extremely important to prevent yourself from believing that you made a mistake and that you lost money that did not have to be lost.

The second way of looking at this experience is to recognize that you are not a perfect prognosticator and that you do not always know in which direction stock prices are going to move. You made a sound decision concerning the need to protect your portfolio against a major loss. As a successful trader, you are going to be facing similar situations down the line. You cannot expect to be correct every time and you will incur investing expenses that -- in retrospect -- were not necessary. But, they were necessary (for you and your comfort zone) and you did not waste money.

One reminder: A loss is not a mistake. A mistake is avoiding something that you believe is necessary to protect the value of your portfolio. If you can remember that single fact, then you can gracefully accept that some decisions will earn money and others will not. If each of your decisions is based on sound reasoning, then your trading future should be quite positive.

Although it is not possible to classify this trade as one that earned a profit (and that is the basis of this article), had you taken a different path and written a covered call -- with a strike price of $190, you would have gained some money instead of incurring a trading loss. Of course, the downside to making that decision is that you would not have had as much protection against a stock-market correction. And because protection is what you wanted, do not feel bad about how this trade turned out.