The Four Biggest Mistakes in Option Trading

Jay Kaeppel

• Publisher: Wiley
• Year: 2012
• Print ISBN:
  9781592802555
• Edition: 2
• eBook ISBN:
  9781118538371
• Topic: Business
• Subtopic: Finance
• Index: Business

With over 50,000 copies in print for the first edition, Kaeppel's insight has undoubtedly made its mark in the options world. Now, he strikes again with an updated and more comprehensive look at those pesky mistakes that traders continue to make in trading options. In easy-to-understand terms, he systematically breaks down each problem and offers concrete and practical solutions to overcome it in the future.

There are big profits to be made in options trading. By avoiding the four most common and most costly mistakes the majority of traders make, you'll be set to win big. System and software developer Jay Kaeppel helps you thoroughly understand each mistake before showing you how to avoid them in future trades.

In this new, color edition, you'll find:

• More in-depth analysis of the four biggest mistakes including volatility calculations, risk/reward relationships, calendar spreads, etc.
• More real world examples with varying scenarios updated to reflect today's market
• More graphs and tables to better illustrate Kaeppel's concepts
• More detailed discussion on the nature of options trading and how to create a consistently winning strategy

Concise and to-the-point, here's an action plan you can read and put into place immediately to become a more profitable trader.

Mistake #1

Relying Solely on Market Timing To Trade Options

WHY TRADERS MAKE MISTAKE #1

Far too many first-time option traders view options as nothing more than a tool for leveraging their market timing decisions. That is, rather than buying or selling short a particular stock or futures contract, they feel that they can buy a call or put option and:

• Commit a great deal less capital than they would to buy the underlying security itself, and,
• Obtain a great deal more leverage than they would if they simply bought the underlying security.

And, in fact, it is possible to attain these benefits via option trading. By putting a relatively small sum of money into an option position, it is possible for a trader to achieve a much higher rate of return on a given trade than if he or she had bought or sold short the underlying security directly. For example, consider a stock that is trading at a price of $55 per share. In order to buy 100 shares of that stock, the investor would need to invest $5,500 (100 shares times $55 per share). At the same time, a call option with a strike price of 55—which gives the buyer of the option the right, but not the obligation, to buy 100 shares of the underlying stock at a price of $55 a share—might be trading at a price of $3 per contract. In order to buy one call option, the investor need only to put up $300 ($3 per contract times 100). The call option trader’s breakeven price in this example is $58 per share (the strike price of 55 plus the premium paid of $3). Hence, the call makes a profit at any stock price above 58. So in this case, the option trader needs to put up only about 5.4% as much capital as the buyer of 100 shares of stock; at any price above $58 per share, the option trader will enjoy point-for-point profit with the more traditional stock trader who invested $5,500 to buy the stock.

That is the good news. Unfortunately, a vast number of market timers adopt the belief that market timing is all they need in order to profit from trading options. Accordingly, they do little or no options analysis—instead adopting the attitude that “if my timing is good, any old option will do.” This is invariably a fatal error in the long run.

Market timers take great comfort in their winning trades—perhaps too much comfort. Any winning trades that they experience serve to reinforce their belief that market timing is all that is required in order to succeed, regardless of how few and far between the winning trades may be. Unfortunately, occasionally achieving a high rate of return on a given trade is not the same thing as making money in the long run. The question to ask is not, “Do I achieve a big winner now and then?” (as even the worst traders can occasionally hit a big winner). The relevant question is, “Am I following an approach that is likely to generate profits over the long run?” Traders who rely solely on market timing to trade options must answer no to this all-important question.

The primary reason that relying solely on market timing to trade options fails in the long run is that it completely ignores one of the most important factors in option trading: implied volatility. Before proceeding to explain why market timing alone fails option traders in the long run, let’s first discuss what implied volatility is and why an understanding of this important concept is critical to option trading success.

Implied Volatility Defined

The “implied volatility” value for a given option is the value that a trader would need to plug into an option pricing model in order to make the theoretical option price generated by the model equal to the current market price of a particular option. This can be accomplished when the other variables—underlying price, days until option expiration, interest rates, and the difference between the option’s strike price and the price of the underlying security—are known. In other words, it is the volatility “implied” by the current market price for a given option. Before proceeding it is important to understand just what implied volatility represents, why it is so important, and the impact that changes in implied volatility can have on your trades.

Calculating Implied Volatility for a Given Option

There are several variables that are entered into an option-pricing model to arrive at a theoretical price, or the “fair value,” of a given option:

A) The current price of the underlying security.

B) The strike price of the option under analysis.

C) Current interest rates.

D) The number of days until the option expires.

E) A volatility value.

For stock options, dividends also factor into the model. However, to simplify things here, we will leave dividends out of the following example.

• Elements A through E above are passed to an option-pricing model, which then generates, a theoretical option price.
• Elements A, B, C and D are “known” variables. In other words, at any given point in time one can readily observe the price of the underlying stock (or futures contract), the strike price for the option in question, the current level of interest rates, and the number of days left until the option expires.

Example of Implied Volatility Calculation

To calculate the implied volatility of a given option, we follow this procedure with one important modification. Instead of passing elements A through E to an option pricing model that generates a “theoretical” price, we pass elements A through D along with the actual market price for the option as variable F, and allow the option pricing model to solve for element E, the volatility value. A computer is needed to make this calculation. This volatility value is called the “implied volatility” for that option. In other words, it is the volatility that is implied by the marketplace based on the actual price of the option.

For example, on April 6th the IBM July 2006 85-call option was trading at a price of $2.40. The known variables are:

A) The current price of the underlying security = 83.70

B) The strike price of the option under analysis = 85

C) Current interest rate = 3.5

D) The number of days until the option expires = 106

E) Implied volatility = ?

F) The actual market price of the option = 2.40

The unknown variable that must be solved for is element E, volatility. Given the variables listed above, a volatility of 14.21 must be plugged into element E in order for the option-pricing model to generate a theoretical price that equals the actual market price of $2.40. Thus, the “implied volatility” for the IBM July 2006 85-call as of April 6th option is 14.21.

Different options may trade at different implied volatility levels. If demand in the marketplace is great for a given option, the price of that option may be driven to artificially high levels, thus generating a higher implied volatility for that option. The differences in implied volatilities across strike prices among options of the same expiration month for a given underlying are referred to as the volatility “skew.” There are a number of different options strategies that are geared to exploit specific volatility skews.

Why Implied Volatility Matters

The actual price of an option, the premium, is the sum of two quantities: intrinsic and extrinsic value. Intrinsic value represents the amount by which the option’s strike price is in-the-money (ITM). Extrinsic value represents time premium. If an option is out-of-the-money, then the price is comprised solely of time premium, or extrinsic value. The amount of time premium built into any option is directly related to the amount of time left until expiration and the implied volatility for that option. As a result, the higher the current level of implied volatility, the higher the price for the option. Conversely, the lower the current level of implied volatility, the lower the price for the option. This has obvious ramifications for any trader considering buying or writing a particular option. If you buy a given call option when implied volatility is high, you will pay more for the option than you would if implied volatility was low. This in turn implies that you:

• Will spend more to buy the call option;
• Will have a greater dollar risk;
• Will have a higher breakeven price basis the underlying stock for a call option and a lower breakeven price for a put; and,
• May experience a meaningful decline in the price of the option if there is subsequently a significant decline in volatility.

Let’s illustrate these factors further with an example. As you can see in Figure 1, over the course of the past five years, the implied volatility for IBM options with more than 90 days left until expiration has ranged from a low of 13 to a high of 54.

Figure 1 - IBM Implied Volatility

Source: Optionetics Platinum

To understand the significance of changes in implied volatility, take a look at how the price of the July 85-call option changes given different implied volatility levels as of April 6th (see Table 1). First, let’s look at the low end. If the IBM July 85-call option were to trade at an implied volatility level of 13, the price of the option would be $2.30. If the option traded at the two-year high for implied volatility of 24, the price of the option would be $4.28. Finally, if the implied volatility for the option were at the five-year high of 54, the price of the option would be $9.65. These differences have significant implications.

Table 1 - Changes in Implied Volatility = Price Shifts

It should be clear from the information contained in Table 1 that implied volatility is a critical piece of information for any option trader to consider. Likewise, any trader who completely ignores implied volatility—for example, one who focuses only on market timing to trade options—will undoubtedly at times be flying blind. This will lead him to buy options in situations where it is not prudent to do so due to high volatility or writing options when it is not a prudent course of action due to low volatility.

Why Implied Volatility Fluctuates

Much of the fluctuation that occurs for an option price is directly related to changes in the price of the underlying security. Clearly, if a stock makes a huge move up, call prices will increase and put prices will decline across the board for that stock. However, the amount of time premium built into a given option is also determined to a great extent by the current level of implied volatility. As we saw in Figure 1, implied volatility levels can change dramatically. Why is this? There are two primary factors – the volatility of the underlying stock and investor perceptions of future volatility.

In order for any option trade to occur, there must be one buyer and one seller, or “writer.” Consider this: if out-of-the-money options had no time premium—in other words, if they were all priced at $0.00—why would anyone assume the risk of writing an out-of-the-money option? The amount of time premium built into each option is essentially the inducement available to a trader to take the risk of writing that option. When the underlying stock price starts to behave in a volatile manner, or if some impending news situation causes investors to think that volatility will rise in the near future, then option writers will essentially demand higher premiums before they will be willing to take the risk of writing options on that stock. This demand for high...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Introduction
• Mistake #1: Relying Solely on Market Timing to Trade Options
• Mistake #2: Buying Only Out-of-The-Money Options
• Mistake #3: Using Strategies That Are Too Complex
• Mistake #4: Casting Too Wide of a Net
• Summary
• About the Author and Optionetics
• Trading Source Guide