“I’ve been hanging onto nothing when nothing could be worse” Heaven When We’re Home The Wailin’ Jennys

As an options trader, I continue to be impressed by the wide variety of choices available to modify a trade that is not quite going the way I initially predicted. This approach may be a bit unfamiliar to the trader whose experience has been primarily with trading stocks. The choices for a stock trader are really only two: open or close a position.

The knowledgeable options trader can structure trades using one or more of the three primal forces of options to increase probabilities of success. These three factors are: time to expiration, implied volatility, and price of the underlying. If these variables are considered in the initial construction of a trade, the options trader can increase the probability of success of a trade. Even more remarkable is the ability to modify the physiology of an existing trade as a result of changing market dynamics.

I thought it would be helpful to examine a trade in which I have had to use several of these factors in order (perhaps) to avoid a loss. In discussing this trade which is still open, a position I have yet to know if will ultimately be profitable, you can begin to understand some of the fundamental concepts which guide an option trader’s decisions.

On March 29, I saw a pattern in X which I considered to be modestly bullish. X is a very liquid stock and as often the case; this liquidity is accompanied by an actively traded options board. In considering my many choices of how to structure this position, I chose to focus on what has been the defining characteristic of the market during early 2011-the low volatility environment.

Most traders are familiar with the VIX being reflective of general market implied volatility, but when considering trade structure it is important to realize there is an implied volatility history for each underlying for which options are traded. A graphical display of such a history is embedded below:

It is clear that X is currently in its lower range of implied volatility. If I want to put as much wind at my back as possible, my objective in every trade, it would be smart to select a structure from the group of trades that benefits from stable or rising volatility. The core knowledge is that implied volatility is well known to be mean reverting and in this case reversion to the mean would result in a rising implied volatility.

One of the best trade structures in a low volatility environment is the calendar trade. In the vernacular of an options trader, it is a “positive vega trade”. In plain talk, this means the trade benefits from increasing volatility.

A calendar trade is constructed by selling a shorter dated option and buying a longer dated option. These options are of the same type; either puts or calls, and is established at the same strike price. The profit curve typically shows a variably broad zone of profitability that reaches its maximum at expiration when the underlying is at the strike price chosen. Because maximum profit occurs at the strike price selected, a directional bias can be established by choosing the appropriate strike.

Risk factors in this trade are two:

1. Price movement beyond the bounds of profitability.
2. Collapse of implied volatility in the long options leg of the structure.

In this case, I chose to establish the calendar at the 57.50 strike when the stock was trading at around 56.50. I put the wind at my back a bit by selling the weekly call at a price of 70¢ and a volatility of 38.5% and buying the monthly call at 36.6%. This volatility skew served to reduce my exposure to volatility collapse in the long leg and broaden the range of profitability a bit. The initial P&L graph for the trade is presented below:

Unfortunately, within 48 hours, the price of X had fallen significantly as a result of a negative analyst recommendation. The short option I had sold was now trading at 3¢. I bought these back for a net credit of 67¢ and remained long the original calls I purchased.

When options you are short trade at less than 10% of the original price at which they were sold, only bad things can happen if you keep them open. Such options MUST be closed regardless of other adjustments you may choose to make. If you choose not to do so, in the words of the Wailin’ Jennys, you will be hanging on to nothing when nothing could be worse.

Following this fundamental tenet, I closed the options, and sold the next week’s option at the same strike short for a net credit of 24¢. On April 5, price had continued to go down; my adjustment was to buy back these calls for 13¢, booking an additional credit of 11¢.

I then chose to convert the trade to a butterfly structure in order to improve the odds of success. My current trade structure is displayed in the graph below. I do not know if this trade will be economically successful, but it represents an exercise in using the dynamic potential of options to accommodate the current “real world” situation.

This trade may or may not work out economically, but it represents a characteristic example of the ability of dynamic use of options to mitigate losses from what turns out to be an initially incorrect hypothesis regarding future price movement. Stay tuned for the outcome; I will be monitoring it closely.

A career in options trading can be one of the most rewarding or frustrating experiences ever. Those who succeed are those who are able to really look within themselves and pin point their needs versus their wants.

For example:

A guy once shared with me his insights on human behavior. He explained that when people come to you and they want to learn how to lose weight they really don’t want to know how to eat healthy or what exercises to try. That’s what they NEED.

What they WANT is to know what do they eat when they are at McDonalds that will help them lose weight.

By now you’re probably wondering what the heck this has to do with options trading.

Well as an options trader you may need a simple step-by-step proven trading system that works, but what you may want is to trade based on news events and emotions and still make money.

Some traders never make this distinction in their personality. They may have a trading system that works sitting right in front their face and they never realize it because they are constantly being distracted by the news commentators on CNBC.

So the key is to find a trading system that works for your particular trading personality, just like one would need to find a diet that works with their particular eating habits and lifestyle.

Options trading is NOT a one size fits all skill.

Creating your own trading system and template takes time, but it is well worth the effort. The first thing one needs to do is to understand options trading and all of its complexities.

Option trading is not restricted to individual stocks. The large commodity market is an option market that deals in all manner of commodities such as grain or cattle. There is also another type of investment known as index option trading.

An index is a listing of a number of different stocks that share something in common, and it represents the composite value of all of them. An example is the Dow Jones Industrial Average which represents the value of the 30 largest and most widely held industrial stocks on the New York Stock Exchange. The Standard and Poor’s 500 is another index that represents 500 different stocks. These two well known indices are used frequently to gauge the progress of the economy and the general health of the stock market. They are familiar to most people, even those with little or no interest in the market, as they are widely quoted on news broadcasts.

They represent just two of a large number. There are broad based ones that reflect a wide range of widely different stocks, and there are ones that are very specific to a certain group. As the Dow Jones tracks industrial stocks, another index called The Morgan Stanley Biotech Index tracks 36 different stocks of companies engaged in biotech research. An index can list companies with similar products, and even similar management styles. There are also a wide variety of foreign indices that reflect the composite value of foreign stocks.

An index may also be classified as to how it is weighted. Some regard every stock equally, and a price fluctuation in any stock in the index will have an impact of the index price no matter how large that individual stock’s share of the index might be. Other indices “weight” the index based on the size of the company. In other words, small companies that experience even a large price change will not have as much impact on the index as a small change in one of the largest companies.

Index option trading is popular in part because the risk is considered to be lower than with individual stock. This is partly because the index, representing a variety of stocks, is less likely to be subjected to the same adverse pressures that may cause an individual company to experience a very rapid decline in its value. The index is seen as much easier to subject to trend analysis, and this makes it a popular part of most Mutual Fund portfolios.

There is another classification of indices that might be of interest to investors with certain social and environmental sensitivities. They are known generally as Ethical Indices as list stocks that satisfy certain criteria in their business operation. An example of one such index is the Wilderhill Clean Energy Index. Sadly, in the current market there is no direct connection between environmental sensitivity and profit, but with an Ethical Index, you can at least feel good about yourself while you make money, or even feel somewhat good if your investment turns out the opposite way.