Archive

Category Archives for "Learn"

It Sucks to be a Rookie Trader — Top 10 Options Trading Mistakes Every Newbie Trader Makes

It sucks to lose money. It sucks to be a newbie trader because that is when you’ll make the most mistakes. It takes time and effort to learn tricks of the trade and master the art of trading options.

top 10 rookie trading mistakes

There is literally so much to learn that making mistakes and losing money is just a matter of when. When will you make a stupid trade, which will be a loss making venture for you? But that is what we want to avoid.

In this article, we’re going to cover top 10 options trading mistakes that almost every rookie trader makes. Sometimes even experienced traders misjudge and make these mistakes because either they get carried away or do not pay much attention.

Top 10 Options Trading Mistakes that Every Newbie Trader Makes

Mistake #1 — Buying Out-of-Money (OTM) Call Options

Trading OTM calls is the easiest way to get started but at the same time, it is the easiest way to lose money. Hence, if you wan to make money consistently, it is one of the most difficult option. If you’re new to options trading, consider investing small amounts or try another strategy first.

Mistake #2 — Doubling Down

When a trade moves against you, it’s tempting to forget the risk, expiration date and repeating the same trade again. Just have a look at stupid trades and tremendous losses I incurred with mistake #1 and #2. You should instead try another approach to mitigate your losses.

long call options losslong call options loss

Mistake #3 — Using Same Strategy All the Time.

Market sentiment, trading conditions keep changing all the time. One strategy which made you money yesterday is not a guaranteed money making strategy for tomorrow if market conditions have changed. You need to tailor your options trading strategies accordingly. Tailor and adapt!

Mistake # 4 — No exit plan

Especially when an option trade is not going your way, you need to have an exit strategy. Booking your losses and getting out is many a times better option that hanging on to your options because unlike stocks, you cannot hang on to your options forever. It is very likely that time decay will render those options worthless.

Mistake #5 — Trading Low Volume Options

Low volume options may be available at lower price but the biggest drawback to this strategy is that you may not be able to square off the trade. When you trade options, pay close attention to the open interest numbers. The more open interest there is, the better it is.

Mistake #6 — Legging into Spread Trades

This is a common mistake among rookies and experienced traders hoping to squeeze the last few bucks out of a trade. Do not fall for it!

Mistake #7 — Not trading Index Funds

Trading ETFs may not sound exciting but this approach can shield you from costly market volatility.

Mistake #8 — Ignoring Expiration Date

Options get a lot of activity near to the quarterly results date. If you don’t pay attention to the expiration dates, you could trade an option that expires before the anticipated event and your options will expire before becoming profitable.

Mistake #9 — Early Assigned Options

When you sell an option, you have an obligation, not a right. If the buyer assigns the contract, you must buy or sell accordingly. If you sell a call, you must sell the stock at the strike price. If you sell a put, you must buy the stock at the strike price.

There’s no rhyme or reason why a trader would exercise an option early. As an option seller, you must be prepared for this situation. You’ll need enough cash to cover the transaction or have possession of the underlying security.

Mistake #10 — Wrong Sized Trades

The size of your trade should match your portfolio. Before investing, figure out how much you are willing to risk on any one trade. Always think of worst-case scenarios and don’t risk your entire portfolio.

On the flip side, though, you don’t want to risk too little. You may play safe and not lose anything but that may also lead you to leaving money on the table.

What is Long Call Option Strategy

Overview of Long Call Option Strategy

A long call gives you the right to buy the underlying stock at a strike price.

The long call option strategy is basically a bullish options trading strategy using which you hope to make money with price of the underlying stock rising significantly more than the strike price before the option expiry date.

By definition, Long Call Option Strategy offers unlimited profit and limited loss.

If you buy a long call option and the price of underlying stock goes up – you make money. However, instead if the stock price goes down or does not go up as much as you expected, you’ll lose money.

The term unlimited profit is theoretical because it refers to a situation wherein a stock just keeps going up. Since stocks do not have a maximum price ceiling they can reach, so it refers to an unlimited price and unlimited profit situation. In reality, stocks never reach a unlimited price point. Their price goes up and then it comes down, which means you’ll have limited profit but that limit is just not a certain limited amount. You’ll however have limited loss because in worst case scenario, you’ll lose all the money you invested in this long call. Your investment can go to zero but not below that.

Example of Long Call Option Strategy

For example, you may like Apple as a company and the products they sell. This makes you believe/hope that the stock price of Apple will be higher than today in the future.

Lets have a look at the below option chart for Apple for a particular day. It is a $165 strike call option for April 18, 2019 expiry.

long call option example

Price (premium) for this call option ranged from 10.50 to 13.98 during the day. It opened at 13.98 and closed at 11.16, so obviously, it was not a good day for AAPL since it dropped 19.42%. Note that the price of AAPL stock did not drop by 19.42%. AAPL stock price in fact dropped by 3.12% but the corresponding drop for this particular option was 19.42%.

If you bought this option during the day, you’d have bought it at a price within this price range. Lets assume you bought a long call option when the price of this option was 12.

i.e. your trade was: AAPL Apr 18 2019 165.00 Call Buy to Open 1 @ 12.00

To buy this option, you’ll have to pay $1200 (1 x 100 x 12). This would be your worst case scenario loss i.e. you’ll lose all your investment i.e. your options become worthless.

For you to make money off this trade, you’ll need the AAPL stock price to be higher than the strike price plus the premium you paid towards it i.e. 165+12 = $177.

You can sell this call option any day before April 18, 2019 and book your profit or loss. Say if the premium reaches say 14, you’ll make $2 (14 – 12 = 2)  per option i.e. $200 profit. Whatever amount higher than 12 it goes to, it would be your profit.

Look at this below long call option trade I did in 2018. I bought and then sold PANW long call option for a nice profit of $177.95 in less than a week.

long call option real life example

I bought PANW 230 call at a price of 4.3 and sold it at 6.1. I could have held it and maybe it would have reached 10, maybe 20, maybe 30.. and so on, which means I had an unlimited upside (theoretically). Worst case scenario, I would have lost all my investment i.e. $431.02 on this trade.

Look at this below long call option trades I did in 2018 in TWTR.

TWTR had mixed results and the stock got hit hard. I saw an opportunity to get in and bought my first long call but unfortunately Facebook scandal broke and it took down other social media companies too. I acted foolish thinking that I have enough time for the stock to recover and kept buying the same one over and over again.

As we know, TWTR did not recover for rest of 2018 and booked my loss (total loss of $1413.10) to reduce my tax exposure for 2018.

When to Close a Long Call Option?

Obviously your aim with long call options is to close them before they expire and make some money. So, it does not hurt to book profits whenever you can irrespective of when the expiration date is. If your expiration date is 4 months from now but you already doubled your investment, I’d say sell it now!

If you’re losing money on a long call option, it is also a good idea to book losses and close the call because as expiration date nears – those options will become zero. If your options have already become worthless, there is no point in trying to sell them and save a few bucks on commission fees (actually they may not even sell because there isn’t any volume.

Role of Time Decay

As date nears the expiration date of the option, the premium price will get realistic and aligned with the actual price. As expiration nears, out-of-the-money and at-the-money calls will lose their value faster than in-the-money calls due to theta decay or time decay.

All the above options are worthless because of time decay.

Take a look below at some more worthless long call options in my current portfolio. Their price has become zero (0.01) and even if I try to sell them to book a loss, they’re not getting sold and hence, I have no option but to wait for the expiry date so that they expire worthless and get removed from my account.

worthless long call options

Important Tips for Long Call Options

Best thing about buying long call options that it is the simplest options strategy to get started with, especially for those new to options trading. However, at the same time, it is a risky strategy as well.

Long call options offer unlimited upside potential, however, practically speaking – there is nothing like unlimited upside. At best you may have a nice upside profit or in worst case scenario, you’ll lose your investment.

Hence, when buying call options, always remember to:

  • Avoid those options, which are way out of money.
  • Size your position appropriately. Don’t invest too much in one option and in one company.
  • Don’t allocate too much capital in one particular strategy.

Have a look at below reckless long call option trades I did in the last quarter of 2018. As markets started correcting, I kept on buying more and more long calls, hoping the markets will recover but it never did and I lost of lot of money doing the same.

Lesson learned, do not invest too much money in long call options. They are simple to get started with but are more like a punt instead of a strategy.

long call options loss

long call options loss

Glossary of Key Options Trading Terms

There is so many different terms associated with Options trading that it is easy to wonder if your understanding is correct. We’ve simplified things a little by providing short definitions in this article for a quick access and easy to understand.

Aim of this article is to just provide short definitions of key terms associated with Options trading. To find detailed explanation of those terms, you’ll have to follow the links to go to the main article.

glossary of terms in options trading

Glossary of Terms Associated with Options Trading

ASSIGNMENT

The receipt of an exercise notice by an equity option seller (writer) that obligates him/her to sell (in the case of a short call) or buy (in the case of a short put) 100 shares of underlying stock at the strike price per share.

AT THE MONEY

An equity call or put option is at-the-money when its strike price is the same as the current underlying stock price.

BACK MONTH

Options that have more than one month before expiry are known as Back month options. They are slightly less liquid than front month options and typically have wider bid/ask spreads.

BREAK EVEN

An underlying stock price at which an option strategy will realize neither a profit nor a loss, generally at option expiration.

CALL OPTION

An equity option that gives its buyer the right to buy 100 shares of the underlying stock at the strike price per share at any time before it expires. The call seller (or writer), on the other hand, has the obligation to sell 100 shares at the strike price if called upon to do so.

CASH SETTLEMENT

A settlement style that is generally characteristic of index options. Instead of stock changing hands after a call or put is exercised (physical settlement), cash changes hands. When an in-the-money contract is exercised, a cash equivalent of the option’s intrinsic value is paid to the option holder by the option seller (writer) who is assigned.

CLOSING TRANSACTION

A transaction that eliminates (or reduces) an open option position. A closing sell transaction eliminates or reduces a long position. A closing buy transaction eliminates or reduces a short position.

COMMISSION

The fee charged by a brokerage firm for its services in the execution of a stock or option order on a securities exchange.

CASH TO CARRY

The total costs involved with establishing and maintaining an option and/or stock position, such as interest paid on a margined long stock position or dividends owed for a short stock position.

CREDIT

Any cash received in an account from the sale of an option or stock position. With a complex strategy involving multiple parts (legs), a net credit transaction is one in which the total cash amount received is greater than the total cash amount paid.

DEBIT

Any cash paid out of an account for the purchase of an option or stock position. With a complex strategy involving multiple parts (legs), a net debit transaction is one in which the total cash amount paid is greater than the total cash amount received.

DELTA

The amount a theoretical option’s price will change for a corresponding one-unit (point) change in the price of the underlying security.

EARLY EXERCISE / ASSIGNMENT

The exercise or assignment of an option contract before its expiration. This is a feature of American-style options that may be exercised or assigned at any time before they expire.

EQUITY OPTION

A contract that gives its buyer (owner) the right, but not the obligation, to either buy or sell 100 shares of a specific underlying stock or exchange-traded fund (ETF) at a specific price (strike or exercise price) per share, at any time before the contract expires.

EVEN MONEY

With a complex strategy involving multiple parts (legs), an even money transaction results when the total cash amount received is the same as the total cash amount paid.

ETF

ETF stands for Exchange Traded Fund and are index funds, which trade just like stocks.

EX-DIVIDENT DATE

When a corporation declares a dividend, it also declares a “record date” on which an investor must be recorded into the company’s books as a shareholder to receive that dividend.

Also included in the declaration is the “payable date,” which comes after the record date, and is the actual date dividend payments are made.

Exchanges set the “ex-dividend” date (“ex-date”) to two business days prior to the record date. If you buy stock before the ex-dividend date, you will be eligible to receive the upcoming dividend payment. If you buy stock on the ex-date or afterwards, you will not receive the dividend.

EXERCISE

To employ the rights an equity option contract conveys to its buyer to either buy (in the case of a call) or sell (in the case of a put) 100 shares of the underlying security at the strike price per share at any time before the contract expires.

EXERCISE PRICE

A term of any equity option contract, it is the price per share at which shares of stock will change hands after an option is exercised or assigned. Also referred to as the “strike price,” or simply the “strike.”

EXPIRATION DATE

The day on which an option contract literally expires and cannot trade any more. For equity options, this is the Saturday following the third Friday of the expiration month. The last day on which expiring equity options trade and may be exercised is the business day prior to the expiration date.

EXPIRATION MONTH

The calendar month during which a specific expiration date occurs.

EXTRINSIC VALUE

The portion of an option’s premium (price) that exceeds its intrinsic value, if it is in-the-money. If the option is out-of-the-money, the extrinsic value is equal to the entire premium. Also known as “time value.”

FRONT MONTH

For an option spread involving two expiration months, the month that is nearer in time.

GAMMA

The amount a theoretical option’s delta will change for a corresponding one-unit (point) change in the price of the underlying security.

HISTORICAL VOLATILITY

A measurement of the actual observed volatility of a specific stock over a given period of time in the past, such as a month, quarter or year.

IMPLIED VOLATILITY

An estimate of an underlying stock’s future volatility as predicted or implied by an option’s current market price. Implied volatility for any option can only be determined via an option pricing model.

INDEX OPTION

An option contract whose underlying security is an index (like the NASDAQ), not shares of any particular stock.

IN THE MONEY

An equity call contract is in-the-money when its strike price is less than the current underlying stock price. An equity put contract is in-the-money when its strike price is greater than the current underlying stock price.

INTRINSIC VALUE

The in-the-money portion (if any) of a call or put contract’s current market price.

LEAPS

Long-term Equity AnticiPation Securities, or LEAPS, are long-term option contracts. Equity LEAPS calls and puts can have expirations up to three years into the future and expire in January of their expiration years.

LEG

  1. One part of a complex position composed of two or more different options and/or a position in the underlying stock.
  2. Instead of entering one order to establish all parts of a complex position simultaneously, one part is executed with the hope of establishing the other part(s) later at a better price.

LOGNORMAL DISTRIBUTION

With respect to stock prices over a period of time, a lognormal distribution of daily price changes represents not the actual dollar amount of each change, but instead the logarithms of each change. Mathematically, this type of distribution implies that a stock’s price can only range between 0 and infinity, which in the real world is the case. So in a sense a lognormal distribution could be considered to have a bullish bias. A stock can only drop 100% in value but can increase by more than 100%. In general, assumptions made by option pricing models about a stock’s future volatility are based on a lognormal distribution of future price changes.

LONG POSITION

A position resulting from the opening purchase of a call or put contract and held (owned) in a brokerage account.

LONG STOCK

Shares of stock that are purchased and held in a brokerage account and which represent an equity interest in the company that issued the shares.

MARGIN REQUIREMENT

The amount of cash and/or securities an option writer is required to deposit and maintain in a brokerage account to cover an uncovered (naked) short option position. This cash can be seen as collateral pledged to the brokerage firm for the writer’s obligation to buy (in the case of a put) or sell (in the case of a call) shares of underlying stock in case of assignment.

MEAN

For a data set, the mean is the sum of the observations divided by the number of observations. The mean is often quoted along with the standard deviation: the mean describes the central location of the data, and the standard deviation describes the range of possible occurrences.

NORMAL DISTRIBUTION

One of the most familiar mathematical distributions, it is a set of random observed numbers (or closing stock prices) whose distribution is symmetrical around the mean or average number. A graph of the distribution is the familiar “bell curve,” with the most frequently occurring numbers clustered around the mean, or the middle of the bell. Since this a symmetrical distribution, when the numbers represent daily stock price changes, for every possible change to the upside there must be an equal price change to the downside. The result is that a normal distribution would theoretically allow negative stock prices. Stock prices are unlimited to the upside, but in the real world a stock can only decline to zero. See “lognormal distribution.”

OPENING TRANSACTION

A transaction that creates (or increases) an open option position. An opening buy transaction creates or increases a long position; an opening sell transaction creates or increases a short position (also known as writing).

OPTION PRICING MODEL

A mathematical formula used to calculate an option’s theoretical value using as input its strike price, the underlying stock’s price, volatility and dividend amount, as well as time until expiration and risk-free interest rate. Generated by an option pricing model are the option Greeks: delta, gamma, theta, vega and rho. Well-known and widely used pricing models include the Black-Scholes, Cox-Ross-Rubinstein and Roll-Geske-Whaley.

PHYSICAL SETTLEMENT

The settlement style of all equity options in which shares of underlying stock change hands when an option is exercised.

PREMIUM

The price paid or received for an option in the marketplace. Equity option premiums are quoted on a price-per-share basis, so the total premium amount paid by the buyer to the seller in any option transaction is equal to the quoted amount times 100 (underlying shares). Option premium consists of intrinsic value (if any) plus time value.

PROFIT+LOSS GRAPH

A representation in graph format of the possible profit and loss outcomes of an equity option strategy over a range of underlying stock prices at a given point in the future, most commonly at option expiration.

PUT OPTION

An equity option that gives its buyer the right to sell 100 shares of the underlying stock at the strike price per share at any time before it expires. The put seller (or writer), on the other hand, has the obligation to buy 100 shares at the strike price if called upon to do so.

RHO

The amount a theoretical option’s price will change for a corresponding one-unit (percentage-point) change in the interest rate used to price the option contract.

ROLL

To simultaneously close one option position and open another with the same underlying stock but a different strike price and/or expiration month. Rolling a long position involves selling those options and buying others. Rolling a short position involves buying the existing position and selling (writing) other options to create a new short position.

SHORT OPTION

A position resulting from making the opening sale (or writing) of a call or put contract, which is then maintained in a brokerage account.

SHORT STOCK

A short position that is opened by selling shares in the marketplace that are not currently owned (short sale), but instead borrowed from a broker/dealer. At a later date, shares must be purchased and returned to the lending broker/dealer to close the short position. If the shares can be purchased at a price lower than their initial sale, a profit will result. If the shares are purchased at a higher price, a loss will be incurred. Unlimited losses are possible when taking a short stock position.

SPREAD

A complex option position established by the purchase of one option and the sale of another option with the same underlying security. The two options may be of the same or different types (calls/puts), and may have the same or different strike prices and/or expiration months. A spread order is executed as a package, with both parts (legs) traded simultaneously, at a net debit, net credit, or for even money.

STRIKE PRICE

A term of any equity option contract, it is the price per share at which shares of stock will change hands after an option is exercised or assigned. Also referred to as the “exercise price,” or simply the “strike.”

THETA

The amount a theoretical option’s price will change for a corresponding one-unit (day) change in the days to expiration of the option contract.

TIME DECAY

A regular phenomenon in which the time value portion of an option’s price decays (decreases) with the passage of time. The rate of this decay increases as expiration gets closer, with the theoretical rate quantified by “theta,” one of the Greeks.

TIME VALUE

For a call or put, it is the portion of the option’s premium (price) that exceeds its intrinsic value (in-the-money amount), if it has any. By definition, the premium of at- and out-of-the-money options consists only of time value. It is time value that is affected by time decay as well as changing volatility, interest rates and dividends.UNDERLYING STOCK

The stock on which a specific equity option’s value is based, which changes hands when the option is exercised or assigned.

VEGA

The amount a theoretical option’s price will change for a corresponding one-unit (point) change in the implied volatility of the option contract.

VOLATILITY

Volatility means activity or trading activity in the price of a stock. High volatility means high activity of trading in the stock. It is measured mathematically as the annualized standard deviation of that stock’s daily price changes.

WRITE

To sell a call or put option contract that has not already been purchased (owned). This is known as an opening sale transaction and results in a short position in that option. The seller (writer) of an equity option is subject to assignment at any time before expiration and takes on an obligation to sell (in the case of a short call) or buy (in the case of a short put) underlying stock if assignment does occur.