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Someone with a $5,000 account (in cash or marginable securities) may borrow an additional $5,000 to buy stock. A marginable security is one that qualifies for margin. Here is a definition from InvestorWords: Stock approved by the Federal Reserve and an investor’s broker as being suitable for providing collateral for margin debt. Depositing marginable stocks (or any other marginable securities) in a margin account is an effective way for an investor to reduce financing charges. However, the criteria to ensure that securities are suitable as collateral for margin debt can be quite strict. The Federal Reserve has a minimum set of standards for marginable stock, but a broker can choose to set stricter standards. Fidelity’s definition which securities are eligible for margin. Equities and ETFs trading over $3 Most mutual funds that have been held for at least 30 days Treasury, corporate, municipal, and government agency bonds The following are not eligible for margin borrowing: CDs, money market funds, annuities, options, precious metals, and offshore mutual funds Margin for Options Trading The rules for borrowing money to trade options are different. NOTE: Use the discussion above to know which securities can be used as collateral (margin) for options trading. However, your option positions must be paid for in full (with your own, or borrowed money) and do not provide any additional buying power. Regular Margin Account (Reg T Margin) The margin rules are not complicated. When you buy an option or a debit spread, you must put up 100% of the cost. Thus, in the worst case scenario, when the options expire worthless, you can never be called upon to put up more money. The trader can never receive a margin call. When you open a debit spread, the trader is required to put up the maximum possible loss – in cash. Again, that trader can never be asked to put up more money because the worst possible situation has been accounted for. If an option trader writes an in the money or at the money option (call or put) the required margin deposit is the premium received plus 20 percent of underlying stock’s current market price. If an option trader writes an out of the money option the required margin for the option trade is the greater of: The premium received plus the 20 percent of underlying stock’s current market price minus the out of the money amount. The premium received plus 10 percent of the current market value of the underlying stock. Portfolio Margin In the United States, traders with an account over $100,000 may apply for portfolio margin. Be very careful. The margin requirements are far less strict and it is easy to build positions that are larger than you should want to trade. In general, the margin requirement is that a trader put up enough cash so that at no point during a market move of between zero and 15% in either direction does the account (theoretically) lose more than the account value. There is often a volatility component thrown in as well. Be aware, it is possible to lose more than the theoretical limit when vega exposure is too high. These accounts are designed to limit exposure to negative gamma, but if vega quadruples all at once, that could spell bankruptcy for some traders. Reg T margin is safer to trade. How Stock Traders Use Margin The idea behind borrowing money from a broker is to have more cash to invest. Obviously the trader has to plan on earning a return that is higher than the interest rate paid when borrowing the money. The good and bad news is leverage. If you invest $2 for every $1 in your account, you earn twice as much money. That part is apparent to everyone. The part that most traders miss is that leverage works both ways. If you lose money, it is lost twice as quickly. Beyond that, it is far easier to blow up a trading account when using borrowed money. When our $5,000 trader uses margin to own $10,000 worth of stock, it takes an unlikely, but possible, result to lose 100% of the account. If the stock price gets cut in half, the account would still be worth $5,000. But that is the broker’s money. The trader’s entire $5,000 has been lost. It is truly easier to go broke when using margin. It may not cost much to borrow the cash, but using margin is not recommended for conservative investors, unless circumstances are truly extraordinary. How Option Traders Use Margin 1) Option buyers do not need margin. They already have a ton of leverage when owning options 2) Sellers of naked options must use a margin account. However, the trader does not have to borrow money from the broker. When you meet the margin requirements using only your own assets, then you are not borrowing money, even though the trades are held in a margin account. Per details above, option sellers may use margin to gain leverage: Extra rewards plus extra risk. 3) Sellers of credit spreads, iron condor traders, iron butterfly traders etc WITH AN ACCOUNT BELOW $100,000 are not eligible to use margin. Their positions must be paid for in cash. The covered call writer may buy stock using 50% margin and then write the call option. 4) Traders with accounts over $100,000 have two major choices. The first is to ignore portfolio margin (by not requesting it) and stay with Reg T margin. The major benefit is that you can never lose more than the value of your account at one time. I know you will be disciplined. I know you will manage size correctly. But, if you are going to do those things, there is no need for portfolio margin. The second is to apply for portfolio margin and enjoy the benefits of being able to trade larger size. WARNING: This is not for anyone who considers himself to be a rookie trader. You have no need to invest more than 100% of your account value (as measured by Reg T margin). In other words, with a $100,000 account, isn’t trading 100 ten-point iron condors good enough? Do you really want to trade 120 or 150 or 200? Conclusion Do not misunderstand. If you are a successful and disciplined trader who manages risk well (and I do not see how you can be successful when you do not manage risk well), then sure, consider using portfolio margin. Just trade with reasonable position size. The rationale behind this post is a request form a member to help him understand how to make use of margin to achieve additional profits. The bottom line is that most option traders do not use (or have a need to use) margin. If you do trade a portfolio margin account, there is every reason to trade with less risk. You can afford to insure positions and thus, trade somewhat larger size. Please remember that insurance only limits losses, it does not eliminate them. It is essential to carefully choose position size.

Questions: Do options ever become so expensive that it is no longer worthwhile to pay the high asking price to buy them? We may know that a news announcement is pending, but so do other investors —and they also want to buy options. Translation: Increased demand results in a significant increase in option prices and implied volatility. How can we determine whether a point has been reached such that we have a better opportunity to earn money by switching to negative-gamma (i.e., the opposite of our traditional) strategies? For this discussion, let’s consider premium-buying strategies are limited to market neutral strategies like buying long straddles and strangles, buying single options, and trading reverse iron condors where you buy the call and put spreads, paying a cash debit to own the position Similarly, the premium-selling strategies are limited to market neutral strategies like selling straddles, strangles and single options. Also the traditional iron condor (sell both the call and put spreads and collect a cash credit). Answers: It should be intuitively obvious that there has to be some price at which it no longer pays to buy options to own positive positive gamma. [For an extreme example, I hope that you would never pay $8 for a pre-earnings, ATM straddle on a non-volatile, $20 stock.] Thus, as intelligent traders, we are limited and cannot adopt our favorite strategies every time there is an earnings announcement pending. Due diligence is required, and that includes analyzing a substantial amount of historical data so that we can estimate what may happen in the future by looking at what occurred in the past. Such data includes: Previous post-news price gaps. We want to know the largest and smallest (based on a percentage of the stock price) and the median gaps when this specific stock announced earnings results. We do not need results from the last 20 years because stock markets change over time and more recent history is far more important. I suggest using 3 to 4 years of data (12 to 16 news announcements). Why is this information so important? The data provides a good estimate of how much you can afford to pay for the options. There are two ways to profit. First, exit the trade whenever there is a satisfactory profit before news is released. When implied volatility increases by enough, your position increases in value and it may be attractive to unload the position and lock in the gains prior to the news release. When the stock makes a big move prior to the news release, the positive-gamma position will be worth far more than you paid for it —and that may be a profit worth taking. Second, when we do wait for the news release, the profitability of the trade depends on the size of the price gap and the cost of the options. By looking at past data, we have a reasonable estimate for the size of any future price gap and thus, the value of our option position. Obviously this is just an estimate and the current trade may perform much better or much worse than the average. But, it is that average that dictates just how much we should pay for our option position. If the ATM straddle is worth $6 (on average) immediately after the market opens after the announcement, then we should not be willing to pay as much as $6 to buy the straddle. The average implied volatility must be considered. If the IV averages 34 for the time slot (i.e., number of days in advance of news), in which we buy the options then we cannot expect to earn a profit when paying 40. The cost (IV) of buying the pre-news options at a variety of times. It is important to discover a good time to buy the options (i.e., before IV has risen too far in anticipation of the pending news). The price history for the stock, in the days leading up to the news release: How often did the stock rally/fall enough to generate a good profit without bothering to hold until the earnings news is released? If this never happens for a given stock, then the price that we can pay for a the straddle decreases because one of our profit opportunities is not present. Results. How would various gamma-buying strategies have performed in the past? This requires examining option-pricing data as well as the stock price. There is a lot of data that a trader may analyze. The work produces guidelines for making trades, and we depend on those guidelines to tell us when to enter, and when to avoid, using our methods. The second question is more difficult to answer because so much depends on the individual trader. For example, some traders will never sell straddles or strangles because risk is too high. Others understand how to manage risk for such trades (most important is choosing proper position size) and would adopt the negative-gamma strategies when the option prices are so high that it is reasonable to anticipate earning a profit by selling them. Be careful. If you decide that paying $9 for a straddle (or paying a 34 implied volatility) is too high to buy the options that does not suggest that it is okay to sell. Selling requires a decent edge. For example, if your maximum bid for a straddle is $6 (reminder: the average post-news straddle is worth $9), I would not want to consider selling that same straddle unless I could collect $12 (or an IV of at least 40). Those numbers describe my personal guidelines and you must choose your own. There is a lot of work to do before investing your money into option trades. Fortunately SteadyOptions does the tedious analysis and we can trade their suggestions. There is no guarantee of success. However, it is always good to trade with the probabilities on your side — and that is what you get with your SO membership. Related articles: Options Trading Greeks: Gamma For Speed Why You Should Not Ignore Negative Gamma Join Us Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four options trading books. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.

Timing Some investors believe they have a ‘feel’ for the market, or individual stocks and ‘know’ when that stock is going to make a large move. If you are one of them, then don’t open an iron condor position unless you believe the stock is NOT going to make such a move before the options expire. As an alternative you can have an iron condor position with a bullish or bearish bias. You do that by choosing appropriate strike prices for the options spreads you choose. Many investors (that includes me) cannot predict the future and are willing to own positions that profit when the market holds steady, trades within a range that’s not too wide, or if the market does move significantly in one direction, does so at a slow and steady pace. Underlying It’s generally safer to trade iron condors on indexes because you never have to be concerned with a single stock issuing unexpected news that results in a gap of 20% or more. True that can happen with an index if there is world-shattering news – but it’s a much less likely event. Most indexes in the U.S. are European style vs. American style. That means they cannot be exercised before expiration – and that’s to your advantage. We’ll discuss the differences between these option ‘styles’ another day. Expiration Month Most iron condor traders prefer to have positions that expire in the front month (options with the least time remaining before they expire). These options have the most rapid time decay, and when you are a seller of option premium (when you collect cash for your positions as opposed to paying cash), the passage of time is your ally and rapid time decay is a positive attribute for your position. However, there are negative factors associated with front-month options: With less time remaining, iron condor positions are worth less than if there were more time remaining. Thus, you collect less cash when you open the position. If the index undergoes a substantial price change, the rate at which money is lost is significantly greater when you have a front-month option position. It’s too early in your education to discuss why this is true in detail, but it’s because they gain or lose value more rapidly than options with longer lifetimes. This is effect of gamma, one of the ‘Greeks’ used to quantify risk when trading options. Because there are so many topics to discuss, I will not be getting to the Greeks for quite awhile. When you sell options that expire in the 2nd or 3rd month, you collect higher cash premiums (good), have positions that lose less when something bad happens (good), but there is more time for something bad to happen (bad). When you have iron condor positions, you don’t want to see something bad (and that’s a big market move). The more time remaining before the options expire, the greater the chance that something bad happens. That’s why traders who sell* iron condors are willing to pay you a higher price for them. Strike Prices and Premium Collected Choosing the strike prices for your iron condor position – and deciding how much cash credit you are willing to accept for taking on the risk involved – are irrevocably linked. Thus, I’ll discuss them together. Assume the call spread and put spread are each 10-points wide. For example: (RUT is the (Russell 2000 index) Sell 10 RUT Sep 620 put Buy 10 RUT Sep 610 put Sell 10 RUT Sep 760 call Buy 10 RUT Sep 770 call If you are not a member yet, you can join our forum discussions for answers to all your options questions. Market bias Most of the time that you open an iron condor, you have a neutral opinion, i.e., you have no expectation that the stock is going to move in one direction as opposed to the other. As a result, you tend to choose a call spread and a put spread that are equally out of the money. To put it simply – the call and put you sell will each be approximately the same number of points away from the price of the underlying security. In our example above, If RUT is trading near 690, the 620 put and the 760 call are each 70 points out of the money, and the position is ‘distance neutral.’ There are other methods you can use to have a position that is ‘neutral.’ Instead of equally far out of the money, you may choose to sell spreads that bring in the same amount of cash. This is ‘dollar neutral,’ a method seldom used. If you understand the term delta (we’ll get to it eventually) you may choose to sell spreads with equal delta. I don’t recommend this method for iron condors, although ‘delta neutral’ trading has a great deal to recommend it under different circumstances. If you are bullish, you can choose to sell put spreads that bring in more cash, attempting to profit if the stock or index does move higher, per your expectation. If you are bearish, you can choose to sell call spreads that bring in more cash, attempting to profit if the stock or index does move lower, per your expectation. How far out of the money Most investors believe that the further out of the money the options they sell, the ‘safer’ their position and the less risk they have. That's one way to look at ‘safety.’ Probability vs. Maximum loss. If you sell the RUT 580/590 put spread instead of the 610/620 put spread, there is a higher probability that the options you sell will expire worthless, allowing you to earn the maximum profit that trading this iron condor allows. I believe that is intuitively obvious, but for those who don’t see it, consider this (and for the purposes of this discussion, assume you hold this position until the options expire): Most of the time the options expire worthless, but part of the time, RUT moves far enough below 620, resulting in a loss. Part of the time that RUT is below 620 at expiration, it is also below 590. But, the probability that it’s below 590 must be less than the probability that it’s below 620 because part of the time RUT is going to be between 590 and 620. Thus, you lose money less often, when you sell options that are further out of the money. That fits the first definition of ‘safer’. But, you can also look at it this way. When you sell the 580/590 put spread, you collect less cash than when you sell the 610/620 put spread. This is always true: the more distant the options are from the market price of the underlying stock or index, the less premium you collect when selling single options or option spreads. This is why it’s so important to find your comfort zone when choosing the options that make up your iron condor. You can trade options that are very far out of the money. These positions have a very small chance of losing money. You can easily find iron condors with a 90% (or even higher) probability of being winners. However, the cash you collect may be too little to make the trade worthwhile. Some investors are willing to sell iron condors and collect between $0.25 and $0.50 for each spread, netting them $50 to $100 per iron condor. If that makes you comfortable, then it’s okay for you to trade this way. For my taste, the monetary reward is too small. NOTE: Selling a spread for $0.40 translates into $40 cash, and the possibility of losing $960. Remember that the maximum loss is very high, and one giant loss can wipe out years of gains. The maximum loss is $950 per iron condor, when you only collect $50 to initiate the trade. You can trade options that are far out of the money, but not so far that the premium you collect is too small. You still have a high probability of owning a winning position. You have the potential to earn more money because you collected more cash upfront. The maximum loss is reduced, and some consider this position ‘safer.’ That fits the second definition of safety. You can sell options that are closer to the money. This reduces your chances of having a comfortable ride through expiration, and increases the chances of losing money. In return for that reduced probability of success, potential profits are significantly higher. You may decide to collect $400 or $500 per iron condor. The maximum loss is much smaller, and again, that fits the second definition of owning a safer position. Your goal should be to find iron condors that places you well within your comfort zone. And if you are unsure of how your comfort zone is defined, use a paper trading account to practice trading iron condors (or any other strategy). I know that real money is not at risk, but if take the positions seriously, you can determine which iron condors leave you a bit uneasy and which ‘feel’ ok. Advice: Don’t make the decisions about comfort based on which trades are profitable. Base the decision on which iron condors make you nervous about potential losses both when you open the position and as the risk changes over time. It’s easy to randomly open positions and hope they work. But it’s better to open positions that fall within your comfort zone. Summary Here’s a statement I am going to make repeatedly when giving stock option advice: There is no ‘right’ choice. As an investor, you want to hold positions that are comfortable for you. The best way to discover your comfort zone is to trade. But, please use a practice account and do not use real money until you truly understand how iron condors (or any other strategy) work. Some traders always trade the near-term (front-month) options, while others (myself included) prefer options that expire in two, three, or even four months. Another comparison is Iron Condor Vs. Iron Butterfly Related Articles: Trade Iron Condors Like Never Before Why Iron Condors are NOT an ATM machine Why You Should Not Ignore Negative Gamma Can you double your account every six months? Can you really make 10% per month with Iron Condors? Should You Leg Into Iron Condor? Exiting An Iron Condor Trade Iron Condor Adjustments: How And When Iron Condor Adjustment: Can I "Roll" It Forever? Is Your Iron Condor Really Protected? Trade Size: Taming The 800-Pound Gorilla Want to join our winning team? Start Your Subscription

I was taught that one of the assumptions used in this strategy is that for the most part, the market has all ready priced the option correctly for the upcoming news so by allowing for some price movement within your strangle, this is more of a volatility play than a price play. Mark's response: 1) To me they are the same, with the straddle being a subset of the strangle In other words, a straddle is merely a strangle when the strikes and expiration dates are the same. I prefer the strangle because it allows the trader to choose call and put strike prices independently, rather than being 'forced' to choose the same strike. I prefer to sell OTM calls and puts – and that's not possible with a straddle. As far as unlimited risk is concerned, that's a decision for each trader. I prefer the smaller reward and increased safety of selling credit spreads (an iron condor position), but that is not relevant to today's post. 2) A clarification. In is not 'volatility' that incurs a large decrease after the news is released. Instead it is the implied volatility of the options. I'm fairly certain that is what you meant to say. 3) Your earnings plays are far riskier than you currently believe them to be. These are not horrible trades, but neither are they as simple as you make them out to be. 4) I must disagree with whomever it was who told you that "the market has priced the option correctly for the upcoming news." The market has made an estimate of how much the stock price is likely to move. Note that this move may be either higher or lower ad that this difference is ignored when the size of the move is estimated. There is no formal prediction of move size. There is nothing that says the stock will move 6.35 points. What happens is the implied volatility rises as longs as more and more buyers send orders to purchase options. And it makes no difference if they are calls or puts. At some point option prices stabilize (or the market closes for the day) and a 'final' implied volatility can be measured. From the IV, the 'anticipated move' for the underlying is determined. AsI said, it's not as is everyone agreed on how much the stock will move. I hope you understand that when the news is released, there is very little chance that the predicted move is the correct move. Many times the move is far less than expected. That's the reason why selling options prior to earnings can be very profitable. The IV collapses because another substantial price change is NOT expected and there is no reason to pay a high IV to buy either calls or puts. However, if you chose to sell an option that was not very far out of the money (OTM), and if the stock moves far enough, then the IV crush. doesn't do a whole lot of good. Sure you gain as IV plunges, but you can easily incur a substantial loss when the short option has moved significantly into the money. Also remember that part of the time that stock price gaps by far more than expected. In that scenario, a higher quantity of formerly OTM options are now ITM. Thus, large losses are not only possible, but they are more frequent that you realize. Apparently your trades have worked out well (so far). Think about this: If those option buyers did not profit often enough to encourage them to pay 'high' prices for the options they buy, they would have stopped buying them long ago. The truth is that these option buyers collect often enough to keep them coming back for more. 5) That means you must be selective in which options you sell into earnings news. This is especially true when you elect to sell naked options. You cannot options on every stock, hoping that any random play will work. This is a high risk/high reward game. It's okay to participate, but please be aware of what you are doing and the risk involved.

Good question. When I trade Weeklys, I do start the trade on Monday and typically exit Wed or Thurs. I look to earn 30 to 40 cents on a 5-point index iron condor. The initial premium tends to be in the vicinity of 80 cents. These options are reasonably far OTM. However, the sales are not naked short like yours. The fact that you prefer to sell naked options changes the risk profile: You do not buy protection, so your short option is much farther OTM than the one I sell. That increases the chances you will have a profitable trade. Your potential loss is gargantuan. I agree that it will not happen often, but in my opinion, it happens often enough to make the sale of naked options too dangerous. If you do not get overconfident and trade this strategy in small position size, then it can be viable for the account of an experienced trader. Why experienced? Because risk management is the key to the trader’s success. The trade If we sell a low-delta, far OTM option, collecting 10% of the margin requirement; or, if we sell a 5-point iron condor for $0.50 – then we have an opportunity to earn that 10%. To earn 10%, we must allow the options to expire worthless. That involves extra risk because each day comes with the tiny possibility of market-moving news. I know that works for many traders, but I never do that. I prefer to eliminate all risk one or two days early and avoid overnight risk for that extra day. So I would be happy to pay 20 cents in the above scenario, reducing profits to a still very acceptable 6% before commissions. Risk We can look at risk as the probability of losing money and I agree that the probability is well on our side. We can also consider risk to be the money at risk, or the sum that could be lost. That is how I prefer to think about risk. From your perspective, risk is low. From mine, it is very high. So is this high risk or not? The answer must be an opinion based on fact, but remains an opinion. That means intelligent people can disagree. For me, short-term options come with far too much negative gamma. Translating that to English for the newer option traders: When we sold an option or spread that looks and feels ‘safe’ because it is somewhat far OTM, when time is short, it does not take much of a move in the underlying asset to push that short option ITM. And that is the high risk of which I speak. When we collect a small cash credit, the potential loss is high. The problem is that too many rookies traders do not know how to react. Some exit far too early in a panic. Others sit frozen with inaction and wind up taking the maximum possible loss. Earnings Potential If you can earn 10% per week and compound those earnings, after one year, $1,000 would become $142,000. I’m sure do not expect to win every week, but I hope that you recognize that it is impossible to earn such reruns with low risk. My conclusion is that your plan is fine for the experienced, disciplined trader who is skilled at managing risk. However, it is far too dangerous for the inexperienced trader. Related articles: Should You Trade Weekly Options? The Options Greeks: Is It Greek To You? The Risks Of Weekly Credit Spreads Options Trading Greeks: Gamma For Speed Options Trading Greeks: Theta For Time Decay Why You Should Not Ignore Negative Gamma Want to learn how to reduce risk and put probabilities in your favor? Start Your Free Trial

Making this logical decision is generally considered as demonstrating good trading discipline. That doesn’t feel right to me. It takes common sense to get out of a bad trade. Does it truly show good discipline? Consider this: When it comes time to make a new trade, is that an important opportunity to demonstrate good discipline? Or does discipline not apply to brand new positions? The technical trader who patiently waits for the correct setup and can ignore situations that are almost, but not quite, good enough shows discipline The swing trader who waits for a buy/sell signal and who does not jump the gun demonstrates that discipline What about the non-directional premium seller? Does that trader require good discipline when entering trades, or only when managing risk? The iron condor trader who considers more than “okay, it is time for my weekly (or monthly) trade” has discipline. Robert Seawight posted an appropriate piece of trading advice in the Above the Market blog. It supplies his opinion on the question raised: “adaptability is important from an investing standpoint. We need to be agnostic as to approach and ideology and simply focus on what works and adjust as things change. Our points of view and opinions, no matter how strongly held, should always be tentative and subject to change due to new or better evidence.” When I get lazy (or overconfident) and enter a new trade because the calendar tells me that the time is right (for me that is often when the 91-day options are first listed for trading), I am taking action that is exactly the opposite of this sage advice. If you are not a member yet, you can join our forum discussions for answers to all your options questions. I chose the iron condor as my primary strategy because I like the way it works and feel comfortable owning the position. I am comfortable with positive theta and negative gamma. I am confident that I can act with discipline when necessary. That package allows me to feel good about my choice. But, is it the most efficient method for selecting trades? Surely not. There is nothing agnostic about that approach. I have a definite bias that favors the iron condor. Traders who stay on top of the market can benefit when they can observe something special. Perhaps it is the start (or end) of a trend. Premium sellers should act differently when the market is trending. For example, the iron condor trader can trade with a market bias, selecting a bias that favors the trend. When a trend ends, that’s the time to revert back to the market neutral iron condor. The problem? It is not easy to determine when a trend has begun or ended. Intelligence and good discipline tells us not to fight the trend. Doing something as simple as that demonstrates excellent discipline. The point is that there are times to avoid your favorite strategy if it feels out of sync with the market. If you sense a bullish or bearish trend, you don’t have to follow that trend. However, have the commons sense to make some change to your usual trade methodology to avoid going against what you see. If that means reducing size, or sitting on the sidelines, or trading with a market bias, then do it. Show the discipline to stop depending on a consistent strategy when you see or feel that it is not going to work. I am not telling any trader to suddenly believe he/she is a market prognosticator. However, if you have a short losing string, cut size. If you are getting hurt by a rising (or falling) market, make new trades with a small bias, or with a stage I adjustment already built in (i.e., trade an off-ratio iron condor, pretending that the new trade has already been adjusted once. Example: Instead of 10 x 10, trade 10 on one side and only 8 on the other.) If unwilling to accept that choice become a market observer until you are ready to enter a new position with confidence. It takes good discipline to wait for the right situation before making a new trade. Many times we can enter our orders, as usual. But the key to remember is that this is not always the right time. Related articles: Are You EMOTIONALLY Ready To Lose? Why Retail Investors Lose Money In The Stock Market Are You Ready For The Learning Curve? Can you double your account every six months? Are You Following "Tharp Think" Rules? Want to learn how to reduce risk and put probabilities in your favor? Start Your Free Trial

A volatility smile is defined as 'a long-observed pattern in which ATM options tend to have lower IV (implied volatility) than in- or out-of-the-money options. The pattern displays different characteristics for different markets and results from the probability of extreme moves' image courtesy of investorglossary.com In other words, black swan events occur more often than predicted by mathematical models, and far OTM options trade with a higher implied volatility than ATM options. In today's world, this volatility smile is so skewed to the downside that the IV of OTM puts is significantly higher than that of ATM options, which in turn have higher IV than OTM calls. This is considered as rational in light of the 'frequent' market crashes. Frequent is defined as far more often than any mathematical model would have predicted. Kurtosis is the mathematical term used to recognize that not all tails of the curve are created equal and that market crashes are far more common than market surges. Thus, PUT IV exceeds call IV. The early texts could not mention 'volatility skew' and many of us 'grew up' in the options business with no understanding of the importance of volatility skew. I now shudder to recall that one of my favorite strategies (late 70s and early 80s) was to own ratio spreads in which I would buy one put with a higher delta and sell 2 or 3 times as many puts with a lower delta. I thought I was capturing theoretical edge by selling puts with a higher implied volatility. Today, if anyone were to use that ratio strategy, it would not be to capture edge. It would be more of a bet on where the market is headed next. Volatility skew is easy to notice. All one has to do is look at IV data for any option chain. Nevertheless, the concept has often proven difficult to explain. When teaching traders who have not yet discovered the importance of volatility skew, the skew can be used to explain why one specific strategy is more profitable under certain market condition that others. This is an important topic for future discussion. Mark Sebastian at Optionpit.com suggests one good method for following the volatility skew for a specific underlying asset. It takes a bit of work, but owning a good picture of skew, as it changes over time, is probably worth the small amount of time that it takes to track the data. Sebastian also makes the important point that it's not a good idea to constantly trade the same strategy, using the same underlying, month after month (Guilty. I'm a RUT iron condor trader.) Instead volatility skew, among other factors, should be considered. Iron condors work well when skew is steep and less well when skew is flatter. Obviously this discussion is incomplete, but just knowing that volatility skew exists and that it can help a trader get better results, makes it a topic that we should all want to understand. Visit our Options Trading Education Center for more educational articles about options trading. Related Articles: Understanding Implied Volatility How Apple Tricked The Options Traders VIX - The Fear Index: The Basics Few Facts About Implied Volatility How We Nailed The Implied Volatility Game Start Your Free Trial

Here are six situations that should be of special concern when expiration day draws nigh. 1) Position Size When trading options, the most effective method for controlling risk is paying attention to position size (number of options or spreads bought/sold). Smaller size translates into less profit and less reward. However, successful traders understand: minimizing losses is the key to success. When options expiration approaches, an option's value can change dramatically. The effect of time is far less on longer-term options. Gamma measures the rate at which an option's delta changes. When gamma is high – and it increases as expiration approaches – delta can move from near zero (OTM option) to almost 100 (ITM option) quickly. Option owners can earn a bunch of money in a hurry, and option shorts can get hammered. However, those short-lived options often become worthless. These are the conflicting dreams of option sellers and buyers. The point is that having a position in ATM (or not far OTM) options is treacherous, and reducing the size of your position is a healthy and simple method for reducing risk. Consider reducing position size when playing the higher risk/higher reward game of trading options near expiration. 2) Margin Calls Receiving an unexpected margin call is one of those unpleasant experiences that traders must avoid. At best, margin calls are inconvenient. Most margin calls result in a monetary loss, even if it's only from extra commissions. Think of it as punishment for not being prepared When you hold any ITM short option position, there is the possibility of being assigned (and converting an option position to stock) an exercise notice. Early exercise is unlikely unless the option is deep ITM. However, you already know that any option that finishes ITM is subject to automatic exercise. Exiting the trade prior to expiration makes it likely (there is still the chance of being assigned before you exit) that you can avoid the margin call. Most put sellers (conservatively) sell puts only when cash secured. That means: cash to buy shares is already in the account. When cash is available, there is no margin call. Those who write call options are subject to the same assignment risk. If the trader is covered, there is no problem. Upon assignment, the shares already owned are sold to honor the option seller's obligations. When you receive a margin call, many brokers (no warning) sell enough securities (to generate cash) to meet that call. Other brokers automatically repurchase your short options (with no advance warning) before expiration arrives. Bottom line: When you cannot meet the margin requirement, do not hold a position that is subject to early exercise. And never hold that position through expiration (when assignment is guaranteed). Find a way to exit the trade to avoid possible margin calls. For clarity: If margin is not a problem, none of this applies to you. 3) Increased Volatility Pay attention to volatility – both volatility of the underlying stock or index as well as the implied volatility of the options themselves. For option owners volatility is your friend. The fact that stocks are more volatile is enough to raise implied volatility, and that in turn increases the value of your options – sometimes by more than its daily time decay. If you get lucky twice, and the volatile market moves your way, the option's price may increase many-fold. That's nirvana for option owners. However, if you are looking at increased market volatility from the perspective of an option seller, volatility translates into fear. Whether a trader has naked short options (essentially unlimited risk) or short spreads (limited loss potential), he/she must recognize that the market (the underlying asset) can undergo a large, rapid price change. Options that seemed safely out of the money and a 'sure thing' to expire worthless are suddenly in the money and trading at hundreds (or thousands) of dollars apiece. When an index moves 5% in one day (as it did frequently during late 2008), SPX options that were 40 points OTM in the morning were 10 points ITM by day's end. When that happens with an increase in implied volatility, losses (and gains) can be staggering. There is good reason for the shorts to be afraid. One good risk management technique is to buy back those shorts – whenever you get a chance to do so at a low price. Remaining short, with the hope of collecting every last penny of premium, is a high risk game. 4) Reward vs. Risk Expiration plays come with higher risk and higher reward. That's the nature of the game. In return for paying a relatively low price for an option, buyers have but a short time for the market to do its magic. Otherwise the option disappears into oblivion. Most new traders believe they are locked into the trade once it has been made. Not true. You should consider selling those options any time that you no longer believe they can make money. Don't sell them for a tiny premium, such as $0.05. For that price, take your chances. But when real cash is at stake, perhaps when the option is priced near $1, then it's a difficult choice: hold vs. sell. Make a reasoned decision. Although it seems to be an obvious warning, when buying options near expiration day, please be aware of what must occur to earn a profit. Then consider the likelihood of that happening. The same warning applies to option sellers. Time may be short, but when the unlikely occurs, the loss can wipe out years of profits. When there's just too little premium, cover the short position and leave the last bit of cash on the table. 5) Option Greeks – Delta and Gamma The Options Greeks are used to measure risk. Once measured, it is up to the trader to decide whether risk is acceptable or must be reduced. It's important to understand the greeks of your position and how they change when the underlying moves. It's not necessary to spend hours studying the data. Use the greeks to get a look at the big picture and decide whether your position is ok as is, should be adjusted, or closed. As has already been mentioned, delta and gamma change more rapidly near expiration (if the option is anywhere near the money). Stay alert to these changes. 6) News Events When news is released, the underlying stock often undergoes a substantial change in price. If you have a position, or are considering opening a new position, be certain that you know whether news is pending. Such news is most often a quarterly earnings report. If you are a risk avoider, don't hold short options with negative gamma in the face of earnings releases. Summary Expiration is an exciting time for traders who are either long or short options. If you want to play in that arena, understand what you are doing. If you are a more conservative trader, it's easy to exit all trades before options expiration draws too near. Related articles: How Index Options Settlement Works Can Options Assignment Cause Margin Call? Options Expiration: Six Things To Know The Right To Exercise An Option? Early Exercise: Call Options Want to learn more? Start Your Free Trial

For instance, do you tend to liquidate your positions in the event of a general market correction that sends a particular stock lower than the general indexes, in the event of your position losing a given amount of value (say, 50% or 33%), in the event of a clear-cut technical trend being broken, in the event of a combination of these and/or other elements, or with the use of some other methods altogether? Answer: 1) The problem is that your questions are those of a trader who plays the market and they are not specific to options. That may seem to be a trivial point, but it far from trivial. It is also one reason that so many newer option traders get into trouble. When using options, you must (my opinion) trade as if you own options and not stock. That requires a different mindset. Bullish stock owners can ignore timing, they do not have to be concerned with volatility, and there is no concern over whether the options are priced fairly (or are too expensive to purchase). None of that matters — unless you own an option position. When trading options, you want to think as an option trader thinks to gain the benefits that come with option ownership. 2) Yes, I have such rules. They are not written in stone, but are general guidelines. If If you have a “long” position, it must be based on your expectation that the stock price will move higher – even if you do not know what the catalyst will be. I would liquidate that position at ANY TIME that you no longer expect the stock to move higher. Sure it can be when the stock price declines by a certain percentage (perhaps 6 – 10%). Yes, it can be when a technical indicator tells you that the buy signal for the stock market or the individual stock is no longer valid. However, if you own an option, then there is an additional consideration: Can the stock price change occur quickly enough to generate a gain when you own an option position? You would not look at the percentage decline in the price of your call option because that is not the crucial factor. If you still believe that owning that specific option (and that means you must evaluate the time to expiration and whether the option is ITM or OTM), then you can hold. The only important factor is your outlook for the stock in the time period from now to expiration — and whether that expectation makes it a good idea (or not) to own the option that you own. If it is a bad idea, then get rid of the option. Do not believe that owning “any call option” will generate a profit when the stock price rises. When IV gets crushed, you option may lose value, even in the face of a rally. When time passes, the ATM or OTM option can lose all of its value if the rally comes too late. Any time you are playing the market, you should have a stop loss. And it can be based on anything that you want. However, in my opinion, it is foolish to buy a wasting asset (call option) when you do not know when the stock price will move higher. It would be better to sell an OTM put spread or by an ITM call spread so that if the stock does not move higher right away, you still earn a profit from your position (the put spread goes to zero when both options remain OTM, or the call spread goes to its maximum value when both option stay ITM).

I encourage all readers to adopt a different way of thinking when appropriate. The following message from a reader offers sound reasons for taking specif actions regarding the management of an iron condor position. My response explains why this specific reasoning is flawed (in my opinion). The question Hi Mark, I have some questions on Chapter 3 (Rookie’s Guide to Options) Thought #3: “The Iron Condor is one position.” You mentioned that the Iron Condor is one, and only one, position. The problem of thinking it as two credit spreads is that it often results in poor risk-management. Using a similar example I (modified a little bit from the one in the book) traded one Iron Condor at $2.30 with 5 weeks to expiration: – Sold one call spread at $1.20 – Sold one put spread at $1.10 Say, a few days later, the underlying index move higher, the Iron Condor position is at $2.50 (paper loss of $0.20): – call spread at $2.00 (paper loss of $0.80) – put spread at $0.50 (paper profit of $0.60) I will lock in (i.e., buy to close) the put spread at $0.60 for the following reasons and conditions: It is only a few days, the profit is more than 50% of the maximum possible profit There are still 4 more weeks to expiration to gain the remaining less than 50% maximum possible profit. in fact, the remaining profit is less as I will always exit before expiration, typically at 80% of the maximum possible profit. so, there is only less than 30% of the maximum possible profit that I am risking for another 4 more weeks. The hedging effect of put spread against the call spread is no longer as effective because the put spread is only at $0.50. as the underlying move higher, the call spread will gain value much faster than the put spread will loss value. Is the above reasoning under those conditions ok? Will appreciate your view and sharing. Thank you. My reply Bottom line: The reasoning is OK. The principles that you follow for this example are sound. However, the problem is that you are not seeing the bigger picture. 1. There is no paper loss on the call spread. Nor is there a paper profit on the put spread. There is only a 20-cent paper loss on the whole iron condor. 2. When trading any iron condor, the significant number is $2.30 – the entire premium collected. The price of the call and puts spreads are not relevant. In fact, these numbers should be ignored. It is not easy to convince traders of the validity of this statement, so let’s examine an example: Assume that you enter a limit order to trade the iron condor at a cash credit of $2.30 or better. Next suppose that you cannot watch the markets for the next several hours. When you return home you note that your order was filled at $2.35 – five cents better than your limit (yes, this is possible). You also notice the following: The market has declined by 1.5%. Implied volatility has increased. The iron condor is currently priced at $2.80. Your order was filled: Call spread; $0.45; Put spread; $1.90; Total credit is $2.35. Obviously you are not happy with this situation because your iron condor is far from neutral and probably requires an adjustment. But that is beyond this today’s discussion — so let’s assume that you are not making any adjustments at the present time. That leaves some questions Do you manage this iron condor as one with a net credit of $2.35? [I hope so] Do you prefer use to the trade-execution prices? If you choose the “$2.35” iron condor, it is easy to understand that this is an out-of-balance position and may require an adjustment. If you choose the “45-cent call spread and $1.90 put spread” then the market has not moved too far from your original trade prices, making it far less likely that any adjustment may be necessary. In other words, it does not matter whether you collected $2.00, $1.50, $1.20, $1.00, or $0.80 for the put spread. All that matters is that you have an iron condor with a net credit of $2.35. 3. You should consider covering either the call spread, or the put spread, when the prices reaches a low level. You are correct in concluding that there is little hedge remaining when the price of one of the spreads is “low.” You are correct is deciding that it is not a good strategy to wait for a “long time” to collect the small remaining premium. If you decide that $0.60 is the proper price at which to cover one of the short positions, then by all means, cover at that point. (I tend to wait for a lower price). If you want to pay more to cover the “low-priced” portion of the iron condor when you get a chance to do so quickly, there is nothing wrong with that. However, do not assume that covering quickly is necessarily a good strategy because that leaves you with (in your example) a short call spread — and you no longer own an iron condor. If YOU are willing to do that by paying 60 cents, then so be it. It is always a sound decision to exit one part of the iron condor when you deem it to be a good risk-management decision. But, do not make this trade simply because it happened so quickly or that you expect the market to reverse direction. If you are suddenly bearish, there are much better plays for you to consider other than buying back the specific put spread that you sold earlier. 4. The differences in your alternatives are subtle and neither is “right’ nor ‘wrong.” The main lesson here is developing the correct mindset because your way of thinking about each specific problem should be based on your collective experience as a trader. Your actions above are reasonable. However, it is more effective for the market-neutral trader to own an iron condor than to be short a call or put spread. You are doing the right thing by exiting one portion of the condor at some “low” price, and that price may differ from trade to trade. But deciding to cover when it reaches a specific percentage of the premium collected is not appropriate for managing iron condors.

Question from a reader: Mark's response: Thanks for the question Tom, It's far more than the risk/reward ratio. But first let me explain that when I offer a strong opinion, it is just that. An opinion and not a fact. I believe that those who sell low-premium spreads eventually blow up their trading accounts. I agree that there are ways to manage risk, but there is often a psychological barrier. Too many traders think in terms of the cash collected when opening the trade and cannot allow themselves to pay $1 or $2 to exit a position when the original premium collected was a mere twenty-five cents. These are the traders who will hold to the bitter end. And that means the occasional $975 (+ commissions) loss. That would not be an insurmountable problem if traders held positions of appropriate size. But Tom, as I'm sure you know, success brings confidence, over-confidence, and cockiness. Eventually position size is too large and that inevitable loss is often enough to destroy the trader. Very sad. Thus, the primary reason I dislike these trades is that the wrong traders use this method. In my opinion, this is not a great trade for anyone, but I'm sure there are experienced people who make decent money doing this. But I feel a responsibility to do whatever I can to discourage this very risky strategy. I would never consider it myself, and am comfortable recommending that everyone stay away form these low reward plays. Plan ahead I agree that having a plan in place is important for the trader who adopts low-premium, high probability trades. I just feel that the inexperienced trader will find any number of reasons for not following the plan. And that's even more true when the first time an adjustment is made – it turns out that the adjustment was unnecessary. Although I'm a big fan of exiting such trades early, there is not much incentive to do so when the original credit is so small. Holding to the end is probably part of the trade plan. I don't think you are missing anything. This strategy, as any other, is appropriate for the right trader. But it requires enormous discipline – just to keep size at an appropriate level – and then more discipline to lock in a loss to exit – even when the probability of success is still on your side (the short options are not yet ATM). I believe that someone who has the experience to be certain he/she has that much discipline would choose a different strategy.

This article was originally published in 2010 on Mark Wolfinger's blog, but it's relevant today more than ever. I've inserted my comments (in blue) amidst his advice. In my opinion, the suggestions offered represent the worst possible advice one can offer to an options trader. Especially when it's intended for a general audience. In my opinion, it imposes the wrong mindset (making profits is easy, picking market direction is easy, trading options is a simple game), giving those who follow the guru little chance of learning to use options profitably. Yes, that's a very strong statement. I believe options education must include information that gives the reader a reasonable chance to earn money. But no one hands that cash to you. It requires discipline, practice, and understanding what you are doing when making a trade. When you teach a beginner to buy options and predict direction, you set him/her on a path of financial ruin. The shameful part is that there's no warning of how difficult it is to earn money via this strategy. All our guru talks about is high leverage and the possibility of making big profits. There's no mention of the odds of succeeding. When we consider that traders who follow these suggestions probably lack much (if any) experience managing risk, it's a recipe for disaster The only redeeming virtue in this article is the recommendation to use only a modest portion your trading account. I have no idea of why Schaeffer's Investment Research believes that most traders can successfully predict market direction when the evidence is clear that professional money managers cannot do it (most mutual funds underperform their benchmark indexes). If this advice is not intended for the masses, but is specifically for people with a proven track record of beating the market, then I can forgive the advice. But when it is general advice offered to the masses, I must fight back. I know his readership is at least 10 (if not 50) times larger than mine, but I'm not willing to let his advice go without making an attempt to salvage the situation. The article: "The stock market gets no respect these days. On July 27, an article entitled "Ten Stock Market Myths That Just Won't Die" was featured in The Wall Street Journal. It attempted to debunk just about every reason your broker has ever given you for investing in stocks – from "investing in the stock market lets you participate in the growth of the economy," to "the market is really cheap right now," to "stocks outperform over the long term." Overall, it adopted a very cynical, negative view of the market." As well it should be. Too many brokers and other financial professionals are out to earn commissions, not to serve customers. Warnings are necessary. "If this article, which ends with the comment "In the long run, we are all dead," is your idea of helpful investment advice, then please read no further. But at the same time, if you're expecting me to try to "debunk the debunker" by giving you 10 reasons to be bullish on the market, then I have a surprise for you. While I do feel that the unprecedented rush to the exits by individual investors and the extremely negative press that has dogged this market since early 2009 will ultimately prove to be very effective contrarian indicators, I understand the frustrations investors feel with the post-"flash crash" market in all its high-volatility, directionless glory. Instead, my message to you is about avoiding these stock market frustrations and actually setting yourself up to make some money. I'm sure you understand this will not happen by you sitting in cash vehicles that guarantee you safety but pay you no return. You are being "rewarded" for the risk you are taking, and that reward is zero. But at the same time I'm not suggesting that your only alternative is putting your money in the market. What I'm in fact suggesting is that you commit a relatively modest portion of your capital to STRATEGIES designed to EXTRACT MONEY from the market, regardless of direction, or even if there is NO direction. And the only investment vehicle that can accomplish this for you is options." Committing only a modest amount of money makes sense. I can agree with that. Adopting strategies that are designed to extract money from the market also makes sense. However, isn't that the purpose of every strategy? The difficult part is knowing which strategies to adopt and when to use them. "So in the format of the aforementioned Wall Street Journal article, but with the goal of providing you with actionable information designed to grow your portfolio, allow me to list for you 10 reasons why you should be trading options right here and now. The calls in your options portfolio will allow you to achieve big leveraged gains if the market catches most investors by surprise and rallies through year-end" That's true. But the bigger truth is that you can readily lose 100% of the capital invested. Bernie, I admire the fact that you caution investors to use only a 'modest portion' of their portfolio for these plays, but they are still high risk plays that require accurate market prognostication. "The puts in your options portfolio will protect you against "flash crashes" and other disruptive market events and even allow you to profit in these situations." This is also true. Are you suggesting that buying both puts and calls gives your investor a good strategy for extracting money from the stock market? I believe it's far more likely to extract money from his/her investment account. As the 'flash crash' made obvious, it's not easy to get orders entered, and even more difficult to get them filled, during such an event. My conclusion is that another flash crash is unlikely, and preparing for it is a waste of time and money. Preparing for a true market debacle is another story, and being certain your portfolio is not decimated when that happens – makes sense. "You can still benefit from the unlimited profit potential of option buying yet limit your loss from any trade to 20-30%." Limit losses? Are you suggesting that option buyers unload their positions when losses reach that 20 to 30% limit? That hardly gives them a chance to profit if that 'big rally' doesn't begin pretty soon. Limiting losses is a fundamental aspect when trading, but not for the scenario you described. You want them to be involved if there is a rally through the end of the year, but you don't want them to own positions when losses exceed a designated limit. Those are conflicting goals. "You can profit from market volatility regardless of the direction of the price movement." You can lose from market stagnation, or reduced volatility – regardless of direction. "You can profit from buying calls on stocks that outperform, and at the same time buying puts on stocks that underperform their industry peers. That's the easy part." We all know how easy it is to pick which stocks will outperform. The proof is in the fact that each of your clients has already achieved multi-millionaire status and is heading towards the billionaire level. And your newsletter must be at least 95% accurate when picking direction. It's a cinch to do this. Just look at all the mutual funds – who pay big salaries for management personnel, and their track records. Hmmm…I must be missing something here. Those managers tend to underperform. But that's okay, I'm sure your customers are much better at picking direction than all those pros. "You can achieve huge leveraged gains by buying options during expiration week, when premiums are extremely low. And now, with the new Weekly Options, there is an expiration week every week." Wow. Yes indeed. Good thing you are so good at picking direction because the nay-sayers would tell you that's it's a great opportunity to lose 100% of your money in a hurry. Did you know that the 'extremely low' option prices are accompanied by exceptionally rapid time decay? I suspect you did know this, but chose not to mention it. Buying Weeklys? Leveraged profits are nice. What about 100% losses? Or do you stop yourself out of these trades after 2 days? "You can profit from the strong tendency of the market to trade in well-defined ranges most of the time with a carefully selected option premium selling program." Well, which is it? Are we to buy or sell these options? You must tell us now, before we actually go out and make the trades suggested earlier. Or is this another example of making option trades when we know how each stock is going to perform? "You can profit from the huge volatility around events like quarterly earnings reports." And do we do that by buying or selling the 'huge volatility' displayed prior to a news announcement? "You can profit by buying call options on stocks that are in long-term uptrends, at much lower dollar risk than buying the stock." Agree. I hope you are referring to ITM options, and not suggesting that traders buy OTM, or even ATM options. I assume that your readers are good at judging which stocks are in firm uptrends. "You can profit in all market environments by trading multiple option strategies on highly liquid exchange-traded funds on broad-market indexes, like the QQQQ." Okay, but you wanted investors to buy calls on the good stocks and puts on the decliners. How does trading an ETF allow for that? Now they must predict market direction for the whole market, rather than for individual stocks. So, does that mean all the advice given above is no longer valid? "In the long run we may all be dead, but we can make the most of the short run by looking to the options market for our trading opportunities." Yes Bernie, all those opportunities are present. But how do your readers know when to buy (or sell) puts or calls? You neglect that one little detail. Or are they supposed to buy your costly newsletters to get the answers? In my opinion, options are designed to reduce risk. Neither buying options nor selling naked options is the investing method that gives trades the best chance of success. A jackpot possibility – yes, it provides that. But that's no different from gambling and I'm disappointed that you shared these inconsistent thoughts with the world. "A good place for you to start might be our Options Center, where every trading day we slice and dice what's happening in the options market and its implications and where you can also find a wealth of options-based tools and filters and explanations of various options strategies." I truthfully don't know how good this information is. But, it may probably worth a look. Bottom line: This is the type of guru advice offered to the average options trader. This is the type of advice that gives options and options trading a bad name. If you want to gamble, follow the advice offered by our guru. If you want to use options with the chances of making a profit on your side, then understand how options work, make good trades, and carefully manage risk. Related articles Why You Should NOT Trust Investment Gurus 10 Signs Of A Fake Guru 3 Words You Won't Hear On CNBC Do You Need A Lawyer? I Don't. SchoolofTrade: Another Guru Busted Want to learn how to trade successfully from real traders? Start Your Free Trial

The truth is that selling straddles is a strategy that seeks a high profit and it must come with significant risk. When you are naked short options, loss is theoretically unlimited – and there's nothing to be done about that. Sure, we know there will not be a 50% one-day rally, nor will there be a one-day 75% decline. But they are theoretically possible and that makes it impossible to estimate the maximum loss for the straddle. If willing to live with the risk of a gigantic loss, then you may be comfortable selling straddles. However, because you are asking about risk reduction, I assume that unlimited loss is something you prefer to avoid. Iron Condor vs. Straddle The best (in my opinion) protection is to buy a put that is farther OTM than your short put. In other words, I am willing to pay that very high price for the put because it provides complete protection against a huge gap opening – or any significant move. By 'complete protection' I mean it establishes a maximum possible loss. When you have the ability to set that loss potential, you are in position to trade more effectively. Money management For example, when you recognize the worst possible result, you are better able to size the trade properly. Translation: You can make a very good judgement about how many contracts to trade. When selling straddles, there is no good method to allow effective money management. Note the difference: You can manage risk by adjusting positions as needed – assuming that there is no large market gap. However, there is no way to practice sound money management money when you don't have a good estimate of how much is at risk. Yes, this is very expensive, reduces potential profits significantly and converts the straddle into an iron condor (assuming you do this on both the put and call sides). However, it does allow you to have a better handle on money management and risk management. Alternative: Strangle If you fear, or anticipate a market decline, you can take out partial insurance right now – when initiating the position. There is nothing magical about selling straddles, and you can trade a strangle instead. In this scenario, you would sell the 1185 call, as planned, but could choose a lower strike put. Perhaps the 1165 or the 1150 put? The point is that you build in your market bias by making a small (not 100 points) adjustment in the strike prices of the options sold. Protection I've been trading options since 1975 and have come to one major risk management rule that suits my comfort zone. I no longer sell any naked options (unless I want to buy stock and elect to sell a naked put in an attempt to buy stock at a lower price). I have incurred too many large losses from being short far too many naked options – both calls and puts. I am NOT telling you to adopt that same limitation. What I am doing is asking you to consider the risk of selling straddles and decide if it works for you. It may be a perfect (high risk) strategy for your trading style. a) Buying debit spreads (puts in your example) is far less costly and provides far less protection than buying single options. And that protection is limited. But if there is no huge gap, this is a very useful method to reduce risk. I'd prefer not to constantly use the phrase 'if there is no gap,' but the truth is, that's the big, ugly enemy for the naked call or put seller. That gap eliminates the opportunity to make a timely adjustment before disaster occurs. b) Another risk management method to consider is to reduce the time that you own the short straddle position. True, the most rapid time decay comes near expiration, but if you take the extra risk associated with selling naked options, you can counter some of that risk by not holding into expiration. Consider owning the position for only two or three weeks, taking the profit, and waiting patiently until it's time to open a new straddle. Being out of the market is one sure method for reducing risk. c) Other solutions exist, but buying single options or debit spreads represent the most simple and effective choices. Another example is an OTM put backspread. But please be warned: The risk graph may look very good today and you may feel adequately protected today, but the passage of time turns these into situations in which you may incur a big loss from the original straddle plus another from the back spread. Example Buy some SPX Dec 1120 puts and sell fewer SPX Dec 1130 puts. Because you own extra options, the gigantic downside move will not hurt. However, if SPX declines and moves near 1120 as expiration arrives, this backspread can lose big money. This is not the appropriate time to go into a further description of the backspread, but some of the problems are mentioned in this post. Related articles Trading An Iron Condor: The Basics How To Blow Up Your Account Trader Mindsets The Options Greeks: Is It Greek To You? Want to learn how to trade options in a less risky way? Join SteadyOptions Now!

Question: "I currently have a RUT Sept IC [iron condor] paper trade that I opened on Aug 27 for a credit of $1.90. This morning the position had a profit of $1.20 and would cost $0.70 to close." If you can watch a position during the day would you advise locking in a profit at a certain point in a situation like this? I cover early. That’s my comfort zone, and you must find your own. However, even that is insufficient. How early to cover and how much to pay remain the unanswered questions. The best place to discover the answers is in the original trade plan. When you have such a plan, it is easy to follow. Sure you can modify it as needed, but the plan gives you a general guideline for making decisions. For example, if your plan was to earn $1.50, then I would say that earning $1.20 is acceptable ONLY when the current position makes you uncomfortable. If you have doubts, then quitting earlier than anticipated makes sense. Lacking a trade plan, I believe: How much you collected originally is immaterial. How much profit you have is immaterial All that matters is this: You can cover this position by paying $0.70. Do you want to take the risk of holding this position when your potential is all, or part, of $0.70? Are the options far enough OTM that you are comfortable when holding? Or would you be holding just because you cannot bear the thought of paying ‘so much’ to close? Would open this iron condor as a new position for $0.70. If ‘yes’ then do not close. If ‘no’ then you have a decision to make. Is it too risky to hold? I cannot possibly know the answer. It’s a personal decision. If you do hold, what is the target? If it is another 5 cents, get than $0.65 cent bid in now. There is no reason to risk losing the whole profit to earn another $0.05. I offer this advice: Don’t allow the actual result to sway you. If you decide to hold, and this time that turns out to be a losing decision, don’t conclude that you should close early next time. If you close early and the position goes out worthless, that does not mean you should hold next time. Trading is about RISK and REWARD. Not how much you coulda, woulda, shoulda earned. Also, your decision on holding/closing should influence your decision. But that becomes part of the trade plan. You are in the learning phase of your options trading career. You are gaining experience. Education is an ongoing process, and requires time. Before you risk real money, you must (IMHO) understand the strategy you are using and have some basis for believing you are capable of managing the risk of your investment, should the market move against you. You are still paper trading. So trade. Manage risk. Keep a daily diary of how you ‘feel’ about your positions: Are you comfortable? Are you concerned about volatile markets or pending losses? Are you confident (overconfidence is a killer)? Are you anxious to lock in profits or do you prefer to try to collect the last penny from a trade? Put your thoughts into writing. Keep a trade plan for every trade. Be conscious of position size and have a good reason for increasing or decreasing size. As time passes, keep a record of how well you like the plan or whether you feel the plan did not serve its intended purpose. Answering these questions – in your diary – is important. Your own commentary will lead you down a path that is good for you. And you can modify your comfort zone as the years go by. It takes time to find a strategy that you can handle effectively. But, no strategy is always ‘right.’ Times change and markets change. Be prepared to change your trading habits. Take your time. If you develop good habits now, those habits will last a lifetime. If you go broke now, you may give up trading options. I cannot tell you what will work for you – but you will figure it out as you go along. The primary goal is to survive. That means protecting your assets. The secondary goal is to make money. The tertiary goal is to build wealth. The fourth rule is to never forget your primary goal. Concentrate on getting experience with iron condors, finding your comfort zone, and protecting your assets. That is what is important. Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University. Related articles: Should You Leg Into Iron Condor? Iron Condor Adjustments: How And When Iron Condor Adjustment: Can I "Roll" It Forever? Why Iron Condors Are NOT An ATM Machine Can You Really Make 10% Per Month With Iron Condors? Is Your Iron Condor Really Protected? Want to learn more? Start Your Free Trial

Some adjustments are made because we anticipate a specific event in the market (buy vega in anticipation of a increase in implied volatility). Others are made because we fear a big rally or decline. However, most of the time adjusters seek to find a trade that reduces risk for as many different market conditions as possible. Traders tend to find that one specific adjustment type is their favorite because it has brought satisfactory result sin the past. Some adjustment techniques are well-suited to a specific strategy and the pair go well together. [Rolling down when trading CTM iron condors] The trap Some adjustment methods are so attractive because they offer a very reassuring risk graph. The problem with that adjustment type is that the graph may be deceiving. This is the topic of today’s post. Readers who are familiar with my philosophy concerning the purchase of individual calls or puts as insurance for an iron condor trade know this: I recommend NEVER buying any option for protection when that option is farther OTM than the option (or spread) being protected. There are situations when ignoring that advice brings excellent results. However, much of the time the trader can get trapped and loses even more money than would have been lost without the adjustment. That is a situation that has to be avoided. So let’s make this one basic premise for all iron condor adjustments: No iron condor adjustment is acceptable when losses may become higher than that of the original trade with no adjustment Translation: An adjustment must never add to losses. An adjustment must earn a profit (if it were a standalone trade) at any time that the position being protected loses more money that it is losing when the adjustment is made. In my opinion, there are no exceptions unless you are sophisticated enough to recognize the extreme danger and will get out of the trade early enough to prevent a disaster. Here is an example: Example: Let’s say you are short the 750/760 call spread for some unspecified index. Wanting protection against a big rally, you buy one or more extra 760 calls. When looking at the risk graph, all we tend to notice is the large potential profit when the index rises to 800, 850, 900 etc. However, the crucial part of the trade gets ignored (by those who have not thought this through well enough). As time passes, those extra calls lose much of their power. Sure, the graph still looks good and the position performs well when the market moves a lot higher. But that is not the scenario for which we bought protection. The adjustment trade must reduce losses when the index creeps higher and approaches the short strike. We should not be concerned with risk when the index rallies to 850. That is an unlikely scenario. The trader has to worry about the market moving to 740, 745, 750 – especially as expiration nears. [One of my tenets is that we should not be holding positions in this very risky situation, but some traders hold anyway]. When your ‘protection’ is owning extra 760 calls, and time is getting short, those calls do not help when the rally continues slowly as the days pass. In fact, they could easily expire worthless while your short spread finishes in the money by as many as ten points. That would be a double disaster: losing a lot of money on the original position and seeing the adjustment trade expire worthless. The problem occurs because the trader bought calls with a higher strike than her short calls. The situation is identical when you buy puts that are farther OTM than the short puts being protected. Unless you know the adjustment is to be held for a VERY short time and will be replaced, do not buy protection that is farther OTM than the position being protected. Two of the most difficult aspects of managing risk for negative gamma positions is deciding when to make the adjustment and which specific trade to make as the adjustment. Today, let’s talk about timing. If we adjust frequently, we run the risk of buying every rally and selling every dip – exactly what we don’t want to do. If we had done nothing, we’d be holding a winning trade. On the other hand, if the market edges higher (or lower, take your pick) day after day, then these frequent adjustments could save us a pile of money because we would never be too far from delta neutral. If we adjust in stages or at predetermined levels (price of underlying, delta of short, money lost etc.) we have exactly the same situation as above – but the numbers are all larger. If we adjust and the market reverses direction, we will have spent a decent sum adding protection when it turns out that we would have been better off not to have adjusted. And to make matters worse, we would have locked in a reasonable loss for at least a portion of the position by making that adjustment. On the other hand, if we do not make the adjustment, we own a position that is out of balance, is currently underwater, and has reached a point where we are threatened with ever-increasing additional losses. That is no time for the prudent trader to become stubborn. It is time to do something to reduce risk. When? There are two basic approaches: 1) Time adjustments for all trades as consistently as possible. The specific method used is less important than being consistent. 2) Use your best judgment to determine the type of market conditions under which you are trading. Use technical indicators, follow the trend, follow your gut, keep careful records of how much the index is up or down every day, etc. If it seems as if we are in a trending bull or bear market, then adjust much more often as a safer way of managing risk. You could even initiate the trade with one adjustment built-in. [begin with an unequal iron condor, perhaps 8 calls and 10 puts; or begin with calls (or puts) with a smaller delta than the other side.] Don’t sit and wait for a reversal that may never arrive. Trade scared and trade with safety in mind. Or don’t trade and wait for better conditions. If it seems that the market is not trending or that you cannot draw useful conclusions about what you see, then return to your standard risk management technique. Be ready to change course for extra safety. Bottom line: Whatever it is that you see in the market, the objective is to play it safe. Play it small. Or don’t play at all. There is a ton of money to be made by trading iron condors or selling credit spreads. But that is only true part of the time. When the markets are unfavorable for those methods, we must minimize losses so that we are in good shape to collect when it becomes our turn. And we do not know when our turn will begin or end. Related articles: Should You Leg Into Iron Condor? Exiting An Iron Condor Trade Iron Condor Adjustment: Can I "Roll" It Forever? Why Iron Condors Are NOT An ATM Machine Can You Really Make 10% Per Month With Iron Condors? Is Your Iron Condor Really Protected? Want to learn more? Start Your Free Trial Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.

What's Your Maximum Loss? However Being confident does not guarantee that the markets will behave Overconfidence leads to ignoring risk management Big size can produce devastating losses The Risk of Ruin increases exponentially as trade size increases Preventing big losses represents the successful trader’s path to wealth Most beginners are shy about making a big monetary commitment and usually start trading with a small investment. When buying options, they set a maximum dollar amount to be invested. It is obvious that the cost of the options represents the most that can be lost. However, when adopting any of the ‘income generating’ strategies, even though the trader may know the results of the worst case scenario, it is often difficult to recognize that such losses do occur. Why is that? I believe it is the result of a natural optimism that accompanies the discovery of options as an investment tool. The conservative trader begins with one-lots. She progresses as her confidence and experience grow. The aggressive trader, who does not (yet) understand how important risk management is to his future success, may begin trading positions that are large enough to destroy 25 to 50% of his account value in a single trade. Let’s take a detailed look at how a trader – especially a new trader – is supposed to determine an appropriate trade size. Hi Mark, I saw your webinar “Can you earn a steady income with Options – The Career Plan.” You discuss a $50k account and suggest that $40k of margin be used, with $10k left for adjustments or other trades. In that $40k you discuss that if we are doing 10-point credit spreads, then the margin required is $1k per spread – so you can take a max of 40 IC’s – so that means if one is doing trades expiring in 2 different months, then that’s 20 IC’s for each expiry. What's the optimal Trade Size? So in short, with a $50k account, a good plan would be to take 20 IC’s in each of those 2 expiring months. ‘Good plan’? That depends on the trader. But, yes, that is what I recommend as the MAXIMUM trade size. It is ALWAYS acceptable to trade less size. It is always safer to keep more money on the sidelines for repairing trades gone awry. One of the worst feelings of helplessness occurs when you are losing money, the market is moving against your position, you see an excellent trade that reduces risk and solves your temporary problem – only to discover that the trade increases the margin requirement and you lack the funds to make the trade. I confess that I did not emphasize that the plan I suggested in the video represents the MAXIMUM trade size. I do not want anyone to believe that an inexperienced trader can handle 40 iron condors when the account size is $50,000. Many experienced traders would find that trade size to be far outside their comfort zones. If you are not a member yet, you can join our forum discussions for answers to all your options questions. Any trader’s individual skill and experience play a large role in determining how much cash you want to hold as a cushion. We must recognize that 20-lots of a 10-point iron condor may not seem too big to handle. And most of the time that is true. However, it is possible to lose as much as $700 or $800 per spread. That unlikely, but possible, loss of $14k to $16k is far too much for a $50k account. Are You An Experienced Trader? The experienced trader; the disciplined trader; the trader who knows that he/she does have the will power to do what is necessary and take appropriate action to insure survival – even it means locking in a big loss; that trader can handle positions of this size. When I refer to a trader who has the will power – I am referring to someone who has done it – more than once. It is far too easy for the less-experienced trader to look at a $5,000 loss and refuse to accept the fact that a given trade is not going to work. The trader who hates losing that much and wants ‘his/her money back’ is not going to be a successful trader. When money has been lost, it is no longer your money. It belongs to someone else. That traders JOB is to salvage his account by fixing the problem. That is accomplished by exiting the trade, reducing size, or making a risk-reducing position adjustment. If you do not know FOR A FACT that you will have the courage – and it does take courage to face reality – that you will act to prevent larger losses and that you will not just close your eyes and hope that the market reverses direction – then you are not yet ready to trade bigger position size. Have patience, gain experience, and trade far below the recommended maximum. I repeat: I did not emphasize those points when making that video. The video discussion was about the minimum amount of spare cash an iron condor trader should keep available. More cash increases the probability that you be able to handle any crisis and survive for the long term. I do understand that you will probably never lose the maximum, because you would adjust and reduce risk. However, are you positive that you would not panic or refuse to act? Do you really want to bet your entire trading account on that possibility? We recognize that the maximum loss is possible if the market crashes, and we do want to think in terms of a worst-case scenario when looking at risk. But one note: If the market crashes, IV will be sky high. Those very deep ITM put spreads will not be trading near $10. You would be able to cover at a price of $7 to $9. You may not want to do that, hoping for a reversal, but the maximum loss would not occur right away, unless it is expiration day. The way I have read about managing risk is to decide how much you are going to risk on each trade. So let’s say I had a $50k and I decide I will not risk more than 4% per trade – so 4% of 50k is $2k. In the above scenario where the risk per IC was $820 I would only do a maximum of 2 or 3 IC’s ($2k divided by $820). Could you advise the pros and cons of each – surely the 20 IC’s will provide much higher return. Yes, the cash returns could be very high. But more than that, the loss potential is also high. Too high in my opinion. As far as risking 1, 2, or 4% of the account value on a trade, that is not for traders who do as we do. That is for the day- or swing-trader or who buys stocks (futures etc). We can take a little more risk per trade because the chances of losing the maximum are very small. That is not true for the day trader. That day trader (or investor) could establish a stop loss at that 2% or 4% level. Losing that maximum is not a rare situation. Similarly, an investor who follows your suggested rule could own more than 20 simultaneous investments. That works for the longer-term investor who does not have to make moment-to-moment trade decisions. We, and our positions, do not allow for convenient stop loss orders (for many reasons). But that does not mean we should go as far as putting 16k (32% of the account) at risk for any trade. We need a more reasonable limit. I am comfortable telling you that if you own two 10-lot iron condors – that is reasonable trade size despite the possibility of losing $8k on each spread, IF AND ONLY IF You are comfortable with that size You have experience making adjustments and taking losses You are not nervous with that size (within comfort zone) If it is early in your career, I would be more comfortable suggesting that you trade two three-lots positions. Related articles: Trading An Iron Condor: The Basics Trade Iron Condors Like Never Before Why Iron Condors are NOT an ATM machineWhy You Should Not Ignore Negative Gamma Are You Ready For The Learning Curve? How Position Sizing Impacts Your Returns Adaptability And Discipline Want to learn how to reduce risk and put probabilities in your favor? We discuss how to do it on our forum. Start Your Free Trial

The Plan Do you buy VIX calls, betting on a big increase in the price of VIX futures? Do you buy options with lots of vega? Do you buy options with lots of gamma? Do you buy straddles/strangles, playing for either a big market move in either direction or an IV surge? Do you plan to scalp delta when the market moves both up and down with big swings? I don’t have a simple plan to recommend. Market volatility can manifest in different ways and a trader does not want to own positions that earn little or no profits when correctly predicting the future. It is a situation that is similar to a bullish trader who buys a ton of OTM calls, only to find that the market does not rise far enough or quickly enough to overcome the passage of time and the declining implied volatility of the calls he bought. Possible trade plans 1. Huge market move. It’s fine to place a bet on a big move. If the market were to rally or decline by 10% or more over a relatively short period of time, the option buyer should be able to earn a tidy profit. Buy options that are not-too-far OTM and which that will become reasonablr far ITM if your prediction comes to pass. The options may seem dear, but if you are correct they will provide a handsome profit. If you also want to bet on the direction of the move, you can save a lot of money by buying only calls or only puts. If you want to plan on a big move, but one that is not large enough for your options to move deep ITM, then consider buying a bunch of OTM spreads. Turning $0.50 or $1.00 into $5.00 is very possible. If you do not have a directional play in mind, you can buy straddles, strangles, or both put and call spreads. That latter plan is the opposite of owning iron condors. The risk: When buying premium, the trader has to be correct. If the market move does not occur; or if time passes and IV does not explode; then the options are going to waste away to nothing. 2. IV Explosion. An alternative is to place a wager that IV will move a lot higher than it is right now. That could be the result of a big market decline or simply a result of fear that comes with uncertainty. If you believe America’s dalliance with the fiscal cliff is likely to provide that fear; if you are very bearish for some different reason; if you believe something startling will be announced; then betting that IV will increase is one way to go. You could buy VIX options, but I must warn you that we have seen big (temporary) IV jumps without participation by VIX options. These options use VIX futures as the underlying asset, and when the market participants see a rising IV but believe that IV will decline again by the time the futures settle, then VIX options do not tend to provide profits for their owners. You could buy vega. The best way to do that is to own some options with a decent lifetime: perhaps three to six months. If and when IV rises, those options are vega rich and should produce a handsome profit. Obviously you must select options on an asset whose IV rises. The problem is that you have to be right without too much time passing. However, there is a second chance to win. IV may go nowhere, but if the underlying moves far enough in one direction, you could wind up with a very good profit. A third plan is to buy gamma. Near-term options cost far less than longer-term options and decay rapidly. However, they come with a lot of gamma and if you get the big move, the profits can be huge. This is similar to loading up on vega because in either strategy, you become an option owner. However, the real difference comes in choosing the lifetime of the options. Longer-term options provide vega and shorter-term options come with more gamma. Then you have the modified plan in which you buy lots of gamma but do not hold for the giant move. Instead, you plan to adjust the position with some frequency (perhaps daily) in an effort to remain near delta neutral but earn profits by selling into rallies and buying on the dips. This works very well when the market moves up and down, but provides disappointing results when the market makes a one-directional move. 3. Bet against the so-called ‘income-generating strategies.’ Sell the iron condor, take a directional stance and bet against the credit spread (by buying the spread); sell ATM calendar spreads or butterfly spreads. This plan works when the market moves far enough so that the positions produce profits. This is not the ideal plan when you anticipate a huge market move, but works nicely when the market makes frequent decent-sized moves. Not only would you gain from owning the correct delta position, but these trades come with positive vega and there could be additional profits if IV rises. No real opinion, other than ‘volatility will increase’? That makes it difficult to choose the best play. However, I’d recommend owning some OTM call/put spreads. Clearly you do not want to go too far OTM, nor do you want to pay a high price for the spreads. But there has to be some price that meets your needs. When buying the iron condor and betting against that volatility, we don’t have too much trouble knowing how much premium we must collect to make the trade viable. If your mindset is to take the opposite bet, it should not be too difficult to decide how much to pay to play the game. The bottom line for me is that I don’t know how to play for the volatile market when I have a generic feeling that volatility is coming. I’d probably choose to own double diagonals. However, if I had a fear that a big rise in market volatility was pending, I would want to own some insurance (if the price is not outrageous) in the form of 5-delta puts and perhaps 10-delta calls. If I had more than a fear; if I were a believer that volatility is coming, I’d exit my traditional plays (for protection) and simply invest a reasonable sum by buying OTM options. As someone who does not trust his market predicting skills, I doubt that I would ever own those options. I would continue as I have been doing, but would trade 50% or less of my normal position size. This was part of the original request for information: Managing risk for any trade involves the same reasoning. the most important factor that goes into a trade is deciding on position size and the maximum possible loss. When you own gamma, risk graphs provide a lot of excitement as we see how much money can be earned. The real danger in those graphs is that they may encourage a trader to overlook the risk of time passing. The next trick in risk management is to have a good feel for the chances of earning money, and more importantly, setting a profit target. Let me assure you than when the market moves your way and your $5,000 investment has become worth $15,000 and the risk graph shows you how easy it is to reach $50,000 or $200,000, it becomes very difficult to exit. I know someone who bought 2,000 shares of a stock priced in the single digits, saw it rise above $120 and who never sold a share as the stock declined back to the mid teens. In fact, on the decline he bought another 2,000 shares at $40. It is so tempting to believe you are in the midst of the trade of a lifetime and that if you hold out for more, you will get it. I urge you to have a plan. If you buy low-delta options and IV really moves higher, do not expect them to move ITM. Scale out, or have a price target for selling the whole position. That’s risk management.The ETF If you pan to trade options on a specific ETF, be very careful. Do not take a long position in the double- or triple-leveraged products. Yes, they are more volatile than the ‘regular’ ETF, but it is safer to stick with the investment that you understand. The leveraged puppies act differently and are not constructed for anyone other than the day trader. If you are going to bet on specific stocks, be careful. It is probably better to select a more volatile rather than a less volatile stock or ETF, but it is far more important to buy vega when IV is reasonably priced. If you buy vega on a product with an historical volatility (HV) of 40 when IV is 60, you would be better off paying 30 IV for an ETF with a HV of 30. At last you would not begin with a position that feels as if the premium is already too high. That is also risk management. I hope this commentary offers enough information to allow you to find a suitable plan to profit if you get that IV hike. I have no recent relevant experience with making this type of play, not having made this wager for decades. Related articles: Can We Profit From Volatility Expansion Into Earnings? Options Trading Greeks: Vega For Volatility Using VIX Options To Hedge Your Portfolio Want to learn how to trade successfully while reducing the risk? Start Your Free Trial

The problem arises when those mindsets, developed over a lifetime, are in conflict with habits that are required to succeed in the new endeavor. For some it's a relatively short lifetime of experience and for others it quite lengthy. Nevertheless, bad habits are difficult to overcome, and that can make it very difficult to succeed as a trader. I often write about the importance of good risk management and money management. Someone who has spent years running up credit card debt, living beyond his/her means, or buying things to impress the neighbors obviously lacks the discipline to be careful when managing money. I'm not suggesting a trader must be frugal. But trading discipline is not easy for someone who spends carelessly and does not understand the importance of avoiding debt – especially at high (credit card) interest rates. Being careful with trading dollars and getting your money's worth from the commissions and fees you pay contributes to success. The frivolous spender may have a difficult time with that aspect. On the other hand, it's possible that the too frugal trader may not be willing to invest money in insurance or in making adjustments. It's certainly not frugal to take excessive risk, but an inclination to watch every penny can get in the way of trading decisions. Maybe this is one reason why so many who advocate a frugal lifestyle also prefer passive investing. Unless you own a portfolio of very conservative positions, occasionally (more often for aggressive traders) you find yourself in a risky situation. It's far better to make decisions based on common sense, previously made plans, and the ability to think well under pressure. Individuals who are accustomed to being ruled by their emotions are not going to do well under these conditions. Thus, if you have a mindset that allows those important, spur of the moment, decisions to be made when emotions are in control, that's deleterious to your chances of winning the trading game. Those who have their emotions under control, are far better placed to make a good decision under pressure. Do you have the mindset that allows sloppiness in your daily life? Can you overcome it and become more disciplined when trading? Do you think of trading as dealing with Monopoly money? Is trading a game to you? Or do you have the mindset of a gambler? That's not the mindset of a serious trader who understands that taking big risk, and losing, can be ruinous. Do you have an understanding of where your comfort zone lies and the importance of trading within that zone? That's a positive mindset because it makes it easier to know when to take your profits or adjust a position. My suggestion is simply to be aware of the recommended characteristics of a successful trader (you can find various opinions online) and be certain that you are aware of any habits that are in conflict with those desired traits. Being aware is the first step towards not allowing those habits to interfere with your quest. Here are some related comments from other bloggers. From Dr. Brett, warning investors to lose a mindset that suggests that each individual trade is a battle that must be won. He warns traders not to become emotionally attached to the results of each individual trade, but instead to focus on the longer-term objective: "For a successful trader, a trade is like a single pitch to a hitter. It is one part of one at bat, which is part of one inning, which is part of one game. The goal is to win the game, not to "win" on each pitch… I focus on being profitable for the week and month- not on each trade, or even each day. For the active trader, there are many trades in a day and there are five days in a week. As long as you don't lose too much in a trade, you can turn the day around. As long as you keep daily losses reasonable, you have a chance for a green week. And as long as a week doesn't dig you into a deep hole, you can still be profitable on the month." The goal is to have a successful season: that view makes it easier to shrug off the pitches that get away from you and focus on what is truly important." This is good advice and corresponds to my admonition that proper risk management is the key to success. Do not take too much risk at any one time – either when the trade is made, or after an adverse move in the market. Your goal is to have a profitable trading/investing career. Larry Swedloe, writing the Wise Investing blog at CBS MoneyWatch, discusses the idea of re-balancing a portfolio. This is a technique used by many investors who adopt asset allocation as the major method for managing risk. (As you know, I much prefer owning collars as a method guaranteed to preserve assets.) Quoting David Swensen, Larry posted: “Dramatic bear markets signal the need for significant purchases of losers, while extraordinary bull markets call for substantial sales of winners. When markets make radical moves, investors demonstrate either the courage or the cowardice of their convictions.” It's not so easy for the average investor, with his/her emotions at their peak (euphoria or despair), to be selling into surging markets or buying when everyone else is panicking. Yet, for true believers in asset allocation, unemotional trading is a necessity. Most investors have the wrong mindset and get excessively bullish when markets are toppingand bearish when they are bottoming. For anyone who likes the idea of asset allocation, re-balancing is an essential part of that methodology and the 'buy the top' mindset must be eliminated to do the job properly. That's difficult for many investors. John, writing The Essentials of Trading, offers this: "The following was posted by a trader on a forum recently. It’s a question which comes up fairly regularly, if not in print then certainly in the minds of new traders wondering at their prospects for success: (slightly reworded) 'I heard a lot of people say 90% of traders lose money. I wonder how long and roughly how much the trader loses before becoming one of the 10% winners.' Of course there is no one answer to this question. How long it takes someone to reach consistent profitability has a lot to do with how much time and effort one puts into it. The more dedication to the task the faster it will tend to happen." I find that many traders want to know how long it will take before they begin making money or before they achieve a specific trading goal. That's the wrong mindset. It assumes that success is coming and all the trader has to do is put in his/her time and the profits will appear. Trading is not a job in which seniority does any good – unless you use the time on the job to learn and understand what you are doing. The proper mindset, in my opinion, is wanting to know where the trader can find information so that he/she can read about, study -and especially – practice, various aspects of the new job (trading). This mindset recognizes that work is required to develop the skills necessary for success. Related articles Trader’s Mindset: Oblivious To Risks Managing A Losing Trade Learn First. Trade Later Adaptability And Discipline Maybe The Market Will Turn Around Trader’s Mindset: Always Collect Cash Want to follow us and see how we trade options while reducing the risk? 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Every so often I receive a question or comment from an option trader that makes me realize something: No matter how basic the explanation, there may be something else going on that causes confusion in the mind of that trader. For example: A trader sells an option, eventually covers the short position and asks whether it is still possible to be assigned an exercise notice. We all know the answer is: ‘NO’ You cannot be assigned an exercise notice when you are no longer short the option. So how can this become a problem? In my opinion it stems from the fact that all our definitions are not quite 100% clear. In this instance, the option owner still retains the right to exercise. However, our definition clearly states that someone who sold that option can be assigned an exercise notice. What is missing is a clear distinction that the obligation is transferred to the new seller when the original seller covers (purchases, in a closing transaction) that position. Bottom line: Only the option owner may exercise; only someone with a current short position can be assigned. Pretty simple concept, but occasional questions arise. A more recent example: I thought spreads were a single trade, and couldn’t be “picked apart. The trader was disconcerted when assigned an exercise notice on the option sold as part of a spread. There are several basic points to be addressed. Yes. The spread is a single ORDER and cannot be picked apart. When you enter a spread order, you are filled on ALL PARTS of the order, or none. It cannot be picked apart. Once the order is filled, the trader owns a spread position. As far as you are concerned, this is a single (hedged) position and you intend to trade it as such. However, the rest of the options universe does not know anything about you or your plans. The OCC (Options Clearing Corporation) knows nothing about you either. Sometimes the conversion of an option into stock can result in a margin call. That is a real problem, especially when the broker gives the customer 10 minutes to meet that call. [some years ago, traders had a few days.] What the OCC does know is that you own option A and that you have a short position in option B. Nothing else matters. Why? When any person exercises an option, the OCC verifies that the person has the right to exercise (i.e., that person owns the option). Next the OCC assigns that exercise notice to a randomly-chosen broker. The broker finds all of its customer accounts with a short position in that option and via specific process (usually random selection) chooses an account to receive that notice. No account is immune. No account owner can say that he/she was hedged and is therefore exempt form being assigned. Once that assignment notice has been received, the deal is final and cannot be undone. In our example, the customer sells 100 shares short and receives the strike price in cash. Consider this possibility: A new option series is listed for trading. That day, the option never trades – except for one spread order. If the option seller were exempt form being assigned, then the option owner would not have the right to exercise, and that is not possible. In the specific situation involving the person who send the question, he was trading in an IRA account. Under no circumstances may anyone be short stock in an IRA, so he was required to fix the situation immediately. He elected to sell his long option and buy the short stock. He could have re-established the original position (risking another assignment) by buying stock and selling the same call sold earlier. Early assignment is not always a problem. However this time a short stock position was in an IRA account and the trader was forced to exit the stock position. Being unable to meet a margin call is always s distinct risk when trading options. Using European-style index options eliminates that risk, but significantly reduces your vehicles for trading. Bottom line: If you are short an American-style option, you may be assigned at any time. Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University. Related articles: How Index Options Settlement Works Can Options Assignment Cause Margin Call? Options Expiration: Six Things To Know Want to learn more? Start Your Free Trial

Opening the trade When selling premium, it's natural to begin by collecting more cash for options sold than you pay for options bought. And those who sell naked options never think about buying protection or limiting losses – because it cannot be done for free. The following discussion of this specific trader mindset refers to trading spreads rather than naked options, although the principles are the same. The opening trade is easy. The traders wants to collect a cash premium and choose one of a bunch of strategies that enable him/her to do that. Managing the trade This part is more difficult. If all goes well and time passes, then the option values decrease and may eventually reach a point that our trader is willing to spend a small sum to exit the trade. However, it's likely that the position will be held, hoping all options expire worthless. Paying a few nickels to exit a trade and eliminate all future risk is not a popular idea. One of the problems with this mindset occurs when the market does not behave in a manner that is friendly towards our trader's position. Premium selling and negative gamma are close relatives. When the market goes against a position, further moves increase the rate at which losses increase and the position becomes more dangerous. Traders with a more normal mindset: "This position requires an adjustment because my current risk is too high and I must avoid a large loss" have no trouble making good trades that reduce risk. Most of the time these trade involve spending cash. Reduce size and buy back some of the position Buy single options for protection Buy debit spreads for protection Buy… The strategy tends to be to buy something and spend cash. However, the trader with the mindset under discussion: "I don't want to pay cash for any option trades. I do want to prevent large losses, but I will find a way to protect myself with no cash out of pocket" has a more difficult time managing the trade. Clarification: It's may not seem to be a more difficult time for the trader. He/she is happy to sell extra premium because it affords an opportunity to make even more money. However, these traders increase overall risk and do almost nothing to take care of the current problem. When the market rallies and the position is short too many delta, this trader does recognize the need for making an adjustment. At those times, the most obvious first choice (for the 'take in cash' traders) is to sell some puts. That not only adds cash to the coffers, but it adds positive delta. That's a feel good trade. However, it's very short-sighted. What's wrong with getting some useful positive deltas by selling puts? Two things. First, it does almost nothing to reduce the current upside risk. The only upside benefit is to keep most or all of the put premium collected. However, that cash is not enough to offset the losses that accrue as the market marches higher and negative gamma soon makes the position lose money more quickly that it did before the adjustment. Second, the position now has risk where none existed – downside risk. And for what? For the cash collected to 'protect' the upside. Selling those puts is not a good idea. If you are not a member yet, you can join our forum discussions for answers to all your options questions. What about rolling? Surely that's a good risk-reducing technique, says our trader. Well, 'yes and no' says I. Rolling works when you move to a good position and exit the risky trade. However, with cash as the driving force behind the roll, the trader often rolls to a position that is already too risky for an initial trade. It feels good because it includes extra cash and moves the short options farther out of the money. As I said that feels comforting. But it shouldn't. The new trade is probably so far from neutral that it already requires an adjustment. That sets up even more risk. And if the call spread was rolled because of a market rally, and if new puts are sold to balance the new position (turn it into an iron condor), then what about those now FOTM puts from the original iron condor? Prudence dictates paying some price to get those puppies off the street, but our intrepid cash collecting trader does not think that way. In fact, in his/her mind those have already expired worthless and that, in an of itself, reduces the bath being taken on the call side of the trade. Then there's the situation when rolling isn't good enough. It's necessary to pay $6 to buy back the (now ITM) call spread and the most reasonable place to roll (to collect lots of cash) is a spread that trades near $4. Most credit spread traders do not sell 10-point spreads for $4 when the idea is to watch the options expire worthless. They are far too close to the money. But the trader with the cash is king mindset will sell 3 spreads for each two bought. That allows him/her to roll the position at even money (buy 2 at $6; sell 3 @ $4). Immediate risk is gone and the shorts are no longer ITM. However, this is a very short delta position, had a potential loss that is 50% greater than the original, and is likely to create additional problems. Rolling for a cash credit may feel nice, it may make the trader falsely believes that no loss has been taken and that there is still a good chance to collect the entire premium – but it's a hollow belief. The truth is that risk has increased. That is not the path to survival as a trader. Exit This is the easy part for most traders. Take the profit and move on. To the cash is king trader, buying in cheap options is a waste of money and the trader believes that options were made to expire worthless. Another misconception and dangerous belief. If the mindset described fits you, please at least think about modifying the way you think about trading options – to something more reasonable. Related articles Trader’s Mindset: Oblivious To Risks Managing A Losing Trade Learn First. Trade Later Adaptability And Discipline Maybe The Market Will Turn Around Want to follow us and see how we trade options while reducing the risk? Start Your Free Trial

Do you have a loss? Let’s look at a simple situation. You invested $10,000 in the stock market. Today you can sell those positions and collect $7,000. Question: Did you lose $3,000? I find it quite surprising that many people believe that they did lose money while a segment of the population believes there is no loss yet. Yes, there has been a loss Here’s how I look at it: The market values this item at $7,000. If the account is with a broker, you may only borrow money based on that $7,000 valuation. Your belief that the stock in your account is worth $10,000 is imaginary. If you receive a margin call (based on a loss on a different investment), your broker will show no tolerance for your argument that the account is really worth $10,000 and that it’s not fair to value it at $7,000. If you want to withdraw cash from your account, your broker will not allow you to take more than $7,000 (assuming 50% margin), even though you believe they should let you take $10,000. If this were a house and not stock, your bank would not give you a $10,000 mortgage based on your estimated valuation. They would base the loan on a $7,000 valuation. Pretty much the whole world recognizes that an investment may have been worth $10,000 at one time but that $3,000 has been lost and the current value is only $7,000. No, there is no loss (yet) The argument in support of believing there is no loss is this: If I don’t sell my asset, I cannot have a loss. A loss only occurs after I exit the trade and have no chance to recover The large group of people who accept those arguments do not recognize reality. This is important to us because it affects how we think — and thus, how we act. Almost all traders accept the truth that managing risk is an essential part of being a successful trader. Those traders also share the opinion that it is unacceptable to incur a large loss and that it is necessary to take some defensive action when a position is losing money and has become too risky to hold. That defensive action is (more often than not) to exit the trade, take the loss, and move on to another trade when the time is right. However, people who believe that they have no loss currently (even though they may admit to being at risk of losing money) may stubbornly refuse to take defensive action. If they believe that closing the position is the act that creates the loss then they will hold onto risky positions, hoping that the loss will disappear. The reason this is a very poor way of thinking is that they tend to hold bad positions when successful traders understand the importance of getting put of losing trades (accepting the fact that the money has already been lost) and reinvest (at the proper time) the money into a better (less risky, more chance to earn a profit) trade. The innocent-sounding mindset that has people believing that a loss is not a loss until it becomes realized (i.e., position closed) keeps them locked into less than satisfactory positions. And that cannot be good for long-term results. Then there is this point: If the position does recover and the $3,000 loss disappears, they feel vindicated and ignore the fact that other positions would have earned double or triple that $3,000 over the same time period. Rethink your position if you believe that a losing trade has not yet ‘lost’ money. Related articles How Much Can I Earn With Options? Trader’s Mindset: Oblivious To Risks Managing A Losing Trade Learn First. Trade Later Maybe The Market Will Turn Around Want to see how we handle risk? Start your free trial

I plan to reply to each question and will group them as part of the Trader Mindset Series. Taken together, they represent how one trading professional, but psychology amateur, views the psychology of how trader's think. Are You Asking The Right Questions? I understand the thought process behind today's question, but it always disturbs me. It's just the wrong question. It would be better to ask any of these: How much time should I expect to devote to my options education before expecting to earn money? How much cash do I need before opening an options trading account? Do most new option traders find success? Or do most give up? I've never traded stocks or anything else. Will that make it difficult to learn to trade options? Should I learn to trade options or pay someone else to trade for me? These questions demonstrate that the person who wants to become an options trader recognizes that this is not a gimmie, and that some time and effort must be expended before rewards can be expected. The commonly asked question: 'How much can I earn?' suggests to me that the person asking 'knows' success is easy, and that the only thing holding him/her back from joining the game is wondering whether it's worthwhile. I seldom, if ever, receive a question along these lines: 'What does it take to succeed?' It's always similar to: 'I'm going to succeed. How much can I make?' A recent letter from Jo: Is it possible for an ordinary person to generate income from trading options if they are able to sustain themselves for a few months without a job while they learn the ropes? How much can one hope to earn through trading options on the conservative side, and how long does it take to become an expert on average? Is it necessary to purchase special software for options trading (technical indicators and such)? Yes. It can be done. You can generate income. However, when you 'need' the money for living expenses, it often places too much pressure on the investor/trader to succeed, and succeed right now. That added pressure can will lead to poor trading decisions. I know you understand. And that's why you plan to have 'a few months' cash in reserve. The good news is that you recognize that profits do not begin from day one. The not so good news is that you are asking whether it's reasonable to learn enough to make a living – during those few months. The first answer is that every student has a different ability to learn and some just have a better aptitude and can understand how options work more quickly than others. So yes, it is possible to produce earnings within that time slot. But not everyone can move that quickly. To succeed, you must understand what you are trading, and that means taking time to learn options basics. You should have no trouble understanding that options are different from other trading vehicles. But I must warn you that some traders never get the special characteristics of options and mistakenly believe that they can be traded as if they were stocks. Options are different. Not difficult to understand, but they are different. If you are brand new to trading, that means there is even more to learn, including basic things such as how to enter an order, how to use your broker's trading platform, the different order types (market, limit, stop etc.). Someone with stock trading experience is already familiar with those items. Discipline In addition to how options work, the trader must possess (or be able to develop) certain personality traits. Jo, if you are willing to learn how options work, and if you believe you can demonstrate the traits listed below, then you may very well be able to succeed. No guarantees. I do want to mention one important point. If you expect to make money (income) by buying options and then selling them for profits, let me tell you that this is an almost impossible path. When earning an income stream, the method of choice is to adopt specific option selling strategies – all with limited risk. Anyone can trade. Anyone can enter the arena and place his/her bets. But to have a chance of making money on a consistent basis, the trader must have: Discipline The ability to recognize risk How much money is at stake for a given trade The probability of losing money Patience to learn before trading Patience to practice what you have learned, usually in a paper-trading account Ability to control your feelings. Fear leads to panic, which results in terrible decision making Greed has you taking too much risk for too little reward Pride has you refusing to recognize that you made a bad trade and must accept a loss Recognize that a few successful trades does not make you a star trader Understanding that you cannot make money every month Understanding that low probability events do occur – just as statistically predicted Recognize that a 90% chance of winning means there is a very real 10% chance of losing Accept the fact that you cannot make much money when you only have a small sum to invest Knowledge that luck plays a role, and your job is to manage risk when luck is bad If you are not a member yet, you can join our forum discussions for answers to all your options questions. Now, to your Question: How much can you make? If you trade high risk strategies, you have a chance to earn a large sum (10+% per month), but that comes with a very high probability of going broke. High rewards come with high risk. If you are more conservative (as you are), you may try to earn 'only 2-3%' per month. That's a very good return. Most professional traders cannot earn that much. Brett Steenbarger once told me that the best professional traders earn 'in the low (emphasis on low) double digits' per year. That sounds right to me. Going by that, earning 1% per month is a realistic target. However, to give you a better answer, I must ask: How much cash do you have for trading? This is a key question that most beginners ignore. They assume they can earn the same amount of money, no matter how much cash is in the account. This is a huge fallacy. Why? When you begin with a small sum, the risk of ruin, or the probability of going broke, is very large. When you have extra cash, you can withstand a string of small losses and still stay in the game. Also: When you have a small account, if you have outstanding success and double the account in one year, the total dollars earned is small. It does take money to make money. Thus, I repeat, how much cash do you have? If you have $10,000 and can do an excellent job and earn 2% every month, that's a grand total of $200/month. That will not take you very far. I assume you would want to earn a minimum of 10 to 20x that amount. To do that you would have to take big gambles. There's a chance that you could have a nice win streak and quadruple your money in a year or so. But the most likely outcome of seeking such huge returns is the loss of all your capital. Yes Jo, you can do it. If you have the patience. If you take the time to learn and are not rushed into trading. And if you have sufficient capital to give you a realistic chance. If you lack the capital, you can still learn and trade part time. If you grow the account, if you save more cash over the years, if you show the talent and discipline, you may eventually have enough to try trading full time. I wish I could offer better encouragement, but trading is not a business for everyone. Being a successful investor can be very rewarding over the years. Trading full time is different. Becoming an Expert On average, far more traders go broke than become experts. Very few become experts. This question depicts another trader mindset that I believe demonstrates no conception of reality. How long does it take to become an expert? A lifetime. Experts are few and far between – assuming that by 'expert' you are referring to someone who knows how to make money and then actually makes it and keep it. With that definition, few are experts. Trading is a game in which you are continually learning. And that's important because markets change over time and if you still do whatever it is that you are an expert at doing, eventually it will no longer work and you will cease being an expert. It is not necessary to become an expert. You do not have to earn more than the next guy. In my opinion, you can do well (earn decent income) if: You have the ability to understand how options work. This is not difficult, but some people just don't have the head for it Trade with discipline and overcome emotions. Fear and greed are harmful. It takes a while to overcome those and trade with confidence You take the time to practice. That means using a paper-trading account with fake money. But to gain useful experience, you must believe it is real money and trade accordingly If you don't have to win right now, you need the time/patience to learn. I don't know if a few months are enough. That depends on you Technical Indicators No. I have NEVER used technical indicators. I know that some traders are very skilled in doing just that. But they do not learn overnight, and anyone who tells you it's easy to learn is not telling the truth. I use no trading software, other than risk management software supplied by my broker. I suggest getting started by reading or attending some free seminars. If you like what you read and hear, if you understand what you see, then go for it. Plan to spend some time in the education mode. Especially if you set a few months as the time limit. There's no time to waste. I wish you good trading. Related articles: Is Your Risk Worth The Reward? 10 Options Trading Myths Debunked Can you double your account every six months? Make 10% Per Week With Weeklys? Why Retail Investors Lose Money In The Stock Market Performance Reporting: The Myths And The Reality Debunking Options Guru Advice Want to see how we handle risk? Join our Options Trading Services

If the options were out of the money, and remained OTM, then the options would expire worthless and the seller would have a tidy profit. I can’t argue with the 2nd sentence. Options that are OTM once expiration day has come and gone are worthless. However, that mind-boggling first sentence is believed by more people than common senses would suggest. Once of the basic truths about investing (even when it would be more truthful to refer to it as gambling) is that some people with little experience believe that it’s easy to make lots of money in a hurry. I don’t know why that’s true, but the fact that skills must be developed over time is a foreign concept to such believers. Confidence that a current investment will eventually work out is common. Stocks decline and many investors like to add to their positions, increasing their risk in a losing trade. The mindset is that the stock only has to rally so far to reach the break-even point. For example, buy 1,000 shares at $50, then buy 1,000 shares at $40 and the beak-even is ‘only’ 45. Add another 1,000 shares at $30 and the trader’s mindset is that this stock will easily get back to $40, the new break-even price. There is no consideration for the possibility that this company will soon be out of business. This investing newcomer just knows that his original analysis must be correct. This is the mindset of overconfidence. In a situation such as this, it’s also being oblivious to the real world. The naked put seller The put seller described above believes that being short an out of the money option is of no concern, as long as it remains OTM. He just doesn’t get it. The possibility of losing a significant sum is staring him in the face and he truly doesn’t recognize the danger. I’m not suggesting that this oblivious mindset is common. However, as option traders we must be careful to avoid that mindset. I’m sure that every reader here understands the risk of being short naked options. However, being oblivious to other risks can result in a disaster. How large of a disaster? That depends on just how blind the trader is to the true risk of a position. If you are not a member yet, you can join our forum discussions for answers to all your options questions. The spread seller As an example, let’s look at a trader’s whose preferred strategy is to sell OTM put spreads, rather than selling naked puts. This is a common strategy for bullish investors. Let’s assume that one trader correctly decides that selling 10 puts with a strike price of $50 is the proper size for his/her account. Even oblivious traders understand that the maximum loss is $50,000. They also recognize that the chance of losing that amount is almost zero, and that it is difficult to know just how large the maximum loss is. Sure, a stop loss order can establish that limit, but stocks have been known to gap through a stop loss, leaving the trader with a much larger loss than anticipated. The ‘flash crash’ was an extreme example of how bad things can get. What happens when this trader decides that selling naked puts is no longer the best idea and opts to sell 5-point put spreads. Each spread can lose no more than $500 (less the premium collected). The problem arises if the trader, not understanding risk, decides that selling 100 of these spreads – with a maximum loss of (less than) the same $50,000 – is a trade with essentially the same risk. When a trader is not paying attention, he/she can become blind when the total money at risk is similar for two different trades. It’s easy to incorrectly believe that risk must be similar. In this example, two positions have vastly different risk. Position size and probability The trader whose mindset includes being oblivious to reality, is either unaware of statistics or ignores them. The big factor here is probability. There is a reasonable probability of incurring the maximum possible loss when selling 100 (or any other number) of 5-point credit spreads. Depending on the strike prices and the volatility of the underlying, the chances of losing it all can be near zero to almost 50%, depending on the strikes chosen. Let’s ignore the ‘near zero’ examples because the premium available when selling such spreads is tiny and no one should be trading those on a regular basis. However, when the chances are one in five, or even one in 10, you know that such results are going to occur (on average) every five or ten months. It takes some good sized wins to be able to withstand those losses. But the truth is that the trader who is not aware of the difference between the chance of losing $50,000 no more than once in a lifetime vs. losing that amount at least once every year has no chance to find success. One important aspect of risk management is understanding how likely it is to collect he profit or incur the loss. The size of that profit or loss is not enough to tell the whole story. Please do not be an oblivious investor. Please understand risk and reward for every trade, as well as for your entire portfolio. Related Articles Probability Vs. Certainty Trap Adaptability And Discipline Selling Naked Put Options Should You Add to A Losing Trade? Want to follow us and see how we trade options while reducing the risk? Start Your Free Trial

1) You can sell it If you collect more than you paid, you have a profit. If you collect less than you paid, you have a loss. You bought this option by entering a buy order with your broker. This time you enter a sell order to close (eliminate) your position. 2) You can exercise it Notify your broker that you want to do what the contract allows. If you own a call option, you may buy 100 shares of the underlying stock. You pay the strike price per share. If you own a put option, you may sell 100 shares of the underlying stock. You collect the strike price per share. 3) You can allow it to expire worthless This is not your ideal solution because it means you lost every penny that you paid to buy the option. When you hold an option, hoping for a favorable movement in the price of the underlying stock, many times that move never occurs and your option is out of the money. When an option is out of the money when expiration arrives, it has no value and is worthless. Because it expires, your right to buy the underlying stock expires. You may try to sell your option before it expires, but if there is little time before expiration, or if the option is out of the money by a significant amount, you may discover that no one is willing to buy the option. If that happens, you still own the option and will have to allow it to expire and become worthless. New Optionspeak terms: Out of the money: a) A call option whose strike price is higher than the stock price b) A put option whose strike price is lower than the stock price In the money: a) A call option whose strike price is lower than the stock price b) A put option whose strike price is above the stock price If you are ready to start your journey AND make a long term commitment to be a student of the markets: Start Your Free Trial

Another choice is to roll the position to one that satisfies all the conditions required for a brand new trade. If rolling is not appropriate, there are other acceptable risk-reducing adjustment choices. The worst choice is to do nothing (after the position reached the point where your trade plan calls for action), and hope that good things will happen. Example Let’s assume that you made a trade in which there is a short call spread and the market is rising. Let’s further assume that this position is essentially unhedged (i.e., if it is part of an iron condor, the put spread is not worth enough to provide any reasonable hedge when the market rallies further). You are short a 10-lot GOOG (price $740) call spread, the Feb 760/770 (or substitute strike prices that place you at the very edge of your comfort zone and where you believe the best move is to cover all or part of that risk). However, you decide to hold for the moment. The option gods are on your side. A few days pass and GOOG retreats to 730. This feels good and you feel justified in not having acted aggressively. However, expiration is still 32 days away, and this stock can easily run through the 760 strike. One intelligent plan is to exit now and take advantage of the fact that you did not lose additional money by acting when the stock was moving higher. When I find myself in this situation, I seldom exit. I feel vindicated that the market moved lower, and all exit plans are put on hold. I believe that postponing the exit is the most common choice for traders in this situation. I am now convinced that this is a poor decision. Another plan is to accept reality: The stock is still near an uncomfortable price level, and the small decline is not necessarily a promise of more decline to come. The conservative trader can covers a portion of the short spread as a compromise between greed and fear. I don’t believe traders make this move either. The common mindset is to heave a sigh of relief as fear fades away. The mindset is that “the stock is finally slowing down and I no longer feel threatened.” The Fallacy This is fallacious reasoning. We feel good. We believe, or at least hope, that the position is once again suitable to hold. However: It only takes one day’s rally to once again put the position in jeopardy. In only takes a relatively small move for the stock to pass its recent high and threaten to surge higher. It only takes that to force you to exit with a larger loss than you had earlier. Unfortunately, this is not a rare occurrence. It is very likely that the stock is not 100% exhausted and will challenge the recent highs. The problem is that we cannot tolerate holding when that happens. We are already at the edge and cannot take more (rally). When we fail to exit when we get that small reprieve, we need MUCH MORE decline to become comfortable. We need VERY LITTLE upside to force an exit. Isn’t the small rally far more likely than the larger decline? If the market behaves; if another week passes and GOOG declines by 1 or 2%, we are not yet out of trouble. For many traders, the spread will remain too expensive to cove,especially when recent market action has been favorable. The problem is that it still takes only a small rally to threaten the large loss. The fallacy is believing that a short-lived sell-off or calm market means that all is well. All is not well because it takes a significant passage of time or a decent-sized decline to bring this spread down to where many traders would finally cover. Being able to get out of the position at a price that is far below the current spread value is far less likely than being forced to exit on the next rally. It is not because the market is bullish. It is because so much more is needed for the trader to earn some money from the position, whereas, it does not take much for the trader to be forced to exit at a price even worse than today. The fallacy comes in believing that the stock has at least as good a change to move higher (enough to force an exit) or lower (enough to make a voluntary exit). It can move in either direction. However, the chances of coming out ahead are small. The penalty for being wrong grows quickly while the reward for being correct accumulates slowly. Thus, the probability of recovering losses is too small to take this risk. The reason for managing risk in the first place is to prevent sitting on bad positions such as this one, and this is not the time to abandon our plans and allow hope to take over as risk manager. Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University. Related articles: Should You Leg Into Iron Condor? Exiting An Iron Condor Trade Iron Condor Adjustments: How And When Iron Condor Adjustment: Can I "Roll" It Forever? Why Iron Condors Are NOT An ATM Machine Can You Really Make 10% Per Month With Iron Condors? Is Your Iron Condor Really Protected? Want to learn more? Start Your Free Trial