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Found 8 results

  1. Michael C. Thomsett

    Premium at Risk

    Premium at risk is not often brought up in the discussion of options, but it should be considered as one of many factors in identifying the true risk involved. Strategies such as covered calls tend to exhibit great variance based not only on time decay, volatility, and open interest, but also on one other factor: selection of the underlying security. Many traders tend to think of the underlying only as the vehicle for protecting option risks, or for reducing required collateral in order to enter a position. The selection of one underlying over another often defines and even sets risk levels. It is even more variable based on the covered call strategy a trader picks: Because there are so many choices, covered call strategies usually fluctuate widely from one trader to the next. Some traders opt to write long-term calls in order to eliminate the hassle of rolling their positions every month. Others choose to write significant out-of-the-money calls in order to maximize the upside potential of their portfolio. [Longo, M. (2006). Buying a young index: A new wrinkle in familiar strategy. Trader Magazine, 1] To many traders, this selection and timing of the call itself is the only variable that matters. But this means the underlying selection often is overlooked, and this is a mistake. An appreciation of the relationship between return and risk is a constant concern for trading options, but this extends beyond the option alone, and must be applied to the underlying, or the premium at risk calculation. Behavior of the underlying should be used to identify an exit strategy or when the time to roll out of danger appears. Focus only on the option easily overlooks this key analysis of risk assessment: One of the simplest exit strategies for securities is selling if the given security falls by a certain percentage. If the underlying security drops by a certain percentage, the option position is closed … there are also stay-the-course strategies such as double-up, covered call and the rollover. These strategies attempt to make the most of a bad situation by increasing the chances to recoup or limit any loss. [Elenbaas, T. & Tsou, D. (Fall 2006). Risk management for option writers. Futures, 35, 22-24] The inherent problem in the strategies designed to offset losses is that they often represent ramping up of the risk. The chances of increasing the loss rather than becoming a viable recovery strategy, involve both the option positions and the underlying. This could be taken to mean it is more conservative to take losses when they occur and free up capital to move to another position. The premium at risk extends beyond the option itself, so rolling over or increasing covered call positions, is not always reasonable. Traders also need to be aware of the risks of holding on to the underlying when the value is declining. If no options were involved, a trader might exit to cut losses, and this is a rational approach to risk management. But when option positions are open, judgment might not be as clear. A trader might stubbornly want to avoid losses and will increase option positions with the idea of recapturing paper losses. But at the same time, the underlying is losing value and the longer this continues, the worse the position might become. For analysis of how risk affects a portfolio, option traders are vulnerable. They may be analyzing impressive annualized returns from relatively limited dollar value of covered calls, for example, while ignoring what is going on with the underlying. Even if the underlying holds value without much change, is it a “good investment?” Options traders may view the underlying as a vehicle for reducing option risks, but does it make sense to keep capital tied up in a position that is not growing in value? It must be assumed that even covered call writers will prefer to see underlying equity positions becoming profitable over time. This is especially true if the covered call strategy is to write deep out of the money positions. If the underlying price moves upward and surpasses the strike, profits are possible from three sources: covered call premium, capital gains on the underlying, and dividends. This is the best of all worlds, but options traders might also tend to sabotage their original good intentions. Increasing the exposure (premium at risk) often is how this occurs. A trade is nice and profitable on a percentage basis, but the dollar amount was not that great. The next position might involve buying more shares and writing several calls, with the idea of greater dollar returns. This ignores the premium at risk, because price movement does not always move in the desired direction – as every experienced options trader knows. The real profit from options trading should take every aspect of risk and return into consideration and increasing the risk in hopes of realizing equally higher return should not be taken up in isolation. There are three factors to be brought into the assessment: The original price per share. If the underlying has appreciated in value since entry, much greater flexibility in the option is possible. This means a strike should be selected out of the money, but able to produce a respectable capital gain in the event of exercise. Options traders may avoid exercise by rolling, but it often makes more sense to take the gain and move to another trade. Price of the underlying when the trade is opened. How does this price compare to basis in the underlying? While this is an obvious factor to consider, some traders set up trades when the price is lower than basis, meaning a strike is selected poorly as well. If exercise would create a capital loss in the underlying (especially one higher than the profit on the call), this entry makes no sense. Strike of the option. The timing of the covered call matters, and the “best” available strike must be selected with the basis in the underlying in mind as well. The analysis of premium at risk should encompass risk and return, not just return. Too many traders have a blind spot about this, which explains why consistent profits often are elusive. Michael C. Thomsett is a widely published author with over 90 business and investing books, including the best-selling Getting Started in Options, now out in its 10th edition with the revised title Options. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on Seeking Alpha, LinkedIn, Twitter and Facebook. Related articles Human Nature and Option Risk Relative Yield of an Option Long Option Risks Option Payoff Probability Fundamental Volatility and Stock Prices
  2. Michael C. Thomsett

    Human Nature and Option Risk

    Options traders tend to like models and want to perform modeling exercises to somehow identify ideas with maximum profit potential and minimum risk. In fact, though, there is a reality about risk and its perception that can defeat even the most cautious approach: “If conditions are perceived to be less risky, then people may take more risk, and if conditions are perceived to be more risky, then the amount of risk taken may be reduced.” [Parsons, K.A., M. Butavicius & L. Ferguson (2010). Human factors and information security: Individual, culture and security environment. Australian Government, Department of Defense] This tendency to equalize risk is not necessarily intentional or even a conscious decision. It is simply human nature. This behavior involves a fear appeal – motivating traders with the threat of danger – or even a greed appeal – encouraging action to take advantage of the current condition – and both share a common flaw. They tend to fall into this risk equalizing type of trade rather than encouraging analytical thought and decision-making based on the science of probability. Failing to properly understand risk invariably leads to losing money or opportunity, and at times both. Options traders can act as contrarians when these situations arise. While everyone else is bullish, options traders can take bearish positions based on analysis of the technical signals. Some people believe that a contrarian is just someone who acts in the opposite way than the majority. But this in accurate. A true contrarian acts according to logic and analysis rather than according to emotion or gut instinct. A closely related problem is one of experience. As traders gain more experience, risk awareness tends to decline. This happens because some traders come to believe that experience is a suitable substitute for analysis and for caution. Traders at all levels of experience will see more consistent results (improved profits and reduced losses) when they are acutely aware of risk tolerance boundaries. Most traders have some idea of risk tolerance, but not of these boundaries and that is where poor decision are most likely to occur: … just as a traveler would be foolish to set out on a journey without packing provisions and studying a map to find the optimal route, a good idea isn’t enough to make a successful business venture. Among the many measures a company or organization should take before setting off on a new project, one of the most important is an assessment of the inherent risks. [Ayyub, Bilal M., Peter G. Prassinos & John Etherton (2010). Risk-informed decision making. Mechanical Engineering 132(1), 28-33] Controlling risk levels, which often is not possible, will help traders remain within their risk tolerance zone. However, because traders often are surprised when option pricing behaves other than as expected, it is healthy to keep in touch with that appeal to fear. It aids in identifying the true risks at hand when it might otherwise not be obvious. Traders also tend to ignore fear as they gain experience. However, experience merely replaces the fear of loss with a different type of risk. This familiarity risk is keenly severe for experienced traders, because the experience itself may cloak very real risks associated with a trade. For example, if you have executed a series of successful covered call trades, over time the actual risks may become invisible. Those risks include the chance of the underlying rising significantly and placing the short call in the money, early exercise, dividend capture resulting in the underlying being called away, or simply poor timing of the trade (for example, with expiration taking place in the same week as ex-dividend date, or immediately after earnings announcements, where earnings surprises can distort everything). The fundamentals may also have changed since the series of trades began, meaning risks are not the same as before. Another form of risk beyond the tangible one of probability analysis, is desirable risk. This is a common problem form options traders and explains the perception that some forms of risk are desirable. Options traders may define themselves as conservative but make speculative or even reckless trades. Others may select highly volatile underlyings because option premium is richer. This desirable risk should be understood as potentially against the stated risk tolerance of the trader. It is an easy trap to fall into because the desire for fast and exceptional profits may overtake risk awareness. Some options traders forget to make distinctions between a probability of a loss taking place, with the impact it could and would create. For example, a trader might find uncovered calls exceptionally attractive because (a) risks are the same as those of covered calls but there is no need to tie up capital in an equity position; (b) a series of similar traders have always yielded profits; or (c) they can be closed early or rolled forward if the puts go in the money. The failure in this example might be to not perform both sides of the analysis. Probability of occurrence (of exercise, for example) might be very low because the trader opens positions far out of the money. But at the same time, if the loss does occur, what is the impact? Having to buy shares could be catastrophic, especially in situations of very high-priced underlyings, or when several puts are opened at the same time. The point of all this is clear: Risk is not limited to a perceived model of probability, or to what may be considered the advantage of experience. It could be that models will not help in truly managing risk, and that experience can blind a trader to the level of risk and the impact of risks being realized. Michael C. Thomsett is a widely published author with over 90 business and investing books, including the best-selling Getting Started in Options, now out in its 10th edition with the revised title Options. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on Seeking Alpha, LinkedIn, Twitter and Facebook. Related articles Trader’s Mindset: Oblivious To Risks Trade Decisions: Risk Or Profits? The Risks Of Weekly Credit Spreads Long Option Risks Probability and Option Risk Options and Invisible Risks
  3. Michael Lebowitz

    McDonald's, Not A Shelter in the Coming Storm

    That is not to say there is no risk, just less risk. Market and economic troughs are akin to the aftermath of a forest fire. After a fire has ravaged a forest, the risks for another fire are not zero, but they are below average.Counter-intuitively, it is at these points in time when people are most fearful of fire or, in the case of investing, most worried about losses.With reduced risks,investors during these times should be more focused on the better than average rewards offered by the markets and not as concerned with the risks entailed in reaping those rewards. Conversely, in the ninth inning of a bull market when valuations are well above the norm,and the economy has expanded for a long period, investors need to shift focus heavily to the potential risks. That is not to say there are no more rewards to come, but the overwhelming risk sare substantial, and they can result ina permanent loss of wealth. As human beings are prone to do, we often zig when we should zag. In January, we wrote Gimme Shelter to highlight that risk can be hard to detect. Sure, high flying companies with massive price gains and repeated net losses like Tesla or Netflix are easy to spot. More difficult, though, are those tried and true value stocks of companies that have flourished for decades. Specifically, we provided readers with an in-depth analysis of Coca-Cola (KO). While KO is a name brand known around the world with a long record of dependable earnings growth, its stock price has greatly exceeded its fair value. We did not say that KO is a sure-fire short sale or even a sell. Instead,we conveyed that when a significant market drawdown occurs, KO has a lot more risk than is likely perceived by most investors. Simply, it is not the place investors should seek shelter in a market storm as they may have in the past. We now take the opportunity to discuss another“value” company that many investors may consider a stock market shelter or safe haven. We follow in this series with a review of McDonald's (MCD). You Deserve a Break Today Please note the models and computations employed in this series use earnings per share and net income. Stock buybacks warp earnings per share (EPS), making earnings appear better than they would have without buybacks. The more positive result is simply due to a declining share count or denominator in the EPS equation. Net income and revenue data are unaffected by share buybacks and therefore deliver a more accurate appraisal of a company’s value. Over the last ten years, the price of MCD has grown at a 13% annual rate, more than double its EPS, and over five times the rate of growth of its net income. The pace at which the growth of its stock price has surpassed its fundamentals has increased sharply over the last three years. During this period, the stock price has increased 46% annually, which is almost four times its EPS growth and more than six times the growth of its net income. Of further concern, revenues have declined 5% annually over the last three years, and the most recently reported annual revenues are now less than they were ten years ago when the U.S. and global GDP were only about 60% the size they are today. To pile on,the amount of debt MCD has incurred over the last ten years has increased by 355%. MCD is a good company and, like KO, is one of the most well-known brands on the globe. Rated at BBB+, default or bankruptcy risk for MCD is remote, and because of its product line, it will probably see earnings hold up well during the next recession. For many, it is cheaper to eat at a McDonald’s restaurant than to cook at home. Although their operating business is valuable and dependable, those are not reasons to acquire or hold the stock. The issue is what price I am willing to pay in order to try to avoid a loss and secure a reasonable return. Valuations Using a simple price to earnings (P/E) valuation, as shown below, MCD’s current P/E for the trailing twelve months is 28, which is about 40% greater than its average over the last two decades. The following graphs, tables, and data use the same models and methods we used to evaluate KO. For a further description, please read Gimme Shelter. Currently, as shown below, MCD is trading 85% above its fair value using our earnings growth model. It is worth noting that MCD, as shown with green shading, was typically valued as cheap using this model. The table below the graph shows that, on average, from 2002-2013, the stock traded 13% below fair value. We support the graph and table above with a cash flow analysis. We assumed McDonald's 5.6% long-run income growth rate to forecast earnings for the next 30 years. When these forecasted earnings are then discounted at the appropriate discounting rate of 7%, representing longer-term equity returns, MCD is currently overvalued by 72%. Lastly, as we did in Gimme Shelter, we asked our friend David Robertson from Arete Asset Managementt o evaluate MCD’s intrinsic value. His cash flow-based model assigns an intrinsic share price value of97.27. Based on his work, MCD is currently overvalued by 124%. Summary Like KO, we are not making a recommendation on MCD asa short or a sell candidate, but by our analysis, MCD stock appears to be trading at a very high valuation. Much of what we see in large-cap stocks today, MCD included, is being driven by indiscriminate buying by passive investment funds. Such buying can certainly continue, butat some point, the gross overvaluations will correct as all extremes do. Even if MCD were to “only” decline back to a normal valuation, the losses could be significant and might even exceed those of the benchmark index, the S&P 500. Now consider that MCD may correct beyond the average and could once again trade below fair value. Even assuming MCD earnings are not hurt during a recession, the correction in its stock price to more reasonable levels could be painful for shareholders. Michael Lebowitz, CFA is an Investment Analyst and Portfolio Manager for Clarity Financial, LLC specializing in macroeconomic research, valuations, asset allocation, and risk management. Michael has over 25 years of financial markets experience. In this time he has managed $50 billion+ institutional portfolios as well as sub $1 million individual portfolios. Michael is a partner at Real Investment Advice and RIA Pro Contributing Editor and Research Director. Co-founder of 720 Global. You can follow Michael on Twitter.
  4. Is this really true? A 65-year-old couple has about a 50% chance of one of them living until age 90, and about a 1 in 5 chance of one of them living until 95. For planning purposes, this means that in most situations it’s not unreasonable to stress test a retirement financial plan until age 95 or even 100. This is 30+ years. When it comes to asset allocation (your portfolio mix of stock funds, bond funds, and cash), two questions should be answered: How many years until I expect to begin withdrawing money from my investments? Once I begin withdrawing money from my investments, how many years do I expect that to last? From my experience, the average investor only thinks in terms of question #1 when thinking about how their portfolio should be allocated, yet question #2 is equally as important.In general, the asset allocation for an 18 year old’s 529 account should have a significantly lower allocation to stock funds than a 65 year old’s IRA. Once someone begins taking withdrawals to pay higher education expenses, the entire account would typically be expected to be depleted within 4-5 years. This means that the allocation to stocks should be very low at this point because market volatility is the most significant risk. Once someone begins taking withdrawals for retirement, the planning process would require there to be a sufficient probability the account(s) might last at least 30 years, as described earlier. Risk at this time horizon begins to transform from being primarily about short term market volatility into inadequate rate of return to keep pace with inflation adjusted living withdrawals. For example, in recent history the worst time to begin taking withdrawals from an investment account would likely have been at the end of 2008, which is when the Global Financial Crisis was near its peak uncertainty and stock declines were substantial for the calendar year. For example, the US equity market lost 37% and Foreign equities lost 44%. College Funding Example: $100,000 account, withdrawing $25,000 per year at the end of each year starting in 2008: Portfolio 1: A 100% Global Equity Fund was only able to withdraw a total of $76,269 due to the losses experienced in 2008. A permanent loss of $23,731 occurred due to the requirement to take large withdrawals to cover expenses. Portfolio 2: A 10% Global Equity, 40% Intermediate Term Bond, 50% Money Market Fund portfolio had a $5,348 balance after 4 the year perioddue to investment earnings. The difference in this example is stark. In the first example, there are insufficient funds left to pay for the vast majority of the final year’s expenses. In the second example, funds are left over that could be used for a variety of purposes such as a graduation gift or applied to the next child in the household. Now, let’s take the same portfolios, but shift the withdrawal example to a hypothetical retirement scenario where we withdraw $40,000 at the end of each year from a $1,000,000 account instead of $25,000 per year from a $100,000 account. Portfolio 1 on January 31, 2020: $1,784,353 Portfolio 2 on January 31, 2020: $819,899 Once again, the difference is stark, but in the complete opposite way from the first example. This time, where the withdrawal amount is much lower to account for the difference in time horizon, portfolio 1 has dramatically increased in value while portfolio 2 is slowly disappearing, like a melting ice cube. This is due to the insufficient rate of return of cash and bonds to keep up with the amount withdrawn and would make it apparent to any retiree that tough decisions may need to be made in the near future. Portfolio 1 experienced a significant initial decline, but since only a small amount of the portfolio needed to be sold and withdrawn to meet living expenses the vast majority of the account was left intact to be able to participate in the market recovery that has followed. Conclusion Time horizon is a critically important component to asset allocation decisions for an investment portfolio and has a significant influence on the primary risks involved. All too frequently, investors only consider their time until they begin withdrawing money from their accounts as their time horizon, while the total number of years the account may be utilized is more appropriate. This article highlights how parents paying for a child’s college education starting within the next year have a different time horizon than those same parent’s taking withdrawals for their own retirement within the next year. It may be appropriate for one account being used for education funding to have very little in equity funds while the other account might be almost entirely in equity funds and other equity like strategies since the money may need to last for 30 years or more. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.
  5. Michael C. Thomsett

    Probability and Option Risk

    These conclusions reveal how maximum profit and loss are calculated and aid in deciding which strategies are good fits for your risk tolerance. Does risk level justify the trade? That is where most options traders begin to address probability. But most often overlooked in selection of an underlying for options trading or for a strategy to be used, is the comparison between probability and risk. Too many traders consider these as the same thing. If probability of profitable outcome is high, it must mean risk is low, and vice versa. Most options traders make this assumption intuitively. Based on proximity of price to the money, time to expiration, and relative status of long or short positions, probability and risk are well known. But what about the correlation between the two, probability and risk? Probability often is the result of a calculation and may be viewed in isolation; the true risk level might not be considered at all, or simply assumed to be conclusive based on what probability reveals. This is a mistake. The correlation of probability and risk Once you decide a strategy is “low risk” what comes next? You might overlook a related next step, the possibility that risk changes once probability increases or decreases. A simplified example is how the probability of a profitable outcome changes when the underline moves unexpectedly close to the money. Does this mean risk is higher or lower? It might. But the point – comparing evolving probability and risk – could also be more subtle. Here is an example: A trader likes short puts because the market risk is identical to that of a covered call. Opening a series of short-term, slightly OTM short puts produces profits consistently and exercise is avoided by early close or rolling forward. But what if the company will be announcing earnings the day before last trading day? What if the company has a history of double-digit earnings surprises? Does this change the probability of profitable outcome? And does that make the risk picture entirely different as well? Yes. Of course, but the degree of risk in holding onto the open position with little or no “?buffer zone” point spread, also defines degrees of risk. The point is that neither probability or risk are absolute factors in judging options and their likely outcomes. There is a tendency among traders to want a binary answer. Is probability high or low? Is profitable income likely or unlikely? The answer depends on other factors like moneyness, time to expiration, historical volatility, earnings reports and likelihood of earnings surprises, and the unexpected announcement that often shows up at the worst possible time. These announcements include merger rumors, SEC investigations, accusations of financial wrongdoing by the top executive, product recalls, class action suits, strikes, natural disasters, and more – the list goes on and could be endless. Another way the correlation works addresses the problem of tied up capital and margin. If you are holding stock especially for use with covered calls, is your probability of loss low? Probably. But is the risk high? In some respects, it might be. For example, the lost opportunity risk of tying up capital for covered calls is rarely discussed by anyone. But it exists. Your capital is tied up in holding shares while you write covered calls. Probability of loss is low, but lost opportunity risk can be very high. Covered calls offer limited maximum profit equal to the premium of the covered call. Could that same amount of tied-up capital be used elsewhere to generate more attractive profits? That is a question with any number of answers, but the point is that in this situation, risk and probability coexist but may be influenced by different things. Anyone who tries to lower risk by keeping their money in low-yielding money market products has accomplished a low probability of loss, at or close to zero. At the same time, they accept a high risk of true net loss, at or close to 100%. This is so because the combination of inflation and taxes virtually guarantees that the low yield on savings cannot produce an after-inflation, after-tax profit. This paradox is real-world stuff, not just theory. It is possible to combine low probability of loss with high risk of loss, in the same product. The example of money placed in a guaranteed, low-yielding account demonstrates how this works. In the world of options, the variables are more complex, but the same point must be made. In options trades, you can lower the risk of loss while improving the probability of profits. For example, if you time trades for those rare moments when the Bollinger Bands exceeds upper or lower band by three standard deviations, the probability of an immediate reversal is close to 100% because the range never remains that far from the center line for long. If you time covered calls for the Friday one week before expiration, you drastically reduce risk because options lose one-third of remaining time value in the one trading day (but three calendar days) between Friday and Monday or expiration week. Does this mean it is possible to set up a foolproof system to make a profit consistently? No, that is never possible. But it does mean something almost as promising: By understanding the events and timing that affect probability, the risk of loss is drastically reduced. Most options traders will agree that this is good enough, given all those variables that tend to get in the way of every “perfect” system ever devised. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook. Related articles Is Your Risk Worth The Reward? Risk Reward Or Probability Of Success? Calculating The Probability Of Option Payoff Option Payoff Probability Probability And Option Risk
  6. Michael C. Thomsett

    Options and Invisible Risks

    The "greed and panic" factor is not unique to options trading. Everyone who has bought stock and lost a big segment of capital knows all about it. The price moves rapidly up so you buy more, and then it all evaporates when the price reverses. Or the price moves down and you panic and get out just before prices rebound. It's the old "buy high and sell low" strategy, when we all should be buying low and selling high. With options, the tendency is the same even while the product is different. Some traders forget that today's price of anything is just the latest in an unending series of price swings. It is not a starting point or the ending point of value, and despite the best intentions, price does not move in the direction we want only because a trade has been opened. Options traders, like everyone else in the market, is vulnerable to wishful thinking. The first step in overcoming this all too human tendency is awareness. Deciding when to enter should rely on several attributes. These include volatility as well as skillful chart reading and recognition of emerging patterns, notably reversal patterns. It also relies on a study of fundamentals and knowing how those affect the technical side. Once in a position, decide when to exit. Set goals for yourself so you know when the timing is right to take profits and move to the next trade. Your goal should set a profit target based either on dollar amount or percentage of return; also set a loss bail-out point, where you will get out of a losing trade to minimize net losses. You're better off booking a small loss than a total loss a few weeks later. This is not as easy to follow through, but it's important to increase overall profits. Succeeding with setting goals and following them is tough, but worth the effort. The key to effective use of options is to use them to manage and hedge risk, not to replace one risk with another one - especially when the new risk is based on greed and panic rather than on trend watching and logical analysis. As the old adage reminds us, bulls and bears can both succeed in the markets, but pigs and chickens get slaughtered. So if you are most interested in low-risk trading, a quick and easy solution is to know your markets. This ultimately may be the secret to success in options trading. Knowing when to act, either on entry or exit, and also being able to follow through on profit and bail-out points, overcomes the tendency to demand either triple-digit profits or complete losses, and settle for nothing else. The true contrarian succeeds in trading options. This often misunderstood method is not merely doing the opposite of the market crowd; it is an observation of motive. Most traders act and react emotionally. The contrarian uses cold calculation and analysis, resisting the emotional urges of greed and panic. The contrarian must apply strong discipline to go against the majority, remembering one crucial point: The majority is wrong more often than not. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
  7. Here are just a few of the shattered risk-related records, a sample of 3 each for the Dow and S&P: Dow: Dow Industrials intraday volatility, lowest on record (95% of days in 2017 had less than a 1% Dow intraday move) Dow Industrials greatest number of days in history without a 1% move (72) Dow Industrials closed at new all-time highs a record 71 times in 2017 S&P 500: S&P 500 annualized volatility of 3.9%, lowest on record S&P 500 Total Return Index gained in every month of 2017, and ended the year at a record 14 consecutive up months S&P 500 ended the year with a record 289 consecutive days without a 3% pullback VIX: Lowest intraday level in history (8.84 on 7/26/17), Lowest daily close (9.19 on 10/5/17), Lowest weekly close (9.36 on 7/17/17), and Lowest monthly close (9.51 on 9/29/17). 2017 also serves as a reminder that future is unknown. Nobody was predicting this to be the least volatile year in modern history. They were predicting just the opposite, in fact, even after the year had already begun… Additionally, US equities have now posted positive returns for nine straight years, tying the record from 1991-1999. I could go on and on, but you get the idea. Some years from now, we'll look back and agree that 2017 was the "exception that proves the rule," and that risk indeed still exists, and must be dynamically managed for long-term success. In my firm, all of our strategies include dynamic risk management, either in the form of option hedging with our Anchor strategy or with trend following rules that react to weakness in equity prices by partially or entirely exiting positions to protect capital. After all, do we demand that the fire department be disbanded as a waste of time and money when a neighborhood experiences a year with no fires? Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter.
  8. Mark Wolfinger

    Trader’s Mindset: Oblivious to Risks

    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 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