1) Markets fall faster than they rise — and options traders know this. Otherwise, arbitraging this difference would be a meal for a lifetime.
2) Market participants perhaps anticipate that the realized volatility during a bear market is greater than a bull market. However, the problem with this analysis is one might expect to see an upward sloping volatility yield curve in out-of-the-money puts (during bull markets), and yet that does not usually occur based on my tests. Conversely, right now have a downward sloping yield curve in out of the money calls — which confirms the hypothesis that market participants anticipate slower price rises in the future. [Note to quants: I am not confusing delta, gamma and vega. I’m using options to predict terminal price at expiration.]
3) For most humans, fear of loss is a stronger emotion/motivator than the pleasure of gain (greed). This is well documented in the psychology and behavioral finance literature. Hence, ceterus paribus, capital market participants (who have a net long position) will, as a group, pull their rip cord faster — to flee from risk — than they will embrace the possibility of profit.
One of the most frustrating things a trader can experience is being dead on right about a trade, taking it, BUT.. still losing money! How can this be? This can happen in five different ways, each of the first four contain a lesson for better planning the fifth way to lose money in this list is just part of the game.
- You enter your trade correctly and it goes in your favor, BUT… you do not have the right exit strategy to capture your profits and they evaporate due to not having a trailing stop or waiting to long to exit to bank those profits. Sometimes winners even turn into big losers win not managed correctly. You have to have a plan to take profits while they are there.
- You enter the right trade BUT… at the wrong time, you either exit not allowing your trade enough time to work or you are stopped out but do not have a plan to get yourself back in the trade with the right set up. The right trade with the wrong timing pays nothing.
- You have the right entry and it goes in your favor BUT.. you pick the wrong stock option to express your trade. If you pick an option with a high implied volatility your trade has to overcome that vega priced into the option, after an expected earnings event that vega value will be priced out and you need the move in intrinsic value to make up that difference. With a far out in time stock option you need the price to move enough in the underlying in the time period of the option to make up the theta cost of time embedded in the option. It is crucial to understand the option pricing model to make the right option trades to express your time period and expected move. Sometimes options also do not have the liquidity in some stocks,or far out time frames, or far out of the money strikes. Getting in and out of an illiquid option trade can be very expensive. (more…)
Get Rich With Options While the publisher choose an aggressive title for this book it does lay out four good option trading strategies. Selling puts on stocks that you want to own at lower prices anyway, option credit spreads, selling covered calls or income on long term holdings, and my personal favorite: deep-in-the-money call options. Very few ever discuss the power of buying DITM call options where you control the full upside of a stock for less risk and with far less capital.
The Bible of Option Strategies This is the encyclopedia of option strategies covering everyone that I know of. You get a description of each strategy along with specific metrics for each one on the steps in creating it, the rationale to trade it, if it is net debit or credit, the effect of time decay on the strategy, appropriate time period, selecting the right stocks and options, risk profile, the Greeks, the advantages and disadvantages and how to best exit the trade. This book is meant as a reference book but I read it through cover to cover.
Trading Stock Options Complete reverse from the above book, this is like the Cliff’s Notes of complex trading strategies. The author shows how he trading real option trades for big profits and a few some smaller losses. He simplifies many strategies to make the understandable especially playing long strangles and straddles through earnings by betting on actual post earnings volatility being greater than the volatility that is priced in to the options through Vega.
Trading On Corporate Earnings This is a great book on how to best play holding through earnings announcements by using options instead of stock. (more…)