eCONomic Scuttle Butt

Poor stock selection?  Improper strategy?  Bad timing?  No.  The biggest reason is simply using too much leverage.

Think about it.  If you’ve traded options for a substantial amount of time, you know I’m right.  So just reduce your leverage.  A lot.  That’s all.  You don’t need to read the rest of this long-winded rambling article. 

It helps to pick a stock that continues to behave in a manner you expect.  If you’re buying options you want it to move sharply in the direction you forecast.  If you’re selling them you might want it to not move much at all.  If you’re implementing a more complex strategy involving combinations of different options, you’ll have correspondingly more complex expectations for the price behavior.  The underlying stock selection also has important ramifications for levels of premium, liquidity, susceptibility to news events, and other factors.

It also helps to use a suitable strategy, one that you understand well and one that is appropriate for your personal financial circumstances such as the amount of risk you can afford to take, the amount of time you have to monitor your investments, possible tax consequences, and impact of the strategy on your overall financial plan.

Timing is more important than stock selection or strategy because with good timing an inappropriate strategy can still work out just fine for you, and a poorly selected stock can behave profitably over a short enough interval.  Conversely, bad timing (on entry and/or exit) can overwhelm ideal strategy and stock selection, making the worst of an otherwise good investment.

All three of the above factors should be considered before making an investment in options.  But in my 22 years of option trading I’ve observed that people lose more money in options more often by taking on too much leverage, than by making mistakes in any of those other three factors.

By too much leverage, I mean structuring their option investment such that even a normal, common market fluctuation (or lack of it) blows them out with a painful loss. 

I had a friend in college who used to always eat two slices of pizza at a time.  He’d flip one over on top of the other to make a pizza sandwich.  That’s leverage.

The way most people try to trade options is like taking an entire eight-slice pizza, folding it in half, then folding it twice more so they have all eight slices stacked in a pile, then trying to cram it down their throat all at once.  That’s too much leverage.

As I’m sure you’ve heard before, if you lose 50% then you must make 100% to get back to zero.  That’s not easy.  Which is why you’ve probably also heard the first rule for making money is to not lose money. 

Unfortunately in speculative investments such as options (unlike somewhat “guaranteed” investments such as C.D.’s, T-Bills, and corporate bonds) losses are a frequent part of the game.  The key is to keep them under control.  This can be done by dynamically hedging your option investment by adding or subtracting partial positions as the underlying stock moves, or by simply limiting losses to a predefined dollar amount or percentage, to the extent that’s possible. 

Set up your option investments to reduce the risk in advance, by keeping a large portion of your option account in cash.  Unsuccessful investors typically run right near the limits of margin requirements.  This is financial suicide in options trading.

For option writing, margin requirements can be increased at any time due to market volatility, individual company events, the stock falling below certain price levels, and other reasons.  Simply having a stock increase in price can increase the margin requirement because it’s partially based on a percentage of the underlying stock price.  If the stock price moves closer to the strike price, either up or down, the margin requirement will increase because the distance out-of-the-money affects the margin.

If you get a margin call and your only way to meet it is to liquidate part of your position because you have no cash in reserve, you’re almost certain to be forced to take an unnecessary loss.  Thus, a fluctuation that should have been insignificant, or even a possible opportunity for additional profit, automatically becomes a realized loss.

Talk to any margin clerk and they will tell you most individual retail option trading accounts are over leveraged.  This is not a minor issue.  It’s the main cause of failure.

People seem to believe that if only they could pick the right stock, or discover some magic secret strategy, or get lucky being in the right place at the right time, then they could make a lot of money.  So they try to do that and use options to leverage up and swing for a home run.  And strike out. 

For option buying, if you’re fully invested you’ve lost all flexibility to take advantage of better entry points to average into a position in the same stock, or to enter a new opportunity that may come up in another stock.  You’ve also given up the capability to properly hedge your position, such as by selling some options further out of the money or further out in time to provide offsetting income.  That requires having extra margin money set aside.

An example of too much leverage buying options is buying calls too far out-of-the-money with too short a duration prior to expiration with too large a percentage of your account.  This is a common mistake.  What happens?  They expire worthless and you don’t have much money left to work with.

Does this mean buying options is worse than selling (”writing”) them?  No.  Despite bogus arguments to the contrary, neither buying nor selling offers any inherent advantage over the other because prices are adjusted by market participants to compensate for the odds.  In other words, while a particular strategy such as buying out-of-the-money options may lose a larger percentage of the time than it wins, the percentage size of the wins is larger than the losses so it all tends to even out.  The oft-cited statistics on the percentage of options that expire worthless are usually misleading because they don’t explain that many are exercised  prior to expiration and many are traded out of prior to expiration and many are hedged as part of a complex strategy.  When exchange-traded standardized equity options were first introduced, premiums were high and tended to favor the option writers.  Today with low interest rates on alternative investments and the large number of option-writing funds the opposite is often true, although volatility and premium levels are in a continual state of flux.  At the moment with the stock market in a trading range just coming off a period of high volatility I’ve observed index options to be overpriced while many individual stock options are underpriced.  Of course this is my own subjective opinion.  Mathematical models can be used to prove otherwise.  They’ve also proven themselves very effective for losing huge amounts of money.

By the way, if your favorite strategy is buying out-of-the-money options, consider financing your option purchases as explained at that link. You’ll automatically keep some cash in reserve and you can generate steady income to help offset your losses.

An example of too much leverage writing options is selling naked puts with nowhere near enough money to purchase the stock if assigned.  If they go in-the-money you must then either buy them back at a loss, or try to roll down and out, which usually requires reducing the number of contracts you have open and locking in a loss.

Similarly, selling naked calls without enough margin on the side to accept an exercise and take the stock short and then possibly hedge with ratio covered puts, is too much leverage.

I don’t mean to suggest that you always keep that much cash available.  I just mean most of the time.  That is, keep a lot of cash except for when you are temporarily moving into a trade and back out.  As an example, while you are waiting for three-month options you’ve written to expire worthless, you might keep enough cash on the side to handle an assignment but from time to time use some of that cash to make other trades of several days duration.

If you’re always habitually fully invested in “good” option positions, not only will you be putting yourself at a big disadvantage for reasons already discussed, but you’ll also never be able to take advantage of the less frequent “great” option trades that become available.  In other words, by keeping a large portion of your option trading capital in cash most of the time, you have a better chance of being ready when those great trades come along.  Then you can get in, get out with a reasonable profit, and return to mostly cash as soon as possible.  This is the opposite of what most failing option traders do.  They’re always fully invested in mediocre positions that are going against them.  When great trades come along, and by great I mean ones that they understand and can clearly see an excellent chance of profit from due to their experience and knowledge of the particular stock involved and the situation that is about to play out, they’re powerless.  Without cash, they can’t take advantage of it.  To get cash, they’d probably have to churn themselves out of one or more of their open positions at a loss plus commissions and slippage.

If you maintain enough cash to handle option assignments, then even random fluctuations can work for you instead of against you.  One of my favorite basic approaches to option trading is to write puts and if they expire fine, if not I often let them be assigned so I buy the stock, then sell covered calls which, if they expire fine, if not I let them be assigned so I sell the stock and I’m back in cash.  On the other hand sometimes I roll the options down and out instead of letting them be assigned, and prior to expiration if the stock is declining and I’m losing on the puts I sell offsetting calls to hedge, often more calls than the number of puts.  Both of these dynamic hedging techniques require that I have money on the side to satisfy the additional margin requirements.  If not, I cannot properly hedge.

It’s true to some extent that option investing just magnifies your investing results.  If you’re a good stock trader using options can make you even better.  If you’re a bad stock trader using options can make you even worse.

But by keeping your leverage reasonably low, you’ll at least maximize the flexibility of options while minimizing unnecessary risk.  That is a prerequisite for success in options trading.

I hope some of these thoughts have been helpful to you.

This entry was posted on Saturday, April 5th, 2008 at 5:06 am and is filed under Options. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.