Article By: Austin Passamonte (Yahoo! Finance)
The mental (emotional) aspect of trading is hands down the toughest hurdle between aspiring traders and consistent success. For sure our technical nuts & bolts portion is vital. It goes without saying that we need some type of method, system or approach for trade entry, management and exit parameters that create a defined edge. The truth is there are countless ways to create such a viable "edge" over the long-term, but human management of such is the weakest link in that chain.
Out there in the real world we are taught to set tangible goals. Timelines, limits, targets and objectives are all part of the path to success. Need a roadmap to get where you're going in order to get there, right? At some point in our career we realize trading is a whole lot different than any other mainstream profession. Most of the rules that apply elsewhere are null & void in our world. Fiscal goal-setting is one of those. It's natural for traders in general and day traders in particular to set structured daily goals. We work a defined set of hours in our given shift... our time is exchanged for monetary reward expected. The people that we know have similar expectations. "How much did you make today?" "How were the markets today?" I see on the news that stocks went up (down) big... how did you do today?"
The word "today" is sprinkled into every question we hear. Yesterday is history, tomorrow remains a mystery. The only measurement of success is today... one day at a time. But in reality our profession is nothing more than a series of wins and losses strung together over (hopefully) long periods of time. There is no way to eliminate risk or loss, because risk is an equal part to reward in our equation. Focus on keeping loss controlled is a very different aspect than fixation on avoiding all losses, period. One is a normal part of operation, the other is a path to failure.
Many times we'll read somewhere and/or hear about traders who never have a losing day. It is said they string together weeks, months or years worth of stretches with nothing but wins in the end. We've also heard about bigfoot sightings all over the world for over a hundred years now. To my knowledge no one has ever produced a physical specimen of the latter or real-money proof of the former. Perhaps traders who never lose and sasquatch each exist, I wouldn't rule either completely out. A little bit of solid evidence would be nice.
Meanwhile, those of us in the real world approach each trading day with one overall goal in mind: perform our functions correctly, follow our script and let the law of large numbers work our mathematical edge in favor. That includes taking valid trade signals after a string of losses. That includes letting the fourth trade work towards its intended profit objective following three straight controlled losses prior. That includes trading through some adverse sessions where nothing we can do results in net-profit for the day.
Punching Clocks Thru Wins And Losses
Just because markets are open at a set time every day does not mean similar opportunities for profit and loss exist. Some sessions make it seem like money falls from the sky between both bells. Other times the morning or the afternoon is generous while the other half is stingy. There are days, sometimes several of them in succession where it appears the market is closed for business. Price action goes nowhere, there is nil chance to make money and nothing can be done about that fact.
Traders revel in those single days where favorable price movement results in profits that would normally reflect an entire week or even month's worth of effort. With the human-nature outlook of exchanging time for reward, we readily accept those occasions without a second thought. Such windfall but infrequent sessions are outside the norm, just like a true choppy or whipsaw congested session where it's all but impossible to avoid stiff losses let alone make two dimes of profit. But we view those impossible-to-profit event differently. Whereas investing one day's worth of effort for a week's average profit result is just fine, investing a second day's worth of effort for one day's average net loss is not fine. To some it is downright terrible.
Patience & Discipline
The worst trading sessions are often followed by the best. Dull, flat, volume-less sessions usually lead to high volume and range expansion the next day. If there are two or three dead sessions back to back, that period usually resolves with several days of hyper-active price movement. Stored energy is released, released energy eventually exhausts movement. It's a fundamental part of financial market behavior. Knowing this cycle exists and expecting it to repeat as usual is important. When we struggle to make headway for a day or two, better get ready for some very active tapes ahead. It's coming.
Obviously we'd all love to have every trading day result in new all-time high profits. None of us would ever opt to experience a net-loss session again. That's just one of numerous human emotions in the mix. Reality is, wins and losses distributed intraday and likewise day to day are all part of the natural course. Traders with gambling tendencies or ultra-competitive personalities tend to struggle with accepting loss as part of our profession. They take various small to extreme measures in fighting the natural process. Sometimes the result is benign, other times career ending.
Personal Pursuit
There are four segments one needs to harness = master before consistent success is possible. They are:
#1 - Ability to read charts/markets and determine whether price is more probable to go up, down or continue sideways from any bar forward. We need to know whether visible clues give odds of probability for pending direction, or not. We need to know this information inside all market conditions: low volatility, normal volatility and high volatility. Intraday traders will commonly face all three varied conditions one or more times daily. We especially need to know when we cannot know what is probable to happen next. When price movement goes from favorable to unfavorable per your method or approach, we need to know that through the shift of change.
#2 - Ability to determine where high-odds trade entry locations exist. Mastery of step #1 makes this process possible. There are no shortcuts... no red arrow/green arrow, no automated systems, no blind following dual indicators, no shortcuts exist to overcome ignorance of reading market action. Everything the market knows at any moment in time is reflected in its chart(s). The ability to weigh = measure = read that collective information determines our ability to identify exactly where long or short entry signal locations with greater than 50% odds to succeed exist in front of us.
#3 - Ability to determine your own method of trade management. I can promise you this: no one on earth can teach you how to manage your trades when your real money is live in the market. When your real money is ebbing & flowing in your account, anything else that anyone tells you will be forgotten. The only thing that will matter to you is making yourself feel good about the end results of that individual trade. That is not an opinion... it is an absolute law of human-nature fact.
#4 - Ability to manage yourself through all aspects of reading market action, determining trade entry and managing live trades from entry through execution to exit. That includes self-honesty of admitting when price action appears measured and predictable versus unruly. Honoring and acting on trade entry signals when confirmed, instead of succumbing to trigger-shy hesitation and/or chasing trade fills well past ideal entry locations due to fears of loss on both counts. Holding stop-loss orders to contain risk at predetermined levels based on logic and reason rather than crowded too close or pulled to avoid loss out of emotional fear.
Those are the four separate legs of our profession that overlap but stand apart. The first two aspects can be taught by someone to others. Managing live trades and managing ourselves through the entire process are learned on your own, because they can't be taught by anyone else.
Survival Instincts
The very moment someone places a live trade in their account, mental = emotional mode shifts from objective gathering of information to tunnel-vision focus on outcome results of the trade. All else ceases to matter from there as survival mode instincts kick in. Voices are tuned out, text is ignored and advice doesn't even almost begin to reach closed minds. The only thing that trader cares about then is exiting this trade in a manner which makes him (her) feel good about the whole experience. That's it... all about the feelings. Any type of profit beats any type of loss, obviously. The measures a trader will take in managing or mismanaging their trade is directly related to emotional comfort needs at that stage of their development.
For these core human instincts, any attempts for one trader to follow another through the process of trade management and exit verbatim will always fail to meet the objective. No two traders, let alone any group of traders will ever hold all of their trades through the same curve of stop management and exit for profit or loss result. Never has happened, never will happen, cannot happen until nature repeals the human nature of survival instincts.
Summation
Too many traders never get past the shallower thinking levels from the point where beginners begin. Yes the technical nuts & bolts aspect of trading is important. Fancy charts filled with arrows, pointers and text instructing someone on where to get in a trade and why always hold everyone's attention. And for good reason. But then what? What do you do once that trade, the next trade and the next ninety-eight to follow all behave somewhat differently from one another? That is where the real measure of success or failure begins to unfold.
Friday, March 27, 2009
Friday, March 20, 2009
Baring It All: The Truth about Naked Trading Part 1
By Tyler Craig (Columnist for Rich Dad Education)
A common misunderstanding in the minds of rookie traders in the options market is that covered calls are one of the safest option strategies, and selling naked options is one of the riskiest. Although naked-option selling sometimes gets a bad rap, don't be too hasty to dismiss this strategy. There are numerous advantages to naked-option selling that merit your attention. Before we delve too deeply into naked-option selling, let's first recap the objective of most traders. The majority of traders use technical and fundamental analysis, market sentiment, or any other method they deem valuable in an effort to predict where the market is going. This applies whether or not the trader is using the stock or options market to place his bets. However, when we venture into naked-option selling, we adopt a different approach and mentality to trading. We are not so much trying to predict where the market is going to go, but where the market is not going to go.Buying either a call or put option gives the option owner limited risk and unlimited reward for calls, and limited reward for puts. Naked-option selling, on the other hand, brings limited rewards and unlimited risk (for naked calls at least). This begs the question: why would anyone want to place themselves in a position of unlimited or substantial risk? The answer is twofold. First, selling naked options can have a much higher probability of success than buying options. Which do you think is easier, predicting where a stock will go in the future, or predicting where it won't go? It is possible to enter naked-option trades that have greater than 90 percent probability of success. Secondly, although naked-option selling has substantial risk, that risk can be mitigated by proper trade and money-management techniques.Another important point to remember is that option buyers have a right to either buy (call) or sell (put) the stock, and option sellers have an obligation to either buy (put) or sell (call) the stock. The following table has helped me to remember which actions are bullish and which are bearish:Bullish: Long Stock, Long Calls, Short PutsBearish: Short Stock, Long Puts, Short CallsNaked Puts:Selling naked puts is considered a mildly bullish-to-bullish strategy. However, they can also be used in stagnant-market environments. By selling a put option you obligate yourself to buy 100 shares of stock at the strike price. Most traders who use naked puts sell out-of-the-money, short-term put options. There are two primary reasons for selling short-term options. First, the shorter the amount of time we are in the trade, the less exposure we have to a potential adverse move in the stock price. Think of time as risk: the longer you are in the trade, the more there is that can go wrong! Additionally, because of the acceleration of time decay, short-term options decay in value quicker than long-term options. The rationale behind selling out-of-the-money options is simple: out-of-the money options have a higher probability of expiring worthless than do in-the-money options.
An illustration will help us understand the naked-put strategy.
NAKED PUT EXAMPLE
Figure 1
October 31st- After experiencing a precipitous fall in its stock price, NOV has begun to show signs of stability and the potential beginnings of an uptrend. To take advantage of the expected sideways to mildly bullish move in the stock price, we could sell an out-of-the-money November put option. Currently the November 20 put option is trading at $1.00 with a Delta of 15. By selling the 20-strike put, we are essentially betting that the stock won't fall below $20 between now and its November expiration.Max Reward = $1.00Max Risk/ Breakeven = 20 - 1 = $19Probability of Profit = 1 - .15 = .85, or 85
Figure 2
Trade Management IThere are two scenarios that could play out at expiration: either the stock will be above the short-put strike price and our put option will remain out-of-the-money, or the stock will fall below the strike price and our put option will expire in-the-money. If the put option is out-of-the-money at expiration, it will expire worthless, enabling us to keep the premium and net our max reward. If the put option expires in-the-money, it will be automatically exercised and we will have to buy 100 shares at the strike price. Obviously, the best-case scenario is that the put option simply expires worthless. Your success with naked puts, however, is not dependent upon your management of winning trades; rather, it is a direct result of your management of the trades that go against you. You never want to realize your max risk, so let's explore a few techniques on how to manage naked puts that go awry. One technique would be to exit the trade when the stock breaks support. Breaking support would signify that the stock is going into a downtrend; consequently, it may be wise to buyback the put to minimize the loss. A second technique would be to exit when you lose a certain percentage of your max risk. For example, if your max risk is $20, you could exit when you lose 25 percent, or $5. These two techniques are efficient techniques for stopping the bleeding. However, they don't really give you a chance to make back any money you have lost. In next month's article we will discuss a few adjustment strategies that have the capability of turning your losing trade into a profitable one.Probability of ProfitBy using the Greek Delta, we can quantify our probability of profit. One of the definitions of delta is that it measures the probability of an option expiring in-the-money. Using a little arithmetic, we can calculate the probability of an option expiring out-of-the-money. Let's assume stock XYZ is currently at $50 and the 45-strike put option is trading at $1.00 and has a Delta of -40. We know that there is a 40% probability of the put expiring in-the-money, or in other words, there is a 40% probability of stock XYZ residing below 45 at expiration. Let's assume we enter a naked put by shorting the 45-put option. To net our maximum reward, we would want the stock to be above 45 at expiration. Since the probability of the stock being below 45 is 40 percent, then there is a 60 percent (1 - .40) chance of the stock residing above 45 at expiration. This is our probability of success. Since Delta gets smaller as you move further out-of-the-money, selling far out-of-the-money put options has a higher probability of success than selling close to the money options. However, the trade-off to raising the probability of profit is that you don't bring in as much premium. In the example above, the 45-strike put was worth $1.00 and had a Delta of -40. We may have also considered selling the 40-strike put which was trading at $..50 with a Delta of -20. This would have increased our probability of profit to 80 percent (1-.20) and decreased our max profit from $1.00 to $.50.Margin RequirementThe amount of margin required to sell a naked put will vary from broker to broker. Furthermore, knowing the formula is not imperative because your broker will calculate it for you. However, for those that are interested, here is one broker's margin requirement:
1. 25 percent of the underlying market price + the premium - amount out-of-the-money
OR
2. 10 percent of the underlying market price (or strike price for OTM puts) + the premium
The greater of these two formulas will be required in order to enter the trade. Using the above formulas, we can calculate how much margin would be required for a naked put on the United States Oil Fund (USO). Let's assume the USO is currently trading at $53 and we short a November 43-strike put for $.85 credit.
($53 x .25) +($.85 - 10) = $4.10
($43 x .10) +$.85 = $5.15
The second method for calculating the required margin is higher, so that is the amount that would be held by your broker. An $.85 return on an investment of $5.15 is a 16.5 percent return. Not too shabby! Keep in mind the margin requirement may increase if the stock were to drop and get closer to the put strike price. To ensure you are able to maintain your naked put position, make sure to have extra capital available in the event of an adverse move in the stock and increase in margin required.Selling naked puts can serve as an alternative to buying stock or call options in a mildly bullish-to-bullish environment. Naked puts can widen your range of profit as well as increase your probability of profit. At the beginning of the article, I mentioned the erroneous notion that covered calls are "safe" and naked-option selling is "risky." Next month, we will dispel this notion by illustrating the similarities between these two strategies, as well as highlighting a few more adjustment techniques for naked puts, finding potential trade candidates, and implied volatility.
A common misunderstanding in the minds of rookie traders in the options market is that covered calls are one of the safest option strategies, and selling naked options is one of the riskiest. Although naked-option selling sometimes gets a bad rap, don't be too hasty to dismiss this strategy. There are numerous advantages to naked-option selling that merit your attention. Before we delve too deeply into naked-option selling, let's first recap the objective of most traders. The majority of traders use technical and fundamental analysis, market sentiment, or any other method they deem valuable in an effort to predict where the market is going. This applies whether or not the trader is using the stock or options market to place his bets. However, when we venture into naked-option selling, we adopt a different approach and mentality to trading. We are not so much trying to predict where the market is going to go, but where the market is not going to go.Buying either a call or put option gives the option owner limited risk and unlimited reward for calls, and limited reward for puts. Naked-option selling, on the other hand, brings limited rewards and unlimited risk (for naked calls at least). This begs the question: why would anyone want to place themselves in a position of unlimited or substantial risk? The answer is twofold. First, selling naked options can have a much higher probability of success than buying options. Which do you think is easier, predicting where a stock will go in the future, or predicting where it won't go? It is possible to enter naked-option trades that have greater than 90 percent probability of success. Secondly, although naked-option selling has substantial risk, that risk can be mitigated by proper trade and money-management techniques.Another important point to remember is that option buyers have a right to either buy (call) or sell (put) the stock, and option sellers have an obligation to either buy (put) or sell (call) the stock. The following table has helped me to remember which actions are bullish and which are bearish:Bullish: Long Stock, Long Calls, Short PutsBearish: Short Stock, Long Puts, Short CallsNaked Puts:Selling naked puts is considered a mildly bullish-to-bullish strategy. However, they can also be used in stagnant-market environments. By selling a put option you obligate yourself to buy 100 shares of stock at the strike price. Most traders who use naked puts sell out-of-the-money, short-term put options. There are two primary reasons for selling short-term options. First, the shorter the amount of time we are in the trade, the less exposure we have to a potential adverse move in the stock price. Think of time as risk: the longer you are in the trade, the more there is that can go wrong! Additionally, because of the acceleration of time decay, short-term options decay in value quicker than long-term options. The rationale behind selling out-of-the-money options is simple: out-of-the money options have a higher probability of expiring worthless than do in-the-money options.
An illustration will help us understand the naked-put strategy.
NAKED PUT EXAMPLE
Figure 1
October 31st- After experiencing a precipitous fall in its stock price, NOV has begun to show signs of stability and the potential beginnings of an uptrend. To take advantage of the expected sideways to mildly bullish move in the stock price, we could sell an out-of-the-money November put option. Currently the November 20 put option is trading at $1.00 with a Delta of 15. By selling the 20-strike put, we are essentially betting that the stock won't fall below $20 between now and its November expiration.Max Reward = $1.00Max Risk/ Breakeven = 20 - 1 = $19Probability of Profit = 1 - .15 = .85, or 85
Figure 2
Trade Management IThere are two scenarios that could play out at expiration: either the stock will be above the short-put strike price and our put option will remain out-of-the-money, or the stock will fall below the strike price and our put option will expire in-the-money. If the put option is out-of-the-money at expiration, it will expire worthless, enabling us to keep the premium and net our max reward. If the put option expires in-the-money, it will be automatically exercised and we will have to buy 100 shares at the strike price. Obviously, the best-case scenario is that the put option simply expires worthless. Your success with naked puts, however, is not dependent upon your management of winning trades; rather, it is a direct result of your management of the trades that go against you. You never want to realize your max risk, so let's explore a few techniques on how to manage naked puts that go awry. One technique would be to exit the trade when the stock breaks support. Breaking support would signify that the stock is going into a downtrend; consequently, it may be wise to buyback the put to minimize the loss. A second technique would be to exit when you lose a certain percentage of your max risk. For example, if your max risk is $20, you could exit when you lose 25 percent, or $5. These two techniques are efficient techniques for stopping the bleeding. However, they don't really give you a chance to make back any money you have lost. In next month's article we will discuss a few adjustment strategies that have the capability of turning your losing trade into a profitable one.Probability of ProfitBy using the Greek Delta, we can quantify our probability of profit. One of the definitions of delta is that it measures the probability of an option expiring in-the-money. Using a little arithmetic, we can calculate the probability of an option expiring out-of-the-money. Let's assume stock XYZ is currently at $50 and the 45-strike put option is trading at $1.00 and has a Delta of -40. We know that there is a 40% probability of the put expiring in-the-money, or in other words, there is a 40% probability of stock XYZ residing below 45 at expiration. Let's assume we enter a naked put by shorting the 45-put option. To net our maximum reward, we would want the stock to be above 45 at expiration. Since the probability of the stock being below 45 is 40 percent, then there is a 60 percent (1 - .40) chance of the stock residing above 45 at expiration. This is our probability of success. Since Delta gets smaller as you move further out-of-the-money, selling far out-of-the-money put options has a higher probability of success than selling close to the money options. However, the trade-off to raising the probability of profit is that you don't bring in as much premium. In the example above, the 45-strike put was worth $1.00 and had a Delta of -40. We may have also considered selling the 40-strike put which was trading at $..50 with a Delta of -20. This would have increased our probability of profit to 80 percent (1-.20) and decreased our max profit from $1.00 to $.50.Margin RequirementThe amount of margin required to sell a naked put will vary from broker to broker. Furthermore, knowing the formula is not imperative because your broker will calculate it for you. However, for those that are interested, here is one broker's margin requirement:
1. 25 percent of the underlying market price + the premium - amount out-of-the-money
OR
2. 10 percent of the underlying market price (or strike price for OTM puts) + the premium
The greater of these two formulas will be required in order to enter the trade. Using the above formulas, we can calculate how much margin would be required for a naked put on the United States Oil Fund (USO). Let's assume the USO is currently trading at $53 and we short a November 43-strike put for $.85 credit.
($53 x .25) +($.85 - 10) = $4.10
($43 x .10) +$.85 = $5.15
The second method for calculating the required margin is higher, so that is the amount that would be held by your broker. An $.85 return on an investment of $5.15 is a 16.5 percent return. Not too shabby! Keep in mind the margin requirement may increase if the stock were to drop and get closer to the put strike price. To ensure you are able to maintain your naked put position, make sure to have extra capital available in the event of an adverse move in the stock and increase in margin required.Selling naked puts can serve as an alternative to buying stock or call options in a mildly bullish-to-bullish environment. Naked puts can widen your range of profit as well as increase your probability of profit. At the beginning of the article, I mentioned the erroneous notion that covered calls are "safe" and naked-option selling is "risky." Next month, we will dispel this notion by illustrating the similarities between these two strategies, as well as highlighting a few more adjustment techniques for naked puts, finding potential trade candidates, and implied volatility.
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