Three Catastrophic Mistakes to Avoid in Options Trading
Every Tuesday Chuck releases a new Trader Tip video on YouTube. This week we will discuss how to avoid major, catastrophic mistakes when trading Options. Watch the Trader Tip Episode for more information!
You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!
1.) Selling options naked.
2.) Buying options in high volatility environments.
3.) Placing stops in an options order book.
Number one never sell options naked. Selling options naked is risky, as naked options carry with them the possibility of unlimited loss and limited gain. What's worse is that when short options trades go bad, they not only lose on price, but the market usually has a combination of volatility explosion, accelerating your loss, and a lack of liquidity in which you can not get out. There is no worse feeling in all of trading than to be stuck short in an option and know that you cannot exit. This is a source of major shock for people when this happens to them. I want you to understand that liquidity is always temporary and illusory. Some days it's there, some days it's not. Many new and small traders do not understand this fact. If you're trading a mid cap stock, and you get stuck, it's possible that you can't get out at all. "Oh, that's bullshit." NO, mark my words that can happen.
Here's my rules for shorting options. Every short option should either be covered or spread, should be covered or spread. Covered means that short options are protected by underlying or a lesser quality of long options that cover the risk of the short options. It's important to understand that covered options can be extremely dangerous as well. We can cover this scenario in detail we talked about ratio spreads, but for now we want to understand that ratio spreads can be dangerous, especially when volatility is low, and having naked short options covered by underlying or covered by long options can significantly reduce the risk versus being naked short options.
Here's an example, a covered call. We're long Microsoft stock and we're short the June 270 call. We are net short options, but our short call is covered by stock. What this means is that if the market explodes, our short call is covered by long stock, and there's a possibility of making money, in this case, we would make money. If the calls go in the money, then we'll make money because we will make more on our long stock than we lose on our short call.
So we either covered or spread more spread or short options, we spread them by protecting them with long options further away or long options and a different expiry, that create a limited loss scenario. Let's consider that we want to sell Microsoft puts to get long Microsoft well rather than sell the Microsoft June 240 put naked, I would buy a June 200 put as protection. That way I know what my max risk is, it's the difference between the 240 strike and the 200 strike, the distance between the strikes minus the credit. In this case, it's $40 minus $1.80 gives me a max loss of 38.20. The loss could still be large and still be a huge problem, but at least it's defined.
Here's an example of the stock ARRY, we're comparing a naked put versus a put spread. We sell 10 ARRY May 20 puts at 20 cents on May 11 on close versus selling 10 of the May 20 May 17 and a half put spreads at 17 cents. The next day ARRY gaps down. It gaps down to $17.92. This is a 4.47 ATR gap on the open and then it continues to sell off through the rest of the day. Closing down 7.3 ATRs. We closed at 2495 The day that we sold the May 20 puts and the day that we sold the day 20 17 and a half put spread we gapped down and then we keep breaking.
Let's look at the difference. On our naked options for short 10 May 20 puts they close at $6.75 for loss of $6,550, it's a negative 32.75R loss relative to its potential profit, huge, huge loss. On our spread position, our spread position goes out at $2.40. Losing $2,230, it's a negative 13.1 2R loser relative to potential profit. Just by buying a 17 and a half put, you reduce the size of your loss by almost 20R while preserving 85% of the profits. See the difference between 33R and 13.R could be the difference between going bankrupt or broke and completely blowing out of your account, or just really bad debt. Vertical spreads always have a defined risk. Meaning at your max loss is defined versus unlimited and undefined when we're just short an option.
Our second mistake is never buy options in a high volatility environment. In high volatility environments, traders start out thinking that they're using options as an effective way to participate in the move and to manage their risk. They're often fearful because volatility is high. They're like "well I'll buy an option and I know what my risk is," but you want to be aware of how options are being priced in high volatility environments.
When we buy options in high volatility environments, the implied volatility, in other words, the value of the option will be high, making it hard to make money on the option. The price then has to overcome the implied volatility, which means the market is at a huge, huge move for you to have any chance of making money. This is one of the things my students have noticed in recent months, this year, in stocks. We usually love to buy options, but in doing our analysis, our students are finding that options are just often too expensive right now, and that's because we have a framework of knowing when they're cheap, and when they're expensive. The reason they're expensive is because we've had high volatility, and it makes it hard to make money.
Many of you know the Gamestop example. The closing price of Gamestop when it exploded back in 2021 Gamestop ran to $325, and it had an implied volatility of 709%. The closing price for GameStop, on February 1 was $225, with implied volatility of 539%. The stock had a $100 drop, and 170% decline in implied volatility. You can see it here. If we're bearish GameStop, and we buy five of the FEB 5, 2021, 230 puts at 6608. The 230 puts have a volatility of 735% and a daily theta of $4.57. On February 1, we break $100, we get a huge move down. The volatility goes down 149%, and here's the crazy thing. You buy the put to try and contain your risk. You think you have unlimited profit potential, but combined with the theta, the puts on $100 break actually lose money. They go from 6608 to $57.40, you actually lose $4,340 on a five lot when you were right. Instead, you could have bought the February 5 320 230 put spread at 4192, Gamestop breaks $100 to 225 and the volatility goes down 149%, but by buying the spread you benefit from the breaking Gamestop while minimizing the impact of volatility and the spread goes from 4192 to 6818. Just buying a six lot of spreads yields $9,756 twice as good, more than twice as good. We want to remember the concept of position basis. Buying options at a high volatility environment creates poor basis, our basis is too high for us to make money and it makes us vulnerable to losses. Vertical spreads often get cheaper with higher volatility especially when they benefit from skew.
The third catastrophic mistake is placing stops in an option order book. What is a stop order? A stop order is an order to buy or sell a security when its price moves past a particular point, ensuring a high probability of achieving a predetermined entry or exit price, limiting investors loss or locking in a profit. Once the price crosses the predefined entry or exit point, the stock becomes a market order. Here's the key point it becomes a market order.
It's important to remember that options are a derivative of the underlying. As a result, the underlying price and the underlying liquidity are a huge factor in option pricing. Therefore, whenever the underlying has a large and quick move, the market makers tend to turn off their models and just get out of the way in order to make sure their models make good trades.
With an option book, there are two major factors. One is the lack of liquidity behind the initial bid offer. If a price quickly trades through the first level or two your stop will go in search of the next bid. Let's say you have a sell stop, and this could lead to a catastrophic fill because there may be no other bids in a book. It's going to go market, it's going to go find the next bid, and what if the next bid is like a dime, or 50 cents? You're going to get destroyed. Destroyed! The solution is to place your stop at the underlying and then work out the underlying versus options position its tied up trade. We spend a great deal of time teaching techniques like this and mechanics of position management in our workshops. You know exactly how to deal with situations like this.
Example: You can see here this is these are two different options. This is a crocs June 105 Call and a Microsoft June 240 put. You can see crocs only has one level of offers and one level bids behind this bid offer, there's nothing. Microsoft has four levels, but it's not deep, and if you puncture through here, if it runs, there's nothing behind here.
One of the things I want you to understand, next week, we have our Verticality Challenge starting, this is our free challenge where we teach you the basics of vertical spreads, not only what the basics are, but why do you want to use these things like this lesson today? Vertical spreads help us manage our nevers. We never sell options naked so we do spreads instead. We never buy options in high volatility environments so we buy spreads instead, and vertical spreads reduce risk, eliminating some of the need to use stops. These are the three catastrophic mistakes to avoid in options trading. Are you aware of this? Do you practice these? Because if you do any one of these three, it's a matter of time until they get you. Learn from this lesson. Make your adjustments and don't ever do this again. Have a great week. I'll see you next week. Bye.