Three Catastrophic Mistakes to Avoid in Options Trading

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!

Three catastrophic mistakes to avoid in options trading. The three catastrophic mistakes to avoid are 1) selling options naked, 2) buying options in high volatility environments, and 3) placing stops in an options order book.

Catastrophic Mistake #1) selling options naked.

Selling options naked is risky. Because when we sell options naked, they come with the possibility of unlimited loss and limited gain. What's worse is that when short option trades go bad, they not only lose on price, but the market usually has a combination of volatility, explosion, accelerating loss, and a lack of liquidity in which you cannot exit. One of the things that most retail traders don't really think about is that there's the possibility that they cannot get out. They think in their mind, they can always get out of a trade, but sometimes you can't, and when you naked sell options, you open the door for the scenario where you get killed, and you cannot get out. There is no worse feeling in the world, than being be stuck short, in an option position that you cannot exit.

Liquidity in the market is always temporary and illusory. Many new small traders do not understand this fact. We want to be careful. Because when we sell options naked, we can not only get killed, but we might not be able to get out in which the losses get even bigger, and you're left to spend a period of time whether it's a few minutes, a few hours or a few days pondering, how are you ever going to get out of this.

I have some rules for selling options naked. Every short options trade should either be covered by underlying or should be spread. We don't ever want to just sell a call. If we want to sell a call, we should be buying futures against it. Well, if we're going to sell a call, we should buy another call against it. When we sell options naked, let's talk about covered first, when short options are protected by underlying or a lesser quality of long options covering the risk of the short options.

Covered, we want to understand that covered options can be dangerous as well. They're just typically less dangerous than just outright naked short. Now we want to understand of the possibilities is being long a lesser quantity. We might be short two calls, we could buy one call that was closer. That would be a ratio spread, and ratio spreads can also be very dangerous, especially when volatility is low. Having naked short options covered by underlying or at least by sub long options can significantly reduce the risk versus just being short calls naked.

Here's an example, a covered call would be long Microsoft stock and short the June 270 call. We're not short options because we're short one call but our short call is covered by long stock. This way if the call goes in the money, we will make money because we'll make more on our long stock than we lose on our short call.

Now let's talk about a spread. When we're short options, we can spread them by protecting them with long options further away, creating a limited loss scenario. Let's consider if we want to sell Microsoft puts to get long Microsoft so rather than sell the Microsoft June 240 Put naked I would buy a June 200 put against it as protection. That way I know my max risk is the difference between the strikes minus the credit. In this case the difference between the strikes is $40, and the put spread is $1.80 so the most we can lose is $38.20. This loss could still be large and in this case it is but at least we have covered with the long option.

Let's look at an example an ARRY where we sell a naked put versus doing a put spread. In this example we could sell 10 ARRY may 20 points at 20 cents on May 11. Or we could sell 10 of the May 20 puts and buy 10 of the May 17 and a half puts and collect 17 cents. The next day on May 12 ARRY gaps down to $17.92. It's a 4.47 daily average true range move at the open against you, and not only that, ARRY goes on to close at $13.46, and that other day of the negative move of 7.3 ATR 7.3 daily at Rs is a move on close. Here's the chart, and you can see how the chart, you get the big gap down and then it breaks goes out on the lows.

In the naked option scenario, we sell the 10 ARRY puts at 20 cents, they close at $6.75, meaning we lose $6,550 per put, or 32.75 times our potential profit, a 32.75 R loser. Okay, versus the spread, and the spread, we sell 10 May 20 points at 20 cents, and we buy 10 May 17 and a half puts at three cents. Well, the spread goes out at $2.40 for a loss of $2,230. This is a 13.1 2R loser relative to profit. So still huge loss. They're both huge losses, but the difference between losing 13 R and 33 R could be the difference between having a big loss in your account and going bankrupt. Using the put spread saved you 20 R or 20 times the risk, while still preserving 85% of the profits. So we can make 20 cents or 17 cents, so we could lose 33 R or $6,550 or 13R = $2,230. Vertical spreads always have a defined risk. Meaning that your max loss is always defined versus versus unlimited loss, it's undefined when you are long the underlying or short term naked put.

Catastrophic Mistake #2) buying options in a high volatility environment.

In high volatility environments, traders start out thinking that being long options is an effective way to participate in the move and manage the risk, and they're always a bit fearful because the markets really volatile. The problem is the volatility is too high. You want to be aware of how options are being priced in high volatility environments. When we buy options in a high volatility environment. The implied volatility will make it really hard if not impossible to make any money on the option. The price needs to move a long, long ways to overcome the implied volatility in the market.

Let's look at an example of Gamestop. This is a famous Gamestop period back in January of 2021 when Gamestop exploded. On January 29 2021, GameStop closes at $325 a share with implied volatility of 709%. On February 1 Gamestop closes down $100 and implied volatility goes down to $539. The stock was down $100 and implied volatility goes down 170%. These are some things that we teach in our workshop, but basically we're able to price the move and see what the market is pricing in as a one standard deviation move versus how much the market actually moves, and here's the chart. We see Gamestop closes at 325 and then it goes and it goes down $100 the next day. See we're bearish Gamestop so we buy five of the Feb 230 points at $66.08. The Feb 230 put has a volatility of 735% and a daily theta of $4.57. You buy a put expecting the market to go down thinking you have limited risk in case Gamestop takes off. Now you come in on Tuesday and Gamestop breaks $100 to $225. You get the move right, but the volatility goes down 149% and your option and combined with a theta you actually lose money, you get a huge move and you lose money. The put actually closes at $57.04 so use $4,340 on a five lot being right. That's why you have to be very careful. Instead, you could have bought the Fed 320 230 put spread at $31.92. This same break of $100 down to 225, if you bought the spread, it would go from 4192 to 6818, giving you a profit of $9,756 instead of losing money, losing $4,300 being long a put itself.

Whenever we buy an option or we buy anything, we got to remember the concept of position basis. Basis is what is the price we paid. Buying options and high volatility gives you a poor basis. It makes you vulnerable to losses. One of the things that's great about vertical spreads is if volatility gets higher, spreads oftentimes, especially at the money, spreads can actually get cheaper, especially when they benefit from the skew.

Catastrophic Mistake #3) placing stops in an options order book.

What is a stop order? A stop order is an order to buy yourself security when its price moves past a particular point, ensuring a higher probability of achieving approved determine entry or exit price, or limiting the investor's loss or locking in a profit. Once the price crosses the predefined entry/exit point, the stop becomes a market order. This is the key thing to realize, soon as it crosses that threshold, it becomes a market order. It's important to remember that options are a derivative of the underlying. As a result, underlying price, and underlying liquidity is a huge factor in options pricing, and options liquidity. Therefore, whenever the underlying is large, quick move, market makers tend to turn off their models, that put quotes into the market for options. If the market as a big move, you'll see the option market disappear.

The lack of liquidity beyond the first few levels, if you look at a typical options book, there'll be a market maker maybe on the bid offer and maybe inside of that, but if price quickly pierces through the first level or to your stop will become a market order and it will go in search of the next bid, so you're long, you have a sell stop, it'll go and search for the next bid, and that that bid in the book could be really far away, which could lead to a catastrophic fill, you could get destroyed just on your fill. Market makers turn off their quoting altogether, leaving no orders resting in the book. This is something we have to be very careful of. We never ever never, ever never ever, ever, ever want to put a stop order in an options book.

The solution is to place the stop in the underlying and then work out of the underlying versus the option position. We spend a great deal of time talking about the mechanics of position management so you understand how to put trades on and how to take them off so you maximize your executions, and you minimize the slippage.

Here's just an example two different books. The book on the left is in crocs. This is the Jude 105 call, and you can see there's only a bid and an offer. It's really wide, but behind it there's no offers, and there's no bids. Here's Microsoft, which is a lot more liquid. Microsoft has four offers and five bids, but notice that some of these are pretty thin. If you had an order, let's say, to sell 200, Microsoft calls, let's say at 202, and this got triggered well you get six sold, forty sold, and one sold, and there might not be anything for dollar below. You can get destroyed on this call of stop loss. We've never want to do this.

There's your three catastrophic mistakes to avoid. This is important to take into account. Stay tuned every Tuesday for additional webinars such as this one where we teach you different ways to think about trading to take your performance to an elite level. Have a great week. I'll see you next week. Bye.