Some Random Thoughts On Option Trading: Option Trading Guidelines

By Lawrence G. McMillan

I was recently asked what guidelines I generally follow in my option trading. This is actually a rather thought-provoking question, especially when it regards something one does almost every day. In our feature articles, many useful general strategies have been given, but not assembled all in one place. After giving the matter some thought, it seemed like it might be beneficial to list some of the "rules" that we follow, either consciously or sub-consciously after all these years. For the novice, they may be eye-opening; for the experienced option trader, they may serve as a reminder. These guidelines are not the path to easy riches, or some such hype, but following these guidelines will generally keep you out of trouble, increase your efficiency of capital, and hopefully improve your chances of making money with options. They are not presented in any particular order.

Trade in accordance with your comfort level and psych-ological identity.

If you are not comfortable selling naked options, then don't; even though such strategies are nicely profitable for some traders, they should not be used if they cause you sleepless nights. If hedged positions drive you crazy because you know you'll have a losing side as well as a winning side, then perhaps you should trade options more as a speculator — forming opinions and acting on them accordingly. The important thing to realize is that it is much easier to make money if you are "in tune" with your strategies, whatever they may be. No one strategy is right for all traders due to their individual risk and reward characteristics, and accompanying psychological demands.

Always use a model.

The biggest mistake that option traders make is failing to check the fair value of the option before it is bought or sold. It may seem like a nuisance — especially if you or your broker don't have real-time evaluation capability — but this is the basis of all strategic investments. You need to know whether you're getting a bargain or paying too much for the option.

Don't always use options -- the underlying may be better (if options are overpriced or markets are too wide).

This is related to the previous rule. Sometimes it's better to trade the underlying stock or futures contract rather than the options, especially if you're looking for a quick trade. Over a short time period, an overpriced option may significantly underperform the movement by the underlying instrument.

Buying an in-the-money call is often better than buying the underlying instrument; buying an in-the-money put is usually better than shorting the underlying (if the underlying is stock)

An in-the-money option has a high delta, meaning that it moves nearly point-for-point with the underlying stock or futures contract. Furthermore, the option's price contains only a small amount of time value premium — the "wasting" part of the option asset. Thus, the profit potential is very similar to that of the underlying instrument. Finally, the risk is limited by the fact that one cannot lose more than the price he paid for the option, while one has much larger risk when owning or shorting the underlying instrument.

Don't buy out-of-the-money options unless they're really cheap.

This is really a corollary of the above rule, but it's important enough to state separately. Obviously, you can't tell if the option is "cheap" unless you use a model. If the out-of-the-money option is expensive, then revert to the previous rule and buy the in-the-money option.

Don't buy more time than you need.

The longer-term options often appear, to the naked eye, to be better buys. For example, suppose XYZ is 50, the Jan 50 call costs 2, and the Feb 50 call costs 2¾. One might feel that the Feb 50 is the better buy, even if both have the same implied volatility (i.e., neither one is more expensive than the other). This could be a mistake, especially if you're looking for a short-term trade. The excess time value premium that one pays for the February call, and the resultant lower delta that it has, both combine to limit the profits of the Feb 50 call vis-a-vis the Jan 50 call. On the other hand, if you're looking for the stock or futures contract to move on fundamentals — perhaps better earnings or a crop yield — then you need to buy more time because you don't know for sure when the improving fundamentals will reflect themselves in the price of the underlying.

Know what strategies are equivalent and use the optimum one at all times.

Equivalent strategies have the same profit potential. For example, owning a call is equivalent to owning both a put and the underlying instrument. However, the capital requirements of two equivalent strategies (and their concomitant rates of return) can vary widely. The purchase of the call will only cost a fraction of the amount needed to purchase the put and the underlying stock, for example. However, the call purchase has a much larger probability of losing 100% of that investment.

Naked put selling is equivalent to covered call writing, but is generally a better strategy.

We've mentioned this often before, but it bears repeating because so many option traders don't follow this rule, or don't believe it. Both strategies — naked put selling and covered call writing — have limited upside profit potential and large downside risk. However, the naked put sale involves less of an investment in terms of collateral required, has a lower commission cost, and allows one to earn interest on his collateral while the position is in place. For these reasons, naked put selling is the better strategy of the two.

The option positions that are equivalent to long stock (or long futures) and to short stock (or short futures) are perhaps the most important ones.

Buying a call and selling a put, both with the same terms (strike price and expiration date) produces a position that is equivalent to being long the underlying instrument. Similarly, buying a put and selling a call with the same terms is equivalent to being short the underlying instrument. The next two rules deal with these equivalences.

The equivalent option strategy may be better than owning the underlying stock itself.

If one buys a call and sells a (naked) put, his investment is smaller than that required to own the stock, and the "investment" may be in the form of interest-earning collateral.

The equivalent option strategy is mandatory knowledge for futures traders, for it allows one to extricate himself from a position that is locked limit against him.

When futures are locked limit, the options will generally still be trading. The prices of the options provide a price discovery mechanism, in that one can see where the futures would be trading were they not locked at the limit. Furthermore, one can take an equivalent option position opposite to his (losing) futures position, and effectively close out the position at the current loss without risking further limit moves on succeeding days.

Naked combo selling in indices is usually less trouble than selling combos in individual futures or equity options.

Selling both puts and calls is an attractive strategy to many option traders, since the benefits of the wasting asset are on your side. Unfortunately, large or sudden moves by the underlying instrument can create some nasty surprises for the option writer. One way to counter this is to concentrate the option selling in index options. The broader the index, the less likely it is to experience a gap opening. There cannot be a takeover attempt on an index nor can an individual earnings report, for example, cause the index to move a great distance as it can for a stock. For the index to gap, many of the stocks that comprise the index would have to gap as well; that might be possible in a very narrow-based index, but is quite unlikely in a broad-based one. These statements generally apply to U.S. indices; indices on foreign markets (JPN or FSX, for example) gap virtually every day since the actual trading in those markets is occurring while the U.S. markets are closed.

Trade all markets.

There are strategic option opportunities in all markets — equities, indices, and futures. To ignore one or two of these just doesn't make sense. The same principles of option evaluation needed to construct a statistically attractive strategy apply equally well to all three markets. Furthermore, there are often inter-market hedges that are extremely reliable, but in order to take advantage of them, one has to trade all of the markets.

Trade in accordance with your comfort level and psych-ological identity.

This is the first and last rule and, ultimately, the most important one.

This article was taken from the 11/26/93 issue of The Option Strategist Newsletter, yet the guidelines still hold true today.

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Trading or investing whether on margin or otherwise carries a high level of risk, and may not be suitable for all persons. Leverage can work against you as well as for you. Before deciding to trade or invest you should carefully consider your investment objectives, level of experience, and ability to tolerate risk. The possibility exists that you could sustain a loss of some or all of your initial investment or even more than your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading and investing, and seek advice from an independent financial advisor if you have any doubts. Past performance is not necessarily indicative of future results.
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