How to Trade Options Better by SJ Options
San Jose Options, SJOptions.com, presents a class on the most common mistakes made by option traders. This class was given to our students live in January of 2013 by our 26-year veteran trader and mentor, Duane. Learn from a trader with many years of trading experience in this presentation. All option traders should watch this, especially those struggling to make consistent returns trading options.
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Alright, well, happy new year to all! Here we are picking up where we left off. It seems like a long time ago since we’re all together. For me, it’s a very welcome break. It was nice where with all this physical cliff, controversy, debate going on, I’d thought, “You know what? I’m just going to really back out, close down virtually most all of my trades.” They we’re kind of wrapping up the most part anyway. And I thought, “I just don’t want to have any of this looming over me during the break. I wanted to enjoy the time off.” We certainly did have but it’s some pretty significant movement around all that once it was “resolved.” I just didn’t want to be ahead of such a big news item but kind of frankly gone either way.
And that really sets up the stage for what we’re going to talk about today in the first session and there’s just some mistakes to avoid. These are going to be things that I think a lot of us probably know or they won’t be surprising but I think it’s really a good idea to talk about it. It’s one of my favorite session to do really, because I always say that if we can just control the mistakes we make, stop doing things that tend to have you lose money then we’re on the road to actually making some wins. It’s always a good reminder and maybe a good time for self-reflection as we go through any of these and the others that you’ll look at yourself and go, “You know what? I can be guilty of that,” or, “Yeah, that sounds like me,” or “I didn’t think about that.” But really take it to heart because it is important and, again, as we really plan on doing these trades year in and year out, again not making the basic mistakes is going to be a very, very important first step.
I think it’s a good class to open up the year with. In the next session today, it’s going to be a one-on-one that I’m going to have so it should be interesting in that regard as we will start that one at 2:45. Also, a little programming note here, we’re going to change the schedule around a little bit. Since we really have a significant international base of members, we’re going to do some classes early in the morning; at early in the morning my time, here in the west coast. That way it’s—in the evening, for the folks over in Australia and Asia and also it’s later in the day that a workable time for people in Europe. We’re going to try that and we’ll kind of monkey around the time to get it just right but you’ll see some of that in the programming. I told Morris as I am always up early anyway, it doesn’t matter what time they are for me. I’m happy to do that so I’ll be the one doing their morning sessions to start with. The question comes in, what do I consider early? We’re usually up a little bit before 4 a.m. here. So, I think no matter what time zone you’re in 4 a.m., it’s kind of early.
Let’s go ahead. Let’s start talking about some of these more common mistakes and get through it. First off, a real quick reminder on how quickly things can change. Here, Russell hit 880 here recently. I was watching it and I wasn’t paying much attention for the 2 weeks that we’re off and when I came back and looked at that I thought, “Is that right? Can it possibly be up there?” But it certainly has made a significant move. I’d say stronger than the rest of the market.
The index has really performed strongly and then, the VIX, volatility in general, relentless in its desire and commitment to stay low. I mean, we’re at a point in time here where we talk about volatility a lot but we see that even with so many unknowns out there, it continues to just be painfully low. But that’s okay. You got to recognize, understand the market conditions and trade the market that we have so I did definitely want to point that out. And then there’s other things that are going on right now that make a new trade for the possibility of new trades quite interesting. We have the physical cliff behind us. I put a couple of question marks because in my humble opinion, it really didn’t do much but kicked the whole thing down the road a little bit further. Yes, we got some new taxes for certain folks but as far as resolving anything, I don’t really think so.
We have the death ceiling, I’m calling apart too. I got this started a year and a half ago and I think anybody that was with us or trading the market in general remembers what happened in August a year and a half ago where the debate went on and on and on and finally at the last possible minute, they raised the ceiling but the SMP downgrade occurred, the market really got slammed, volatility shot through the roof. It was the perfect recipe for disaster. We have that here coming up. I’ve heard anything from the middle of February to the first part of March is when something’s going to happen in that area and if you’re following the news at all, the stage is set for a lot of drama and a lot of fist fights. That’s another thing.
We have an ongoing sequestration and it’s still looming. That was the part of the budget cuts that were supposed to automatically kick in and like I say when they resolve “the physical cliff,” they attacked the revenue side but did nothing really as far as the spending aside. We’ve got a lot of events I guess is the point that we’re looking at here and we want to be aware of.
Let’s get into some of the common mistakes to avoid and what we’ll get into it. I like to say, especially for the new folks, it’s a great time to learn from others. There’s a time when odds are a lot of mistakes that can be made have been made and so if we can talk about them beforehand, then you’re at least aware of them. You can know how to step around some of those pot holes. We’re going to go through some of the very, most common ones. There’re ones that, personally, I think are rather timeless and universal. Universal in the sense that everybody tends to fall victim to these at some point in time and timeless because they’re always there and they continue to be made over and over again by new and experienced traders.
Here we go. Trade size, this is likely the number one mistake. Sometimes, you can find that when you have successes, it bolsters the confidence and may get into a situation of overconfidence and as that occurs, you start piling on more and more. Instead of being more structured in your plan, realizing and remain humble about the fact that the market wants to and usually does beat those trying to play. Again, discipline around maintaining your trade size and aware of the trade size around what may the certain volatility situations or things like that, very, very important.
I make the point here, look for reasons why the trade might fail and what the potential damage could be. That’s an interesting one because, you know, I get to talk to a lot of folks and as we’re going through various conversations, I’ll say, “Let’s really add up what your exposure is at this point in time.” And often I’m surprised that they don’t really fully grasp the significance of the exposure that’s there. You want to make sure you’re understanding your trades, you want to look for the reasons why they might fail. That’ll also help you prepare on what to do if it starts to fail. It kind of is a not only an endgame but also it’s going to help you develop a plan as things evolve and unroll in front of you.
Also, the comment at the bottom here: remember to save buying power for the needed adjustments. You need to have those reserves there for a couple reasons. One, if the trade starts to break down, we’ll maybe the house and fire power available to adjust and get it healthy again or even worse yet, you might have a trade that really is running flawlessly and things are looking great. But if you ran out of buying power to continue that trade, it’s almost more tragic because you have the opportunity right in front of you to have maybe those one or two really big winners that come our way but you have to close out because you didn’t have enough buying power. So, really, really watch the trade size.
Let me hit the chat real quick. The question comes in from Greg. It’s a very, very common question as far as, what percent should you have set aside for adjustments? I’m going to give kind of a little bit of a wishy-washy answer to that for the point of view that it really kind of depends on the account size itself. But I would say this, if you’re just starting up, I would start off with at least 50% available. Go ahead and go through a couple cycles of the trades. Get comfortable with how much these adjustments for the kinds of trades and the size of trades that you have.
How much those adjustments cost and then you can get a better finger on how much you really should have set aside. It also definitely is a factor if you’re trading in a reg T-style account. So say an IRA or a standard margin investment account or portfolio margin account but for the guys that are new, start by keeping more than you think you need and as time goes by you’ll develop a little bit of an extra feel. It’s not uncommon, I’d say for me or some of the others to keep a 50% additional buying power. What’s also interesting is that with some of the styles of trades that should move towards expiration, the trade cost actually becomes a little bit more so that number, that percentage will definitely get smaller. But it’s almost by design. You understand what and why things are going on and working with that. But again, just for a nice round number starting off with, keep 50% behind, see what that does for you and then you can offer it to your size of trade and types of trades that you have on.
Next common mistake I have is over trading and over adjusting. First off, it could be just the number of trades where all of a sudden you have piled on to several different months a whole bunch of trades which interestingly enough often start to look very, very similar. It is kind of another attribute of a common mistake I’ll get to later but just watch the number of trades that you have. I point out trade concentration, too many trades in one month or too many opened at the same time at different months. Again, you want to be somewhat diversified from the point of view where you don’t want to open 10 new trades all at once in a 3 or 4-month period where they’re all going to look and act the same. After this nice run up that we had with the Russell, it maybe gives a good opportunity for opening a particular trade that wouldn’t have existed when the Russell was down at 830, which was only a couple of weeks ago. Again, watch the concentration of those trades.
The final point that addresses more of the over adjusting is with the higher volatilities, the market is going to jump around more. You want to be – you want to follow the guidelines for use in the DV ratios and balancing out of the trade. But you don’t want to just blindly let the numbers dictate what you’re doing. What I mean by that is you maybe want to really look at the chart. What is the directional trend? Is this adjustment a good one to make? Sure, I perhaps consider making a half size adjustment instead of doing a full up adjustment because what’s going to happen is you wind up where you adjust one way on one given day and then the next day or next couple of days you end up adjusting right back the opposite directions so that whips all against the hold of you and all of a sudden you’re really just treading water and the only thing that’s growing is the amount of commissions that you’re paying. It’s a good thing to be watching for and one that frankly, we talk about a lot in the daily case studies and it’s almost like you have to go through that and watch and understand and start to develop a better feeling for it before you have the confidence of knowing which adjustment you should be making and which ones you shouldn’t.
We started a little comparison awhile back just blindly doing more of a computer program exclusively on the DV ratio and that’s it versus one where I was looking at the ratio but also looking a little more closely at the charts and going through why even though, at certain times, an adjustment might be made, why I might not let you take that adjustment and the rationale behind it. We’ll be doing a lot of that this year but again, it’s a very common mistake where we have an over adjusting phenomena to take place and it’s a very common one especially for the new members.
Next I have the scratch record trading. What I mean by this is making the same trade the same way over and over, regardless of the actual market conditions. This sort of gets back to some of the other ones. You start to see how these things kind of blend together where you have a trade, things are going well, you get confidence, you should say it wins again, you get more confidence, so on and so forth. You just become a little bit blinded by the fact that the market conditions really have changed. It’s important to always step back and understand why you’re implementing a trade and not just doing it out of the force of habit.
It’s interesting too because this is a very common iron condor trader downfall. In fact, any of you who’ve been out there had traded the typical and traditional iron condor strategy of selling the 10 deltas at a 45-day period, trying to get your credit. It works. It works. It works. And then it just blows up. That’s really what I mean here by the scratch record trading. If things dramatically change in the market, make sure that the strategies that you’re implementing are really developed and working with those market conditions and not just working the same way they did the last couple times when the trade actually worked. The example around the brick, you know the different kind of ratio you may want to be using and definitely one of the biggest factors is the volatility, where they are and what that really means.
Chart blindness, I thought of this one where I am probably the most guilty of it of anyone I knew in that. When you’re looking at the charts, it’s almost easy to come up with something every single time that justifies or validates your personal opinion. If you think the market’s going up, you’ll look at the chart, you’ll find out some reason why you can say, “Yes, that really is happening,” going down the same type of thing. What I think is really important is really be honest with yourself, look at and see what the chart really is trying to show you and not seeing if you can find what you want to find, what you’re looking for. I think you’re kind of out there where sometimes you look at the chart and go, “I can’t make any sense of this whatsoever.” Just turn the thing upside down and look at it.
Again, just look at for obvious things that might jump out at you that you maybe didn’t notice the first time around ‘cause a lot of times they’re there and these could be support levels, they could be channels that you’re trading in, it could be something as simple as a head and shoulders pattern or some other well-known, well-recognizable and fallen type of pattern that for whatever reason, you’re not just seeing it for whatever reason. You’ll see sometimes in the class, I’ll go ahead and I’ll erase all of my lines that I have on there, all of my notes, so on and so forth, get a clean chart so to speak so that I’m not distracted by all that busy work, all that graffiti that I can start adding into the charts as I’m trying to identify certain things.
Again, it’s really important and this plays right back to the slide I was just on where if you’re going to want to start to minimize your over adjusting, make sure you’re looking at the chart and seeing that it really is telling you something that’s going to help you make the decision around that adjustment. I fault myself on this one where it was a couple years back. This mark was moving up and then I moved it up just continuously. The whole time I just was rationalizing why it’s going to roll over, know next month it’s going to roll over. Of course it never did. What that meant is that I missed a lot of opportunity to the upside simply due to my chart blindness.
Now I come to the depress and the analyst and we were just overloaded these days by the instant opinion and the breath of those providing those opinions that can be very confusing and misleading. For the point of view, it’s not uncommon to have two very well-spoken, clearly educated and capable people coming and presenting their assessment of what’s going on. They’ll be the exact opposite opinion, both of them spoken very well, very believable and all of a sudden you’re just confused and frozen by that. worst yet, you might have a slight concern or fear over a particular aspect of the market in the trade you’re in and then you hear somebody that kind of reinforces that and immediately you take action because it just confirms your fear around that. All of a sudden, after the fact you realize you kind of overreacted to the situation and it was really ignited or exacerbated by the fact that some talking head on one of the news shows has something to say about the trade that you’re already concerned about or you know the options true and hopeful for.
I guess on this one I’d say it’s important to know what’s going on. I follow the news quite closely but when it comes to the amount of analyst input and directional input that you’re going to take form a 3rd party on your screen, just be a little mindful of it and know that that’s going on. Again, you don’t want to ignore everything out there but I think we all know that at least half the time, most of what you hear is exactly wrong. Let’s face it, at the end of the day they’re just like the rest of us trying to figure out the best they can and while they may have more experience than a lot of folks, a lot of you trading, the simple fact is they can misread things or the market changes on them just like the rest of us.
The other thing, my final point on this one is that, they can flip flop as quickly in one direction as they were taking off in the other. A lot of times some of the input you get, there’s no timeline associated with it. It may literally be a big opinion change based on a recent event that comes along and you know there you are kind of blindly being led by an analyst who’s just talking for the sake of talking, which is what they do. But at the end of it all, it really hasn’t done much to help you.
That’s it. Let’s keep 2013 mistake-free the best we can, anyway. We’ll be looking at opening up some new trades next week. I probably won’t do any tomorrow. I’ll talk a little bit more around the reason for that but we’ll get kind of a clean slate here, start opening some trades and managing the kinds of trades and the account sizes that we have with things that are prudent for the current market environment. Let me go ahead and shut this recorder down. I’ll start up at 2:45 with the next session. It will be a one-on-one here so we’ll have a question and answer and you guys can watch if you like to. I’ll talk to you again soon.