3 Reasons Why Options Traders Share their Secrets

So, you’ve read this great piece – an article in a magazine, a blog post, or email newsletter in which an experienced options trader, a so-called options trading ‘guru’, shares a trading strategy that has worked well for him or her. And, you wonder – how much can I trust this article? If it were really that good, would he be sharing it? What axe does she have to grind? And, you doubt!

If you can, set your skepticism aside for a short while, and read on.  There are legitimate reasons why experienced options traders might share their secrets. The first 2 listed below benefit the options trading community at large, while the third benefits that options trader who shares his or her secrets.

More Options Traders = More Liquidity in the Options Markets

Simply stated, the more options traders in the market means that the bid-ask spread for the option being traded will be ‘tighter’. For the options buyer, this means being able to buy the option while paying less than if the bid-ask spread were large. For the options seller, this means being able to sell the option at a higher price than if the bid-ask spread were large.  The ‘tighter’ bid-ask spread is something every experienced options trader loves and looks for when trading options. Hence, if she writes a great article that entices more folks to begin trading options, she has nothing to lose and much to gain. For the mathematically inclined, see ‘Why Liquidity is Important’ for a more detailed explanation of how increased liquidity benefits the options trader.

Options Trading is a Two-sided Market

If you want to buy something, there needs to be someone to sell it to you, and vice versa.  Experienced options traders recognize that options trading, like trading in general, necessarily requires a two-sided market.  If they are to remain viable and successful trading options, the more people that trade options the more opportunities they have to make money in the market.  Since options are ‘derivative’ instruments (meaning they are based on or ‘derived’ from some underlying financial instrument), it helps the options trader to have more people trading options – since, people invariably cannot agree where the markets are headed. One only needs to watch TV and listen to the ‘talking heads’ to realize that for every one person who thinks the market is headed higher, there is someone who thinks it is headed lower.  Either way, for the options trader, there is money to be made – as options allow one to bet on movement to the upside and downside at the same time, quite unlike stocks where one has to choose to buy (if one thinks the market is headed higher) or sell (if one thinks the market is going to fall).  See ‘Options Trading Strategies’ for a simple primer on options trading strategies.

The Universe Rewards those who Share

Here is a little known secret for all those who desire wealth – ‘Those who give receive’.  Some of the greatest philanthropists in the world are people with the greatest wealth – for example, John Templeton, Bill Gates, Warren Buffet, etc.  While it might be tempting to argue that they can give because they have great wealth, the opposite is more likely the case – they have great wealth because they give. They give of their money, their time, and their talent. What’s more, the more they give, the more they seem to acquire.  While not everyone has great wealth to give, everyone begins each day with the same amount of time, and everyone has some talent to share, they may not realize it yet. Experienced options traders know that sharing their wisdom, time and talent is the right thing to do – and their altruism will pay them handsomely in the end. The secret of ‘How to Get Rich’ was published over 100 years ago, and has been practiced since Biblical times by people of great wealth.

In conclusion, experienced options traders may have many reasons to share their knowledge, not the least of which are the altruistic ones mentioned above.  More direct benefits may also be accrued by them by establishing themselves as an expert in the field and getting referrals from others who might seek their expertise.  For the reader, the question to be asked is whether or not the article written has some nugget of wisdom that can make them wiser and help them trade better and more profitably.  A good tenet to follow is if one can learn ‘just one new thing’ each time, in time one will be a great deal wiser.

Happy Trading!

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The White Coat Investor: A Doctor’s Guide To Personal Finance and Investing – Book Review

The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing, published 10th February 2014, is a book written by a James Dahle, an active practicing Emergency Room physician in Utah.  The book’s targeted audience is high-income professionals like physicians, dentists, and other highly educated professionals who often have spent many years training to do what they do, but, for a variety of reasons, have not paid much attention to their own financial matters.  While Dr. Dahle has offered bloggers a copy of the book to review, presumably for free, my own review is based on a copy I bought shortly after the book was published. In essence, my opinion has not been influenced by any sense of gratitude by being offered a free book.

The White Coat Investor

The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing

Physicians, and other busy professionals, usually want the bottom line – here it is. This book is an easy to read, high-yield book with much practical knowledge that medical students, resident doctors, physicians in fellowship training, and junior faculty and attending physicians will find very useful. Currently offered on Amazon.com for less than $20, it will be the best $20 you ever spend.

Chapter 1: The Big Squeeze

How increasing tuition, decreasing reimbursement, and regulatory hassle are trying to ruin your life

Chapter 2: Millionaire by 40

How to have a seven-figure net worth five to ten years out of residency

Chapter 3: If I Had a Million Dollars

How to convert income to wealth and vice versa

Chapter 4: Medical School and Your Wealth

How picking the right school and specialty can affect your bottom line

Chapter 5: Residency and Your Wealth

Which financial chores you must do as a resident

Chapter 6: The Secret to Becoming a Rich Doctor

How to get out of debt, buy your dream house, and hatch a nest egg within five years of residency graduation

Chapter 7: The Retirement Number You Control

Why your savings rate matters more than your investment return

Chapter 8: The Motorway to Dublin

How to quit throwing your money away on stupid investments

Chapter 9: Getting Off the Motorway

What you need to know about investing in real estate, whole life insurance, private investments, and your own house

Chapter 10: Paying the Help

How to get good advice for a fair price

Chapter 11: The Basics of Asset Protection

How to protect your hard-earned money from lawsuits

Chapter 12: Estate Planning Made Simple

How to avoid estate taxes, protect your heirs, and avoid probate

Chapter 13: Income Taxes and the Physician

Why you pay too much in taxes and what to do about it

Chapter 14: Choosing a Business Structure

Why incorporating will not protect you from malpractice suits or save you much in taxes

Chapter 15: Enjoying the Good Life

How to quit worrying about your finances

Chapter 16: The Mission of The White Coat Investor

How to help doctors quit getting ripped off

 

What The White Coat Investor Book will Teach You

James Dahle, MD has walked the walk and faced the same challenges that medical students, residents, physicians, dentists, and other high-income professionals face, and offers some very practical insights on how such professionals can prevent the financial problems that most assume are inevitable.  For example, on the ‘secret to becoming a rich doctor’ he suggests ‘live like a resident’ when first making the jump to an attending physicians and getting a big paycheck.  While this may seem unconventional advice, (after all, hasn’t that young physician been waiting years to earn the big paycheck?), it is based on very sound mathematical principles – namely, it puts the power of compounding to work, as dollars saved early have more time to work and work more powerfully towards one’s financial freedom than dollars saved later in life.  Another suggestion he has is ‘try not to buy a house’, and gives ‘six reasons why residents should not buy a house’.  While talking about retirement, he focuses on the practical ‘the retirement number you control’ rather than what cannot be controlled. Many of his suggestions might seem like common sense, however, physicians and other ‘white coat’ professionals receive little to no training in business, personal finance, investing, insurance, taxes, estate planning, and asset protection, and his common sense manual covers many vital topics.

This book will teach medical students how to graduate from medical school with as little debt as possible, and minimize and pay off student loans quickly after residency.  It will teach residents how to acquire the right types of insurance (that are least expensive earlier), and how to decide when to buy a house. And, for young attending physicians, it will help them learn about the different types of investments and how they may become a millionaire within five to ten years of residency.  In addition, it has many tips on a variety of topics such as how to minimize the effects of taxes, and how to find and choose a financial advisor.

What The White Coat Investor Book will NOT Teach You

Despite its many great attributes, the White Coat Investor Book is not an in-depth manual, and those hoping that the book will be the only investment book they will ever need will be sorely disappointed. However, to his credit, Dr. Dahle provides many references at the end of each chapter that interested readers can puruse at their leisure.  Although, in discussing the investing, he discusses types of risk, diversification and investment expenses, it is not an in-depth discussion. Furthermore, he does not discuss specifically how to pick investments or which funds to pick; rather he gives general comments on why chasing specific mutual funds or fund advisors is not a good idea.  Readers interested in a greater discussion of the effects of expenses on fund performance or how to choose which type of fund might be interested in reading The Lies about Money by Ric Edelman.  In ‘Getting off the Motorway’, he discussing different types of investments, however it is a brief survey of the common types, and not in any depth at all.  Readers interested in taking their financial future in their own hands, and delving into investing in the stock market would be well served to learn about options trading and how combining stock options with investing in stocks can make their stock market investments safer.  For more on this topic, read Who Should Trade and Who Should Trade elsewhere on this website.

In conclusion, the White Coat Investor: A Doctor’s Guide to Personal Finance and Investing has many great financial basics that all ‘white coat’ professionals need to know early in their training, and I highly recommend it to all busy ‘future’ high-income professionals as essential reading.

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Simple Options Strategies To Profit From The Coming Gold Rush

The only reason any investor or trader is in the stock market is to make money. Historically, gold has always been a great investment, as people love gold and it stood the test of time. Recently however, over the past couple of years, it seemed that gold had fallen out of favor, and the popular gold indices fell and stayed below their 50 day moving averages. Times seem to be changing, and it may be time to reconsider gold as an investment.

JUSTIFICATION FOR THE EXPECTATION OF A GOLD RUSH

Some might argue that ‘Gold Rush’ is too strong a label for what I am about to suggest, since there is no way of knowing the future and what might be.  However, something to consider is, like the great US Gold Rush, those who get in early will likely make the most profit.  Prudent investors and traders might ask the logical question ‘What proof is there that I should consider gold as an investment now?’  To them, I answer – one has to learn to read the signs of the times in the stock graphs to know that it would be wise to consider gold as an investment or trading opportunity now. Let me explain.

Most prudent investors and traders may broadly be divided into those who base their decisions on fundamental analysis or technical analysis (I am discounting the naïve wannabe investor who follows every hot tip).  While fundamentalist attempt to evaluate the underlying worth of the investment (which may or may not agree with similar analyses done by others), the technical trader chooses to wait until popular sentiment is noted on the stock chart before they start investing.  This generally means that the technical trader will enter the market later than the fundamental investor.  However, this does not matter for the individual trader since most major investments nowadays are done by institutions and hedge-fund managers, and they usually enter into their positions slowly over many weeks. The best strategy for an individual investor and trader is to spot a trend relatively early, and hop on for the ride as soon as he/she is able.

GLD gaps above the 200 day moving average

GLD gaps above the 200 day moving average

GDX gaps up confirming the break above the 200 day moving average

GDX gaps up at the open confirming the break above the 200 day moving average

 

HUI breaks above the 200 day moving average

HUI establishes a new high for the year, breaking above the 200 day moving average

Above are three graphs of the popular gold ETFs with overlay of the 50 and 200 day simple moving averages. One will note that all the indices hit a recent bottom at the end of December 2013, and have since been trending up. Most investors and traders who follow trends, especially mutual fund and hedge fund managers, wait for the stock (or underlying) to rise above the 200 day moving average before they begin investing (see The True Importance of the 200-day Moving Average).  Once they begin investing in a particular underlying stock or ETF, they usually do so slowly over a period of weeks attempting to buy the underlying at the lowest possible price.  Hence, I use the term ‘Gold Rush’ as I expect once this trend starts, it will likely continue for a long time.  The next logical question for the investor or trader is ‘How can this knowledge help me?’

BULLISH OPTIONS STRATEGIES TO PROFIT FROM A GOLD RUSH

Assuming that the technical signal given by the 200 day MA holds, how should an investor or trader capitalize on it? The answer depends on many factors including the investor/trader’s time horizon (short-term vs. long-term), available capital (money ready to be deployed), and investing and knowledge and expertise. The following is a non-exclusive list of some of the choices – not surprisingly, options traders have more options than the ‘pure stock investor’:

  1. Buy the ETF – This usually is only a viable option for major institutions and hedge-funds as it involves a lot of capital. It is also the simplest to understand – buy low, sell high.
Buy GDX ETF

Choice 1 – Buy the GDX ETF

  1. Protective put (married put) – Like the above, this requires a great amount of capital, but it has the advantage that it limits the down-side risk (see Protective Put).
Buy GDX Protective Put

Choice 2 – Buy GDX Protective Put

  1. Buy a call – For the options trader, this is the simplest bullish strategy to follow. Usually, the best option to buy is one that is slightly out-of-the-money (OTM) as it gives you ‘more bang for the buck’. For more details on why and how the delta of these options matter, see Options Trading Strategies.

Buying a call substantially decreases the amount of capital required, and often traders may buy lots of 10 or more to take advantage of the leverage offered and the lure of unlimited upside profit.

Buy GDX call

Choice 3 – Buy GDX Call

  1. Buy a call spread – This is a great strategy for the options trader, but does require a little more understanding of the relative effects of price movement on the long and short options, and a decision of which options to buy (‘how far out in time to go’). For more detail, see Options Trading Strategies.  Like buying the call, as the amount of capital at risk is low; unlike the call, upside profit is limited.  The advantage of the spread over the call is that the ETF only has to rise a little for the trader to make a great ROI (return on investment), and often buy many lots of 10 rather than single spreads.
Buy GDX Call spread

Choice 4 – Buy GDX Call spread

As noted in the examples above, the profit attainable and risk assumed differ with the strategy chosen, and each investor/trader needs to decide what works for them.  Although the future is not predictable, smart investors and traders learn to consider the reward-risk ratio in their decisions; the current graphs suggest that for an investment in gold now, the rewards outweigh the risks.  Although the examples are using GDX (screenshots courtesy OptionsXpress), the strategies listed above can be done with any of the other ETFs. For more on how to place orders, see How to Trade Stock Options Online.  Options traders have many, many more choices to consider depending on their level of understanding of sophisticated strategies – including the collar, rolling collar, rolling protective put, backspread, and combining strategies such as a protective put with a backspread.  The advantage of more sophisticated strategies is the ability to combine unlimited profit with limited risk.  That’s a topic for another day …

Happy Trading!

optionsXpress

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A Simple Technique to Profit from Volatility

Volatility scares investors, as it usually rises sharply when the stock market is falling.However, savvy investors and options traders love volatility as they can profit faster from the stock market’s random movement. There are many ways to profit from volatility, and pure stock investors might take the opportunity to buy undervalued stocks cheap when the market falls irrationally on news of global terror or other ‘bad’ news unrelated to their individual stock. Buying undervalued stocks cheap when the stock market drops is a very successful method espoused by none other than investing legend Warren Buffett, who said ‘Buy when everyone is selling and sell when everyone is buying’.While this is good advice, this requires a lot of capital, a long-term horizon, and the ability for the investor to analyze stocks to find the ones with ‘good fundamentals’ that they would be willing to hold for the long run.Options traders are more fortunate as they don’t need to have this unique analytic ability, nor do they need a long-term horizon to make money.

First, one needs to know what the VIX is, and how it is calculated. In brief, the VIX is the CBOE’s volatility index, and is derived from a range of strike prices of the S&P 500 index option chain.It is based on real-time option prices and changes during open market hours.

Second, one needs to know what a change in the VIX means to be able to profit from it.Since the VIX is derived from the prices of the S&P 500 index options, the VIX will rise if the options become more expensive, and fall if the options become cheap.Hedge fund managers and professional traders use the options on the major indices (like the S&P 500) to hedge their portfolios.Since option prices (like stock prices) are determined by supply and demand, when more numbers of options are bought, the prices of the options rise.Usually there is a sudden increase in demand when the stock market is falling, and professional traders scramble to buy put options for fear of a market crash.This surge of demand drives up the prices of the S&P 500 options, and in turn the VIX.Because of this relationship, the VIX is sometimes called the Fear Index.As the VIX can be plotted on a stock graph just like other stocks, options traders are able to monitor its movement and plan a trade accordingly.

HOW TO PROFIT FROM A VOLATILITY SPIKE – SELL VOLATILITY

In the stock trading world, a common adage is ‘Buy low, sell high’ – implying that one should buy a stock at a low price and sell it at a high price.For the options trader, the same adage can be said about volatility – ‘Buy low, sell high’ – that is ‘Buy when volatility is low, and sell when volatility is high’.The converse is also possible – ‘Sell when volatility is high, and buy when volatility is low (falls)’.To do this, one needs to monitor the VIX, and place a trade when it is either at historic lows or at historic highs. The rational being that, in time, the VIX will return to ‘normal’ – this concept (for math buffs) is termed as ‘reversion to the mean’.See graph of VIX below.

VIX range

VIX in 2013

S&P 500 Candlestick graph

3 Month Candlestick graph of S&P 500

The first graph above displays the range of the VIX over the past year with superimposed Bollinger bands.The second graph is a candlestick price graph of the S&P 500 over the past 3 months with superimposed Bollinger bands. Bollinger bands are a technical indicator invested by John Bollinger to graphically display volatility of the movement of a stock or index being followed.The standard display shows a 20-day simple moving average with envelopes of 2-standard deviations around the average. The premise being followed is that whenever the price of the underlying goes beyond the envelopes, it will trend back to the average.One can see in the top graph whenever the VIX reached a high outside the envelope, within days it fell back into the envelope towards the average.

For the options trader who seeks to sell volatility, a potential trade might be a put credit spread – based on the premise that both the S&P 500 and VIX will revert back to the mean to garner a quick profit.Even with a plan for a credit spread, the prudent options trader will likely position his/her short strike far away from the current level of the underlying.In the example depicted in the graphic below the short strike on the SPX options is placed at a delta of 10, almost 150 points below the current level and way below the recent support.

SPX Put Credit spread as a volatility crush play

SPX Put credit spread as a Volatility crush play

As noted in the daily report below the illustrative trade, in the days following, as the index rose, IV dropped and the trade became profitable.

Caveat Emptor! The above options trade is described purely to illustrate how savvy options traders may benefit from selling volatility spikes – it is not a trade recommendation. Readers are responsible for their own trades. An astute observer might note that sometimes the VIX rose only to rise again before dropping, and the S&P 500 dropped only to drop further before rising.  One needs to know and accept the risk in the trade, and to know how to respond if the S&P 500 drops towards the short strike.  But, that’s a discussion for another time …

Happy Trading!

If you currently trade volatility spikes –

Please share an example that illustrates how you made a quick profit.

If however you attempted to do so and were ‘burned’ – please share the lessons learned. 

 

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Why Options Traders Love Volatility

In recent days, financial markets around the world have seen much turmoil, and market indices have dropped dramatically. Many wonder how long the ‘correction’ will last or whether this is the start of another bear market.  While stock investors are understandably worried, such market uncertainty is what options traders live for.  Increase in volatility of the markets means more opportunity to make money – especially for the savvy options trader. Falling markets are generally associated with an increase in volatility. It is said that the bull takes the stairs up, and the bears the elevator down – implying that stocks and markets generally fall faster than they rise.

US Markets Drop

US Markets Drop Yet Again

Firstly, it is important to understand how volatility influences options pricing to be able to understand why increase in volatility is a ‘gift’ to the options trader.  To understand how volatility affects options prices, one needs to at least know about the Black-Sholes formula, a common model used to calculate options prices.  Fortunately, one does not need to know how to do the calculations as all brokerages nowadays use computers that do the calculations automatically based on certain inputs from the market makers.

Secondly, it is also important to distinguish between historical volatility (what the market or stock has done in the past) and implied volatility (IV, what is implied by the options pricing model). A quick analysis of what has happened in the past can help one decide what might happen in the future – although, there is no guarantee that history will repeat itself.  A rise in implied volatility without a corresponding increase in real (historical) volatility is good news for the options trader, as it allows him/her to be more creative in trading .

In brief, options prices are determined by the following main factors:

  1. Current price of the underlying stock or index
  2. Strike price of the option
  3. Time until expiration
  4. Risk-free interest rate
  5. Implied volatility

As one can see from the above list, of all the factors, the only one that is ‘nebulous’ is implied volatility.  In reality, the implied volatility is a term that is derived to explain option prices.  Although at the start of a trading day, market makers can input a given implied volatility into their calculations to set options prices, during the trading day, the options prices are set by the market forces – what folks are willing to pay for a given option.  Traders who recognize that option prices imply a certain volatility of the underlying stock or index can profit immensely, as people are terrible at predicting the future, and the volatility implied by the option prices rarely comes to pass.

UNDERSTANDING AND PROFITING FROM IMPLIED VOLATILITY

To profit from changes in implied volatility, one needs to understand some basic thoughts. Let’s review them below …

  1. It is vital to know how high implied volatility is currently compared to where it was in the past. For example, see graph of VIX below
  2. Effects of IV are greatest at the ‘at the money’ (ATM) strike, and less so further away from the ATM strike forming what is known as the ‘bell-shaped’ curve of a ‘normal’ distribution.
  3. Effects of IV are greater on options with more time until expiration, as ‘Vega’, which quantifies the effects of IV on the options, is higher in longer term options and lower in shorter term options.
  4. The effects of IV can be minimized by combining both long and short options in a single trade, such as in a spread or condor.
VIX spikes to new highs for year

VIX spikes to record levels

Since a high implied volatility implies that the stock or index will move a lot, some option traders might choose to play delta-neutral plays such as straddles or strangles, trades that profit if the underlying moves – in any direction. High volatility, especially intra-day volatility or short-term volatility, can also allow the options trader to ‘lock in profits’ by use of strategically placed GTC orders at pre-determined targets.

Since high implied volatility ‘pumps up’ option prices, traders who love theta-positive trades like credit spreads or iron condors like increases in implied volatility as it allows them to place their trades further away from the underlying (and profit when IV drops back to normal values).

Since IV has jumped to its highest levels in the past year (see graph above), the current markets are an options trader’s playground!  Caveat Emptor! Do not place trades you do not understand, as high volatility also means it is easier to lose money as it is to profit. Until next time …

Happy Trading!

If you currently trade stock options –

Do you use volatility-based trades as part of your trading strategy?  If so, please share an example when high volatility allowed you a ‘quick profit’. 

 If you do not trade during high volatility markets –

What is it that you are most afraid of that prevents you from venturing into such markets?

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