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April 11, 2006

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Options: When to Buy and When to Sell

Name: Ward Chambers

Company: CFTI Trading

Learn More About Today's Author
Years Trading: 14

Favorite Movie: Wall Street

Options: When to Buy and When to Sell

JC: Ward, I don’t feel you need an introduction – you’re becoming quite a fixture on the financial scene! I’m really enjoying these interviews. Shall we talk about options? You seem to be a strong believer in using options as part of overall an overall trading strategy.

WC: Firstly, thank you for the compliment. I’m glad you find our chats informative and fun. You’re right. I do feel that options are among the least understood and most misused tools available to traders.

JC: That’s a powerful statement; why are options misused and poorly understood?

WC : By their very nature, options are confusing. Once you venture outside of simply buying a call or a put, the learning curve tends to get steep very quickly. When you add the fact that the VAST majority of brokers receive little training other than ways to build a client base, a case of “the blind leading the blind” quickly develops.

JC: Why not just buy a book or take a course?

WC: Have you seen the price for most books on options! To actually pay for such poor writing quality – watching paint dry is more enjoyable and exciting. The books and the courses tend to be so overburdened with math that one of two things happens: the reader has difficulty understanding and applying the concepts in a real-world setting; or the mathematically inclined reader doesn’t realize the major difference between theoretical and applied trading. The net result is the same. People normally lose money when they trade options.

JC: If that’s the case, why would you suggest that all traders use options?

WC: Simple. I feel that all traders can correctly use options. The operative word is “correctly.”

JC: OK. Easily said. I’d love to hear some examples, though.

WC : Sure. Let’s establish things on the buy side first. When you buy an option you have to be 100% correct on three fronts:

  1. Market direction –you must accurately predict the direction in which the market will move.
  2. Time frame of the expected move –not only must you accurately predict the direction, but since options lose value as time moves forward, you must also be accurate about the time frame.
  3. Magnitude of the move –this is the one variable that too many traders ignore. Even if you’re right about the direction and the time frame, you also need to make sure the market will move enough to cover the cost of the option, and turn a profit.

JC: Thank you. Now, let’s assume we want to buy a crude oil option, how would you approach this market and how would you determine exactly what option to buy?

WC: Before I enter any market, I take several days, sometimes weeks, getting to know how and why it moves. I don’t believe that “a chart is a chart.” Each market has its own distinctive personality that I feel must be respected and understood. Most of the people I know with that “chart is a chart” mentality tend to lose a lot of money. My next step would be to establish key support and resistance points, and the relative strength of the trend. I use a modified version of Gann lines to help establish the strength of the trend. The chart normally ends up looking like this:

JC: What are you able to gain from this chart?

WC: I’m able to gain a lot of information from this chart. Firstly, the lower end of this uptrend was at the $64 per barrel level when this chart was analyzed. I can see clearly that major support is sitting at the $59 level, and I can see the market has stalled at the $70 level twice since 2005. This uptrend looks very stable. I also know that refineries are switching over to summer blends and that often causes bottlenecks, which can lead to spikes in the market.

JC: It’s all there, isn’t it? So Ward, let me test you: what position would you take, knowing all this?

WC: I love these questions! Since I’m just looking at buying an option position, my choices are fairly limited. Working with a $10,000 account, I would either buy the June $70 call for $2000 or less if I felt the market would go significantly past the $70 mark. Since the market tends to stall around that level, I would be more inclined to buy the June $70 call for $2000 and sell the June $73 call for $1000, taking a bull call spread.

JC: What are the pros and cons of each position?

WC: I’m going to work with prices at expiry, just to keep things simple. If I just bought the call for $2000, I would need the market to go past the $72 level to break even. If the market stays flat or falls, I would run the risk of losing up to $2000. The potential profit is “unlimited,” but the maximum loss is capped. When taking the bull call spread, you are limiting your maximum loss – in this case to a maximum of $1000. Your profits are capped as well at a maximum of $3000. The reason putting a cap on profits makes sense is because a market can move only so far in a given time period. A $5 per barrel increase in the price of oil is a very real possibility, while a $50 increase in a few weeks is not likely to occur.

JC: So in this case you prefer the bull call spread, correct?

WC: Yes, it makes the most sense in this situation. It’s also a more flexible position because it gives you more exit choices, if the market moves against you.

JC: Overall buying options sounds like a good strategy, if you’re able to get all of the criteria down. What are the risks?

WC: Buying options is inherently risky. When I was a broker, many years ago, we felt buying options was a great way to control losses, but not build accounts. In any given month, 70% - 90% of all options expire worthless. With such large percentage expiring worthless, buying options can definitely be risky. Once premiums are paid, they are gone. If you missed the mark on that position, your account takes a hit. No matter how big an account may be, it can only take so many hits before being depleted.

JC: What are the alternatives? If buying options is generally a losing proposition, what should traders do?

WC: Sell options! This is where many traders run into challenges. Selling options, also called “option writing,” is an approach that too few traders understand and even fewer use. It can be very profitable and consistent, but it MUST be done with a strategist or broker who has a lot of experience.

JC: Certainly there are courses available for traders to take. Why not just take one of the higher quality courses and get a good foundation?

WC: I know there are a lot of courses out there; some of them are quite good, actually. That said, when writing options, your biggest foe is yourself. The money comes into your account so quickly that it becomes hard to stay objective. I will not let my clients write options unless they can show me they have six months of successful writing under their belts. When writing options, you need that long-term support or the losses can add up very quickly.

JC: Let’s get specific: how does option writing work?

WC: It’s actually not too hard to execute. All you need is to analyze a market and then write options at levels you feel it will not reach before the option’s expiry. I like to say this approach to trading is “deceptively simple.”

JC: It sounds simple enough. Can you give me an example?
WC: Let me show you how “simple” it can be. I’m going to surprise you in the end though.

JC: Go right ahead. I like surprises, especially where profits are involved.

WC : Let’s take a look at this chart. Here is a market that has clearly defined support levels around the 1.2400, 1.2700 and 1.3100 levels. By looking at this chart, it would be completely reasonable to assume that this market is well on its way to retesting the high at the 1.3600 level. Since put options are sold when a market is expected to rise, most option traders would look at selling put options close to the major support area at 1.2700, or being very conservative, the 1.2400 area. With 90 days to expiration, and for the sake of this illustration, we’ll assume the 1.2700 put would bring in $2000 and the 1.2400 put would bring in $1000.

JC: To make sure I understand, I am able to sell either one of those put options and collect up to $2000?

WC: That’s correct. When you look at the chart, do you think that move makes sense?

JC: Looking at the chart, it does look like this market is in a recovery phase. The 1.2700 level looks really far away and the 1.2400 level looks like it would be a comfortable conservative bet. I think either one makes sense. Is there anything else I need to know?

WC: Good analysis. There is one more thing: for each position you want to write, the exchange is going to ask you to have $2500 in your account. For options, this is called “SPAN” margin, a requirement to write any option position.

JC: If that’s the case, I would be conservative and write one of the 1.2400 put options. I’d need at least $2,500 in an account to take the position, so $10,000 would cover it nicely. I’d be looking at a net return of 20% in three months. I think that’s a good return for so little work.

WC: Great! You’ve given our readers a working example. That’s exactly why I say option writing is deceptively simple. You would have taken that position, expecting to pull in a tidy 20% return on your money. Here is what the market did three months later:

WC: As you can see, the market was trading at 1.2045 three months later, well below the strike price of your options. This would have pushed the position into a loss. This is why practical trading knowledge is so important, and why working with a real professional can be so beneficial.

JC: I’m glad this is just an interview! OK Ward, why would my position have been such a big loss, and more importantly, what could I have done to protect myself?

WC: When you buy a call, it gives you the right to participate in any gains the market makes above the strike price of the option. Therefore when you buy a call, you want the market to go straight up. When you buy a put, it gives you the right to participate in any declines the market makes below the strike price of the option, which means you want the market to drop like a stone. When you sell an option, you want the opposite to take place. When you sell a call, you want the market to collapse and when you sell a put you want the market to skyrocket. You lost because the market fell below the strike price of your put, which was 1.2400. By selling the option, you were liable for any market moves below that price level.

JC: How could I have protected myself?

WC: The easiest way to protect yourself is to avoid getting into trouble in the first place. After that, you could have done several things, including entering the market or turning the position into a spread. This example perfectly illustrates why you need to work with an experienced professional for a longer period of time. My team, in my view, has some of the top traders and option writers in North America.

JC: Let’s clarify, option buying is normally a losing venture, but option selling is not?

WC: Exactly. Done properly, option selling can be a great way to build an account. In the example we just covered, with the right tools and guidance, you could have turned the position into a very profitable trade. I think option writing should be combined with day trades and position trades to maximize account growth potential.

JC: Do you have any examples of option trades that worked out?
WC: Yes. I have many examples of option trades that worked out. Currently I am involved in a crude oil short option position that is set to gross $1500 on about $6000 in SPAN margin. This works out to a 25% return in four weeks. I have also completed several option positions and had an 87% success rate over the course of a year.

JC: Anything else we should know?
WC: Educate yourself! Make sure you learn from an experienced trader or strategist who is willing to work with you over the long term. Education without experience is still lacking. Option writing, done properly, can contribute significantly to your account. I don’t think option writing is the best stand-alone strategy; it works better at certain points in the price cycle and it also works better in certain markets. I encourage clients to combine it with my day trading strategies.

JC: Once again, it has been a pleasure! I’m learning. So, do you think I’m on my way to those profits with your “deceptively simple” approach?

WC: Well, you’re getting there Janice, as I can see from your interview. Now all you have to do is sign up.

JC: You may have a point there. Thank you, Ward Chambers, from CFTI Trading.

WC : It was my pleasure.

About Today's Author