It takes knowledge and experience to trade options successfully. One of the best ways to get the know-how that’s needed to navigate the world of options is by learning from some of the most experienced options traders around.
On September 28, 2016, Fidelity hosted an options summit featuring four well-known names in the options industry:
- Joe Burgoyne – Director of institutional and retail education for the Options Industry Council, and managing partner of Burgoyne Capital Management. Previously, Joe was a floor operations manager at the Philadelphia Stock Exchange.
- Larry McMillan – President and founder of McMillan Analysis Corporation, best known as author of Options as a Strategic Investment. Previously, Larry was a proprietary trader at two major brokerage firms.
- Marty Kearney – Options trader at the Chicago Board Options Exchange (CBOE) and senior instructor at the Options Institute.
- Dan Passarelli – Author of two books on options trading: Trading Option Greeks and The Market Taker’s Edge. Previously, Dan was a market maker on the CBOE.
For some of their insights on how to improve your options trading skills, watch the video clips and read below.
Assessing your options
Trading options is more complex than simply buying or selling a stock. Even the language of options—words like calls, puts, premium, and roll—can sound foreign at first. So, options may not be right for everyone. However, with education and experience, it’s possible to learn how these investments work, and in what ways they may help you invest the portion of your portfolio that you manage personally.
Every investment plan should include an assessment of your individual goals, risk constraints, time horizon, tax constraints, and liquidity needs. Options have unique characteristics and risks, and should be carefully considered within the context of your overall investing plan. Investors can trade options if they sign an options agreement and are accepted to trade options by a brokerage firm.
Before trading options, it’s particularly important to know how much risk you are willing to take. “For many investors, and especially those just starting out with options, it’s vital to know what kind of investor you are,” says Joe Burgoyne. “For instance, what type of risk are you comfortable with? And how thoroughly do you understand the way options work? The answers to these questions can help you decide if options are right for you, as well as the types of options strategies that might best align with your objectives and risk constraints.”
Be a nimble options investor
When it comes to options, the flip side of complexity is flexibility—to manage your positions actively and change course as needed.
“An options trade is an actively managed strategy, which is to say that you don’t want to set it and forget it,” says Greg Stevens, vice president at Fidelity and moderator of the panel discussion. “When an options trade is open, there are several choices you may make throughout the life of the contract—including closing out the trade, letting the option expire, and if you still want to be in the position, rolling it out. Of course, if you sell an option, assignment is out of your control.”
- Closing out a trade can involve taking an offsetting position. For example, if you purchased a call option, you could sell an identical call option to effectively close the trade out.
- Letting an option expire is when an option is not exercised, and is possible if you purchase or sell a call or put.
- Rolling out an option involves closing out an option that is about to expire and simultaneously purchasing a similar trade with a later expiration date.
- Assignment can happen if you sell an option—meaning you might have to receive or deliver shares of the underlying stock.
Knowing these strategies can help you better navigate an options trade. “Suppose when you learned to drive, you only did so by driving to a single destination and you always took one road,” Dan Passarelli says. “Well, what happens when that road is blocked? If you know alternative routes, you’ll be able to use them. This is analogous to investing in options, as you can take various routes with an options trade.”
Of course, before you get to these potential forks in the road, it’s critically important to know how to set up an options trade—including picking the right expiration date and selecting the right strike price.
Also, when you are setting up a trade, you should have a plan for how to exit the trade. Larry McMillan recommends using trailing stop orders applied to an option’s underlying stock, as a trigger for when to consider closing out options positions that are profitable.
“The reason I like this strategy for options trades is that, when an option’s delta [an option Greek that measures the sensitivity of an options price to the change in the price of the underlying asset] is large, the option tends to act a lot like the stock,” McMillan says. “So, the trailing stop will rise with a rising stock, providing a trigger to let you know when you might want to protect your profits and close out the options position.”
Trailing stop orders are typically set at some percentage of a security’s price. For example, if you bought a stock at $20, you might set a trailing stop order of 5%. If the stock fell 5% to $19, a trailing stop order would sell the stock. If the stock climbed to $23, the trailing stop is still in place, and the new trailing stop order to sell the stock would be 5% less than $23, or $21.85, and so forth.
McMillan is not suggesting that you need to hold both the underlying stock and the option. Rather, the trailing stop order on the underlying stock only serves as a signal as to when you may want to consider closing out the options position. Be careful though, as orders do not protect against a loss, and if you set a stop order too close to the current price, it could trigger a sell order or sell signal before you might want to exit the trade.
Learn from mistakes, learn the nuances
It can be a cliché to say that investors can learn more from mistakes and losing trades. However, this is a cliché that is grounded in reality for many of the most experienced options investors. Indeed, Dan Passarelli can still recall one specific trade, from many years ago, where a trade went in an unexpected direction, and the hard lesson he learned helped shape his strategy to this day.
“It was a scenario where I had acquired a substantial call position in a major automobile company that was planning to spin off a lot of cash to investors,” Passarelli recalls. “Well, everyone in the trading pit and I didn’t expect that the stock—and ultimately the options we owned—ended up having a lot of volatility exposure that this cash spinoff wasn’t mitigating. The lesson learned was this: The more you know about the nuances of options, the [less likely] that you run into situations that you’ve never seen before... where there’s a little quirk that can cost you a lot of money. With practice and experience, you might learn how to avoid these scenarios.”
The potential impact of dividends upon options is another one of those nuances that it’s important to be familiar with. “I always ask myself before initiating an options trade if the stock pays a dividend,” says Marty Kearney. “If it does, you have to examine if it’s close to or in the money [the option is worth being exercised] as expiration approaches. This is because, if the dividend is greater than the time value of the option [see sidebar], then the stock could be assigned [meaning the owner of the option could exercise the option in order to earn the dividend payment, and you would be forced to sell the stock].”
Fortunately, you may not necessarily get stuck with being assigned in this scenario. “You may have a choice in advance of that dividend payment,” Kearney says. “You could wait and see if the stock will be assigned, or, you could close the position and roll it out to a later month to potentially avoid assignment. In fact, almost two-thirds of all options are closed out before they expire. This is one of the many ways that you can manage your risk with options.”
Timely options strategies
“We’re in a low-interest-rate environment, and so we have a lot of clients asking about ways to potentially generate income,” says Andrew Rakowski, regional brokerage consultant at Fidelity. “At Fidelity, we believe clients should consider their investing objectives and risk constraints, build a portfolio that is allocated according to their goals, and stick with their plan. For active investors whose goals include generating income from the portion of their portfolio they manage, there are options strategies—like covered calls and cash-secured puts—that might be worth considering.”
Each options strategy is unique, and in order to put yourself in the best possible position for success, it’s critical to know the specific characteristics and risks of each position.
“For example,” adds Brian Isabelle from Fidelity’s Trading Strategy Desk, “when clients inquire about covered calls, I always stress that they should first fully understand this trade. Covered calls can help you generate income on stocks you own, but you are essentially capping the upside potential that you could earn from the stock price going higher. Moreover, you are still exposed to the risk that the underlying stock could go to zero; the premium you take in for selling calls doesn’t offset all of the potential loss you are exposed to. So, it’s important to know what you own—know your upside and downside exposure from moves in the underlying stock price.”
One tool that you can use to help generate investing ideas—including covered-call strategies—is the Trading Ideas tab on Fidelity.com’s option research page (log-in required).
Chart a path to trading options successfully
If you want to put yourself in the driver’s seat, consider making use of all the resources that are at your disposal. “For some people, options may just be too complicated,” Burgoyne notes. “However, there are many tools and resources that can help you understand options.” For instance, at Fidelity.com you can consider exploring Fidelity’s Learning Center and the options strategy guide, options research page, and also Fidelity Viewpoints options content.
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