Last week on Schaeffers Market Mashup Henry Schwartz, Senior Director, Head of Product Intelligence, Cboe Global Markets, and Robert Hocking, Senior Vice President, Head of Multi-Asset Solutions and Derivatives Strategy, stopped by to discuss the biggest mistakes options traders made at the beginning do. They discussed the lessons they would teach their former self, the five most common mistakes he sees in options traders (4, the wider surge in retailer market participation, and how to educate yourself).
Below is the transcript of the first half of their conversation about the most common mistakes options traders make when getting started. To hear the rest, click the Spotify link below.
Let’s jump into the DeLorean for a second. What would you say to the younger you when you started trading options?
Robert: Let’s get to the river capacitor! The only advice I would give is to just be patient with the learning curve and really dive into that much Educational materials as you can find. When I first stepped into the options world, it was intimidating. Unlike stocks that go up and down, now you have to learn a whole new Greek language. Things like gamma, theta, vega, and how each affects your position. It takes time to get used to these new inputs and concepts. I’ve found that learning is phased. In the first phase you learned the basics of communication. In the second phase, you can anticipate how a position would develop if the underlying asset moves. In the third phase, you can begin to actively position yourself and take advantage of these anticipated steps. This leads to the final phase in phase four, and you can begin developing specific strategies for your desired outcomes. The process takes time, you can’t really hurry and you have to be patient. Hurrying can really lead to undesirable results.
Henry: Finding a good mentor and working really hard at surrounding yourself with people and resources to learn is one of the most important things.
Power ranking is on everyone’s lips these days. Let’s try power ranking, the five most common mistakes options traders make.
Robert: I am definitely guilty of a lot of these when I got into business.
#1: I would start by not having a clear entry / exit point for your number one trade. I would really stress the exit point. I think it’s easy to keep track of different stocks and ones you like or companies you are associated with. But then you have to take that general interest and turn it into clear metrics where you get in a trade and then get out again. This applies to the establishment of criteria for winners and losers. Not all trades are winners, even if we like to believe they are.
# 2: Don’t let emotions guide your trading decisions. It helps to remove all emotions. When emotions are involved, it becomes easier to pull off your winners too soon and ride your losers longer than you should. By setting these clear entry and exit points and removing that emotional component from your trading, you can avoid questioning your decisions in the heat of the moment and play the Monday morning quarterback with your trading decisions. As a rule, this is always a losing proposition.
# 3: I want to point out that you do not fully understand the liquidity of the product you are trading before jumping into trading. With some products, it may be easier to get into a position than to take them off. By understanding the liquidity constraints of each product, you can more realistically determine those entry and exit points and the related performance that you can expect. You can be realistic about what is possible.
# 4: Misunderstandings leverage. Options offer leverage due to their 100 multiplier and sometimes appear a little cheaper compared to an actual stock. This can result in investors having larger notional option positions than they would otherwise have thought. Unfamiliarity with this component can lead to wrong decisions.
# 5: Failure to understand the impact of corporate actions and their impact on option positions. In many situations, options need to be adjusted due to stock splits, mergers and acquisitions, special dividends, reverse splits, etc. For example, if a cash dividend is paid, it will usually not affect the option. However, if a stock split occurs, this can affect the exercise price of the option. Understanding when and how these events will affect your positions is extremely important.
Henry: I also made a lot of mistakes. That is part of learning something. There are a few principles that seasoned traders have gathered. It’s the kind of stuff guys on the floor would scream that are catchy and get stuck in your head.
#1: The sizing of positions and trades. You want to be consistent in setting up your trades and how much money you want to risk and how big you want to be. You can’t give it wings!
# 2: Don’t be patient and don’t wait for the opportunity you think will come because you are impatient. You need to find everything that fits your criteria, then methodically execute a plan.
# 3: Illiquid options; You can pose a problem with how the market has evolved over the past few years. It is a very liquid market for the most part. But you need to understand when liquidity is good and when it might not be good. You have a very different outcome on a trade, or you can get stuck in something that was relatively tight when you entered and now you are suddenly in a fix. Then what’s your plan B? Can you manage or otherwise offset the trade?
# 4: Covering shorts. I’ve heard a lot in the pits; If you should buy back your short options, don’t be an idiot for a tick. That said, if an option you’re short on is down two or three cents, you should cover. There is no reason to leave the risk even if it expires tomorrow. Many broker platforms now do not charge any commission at all for ordered options, which makes it a little easier. It’s just disciplined.
# 5: Legging in spreads, which is difficult. You have a whole selection problem there. By doing this, you will better understand the risk you are taking.
Can you imagine a specific moment in the past two years when it would have been advisable to know about these mistakes?
Henry: Just in the past six months, we’ve seen insane behavior on some of these meme stocks, with things moving faster and further than most people would expect. And this is exactly where dimensioning comes into play. You can take a trade and say, “Look, there’s no way this stock is going to double through Friday.” And most of the time, it probably won’t. There’s that chance of one in a million or one in a thousand. Position sizing is just a smart way to avoid getting blown up. Strange things happen. So if you are properly disciplined and get some element of diversification by keeping your trades relatively small, it will keep you safe. This year was a great example with GameStop (GME) and AMC Entertainment (AMC). These stocks have made some really strange moves – very surprisingly, things that are practically impossible in your typical probability analysis. And the sizing of the positions is what covers your bum in those cases.
Robert: Understand what to expect and what to want, and establish this plan. Because choosing entry and exit points and removing emotions from your trading decisions is extremely important. And if you don’t set those clear boundaries on your trading positions, you could end up chasing positions or, worse worse, having your B / D close out your positions for you, which no one will ever want. But when you get into trading and look at the underlying volatility of the stock, get used to the expected moves you might see, and then set clear points to get in and out of, you are limiting yourself to those defined results and you have seldom, if ever, encountered a situation in which this outcome is unexpected.
Bernie Schaeffer’s subscribers Chart of the week received this comment on Sunday June 20th.