Tips for Managing Your Options Trades
Carley Garner of DeCarley Trading shares some of her insights into indicators, strategies, and trader psychology. The author of Currency Trading in the Forex and Futures Markets explains what she sees as some risky moves traders make, and shares some tips for potentially mitigating risk.
Kate Stalter: Today, I’m pleased to welcome back a return guest, Carley Garner of DeCarley Trading. Carley, I wanted to start out today with the big picture about options trading. A lot of equity traders and investors hear the horror stories about options, and it scares them off. But you’re actually a long-time proponent of this.
What’s a good options strategy that could be used at this juncture? There seem to be a number of ways the equity market could go at this point. Say we go into a confirmed rally on the equity markets. What would be the best way to use options in that situation?
Carley Garner: Well, the great thing about options is they can be extremely versatile. You can make an option trade or spread as aggressive or conservative as you want it to be.
Obviously, there are basically two things you can do with options: you can either buy them or you can sell them. But the beauty is, you can put together a trade that combines both buying and selling, maybe calls or puts, to accomplish one goal.
So it can get extremely complicated, obviously. But one idea of somebody that might be bullish to the S&P but they don’t want to take the risk of just buying the market outright, or buying a futures contract or whatever venue they’re trading in, they could do something that’s called basically a bull call spread with a naked leg, where you buy a call near the market.
But we all know options are really expensive and they’re priced to lose, so anytime you’re forking out a ton of money for a call option close to the money, your odds of success maybe aren’t that great. So what you want to do is, look for ways to finance that trade. You can do it somewhat conservatively, by maybe selling a call option up above and then maybe also selling a put below, to basically bring in enough premium to pay for the option you buy.
Depending on how you structure it, it might even be a free trade as far as cash outflow. But what you’re paying for is the liability, of the risk of the market really selling off sharply and causing you trouble on a short put. Because anytime you sell a put underneath the market, your risk is theoretically unlimited beneath the strike price of the put.
So basically you’re paying in risk instead of money, is really the difference, but you’re getting in-the-money call option. If you really did your homework and you feel good about the market going up, that might be a good way to play it.
One thing to point out also in a trade like that, even though you do have theoretically unlimited risk beneath the strike price of your put, you’re not necessary taking immediate risk. What I mean by that is, if you bought the market outright, whether it’s an ETF or futures contract or whatever it is, your risk is immediate. You’re immediately making or losing money as the market goes up or down.
With an options spread like this, it slows the trade down. The S&P might drop ten points. Your option spread might not lose much value, so you might be losing, but it’s not going to be nearly as much as you were losing if you just bought the market outright.
Obviously, it goes both ways. If you’re right, and the market rallies, you’re probably not going to make as much on an option spread as you would just buying the option outright, but the idea is, you’re slowing things down and you’re giving yourself a little better odds of success.
Kate Stalter: One thing that I seem to be hearing about a lot more lately: More individual investors are starting to use covered calls as part of their strategy. Are you seeing that more often, and is that something you suggest?
Carley Garner: We typically deal with the commodities side of things, and futures, and options on futures, so it’s a little bit different than in stocks. I do have a lot of traders that do covered calls in commodities or in futures. But the difference is: we’re trading on leverage, and so it doesn’t work out quite as well. It’s not nearly as conservative as a strategy as it is on the stock side of things.
Let’s say you go long the market, you sell a call, it provides you a hedge. But if the market drops sharply, you’re holding a leveraged instrument. That call is going to help you out a little bit, but it’s not nearly as exciting as it is in an unleveraged investment.
But what people do in the futures markets, instead of doing a one-for-one covered call—for example, if they buy an e-mini S&P future, they might sell two calls above or three calls above. The risk on that is obviously if the market rallies sharply, then the three calls aren’t going to keep up with your one long future, but the principle is the same.
Kate Stalter: Can you give us a couple examples of some recent trades that did work and explain why they did? Maybe a lesson here for some of our listeners today?
Carley Garner: Well, to be honest, it’s been kind of a crazy year, but we do a lot of option selling. So obviously, you have some good trades and you have some bad trades, but it’s been kind of a rough year for pure option sellers, because the volatility has been so high. We’ve seen so many periods of stagnant markets and then followed by explosions, so it’s definitely been a challenge.
Probably in recent times, a trade that we’ve done pretty decently with is in crude oil. Crude oil seems to get a lot of speculators, especially once the market starts moving. People start seeing things on the front page of The Wall Street Journal and they start seeing things on TV about crude, and they get excited. Whether it’s on the way up or the way down, it gets people excited.
So what happens is, the margin in crude oil is actually pretty hefty. So a lot of the small speculators buy options. They’ll either buy a call or buy a put, trying to speculate on prices instead of getting into the commodity itself, and what happens is those options get really expensive.
So what we look to do is, when the market whips up—like for example the last couple of days, on Friday it was up $8, today it was down $3 at one point. So there’s a lot of volatility there on both sides of the market. Sometimes the best trade on a whipsaw market like that, where prices are moving sharply, is to just sell a strangle. You can sell options deep out-of-the money. I’m not saying get real close to the fire, but $10 or more on both sides of the market, and just let the volatility die.
Because usually the market will explode, the volatility will explode, and then people either lose too much money or get scared or whatever the case is, and then the volatility sucks back in as everybody leaves the market and it goes somewhere else. So that type of trade has worked pretty well over the last several months.
Kate Stalter: Let’s talk a little bit then about some of the technical indicators. Do you advise using the VIX to understand market signals or are there other indicators that you like to use frequently?
Carley Garner: You know, I have a handful of indicators I use. I do keep an eye on the VIX, just because that kind of gives you an idea of where the panic is, and as an option seller you’re looking for panic is really what you’re doing. You’re hoping that you’re getting in while others are panicking, but you’re hoping that they don’t continue to panic, is the problem with option selling.
But the VIX is great for stock traders. They actually do have an oil VIX and a gold VIX nowadays, but I don’t think it’s nearly as helpful as the VIX on the S&P.
But what I look at are just basic technical indicators like RSI. I look at volatility measures like historical volatility, and just kind of get an idea of: Is the volatility contracting, is it declining, are markets overheated?
Once I start seeing RSI and Williams getting overheated, that’s when I start to get interested in possibly looking at selling some options against the trend, because that’s exactly when everybody kind of climaxes. Everyone gets so excited and thinks the market is going to go up or down forever, and that’s usually when it doesn’t—when it exhausts itself and turns around.
Kate Stalter: Let’s talk a little bit about your latest book, Currency Trading in the Forex and Futures Markets. One thing that has struck me as I was reading that book is that you’re very careful to caution the retail trader about what to expect in terms of actual risk and reward. I know a lot of people like to hear technical trading tips, but more and more traders, including yourself, are emphasizing some of the psychology that’s so important behind trading. What do you see as the most important element to be managed?
Carley Garner: Right. Well, the way I look at it is really, we all have the same goal, which obviously is to make money, and we all kind of have the same tools. Any charting software you get or anything you look at, you’re basically going to have statistics and Williams and MACD. Every trader in the world has access to these things.
It’s true that you can change the parameters and do all those sorts of things, but in my opinion, I don’t think that any one particular indicator is going to be the special sauce that guarantees that anyone’s going to make money. I just don’t think it works that way.
But what I do think the difference is, is not necessary the tools that you’re using, but how you use them. That really comes down to the mental stability of whether you’re on a hot streak and things are good. Letting yourself get too complacent is always a recipe for disaster, and we’re all guilty of it. Nobody’s perfect. It happens.
Then on the other side of the boat, a lot of times I see traders that they have a tendency to panic if the market has gone bad against them, they panic. You’ll notice when markets spike up or spike down, the last part of that spike is usually people that were hanging on to their trades by fingernails and torturing themselves, finally just throw in the towel and get out. Unfortunately, that’s usually the exact wrong time to get out, but that’s just how it happens.
So I think really the bottom line is being able to avoid that panic. It’s not easy to do. It’s easy for me to say that, but try and make sure that you’re not the guy that’s caught up in panic and exiting at the exact wrong time—it really makes a huge, huge difference in your trading results.
I mean, doing that and then watching the next day, the market comes all the way back for you, it’s really a nightmare. Not only do you lose money on that trade, but then going forward, it messes up your mindset and it probably follows you for a little while.