Six Steps for Option Trading (Part 2)

06/03/2010 12:01 am EST

Focus: OPTIONS

Continued from Part 1

I often get e-mails from our students asking me to comment on their trades. In this article, I will comment on one of the most recent e-mails and give my take on it.

Hi and I hope everything is well. How about this market? Fortunately, I am long with puts and have some bear calls. Actually, I have sold some puts to buy some stocks that pay decent dividends and I was doing well until today, Thursday. They are all in the money as of today and I assume will be assigned tomorrow (or Saturday).

I have the following May puts:

ABT 48 Strike 10 Contracts Rcvd 0.33 Premium
T 25 Strike 10 Contracts Rcvd 0.17 Premium
VZ 29 Strike 10 Contracts Rcvd 0,23 Premium

Let me start by focusing on the things that this trader has done correctly. First, his intention was to own these stocks, yet instead of buying them outright, he sold ten contracts of the cash-secured put on each of these stocks. This is correct thinking. Secondly, he has done this on the front month, which is also accurate because every time we sell something, we want to do it with less than 60 days until expiry. Thirdly, his intention is to own these specific issues due to the fact that they pay high dividends, which is logical.

Now, let us move onto the other side of the spectrum and address the things that are missing. As it is evident from above, I have gotten some trade info, but not a trading plan. The only data we are given is how much of the premium was received at the point of entry and that his account must be able to accommodate this position size since his intention is to actually own the stocks. But whether the position size is appropriate for his account size is not given. Other essential information is missing. I would like to see the trading plan for each and every one of these trades. Our Online Trading Academy students know how much we emphasize the "Plan the Trade and Trade the Plan" philosophy. Each trade, regardless of whether it is a long or short, must have something that I call SET: S for the stop loss, E for the entry, and T for the target.

The stop loss is the first letter in the abbreviation and the most important one. Before jumping into a position, a trader must determine how much he or she is willing to risk. In the case above, the following question needs to be asked: "At what level do I not want to own the shares of these companies, no matter how high the dividends are?" The e-mail did not provide any of these specifics.

The second letter is E for entry. When trading options, the entry includes not only info about the premium paid/received, but also the price of the underlying.

The third letter is T for target. In this particular trade, is there a point at which the stocks will be sold for profit?

Next, let us revisit the steps that should have been taken prior to entry into any of these positions. These are the same steps that I listed in my last article, Six Steps for Option Trading.

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Step One: Fundamental Analysis
As I have mentioned before, fundamental analysis, or FA, is "what to buy," and I hope that these stocks were not selected based only on one criteria: The high-paying dividends. Other things such as the earnings release and stock splits must be checked as well.

Step Two: Technical Analysis

If the FA was the “what," then the technical analysis, or TA, is the “when," or the correct timing of trade entry. Currently, as the broad market is in a downtrend with no clear sight of where it could stop, this may not have been the best time to get into any long-term positions, dividends or not.

Step Three: Implied Volatility

Having the specifics about how much premium was received indicates that they were rather "juicy." Nevertheless, the high premium does not mean that it was the right time to own these issues, which then goes back to the step two, technical Analysis. In the implied volatility (IV) stage, you must select the option strategy that matches the market environment as well as the timing.

Step Four: Proper Position Sizing

It is impossible for me to comment on the correct position sizing for this trade since the student doesn't give those specifics. Suffice it to say that your position sizing should be relative to your account size and market conditions.

Step Five: Entry and Active Monitoring

As with any trade, we cannot just place them and never look at them with the exception of the time when the dividends are paid out. A stop loss needs to be in place, as well as a target or trailing stop loss. There needs to be a point when the position will be exited either in terms of time or price. Many times, when the students are talking about buying shares of a stock, they do not have a (vertical) price target, or a (horizontal) time target. They just want to hold the stocks for a long time and there is no vertical target at which to take profits. When I challenge them to have a horizontal target, they get that confused look on their faces. For instance, if they want to pass the shares of stocks onto their children, there still needs to be some kind of exit plan.

Step Six: Exit and Learn from It

There are several possible exit plans for this trade that should be in place in the trading plan.

  1. If the stock never drops below the strike prices of the sold puts, then they expire worthless and the trader keeps all of the premium.
  2. If the stock has been assigned, and as long as the price stays above the stop loss, simply sell the shares after receiving the dividend.
  3. If the stock has been assigned, continue holding onto the stock and keep receiving the dividends from it until it hits either the stop loss or the profit target.

Having gone through all the steps, let us look at the bottom line of what happened utilizing the May expiration close as a gauge to know which of these stocks our trader ended up owning. These are the closing prices:

ABT sold 48 and it closed @ 46.98 - assigned
T sold 25 and it closed @ 24.69 - assigned
VZ sold 29 and it closed @ 27.96 - assigned

At the time of writing this article, each of these issues had gone lower, as the cautions discussed in steps three and four indicated could happen. The trader would then need to follow the appropriate actions, as written in his/her trading plan for owning the stock.

In conclusion, we have emphasized the importance of having a trading plan, and in addition, the six steps that I personally take in my trading plans were utilized.

Trade safe and trade green!

By Josip Causic, instructor, OnlineTradingAcademy.com

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