25 Option Lessons Learned the Hard Way

05/13/2015 8:00 am EST

Focus: OPTIONS

Dr. Bill Burton reflects on his career spanning more than two decades in order to identify a bounty of valuable lessons learned from inevitable mistakes and losing trades.

The human brain is a wonderfully complex organ that is masterfully organized in both structure and function. To the observer first studying its anatomy, the most readily appreciable feature is the complex topographical organization of the external cortical surface of the frontal lobes, where higher levels of thinking occur.

The external surface is thrown into broad serpentine ridges (gyri) separated by deep narrow grooves (sulci). I always thought it an apt metaphor that knowledge gained by experience made the grooves more complex, much as the experience gained in life is often reflected in a deeply furrowed brow.

These things I learned the hard way:

  1. Ancient Chinese philosophers realized that with great danger often comes great opportunity. This nexus is further reinforced by the fact that the Chinese character representing both danger and opportunity is the same. Remember that only those who possess and use the necessary skills to survive the period of great danger are in position to profit from great opportunity. Risk control is paramount.
  2. The extrinsic (time) component of the option premium goes to zero at option expiration. Always.
  3. Although statisticians would argue, the probability of occurrence of an extremely unlikely event is much greater if you "bet the farm" on the event not occurring. Never forget that black swans do exist.
  4. The human brain is not inherently logical. It evolved for survival and is prone to make erroneous assumptions and draw incorrect associations. To guard against these potentially costly errors, continuously challenge your assumptions.
  5. Thinly traded options are usually characterized by egregious bid/ask spreads. You may be able to negotiate acceptable spreads to enter the trade. You will not be able to do so if you need to exit. It is usually better to stay away from these snares.
  6. Option orders executed as spreads always receive better fills than individually placed orders.
  7. Failure to consider current implied volatility (IV) in an historic framework for the particular underlying will usually cost you money.
  8. Failure to follow predicted changes in volatility prior to a known event (e.g. earnings) indicates there is some factor of which you know not. When discovered, it usually impacts your position negatively.
  9. Failure to use and understand option modeling and option modeling software puts you at a significant competitive disadvantage to other participants in the options market. The only thing more expensive than having appropriate tools is not having them.
  10. It is stunningly easy to "roll more than you can smoke." It is usually disastrous to attempt to smoke all you rolled if you find yourself in these circumstances. This is another reason to model trades and crisply define risk.
  11. If you create multi-legged option beasts by manually entering the orders as opposed to entering from a graphical presentation, you will enter positions incorrectly and end up "upside down" and commit other similar errors more often than you thought possible.

    You must monitor the magnitude of extrinsic value when short options are in the money (ITM). Failure to do that, and considering your trade plan in light of these developments, will result in unanticipated early assignment at the most inopportune times. Option positions can be easily adjusted to improve their structure only before they enter the ICU.
  12. Forgetting to honor time stops when holding certain varieties of option beasts can be as costly as forgetting price and/or P&L stops.
  13. Good traders know what they know; great traders also know what they don't know.
  14. If you don't understand the trade and its structure, you will lose money.
  15. Buying out-of-the-money (OTM) options as a single position (as opposed to representing one of several legs of a spread) is almost always a bad idea.
  16. Keep your trade sheets tidy. Allowing short options with minimal value to remain on your sheets as opposed to closing them for trivial cost is not being frugal; it is denying the existence of unforeseen and unforeseeable risk.
  17. When trading options, as in life in general, you will make many errors. Each mistake contains a lesson. Study your mistakes and learn the lesson each teaches. You already paid for the instruction.
  18. Pickpockets prowl the option markets with great regularity. Their bread and butter trade is buying ITM options for less than the intrinsic value. Never sell an option for less than intrinsic value. Be aware of "Plan B" to capture the entirety of the intrinsic value.
  19. If all you have is a hammer, everything looks like a nail. The available option strategies are numerous and designed to accommodate a variety of market conditions. If you limit yourself to one or two strategies, you are not taking full advantage of the inherent flexibility of options. Learn several strategies, their nuances, and indications for their use.
  20. Avoid having open option positions on stocks that will split. Option trading has adequate complexities without dealing with non-standard strikes and changes in contract size resulting from splits. Your head will explode trying to deal with these complications. Avoid them like swine flu; spend your energy elsewhere.
  21. Understanding the various concepts of volatility is essential for success. Volatility can be considered in light of: 1) What was (SV, statistical volume, HV historical volume); 2) What is; and 3) What shall be (IV, implied volatility, Market Implied Volatility (MIV); confusingly disparate words and acronyms signifying identical concepts)
  22. Of these three, IV is by far the most important. The nexus point is right here, right now. The future is unclear and always will be so. It is essential to understand IV and its various implications.
  23. Be relentless in your pursuit of perfection but accepting of the fact that you are human and will never achieve it.
  24. The first half hour of each day in the option markets is usually quite noisy; the predominant activity is fleecing the sheep. Don't be one of the sheep.
  25. Obfuscation of the basic concepts and structure of option strategies is the everyday business of the option community. The names of various strategies are multitudinous and confusing. Understand the concepts and be conversant with the various names of the strategies; success lies in analysis and execution, not nomenclature.

By Bill Burton, contributor, MarketTaker.com

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