Sidestep These 5 Common ETF Option Mistakes

10/29/2013 8:00 am EST

Focus: OPTIONS

Price Headley

Founder and Chief Analyst, BigTrends.com

ETF options give you many ways to profit from significant movements in major sectors, and yet its leverage can be a double-edged sword for those who know just enough to be dangerous, writes Price Headley of BigTrends.com.

Let's examine the five biggest mistakes I see traders making when it comes to trading options on ETFs, and how you can see these blind spots to improve your own trading prowess.

1) Not Having a Defined Plan BEFORE You Enter the Trade
I see many traders who are reacting to market news, the latest rumor or tip, or the biggest jump for the day, hoping to get a piece of the action. In reality, there are many occasions where the risk a trade might require is simply too high by my standards relative to the potential payoff. So I pass on a number of ETF option trades if the ratio of reward-to-risk is not at least 2:1, and prefer 3:1 or higher.

When you define your plan in advance, in writing, note what price level will require you to exit the trade…NO MATTER WHAT! This is called “accepting the risk” of the trade, and the reality of trading is that good traders take their losses quickly while letting their winners run, while poor traders let their losers run too long, while jumping out of their winners for smaller gains (for fear of seeing a winner turn into a loser). Your written plan should factor in how you will “trail” your stop point as well, so that when an ETF trend does change, you exit your ETF options to capture the remainder of your profits.

2) Focusing Just on the Price of Your ETF Option
With ETF options, time is also a very important factor, as are potential changes in the volatility of the underlying ETF.

One of the key investment themes you must always remember is opportunity cost: if you have an option that's up 20% and another option is up 60%, you have left the 40-point difference on the table as a lost opportunity. Now, I don't expect perfection in my own trading, but I do expect to rotate my capital to the relatively better performers, while getting rid of the non-performers as quickly as I can within reason. Compare this to any business that carries an inventory of items for sale. If you have items you can't keep on the shelves, you're going to want more of those items for future consumption (traderspeak: keep coming back to the stocks that work best!), while items that don't sell should be cleared out of your inventory (traderspeak: exit non-movers) to make room for future goods that will be in more demand.

As a result, I often like to use a “time stop” for non-movers. Even if the option is a slight loss or breakeven but no better after a certain time frame, without violating my price stop level, I will say SAYONARA to the trade and get that capital back to move on to fresher opportunities. When you get stuck hoping for a move that just isn't coming, that can often set you up for bigger losses, both in absolute decline risk and also relative opportunity lost.

3) Loading the Boat on a “Surefire” Trading Idea
Hey, we all know we're BRILLIANT when it comes to our ETF analysis, right?! Well, I can tell you based on lessons learned the hard way early in my trading career that it doesn't matter how much you've been on a hot streak, or how much time you spent researching a given trading opportunity, there's one thing that's certain in the markets: CHANGE! The phrase “adapt or perish” comes to mind for trading success, and one of the biggest hindrances to objective decision-making occurs when you load up on an idea you are “sure” will win. Let's face it, there is no such thing as perfect certainty in trading…we're dealing with a probability game. Once you recognize this, even if you have an 80% win percentage that still leaves 20% of the time where you don't win.

So you must have a consistent capital allocation method, where you don't exceed a certain maximum threshold of risk. If that's a dollar risk value, then stick with it. Or if it's a certain percentage risk on your portfolio that you're not willing to exceed (which is my preference, no more than 10% risk at maximum for any one position within BigTrends ETF Options Trader.

4) Thinking That “Double the Leverage” on ETFs = Double the Profits on Leveraged ETF Options
Many ETF traders are confused by the leveraged ETFs and how they work compared to non-leveraged ETFs. The main point to remember is that the leveraged ETFs (where they can be two or even three times the leverage of the standard non-leveraged version) are only meant to create that leverage for that one trading day! Over time, the more volatile the moves, the more this hurts compounding. For example, if you lose -10% in one day and then make 10% the next day, are you back to even? No! You would be down -1%.

A great example of this effect over time occurred when the SPDR Financial ETF (XLF) lost more than 50%, while the “inverse” 2-to-1 bearish ETF ProShares UltraShort Financial (SKF) was up only about 3% for the full year 2008! Sure it had some incredible swings, but these vehicles are not meant to be held, but rather traded quickly. And for ETF options traders, remember that when you buy options on a 2-to-1 leveraged ETF, you're typically going to pay TWICE the PRICE for the options due to double the volatility expected. It's tough to get the best bang for your buck if you have to pay up for the option's premium, so as a result, I typically prefer options on the non-leveraged ETFs, while saving the leveraged ETFs for day trades or swing trades on the ETF itself.

5) Thinking “All or None” on Your ETF Options Trades
One of the greatest stress reducers for me is taking partial profits at pre-defined points during a trend move. Most traders are often thinking they should get out of all of a trade, or none of it. When they do get out, then they keep looking back at their trading screen to beat themselves up if they were wrong, or gloat if they were right. To me, this is not only ego-based thinking (your desire to be proven right, which is not directly correlated with the proper trading mentality to be willing to take quick small losses while letting winners run), but it is also wasted energy—you want to move your attention and your focus on the NEXT opportunity.

So what I like to do is place an open order to exit HALF my position if and when the option hits a certain level of % gain (which I often only cancel if I get another exit rule triggered before this price is reached), which gets back some of my risk capital and lets me stay with the best trend moves without any emotional worry once some of my initial risk money is back in my pocket.

These quick fixes for some classic ETF options trading mistakes will allow you to follow a more defined system that will prevent you from agonizing over any trade, simply by having a clear set of rules to guide you through any market turbulence.

As Rudyard Kipling noted in his poem If…“If you can keep your head when all about you are losing theirs…you'll be a Man, my son!” Following a rules-based method truly will allow you to not only retain your sanity and effectiveness amid the chaos, but also will help you be a winner in the ETF options race.

By Price Headley, Founder and Chief Analyst, BigTrends.com

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