Trade Smarter, Not More

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How to Avoid the Top 10 Mistakes in Option Trading

When trading options, it’s possible to profit if stocks go up, down, or sideways. You can use option strategies to cut losses, protect gains, and control large chunks of stock with a relatively small cash outlay.

Sounds great, right? Here’s the catch.

You can also lose more than the entire amount you invested in a relatively short period of time when trading options. That’s why it’s so important to proceed with caution. Even confident traders can misjudge an opportunity and lose money.

This covers the top 10 mistakes typically made by beginner option traders, plus expert tips from our inhouse expert, Brian Overby, on how you can trade smarter. Take time to review them now, so you can avoid taking a costly wrong turn.

Top 10 Mistakes Beginner Option Traders Make (Click to watch how to trade smarter now!):

Why even bother trading options?

#1 Option Trading Mistake: Buying Out-of-the-Money (OTM) Call Options

Buying OTM calls outright is one of the hardest ways to make money consistently in option trading. OTM call options are appealing to new options traders because they are cheap.

It seems like a good place to start: Buy a cheap call option and see if you can pick a winner. Buying calls may feel safe because it matches the pattern you’re used to following as an equity trader: buy low and try to sell high. But if you limit yourself to only this strategy, you may lose money consistently.

Watch this video to learn more about buying OTM call options.

How to Trade Smarter

Consider selling an OTM call option on a stock that you already own as your first strategy. This approach is known as a covered call strategy.

What’s nice about covered calls as a strategy is the risk does not come from selling the option when the option is covered by a stock position. It also has potential to earn you income on stocks when you’re bullish but are willing to sell your stock if it goes up in price. This strategy can provide you with the “feel” for how OTM option contract prices change as expiration approaches and the stock price fluctuates.

The risk, however, is in owning the stock – and that risk can be substantial. Although selling the call option does not produce capital risk, it does limit your upside, therefore creating opportunity risk. You risk having to sell the stock upon assignment if the market rises and your call is exercised.

Want to develop your own option trading approach? Check out our free section for beginners, experienced, and experts.

#2 Option Trading Mistake: Misunderstanding Leverage

Most beginners misuse the leverage factor option contracts offer, not realizing how much risk they’re taking. Often, they are drawn to buying short-term calls. Since this is the case so often, it’s worth asking: Is the outright buying of calls a “speculative” or “conservative” strategy?

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Before you answer the speculative-or-conservative question about long calls, consider the theoretical case of Peter and Linda presented in the video below. They both have $6,000 to invest.

Watch this video to learn more about leverage.

How to Trade Smarter

Master leverage. General rule for beginning option traders: if you usually trade 100 share lots then stick with one option to start. If you normally trade 300 share lots – them maybe 3 contracts. This is a good test amount to start with. If you don’t have success in these sizes you will most likely not have success with the bigger size trades.

#3 Options Trading Mistake: Having No Exit Plan

You’ve probably heard it a million times before. When trading options, just like stocks, it’s critical to control your emotions. This doesn’t mean swallowing your every fear in a super-human way. It’s much simpler than that: Have a plan to work and stick to it.

You should have an exit plan, period. Even when things are going your way. Choose an upside exit point, a downside exit point, and your timeframes for each exit well in advanced.

What if you get out too early and leave some upside on the table?

This is a classic trader’s worry. Here’s the best counterargument: What if you make a profit more consistently, reduce your incidence of losses, and sleep better at night?

Watch this video to learn how to define an exit plan.

How to Trade Smarter

Define your exit plan. Whether you are buying or selling options, an exit plan is a must. It helps you establish more successful patterns of trading. It also keeps your worries more in check.

Determine an upside exit plan and the worst-case scenario you are willing to tolerate on the downside. If you reach your upside goals, clear your position and take your profits. Don’t get greedy. If you reach your downside stop-loss, once again you should clear your position. Don’t expose yourself to further risk by gambling that the option price might come back.

The temptation to violate this advice will probably be strong from time to time. Don’t do it. You must make your plan and then stick with it. Far too many traders set up a plan and then, as soon as the trade is placed, toss the plan to follow their emotions.

#4 Options Trading Mistake: Not Being Open to New Strategies

Many option traders say they would never buy out-of-the-money options or never sell in-the-money options. These absolutes seem silly— until you find yourself in a trade that’s moved against you.

All seasoned options traders have been there. Facing this scenario, you’re often tempted to break all kinds of personal rules.

As a stock trader, you’ve probably heard a similar justification for doubling up to catch up. For example, if you liked the stock at 80 when you bought it, you’ve got to love it at 50. It can be tempting to buy more and lower the net cost basis on the trade. Be wary, though: What makes sense for stocks might not fly in the options world. Doubling up as an option strategy usually just doesn’t make sense.

Watch this video to learn more option strategies.

How to Trade Smarter

Be open to learning new option trading strategies. Remember, options are derivatives, which means their prices don’t move the same or even have the same properties as the underlying stock. Time decay, whether good or bad for the position, always needs to be factored into your plans.

When things change in your trade and you’re contemplating the previously unthinkable, just step back and ask yourself: Is this a move I’d have taken when I first opened this position?

If the answer is no, then don’t do it.

Close the trade, cut your losses, or find a different opportunity that makes sense now. Options offer great possibilities for leverage on relatively low capital, but they can blow up just as quickly as any position if you dig yourself deeper. Take a small loss when it offers you a chance of avoiding a catastrophe later.

#5 Options Trading Mistake: Trading Illiquid Options

Liquidity is all about how quickly a trader can buy or sell something without causing a significant price movement. A liquid market is one with ready, active buyers and sellers always.

Here’s another way to think about it: Liquidity refers to the probability that the next trade will be executed at a price equal to the last one.

Stock markets are more liquid than option markets for a simple reason. Stock traders are trading just one stock while option traders may have dozens of option contracts to choose from.

For example, stock traders will flock to one form of let’s just say, IBM stock, but options traders could have six different expirations and a plethora of strike prices to choose from. More choices, by definition, means the options market will probably not be as liquid as the stock market.

A large stock like IBM is usually not a liquidity problem for stock or options traders. The problem creeps in with smaller stocks. Take SuperGreenTechnologies, an (imaginary) environmentally friendly energy company with some promise, might only have a stock that trades once a week by appointment only.

If the stock is this illiquid, the options on SuperGreenTechnologies will likely be even more inactive. This will usually cause the spread between the bid and ask price for the options to get artificially wide.

For example, if the bid-ask spread is $0.20 (bid=$1.80, ask=$2.00), and if you buy the $2.00 contract, that’s a full 10% of the price paid to establish the position.

It’s never a good idea to establish your position at a 10% loss right off the bat, just by choosing an illiquid option with a wide bid-ask spread.

Watch this video to learn more about trading illiquid options.

How to Trader Smarter

Trading illiquid options drives up the cost of doing business, and option trading costs are already higher, on a percentage basis, than stocks. Don’t burden yourself.

If you are trading options, make sure the open interest is at least equal to 40 times the number of contacts you want to trade.

For example, to trade a 10-lot your acceptable liquidity should be 10 x 40, or an open interest of at least 400 contracts. Open interest represents the number of outstanding option contracts of a strike price and expiration date that have been bought or sold to open a position. Any opening transactions increase open interest, while closing transactions decrease it. Open interest is calculated at the end of each business day. Trade liquid options and save yourself added cost and stress. There are plenty of liquid opportunities out there.

Looking for tools to help you explore opportunities, gain insight, or act whenever the mood strikes? Check out the intelligent tools on our trading platform.

#6 Options Trading Mistake: Waiting Too Long to Buy Back Short Options

This mistake can be boiled down to one piece of advice: Always be ready and willing to buy back short options early.

Far too often, traders will wait too long to buy back the options they’ve sold. There are a million reasons why. For example:

  • You don’t want to pay the commission.
  • You’re betting the contract will expire worthless.
  • You’re hoping to eke just a little more profit out of the trade.

Watch this video to learn more about buying back short options.

How to Trade Smarter

Know when to buy back your short options. If your short option gets way OTM and you can buy it back to take the risk off the table profitably, do it. Don’t be cheap.

For example, what if you sold a $1.00 option and it’s now worth 20 cents? You wouldn’t sell a 20-cent option to begin with, because it just wouldn’t be worth it. Similarly, you shouldn’t think it’s worth it to squeeze the last few cents out of this trade.

Here’s a good rule of thumb: if you can keep 80% or more of your initial gain from the sale of the option, you should consider buying it back. Otherwise, it’s a virtual certainty. One of these days, a short option will bite you back because you waited too long.

#7 Options Trading Mistake: Failure to Factor Upcoming Events

Not all events in the markets are foreseeable, but there are two crucial events to keep track of when trading options: earnings and dividends dates for your underlying stock.

For example, if you’ve sold calls and there’s a dividend approaching, it increases the probability you may be assigned early if the option is already in-the-money. This is especially true if the dividend is expected to be large. That’s because option owners have no rights to a dividend. To collect, the option trader must exercise the option and buy the underlying stock.

Watch this video to learn how to prepare for upcoming events.

How to Trade Smarter

Be sure to factor upcoming events. For example, you must know the ex-dividend date. Also steer clear of selling options contracts with pending dividends, unless you’re willing to accept a higher risk of assignment.

Trading during earnings season typically means you’ll encounter higher volatility with the underlying stock – and usually pay an inflated price for the option. If you’re planning to buy an option during earnings season, one alternative is to buy one option and sell another, creating a spread. (See Mistake 8 below for more information on spreads).

#8 Options Trading Mistake: Legging into Spreads

Most beginning options traders try to “leg into” a spread by buying the option first and selling the second option later. They’re trying to lower the cost by a few pennies. It simply isn’t worth the risk.

Sound familiar? Most experienced options traders have been burned by this scenario, too, and learned the hard way.

Watch this video to learn more about legging into spreads.

How to Trade Smarter

Don’t “leg in” if you want to trade a spread. Trade a spread as a single trade. Don’t take on extra market risk needlessly.

For example, you might buy a call and then try to time the sale of another call, hoping to squeeze a little higher price out of the second leg. This is a losing strategy, if the market takes a downturn, because you won’t be able to pull off your spread. You could be stuck with a long call and no strategy to act upon.

If you are going to try this strategy, don’t buy a spread and wait around, hoping that the market will move in your favor. You might think that you’ll be able to sell it later at a higher price. That’s an unrealistic outcome.

Always, always treat a spread as a single trade. Don’t try to deal with the minutia of timing. You want to get into the trade before the market starts going down.

Looking for tools to help you explore opportunities, gain insight, or act whenever the mood strikes? Check out the intelligent tools on our trading platform.

#9 Options Trading Mistake: Not Knowing What to Do When Assigned

If you sell options, just remind yourself occasionally that you can be assigned early, before the expiration date. Lots of new options traders never think about assignment as a possibility until it happens to them. It can be jarring if you haven’t factored in assignment, especially if you’re running a multi-leg strategy like long or short spreads.

For example, what if you’re running a long call spread and the higher-strike short option is assigned? Beginning traders might panic and exercise the lower-strike long option to deliver the stock. But that’s probably not the best decision. It’s usually better to sell the long option on the open market, capture the remaining time premium along with the option’s inherent value, and use the proceeds toward purchasing the stock. Then you can deliver the stock to the option holder at the higher strike price.

Early assignment is one of those truly emotional often irrational market events. There’s often no rhyme or reason to when it happens. It just happens. Even when the marketplace is signaling that it’s a less-than-brilliant maneuver.

Watch this video to learn about early assignment.

How to Trader Smarter

Think through what you’d do when assigned well ahead of time. The best defense against early assignment is to factor it into your thinking early. Otherwise it can cause you to make defensive, in-the-moment decisions that are less than logical.

It can help to consider market psychology. For example, which is more sensible to exercise early? A put or a call? Exercising a put or a right to sell stock, means the trader will sell the stock and get cash.

Also ask yourself: Do you want your cash now or at expiration? Sometimes, people will want cash now versus cash later. That means puts are usually more susceptible to early exercise than calls.

Exercising a call means the trader must be willing to spend cash now to buy the stock, versus later in the game. Usually it’s human nature to wait and spend that cash later. However, if a stock is rising, less skilled traders might pull the trigger early, failing to realize they’re leaving some time premium on the table. That’s how an early assignment can be unpredictable.

#10 Options Trading Mistake: Ignoring Index Options for Neutral Trades

Individual stocks can be quite volatile. For example, if there is major unforeseen news event in a company, it could rock the stock for a few days. On the other hand, even serious turmoil in a major company that’s part of the S&P 500 probably wouldn’t cause that index to fluctuate very much.

What’s the moral of the story?

Trading options that are based on indexes can partially shield you from the huge moves that single news items can create for individual stocks. Consider neutral trades on big indexes, and you can minimize the uncertain impact of market news.

Watch this video to learn more about index options for neutral trades.

How to Trade Smarter

Consider trading strategies that could be profitable when the market stays still like a short spread (also called credit spreads) on indexes. Index moves tend to be less dramatic and less likely impacted by the media than other strategies.

Short spreads are traditionally constructed to be profitable, even when the underlying price remains the same. Therefore, short call spreads are considered “neutral to bearish” and short put spreads are “neutral to bullish.” This is one key difference between long spreads and short spreads.

Remember, spreads involve more than one option trade, and therefore incur more than one commission. Keep this in mind when making your trading decisions.

Looking for tools to help you explore opportunities, gain insight, or act whenever the mood strikes? Check out the intelligent tools on our trading platform.

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Comment on this article

Comments

MUHAMMAD N. on March 13, 2020 at 9:14am

Portela on May 10, 2020 at 8:26am

“Trading OTM calls is one of the most difficult ways to make money consistently” Really? Who cares about making money consistently. I bought OTMs (puts and calls) for the past 8 years in Brazilian market. In one of the assets I made 92 operations (buying otm puts). I lost money in 88 of those. But the profit I made in the other 4 was enough to give me a return of 291% at the end of the 8 years. This is equivalent to 18.6% each year! So, tell me more about not buying OTMs.

Don on July 26, 2020 at 10:13am

I trade OTM too its hard but theres good returns if your right specially when you strangle making the market maker a lot nervous

ISHWAR C. on September 19, 2020 at 11:11am

In fact OTM option is cheaper than ATM and ITM option.most appropriate reason for preferring OTM is its cost factor.Those who know that buyers of cheaper articles have to cry time and again and the buyer of dearer article has to cry only once,never go to OTM option rather they prefer ITM and ATM .However keeping in view the cost ATM is advised. As one analyses the trend with the stages upward/downward and expects a desired level in a direction ,for immediate result ATM is best suited.Though it is less lucrative in comparison to ITM but it is best with respect to cost factor.

Donald H. on October 25, 2020 at 3:07pm

Good info for the beginner but I would like to see an example with real values as well as what the minimum dollar amount would be .

Ally on November 1, 2020 at 11:41am

Thanks for that feedback, Donald. We’ll pass your request along to the team!

Susan S. on July 16, 2020 at 9:06am

What is Brian Overby’s email? Can’t get the link to work.

Jk on October 19, 2020 at 4:01pm

Great article. just found out how many mistakes I made!

Ally on October 28, 2020 at 3:37pm

Hi Jk, so happy to hear that you found this helpful. Thanks for reading!

Todd on January 15, 2020 at 8:26am

It was helpful, however, I feel that it was lacking examples and knowing what your goal or object was besides making the money. Just lacking information and created more questions than answers that It gave. But at the same time this course is based on the top 10 mistakes and pointing them out. So looking at it from that standpoint, I guess I got it.

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Trade Smarter, Not More

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Why is Forex filled with so many scam teachers? Because these teachers realize that taking exorbitant fees for their classes is like taking candy from a baby. Few people ask the critical questions we recommend to determine a teacher’s credibility before signing up. Why? Because most of the forex teachers are selling the dream of easy money, and the allure of making so much money drowns out the voice of reason and caution. Their sales pitch fuels our dreams of finding an easy way to get rich and our hope makes us blind to the failings we would otherwise see.

Before signing up for your next course, you need to extricate yourself from the blinding effects of that yearning long enough to ask all of these questions that we are outlining for you. That way you can tell the difference between the true forex mentor whose intention is to give you the tools you need to successfully trade forex from the “miner” who focuses on harvesting your class fees as their personal gold mine.

(We began this series of questions two issues ago. Here are the links in case you missed them or want to refresh your memory.
Forex Mentor or Miner? Which Is Your Forex Teacher?
How Forex Teachers Scam You – Revealed Here”

In this issue we want to point out how forex teachers often say one thing and then do something else, particularly when it comes to money management.

7. How much of the teacher’s instruction covers money management?

If the answer is 0-30 minutes, you know right there and then that you are talking to a “miner” and not a mentor because that reveals that they are not thinking of your long term success, which has to be based on understanding the principles of money management. They just want to get you in the door, get your course fees and wish you well. When you turn around and lose your money trading, don’t worry, they have lots more students waiting in line to take your place.

If your teacher says they teach money management and then hands you a spreadsheet or handout that simply shows you how many lots to trade at different equity levels (ex: 0-$10,000, trade 1 lot; $10,000-$20,000, trade 2 lots, etc.), do not think that you’ve just been taught money management. Just the opposite! Your teacher is revealing that they don’t understand adaptive position sizing and they don’t think you’re smart enough to notice that different stop sizes drastically impact how much you might make or lose on a trade by trade basis. To use the same position size regardless of the stop used or currency pair traded is “Money Management for Dummies”.

A good position size calculator makes it so easy and fast to accurately adapt your position size to your trade. Think about why your teacher wouldn’t want you to be using this kind of tool.

On the other hand, if your teacher spends time discussing money management, tip your hat to them, because it’s not easy to teach. Trust us – We know from our own experience that making people aware of its importance is an uphill battle! People struggle with the idea that first they have to know how much money they might lose before they can move on to how much they might gain by using correct position sizing. It’s definitely not the sexy part of trading. If your teacher spends time explaining it, then they must really have your best interest at heart.

A forex miner who is just out for your money will never touch money management education because they’re all about attracting “fresh meat” and this part of trading is not the glamorous part, even though it’s the most critical component along with psychology (they usually won’t touch upon this subject either).

[By the way, if you don’t have that foundation of education in money management from anyone else yet, be sure to spend extra time on the videos we offer as part of our private membership area of the Forex Smart Tools site, and please – make sure you are using the Calculator before you place a single trade.]

If your teacher passes out one of their own trading statements or one of their student’s statements showing unusually high returns, remember that they’re trying to get you to look at the bottom line profit. They’re manipulating your attention right where they want it and pandering to greed. Pull out your Forex Smart Tools position size calculator and quickly figure out what kind of money management is being used. You can reverse engineer their trades to see what percent of their account they are risking per trade (risk profile). If it’s in line with what they are recommending in the class, that’s great and highly commendable. This kind of honesty is also very rare.

We mention this because reverse engineering is something that we always do. Almost every time we’ve been given a statement from a teacher, it turns out that an outrageous risk was being used to generate the profits being bragged about. One time we went over each and every trade that had been listed on a statement like this and saw that the trader was only 2 pips away from a margin call on more than 1 trade and was only able to pull off the phenomenal returns shown because they were on a 500:1 broker. Many of their trades would have blown up their account on any broker offering less aggressive leverage.

Not sure how to ‘reverse engineer’ a trade? It’s an important skill to have, so let’s walk through this example. If you were presented a statement like this:

The teacher wants you to see how profitable the trades are. But what risk was used to get this ‘great’ trade?

Step 1: Locate the same trade on your chart. If the entry and exit times don’t line up with the prices you see on your own charts, then you know that the GMT offset must have been a little different for the broker that was used. Simply shift the entry and exit times a few hours to the left or right until the candles or bars match up or see if you can open a demo account on the same broker that was used and plot the trade there. Here is the trade shown in this statement – click it to expand it larger:

Step 2: Look at the chart and measure how many pips the trade went in the opposite direction (drawdown) before profit was seen. In this particular trade we see that a buy was entered at 0.8810 and price dipped to 0.8730 before going up to take the profit shown on the statement. Remember that the statement hides critical information like how much the trade went against you before going to profit. This particular 80 pip drawdown doesn’t show up on the statement does it?! You have to look at a chart and measure the candles in order to see it. There are many strategies that use large stops, so just seeing an 80 pip move against the trade is not a problem in and of itself. What you have to determine is what risk was used. For that, go to the next step.

Step 3: Back out the profit shown to know what the equity was before the trade was taken. In this example we see an ending balance of $14,316. If we subtract the $3,796 profit we see that the balance before the trade was taken was $10,520.

Step 4: Open your position size calculator or spreadsheet and do the math so you can see what risk was taken for the given lot size shown. If you own the Forex Smart Tools Calculator, this is easy to do. Begin on the Setup tab and enter the starting equity, $10,520. Then go to the ‘trade plan’ tab – We show a condensed version of it here (click it to see the full sized version):

First enter the same number of lots you see on the statement you are analyzing, and then the entry price. You may not see a stop price on the broker’s statement, and even if you do, it may not be the stop used when the trade was first taken. The broker prints the stop loss at the time the trade is closed and the stop might have been moved during the trade many times – or perhaps a stop wasn’t even used! So for the stop value, use the most extreme point of the drawdown, which in this case was 0.8730.

The column in red at the bottom of the trade plan tab reveals the truth. If the trade had triggered a margin call or been closed by the trader at the extreme point of drawdown, it would have blasted a 21% loss in this trader’s account, instead of the attention-grabbing 36% gain the teacher was eager for you to see. Is that a level of risk that you would be comfortable taking? Is that a level of risk that this teacher would condone?

This is the kind of deep research you need to do on any teacher you are thinking about studying with. Don’t be scammed!

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What is Mixpanel

MixPanel is a leading product analysis, that lets you track how people behave in your mobile or web application.

Benefits of using Mixpanel

MixPanel enables you to discover how people use your application. By doing so, you can get the most relevant data you need to improve your app’s performance with mobile & web analytics. Measure engagement. With MixPanel you can measure the user’s engagement with your app, by tracking time spent on it and actions people take.

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Mix Panel tools let you understand every user’s journey. Advanced stats will give you an overview of the strengths and weaknesses of your app, in order to decide your next improvement to grow your business. Increase customers’ retention Mix Panel allows you to increase retention and get customers come back to by using email and push notifications. Moreover, with MixPanel you can track sources of web traffic, measure events and page views.

What is Trade Smarter

Trade Smarter is a technology provider offering B2B solutions for the retail derivatives trading industry, as well as electronic trading platforms and CRM & Back Office systems. Leveraging the latest technologies and a unique user interface, allows you to easily implement the code on mobile and web applications around the world. TradeSmarter is currently based in Singapore, with research and development offices throughout Europe and the Middle East, as well as the Bangkok office.

Benefits of using Trade Smarter

TradeSmarter offers: FinTech solutions for Forex, CFD, CRM solution, White Label Solutions, MT4 / MT5 bridge providers, Risk Management, Development Companies and brokers tools. Borrowing from the social trading structure we have in the forex market, Tradesmarter has implemented a social trading engine on its white-label solutions. This feature allows traders to visualize the trade positions of other experienced traders, witness their trade decisions and decide which to copy on their own accounts so as to replicate a trader’s potential success.

Why should I use Trade Smarter

With Trade Smarter You can sell your active option back to the broker just prior to the expiry time. This enables traders to lock in profit when their position is in-the-money and the outcome of the trade is not certain. It can also be used as a form of stop loss if their position is out-of-the-money and the perception is that the outcome is not going to change. Trade Smarter platforms now feature a hedging tool which allows for reverse trading as expiry times approach. You can invest the same amount in the opposite direction to your open positions. The investment amount, asset and expiry time are all the same and are based on the current asset price and payout.

Trade Smarter With Equivalent Positions

How can two trades have the same risk and reward when they look so very different?

That’s the frequent response when investors first learn that every option position is equivalent to a different option position. For clarification, “equivalent” refers to the fact that the positions will earn/lose the same amount at any price (when expiration arrives) for the underlying stock. It does not mean the positions are identical.

Of all the ideas that a rookie options trader encounters, the idea of equivalence is a real eye-opener. Those who grasp the significance of this concept have an increased chance of succeeding as a trader. (See also: Investopedia Academy’s Options for Beginners.)

Different But Equal

Let’s begin with an example, and then we’ll discuss why equivalent positions exist and how you can use them to your advantage. And it is an advantage. Sometimes you discover that there’s an extra $5 or $10 to be earned by making the equivalent trade. At other times, the equivalent saves money on commissions.

There are two commonly used trading strategies that are equivalent to each other. But you would never know it by the way stock brokers handle these positions. I’m referring to writing covered calls and selling naked puts. (See also: Understanding Option Pricing.)

These two positions are equivalent:

  1. Buy 300 shares of QZZ
    Sell 3 QZZ Aug 40 calls
  2. Sell 3 QZZ Aug 40 puts

What happens when expiration arrives for each of these positions?

Buying the Covered Call:

  • If QZZ is above 40, the call owner exercises the options, your shares are sold at $40 per share, and you have no remaining position.
  • If QZZ is below 40, the options expire worthless and you own 300 shares

Selling the Naked Puts:

  • If QZZ is above 40, the puts expire worthless and you have no remaining position.
  • If QZZ is below 40, the put owner exercises the options and you are obligated to purchase 300 shares at $40 per share. You own 300 shares.

Trade Conclusion

After expiration, your position is identical. For those who are concerned with details (and option traders must be concerned) the question arises as to what happens when the stock’s final trade at expiration is 40. The answer is that you have two choices:

  1. Do Nothing
    You can do nothing and wait to see whether the option owner allows the calls to expire worthless or decides to exercise. This places the decision in the hands of someone else.
  2. Repurchase the Options
    Before the market closes for trading on expiration Friday, you can repurchase the options you sold. Once you do that, you can no longer be assigned an exercise notice. The goal is to buy those options for as little as possible, and I suggest bidding 5 cents for those options. You may want to be more aggressive and raise the bid to 10 cents, but that should not be necessary if the stock is truly trading at the strike price as the closing bell rings.

If you do buy back the options sold earlier, you may write new options expiring in a later month. This is a common practice, but it’s a separate trade decision.

The positions are equivalent after expiration. But does that show that the profit/loss is always equivalent? No, it doesn’t. But the truth is that options are almost always efficiently priced. When priced inefficiently, professional arbitrageurs arrive on the scene and trade to take the “free money” offered. This is not a trading idea for you. Instead, it’s a reassurance that you will not find options misspriced too often. The available profit from these arbitrage opportunities is very limited, but the “arbs” are willing to take the time and effort to frequently earn those few pennies per share. (See also: Arbitrage Squeezes Profit From Market Inefficiency.)

Proof

To determine if one position is equivalent to another, all you need to know is this simple equation:

This equation defines the relationship between stocks (S), calls (C) and puts (P). Being long 100 shares of stock is equivalent to owning one call option and selling one put option when those options are on the same underlying and the options have the same strike price and expiration date.

The equation can be rearranged to solve for C or P as follows:

C = S + P
P = C – S

This gives us two more equivalent positions:

  1. A call option is equivalent to a long stock plus a long put (this is often called a married put).
  2. A put option is equivalent to a long call plus a short stock.

From the last equation, if we change the signs of each attribute, we get:

-P = S – C, or a short put equals a covered call

As long as you are cash-secured, meaning you have enough cash in your account to buy the shares if you are assigned an exercise notice, there are two very practical reasons for selling a naked put:

  1. Reduced Commissions
    The naked put is a single trade. The covered call requires that you buy stock and sell a call. That’s two trades.
  2. Exiting the Trade Prior to Expiration
    Sometimes the spread turns into a quick winner when the stock rallies way above the strike price. It’s often easy to close the position and take your profit easily when you sold the put. All you must do is buy that put at a very low price, such as 5 cents. With the covered call, buy the deep-in-the-money call options. Those usually have a very wide market and there is almost no chance to buy that call at a good price (and then quickly sell the stock). Thus, the strategic edge belongs to the put seller, not the covered call writer.
    1. Sell ZXQ Oct 50/60 Put Spread = Buy ZYQ Oct 50/60 Call Spread
    2. Sell JJK Dec 15/20 Call Spread = Buy JJK Dec 15/20 Put Spread
    3. Sell XYZ Nov 80/85 Put Spread = Buy 100 XYZ; Buy one Nov 80 put; Sell one Nov 85 call
  3. Other Equivalent Positions
    These positions are equivalent only when the options have the same strike price and expiration date.
    Selling a put spread is equivalent to buying a call spread, so:
    Selling a call spread is equivalent to buying a put spread, so:
    Selling put spread is equivalent to a buying collar. so:
    To convert a call into a put, just sell stock (because C – S = P)
    To convert a put into a call, just buy stock (because P + S = C)

The Bottom Line

There are other equivalent positions. In fact, by using the basic equation (S = C – P) you can find an equivalent for any position. From a practical perspective, the more complex the equivalent position, the less easily it can be traded. The idea behind understanding that some positions are equivalent to others is that it may help your trading become more efficient. As you gain experience, you will find it takes very little effort to recognize when an equivalent is beneficial. It just takes a little practice thinking in terms of equivalents. (See also: Option Spreads Tutorial.)

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