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Rookie Corner : The Next Live Trade Part III

August 9, 2018

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Hello, Rookie Traders!  This week’s blog is going to be all about attention to detail. Did any of you see what I did wrong in last week’s video?  Did you catch the error?  If you did then you can probably see how easy it is to miss a step or hit the wrong key.  In last weeks video when putting on the orders, I put less than or equal to instead of greater than or equal to.  It is that easy to make a mistake in this business and therefore we really need to slow down and review our orders and use the tools at our disposal.  TOS and most broker platforms have an automatic order checking screen before transmitting the orders and this is where we need to be diligent in going over the order and understanding what we are trying to accomplish in the trade.  These kinds of errors happen to both seasoned traders and rookie traders but typically it is more frequent for newer traders.  So despite the hiccup, the long call trade is working in our favor at this point.  We are going to review the trade and see if we need to adjust anything and this week I was asked about what a trader would do if they had a smaller account and didn’t have the capital available to buy an option that cost $16.50 per share.

Let’s first talk about what some traders do that is a fools’ errand when it comes to options.  The reason I mention this is because I don’t want any of you budding traders to fall in the trap.  The trap I am referring to is the trap of cheap out of the money options.  Cheap options can sometimes have the song of a siren and lure many unexpecting traders in with their cheap price points and then they realize that they can’t possibly win with those options because they are so far out of the money that any movement in the stock couldn’t be near enough to offset the distance between the current stock price and the strike price of said options.   If the options are far enough out of the money to make them cheap then you not only need gargantuan price movement but you also need a volatility explosion that would rival the explosion of Mount Vesuvius in 1979!  This is highly unlikely.  These options are essentially lottery tickets and most likely have the same odds of success.  If you are unsure what I am talking about taking a look at the option chain below, I have circled the 60 delta, $16.50 option that we used last week and I have also circled a far out of the money call that some traders would use because it cheap.

You see the one circled in blue is our option and it has a probability of success of approximately 60% and that is one of the reasons we chose it.  If you look at the one circled in red it has about a 10% chance of success, but its cheap so why not right?  Buying that option is akin to throwing money out the window.  One of my mentors who used to be a market maker on the CBOE once told me that he put all his kids through college just by selling those options to anyone who would buy them.  He knew that the odds of him losing on that trade were so low that he would be happy to take that trade anytime day or night.  He actually had a term for those options, he called them the roach motel because he knew anyone who was willing to buy those way out of the money options was never going to get out of trading with their account intact.  To put this scenario into numbers, that out of the money option would need the stock to move at least $5o dollars to be in the money and the expected move of that stock in the 138-day timeframe is plus/minus $28.  I think you get the picture of why going with cheap options is a bad idea.  So back to the original question, how does one trade this kind of stock if one has a smaller account?

That is were spread trading comes in.  In the case of the Long Call, we are buying one single option and it is costing us $16.50 or $1650 per contract.  What if we bought that Long Call for $16.50 and sold a call to someone else and collected some money for doing so?  This could offset our initial cash outlay, yes?  Check out the video below to see what that trade looks like and how it can benefit a smaller account size.

 

Happy Trading!

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