I have been quiet here since February.
I found that paid subscribers wanted trade alerts from me, and I realized that was not something I was ready to deliver. An alert gives you a trade but not the reasoning. In options, that is risky. So I shut down the service, refunded subscribers, and took a break to reflect on what value I want to deliver.
Also, this year has been a challenging one for my strategy, and I spent a lot of time fine tuning it to this year’s market.
At the same time, more and more of our communication happens online, and it can feel lonely. I want to contribute something real. On these pages, I will share how my strategy is going and the lessons I learn along the way, so you can benefit from them too.
The first write up is about what makes options risky to copy without understanding them as an instrument.
Why options trades do not copy well
A stock trade copies fairly well. You buy the same stock and you hold roughly the same position.
An options trade does not. The strikes, the expiry, the size and the price you get all change the trade. If you enter later at a worse price, your risk, your breakeven and your payoff are all different from the trade you copied. And if you do not know why each piece is there, you will not know what to do when the market moves.
So before you take any options trade, yours or someone else’s, answer these five questions.
1. What is my total risk?
For a trade you pay for, it is the debit. Write it down and say it plainly: that is the entire risk. If you cannot name the most you can lose, stop here.
2. Where is my breakeven?
For a call spread you pay for, breakeven at expiry is the long strike plus the debit per share. Then ask how far the stock has to move from today’s price to get there.
3. What is my rent?
Every day the stock does not move, the position loses some value. That is the rent you pay for time. Measure it per day, per month, and as a percent of the position per month. If the rent is high, you need the move to come soon.
4. What is my max payoff?
Know the most you can make and how far the stock must move to reach it. Compare it to your risk. Is the trade worth it?
5. When am I wrong?
Write one line before you enter: this trade is wrong if this happens, by this date. If you cannot write it, you do not know what you are betting on.
An example with round numbers
The stock trades at 48. You buy the 50 call and sell the 55 call, same expiry, for a debit of $2.00 per share. One contract costs $200.
Total risk: $200. That is the entire risk.
Breakeven: 50 plus 2 = 52. The stock needs to rise 8.3%.
Rent: for illustration, say the position loses about $3 a day if nothing moves. That is about $90 a month, or 45% of the position per month. Time is expensive here.
Max payoff: 5 minus 2 = $3 per share, or $300 per contract. The stock needs to rise 14.6% to reach 55.
Wrong if: the stock is not above 52 before the catalyst you expect, by a date you name.
Now imagine you copied this trade one day late and paid $2.50. Your risk is $250. Your breakeven moves to 52.50. Your max payoff falls to $250. Same trade on paper. A different trade in your account.
How to use this
Take your last options trade and write the five answers. It takes five minutes. If one of them is blank, that is where your risk is hiding.
If you are new to options, start with my complete beginner guide. It covers what an option is, how it is priced, the four basic positions, and how to place a first trade, with real examples.
Regards,
Iskan
Well said! I think it is a good idea to write down what you bought, why and the risk/reward parameters. And from that build on what works for you.