In this week’s issue of the Market Slice, we discuss call options, using spreads to your advantage, and understanding your personal risk profile!
Options Frenzy Reaching Record Heights
In case you didn’t notice, options volume is going through the roof.
This chart from Goldman Sachs shows the recent explosion in call option volume. As retail traders load up on calls – often with no clue about how options actually work or the risks involved – it drives up the value of the underlying stocks, as short positions scramble to cover their bets.
But the Wall Street Bets/Robinhood crowd aren’t the only ones playing this dangerous game. Institutional traders are also going all-in on call options, throwing caution to the wind in the belief that the market will continue its relentless upward climb. Even Fed Chairman Powell’s announcement that he will cautiously begin tapering failed to slow the bull market momentum… most commentators agreed that this gradual reduction in Fed bond purchases was already priced into the market.
Recall that in previous issues we talked about how major corrections can only unfold when sentiment is overwhelmingly positive. Our view has been that inflation fears, worries over the “China contagion” debt bubble, and ongoing COVID concerns represented enough pessimism to ensure that the market rally would continue. As long as any significant number of observers are expressing bearish sentiment, in other words, a major downturn is precluded. It’s Market Psychology 101. Now, however, we are seeing signs that these “voices of reason” are fading to silence. Are we approaching the point of near-universal belief in the Permanent Bull?
Here’s another chart, this one showing the relationship between the S&P Index, and the put-call ratio in equity options.
Open put interest is at historic lows… reflecting the squeeze that has driven most of the shorts out of the market. If we ask ourselves what might drive this ratio back toward the mean, there is one obvious answer: a sudden reversal in the market would fore longs to cover by selling. Are we nearing that point now?
If you’re still trying to figure the markets out all by yourself, you are making it harder than it has to be. FFR Trading’s Strategy Team is here to help you think through your strategy, and find the right approach to trading profitably, in up markets as well as down. Call 1-800-883-0524 to set an appointment with your Strategist today!
Option Spreads – A Reasonable Way to Manage Risk
Options provide a very important advantage in the markets. They allow the trader to control a large amount of stock (or commodities) with a small investment.
This is a form of leverage. Usually we think of leverage in terms of borrowing money to cover a trade… leveraged accounts allow the purchase of several times the account equity. The problem is that any loss is multiplied by the leverage factor… this means that even a small move against you can have devastating consequences. As Navel Abdali has said, “leverage has the potential to turn a reasonably good investment into disastrous gambling!”
With options, leverage takes a different form. As an options buyer, your risk is strictly limited… to the full amount of your investment. You can only lost what you spend on the option. However, that is more than enough risk in most cases.
(Note: Selling options is another matter. Do not undertake an option selling strategy – no matter how many get rich quick guys recommend it – without a thorough understanding of the risks involved!)
The leverage gained with options is different from that in a leveraged trading account. Instead, the trader exchanges time value for the right to control a block of stock.
Since options re time-limited (by expiration dates), the option you buy today is worth less as time passes This is called “time decay,” and it represents the erosion of value in the contract due to the passing of time. Time decay leads to many options expiring worthless. Traders who buy options that do not reach the strike price within the allotted time will lose 100% of their premium. This is not good for your trading account balance!
How Spreads Reduce Risk
A “spread” involves buying two (or more) options, to create a risk profile that protects your trading capital better than using straight puts or calls. There are many different ways to trade spreads. While we don’t have room to cover that here, a quick look at how these risk profiles are formed could be instructive. This is a “bull call spread.” Using a lower priced call and a higher priced put, you position yourself to make money from a small upward price move. You give up “to the moon” potential, in return for relative safety.
With a Bear put spread, the process is reversed. When prices go down, you get into profit faster than you would with a straight put. But your potential gain is capped, as well.
This illustrates how spreads can be used to limit the risks involved in options trading.
Trading options can be intimidating if you don’t know what to do. Don’t worry! We have a free e-book to help you learn the ropes. Click here to download Joe Duffy’s Target Zone Options: Trade Options Like a Pro. Then call (800) 883-0524 to speak with an FFR Strategist.
Understanding Your Personal Risk Profile
All investing entails risk. Conventional wisdom says that mutual funds and bonds are less risky, whereas stock options and futures carry greater risk of loss. Leverage – that is, aiming for increased returns by accepting more risk – is considered unwise by the nabobs of the financial world. But is this accurate?
The reality is, as usual, more complex than conventional wisdom allows. In truth, the riskiest positions can sometimes be totally unleveraged; for example, leaving one’s savings in a bank account, earning virtually no interest, runs the risk of losing ground to inflation. And holding “safe” stocks can be disastrous when a severe downturn occurs, as was the case in the stock market crash of 1929, and as we saw in March of 2020.
Simply put, risk is not a two-dimensional proposition. Rather, risk is subjective to each investor. Your goals, your time frames, your comfort level with temporary declines in the value of your portfolio (called “drawdowns”)… these are the factors that go into your own personal risk/reward ratio.
Risk, Reward, and Probability
Understanding your personal risk/reward ratio is essential for a winning trading plan. Some traders are comfortable knowing that they will sometimes see significant declines in their portfolio balance. Because they have selected their trading strategy wisely, they are confident that any losses will be recovered in time.
Others do not sleep well when they experience even a short run of adverse trades. They recognize that they need the higher returns that speculative trading can bring, in order to achieve their financial goals, but they can’t stand the thought of losing even a small portion of their capital. You might want to print the following exercise out, so you can actually do it in writing.
Developing a Personal Risk Profile
These two outlooks can be classified as Conservative (minimizing losses as the primary objective of the trading plan) or Aggressive (maximizing gains.)
Where am I on this spectrum? Conservative 1 2 3 4 5 Aggressive
Important point: Another aspect of “holistic” risk evaluation is understanding the role of probability. Conventional wisdom says that for every reward in the market, there is a commensurate risk. What the talking heads won’t tell you, though, is that market risk is distributed unequally among market participants!
This chart, taken from an article at efinancialcareers,com, shows the 2018 trading results for Goldman Sachs. Please note: the chart shows only 16 losing trading days for the entire year! The article shows similar results for several leading investment banks. If the big investment firms win millions of dollars virtually every day, where do you suppose those winnings are coming from? That’s right. It is individual investors and retail traders who give up losses to these institutional traders.
Professional traders have learned to put probability on their side, and as a result they win regularly. Average investors do not utilize proven high-probability trading strategies, and as a result, they lose consistently.
I am confident that I have an accurate understanding of risk and probability: Yes / No
I believe I can compete and win against the biggest traders in the market: Yes / No
Understanding Trading Risk
Different trading strategies have different risk profiles. Some traders aim for more frequent wins, others seek larger gains per trade. Some trade frequently, others less so.
Among the most likely losers in the markets are retail day traders. It has been estimated that over 90% — and possibly as high as 97% — of day traders end up with busted accounts. It is vitally important that you get a very clear picture of the trading risk of any strategy you are undertaking, or considering.
The most important part of my trading plan is: Trade Frequency 1 2 3 4 5 Trade Success
I know how to assess the risk profile of any trading strategy: Yes / No
I need help determining my risk profile for successful trading: Yes / No
FFR’s Strategy Team will help you design a risk management plan that suits your objectives. What are you waiting for? Call today for a FREE strategy review at (800) 883-0524.
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