Option Obliteration: Lessons in Options Trading

This week I broke one of my cardinal rules about options trading taking advantage of an arbitrage situation on the final day of an option. I sold a vertical way too close to the money line trying to make a quick buck. Like many people in that situation I know I have coverage with my long strike against massive loss, but like anyone who doesn’t have big bucks to throw away I was nervous. The last thing I wanted was to have the money line pass my short strike and sit between it and my long. This style of options trading is essentially an exercise in gambling, and with the position I was chasing in the news like it was there was increased volatility in the position.

Now, let’s remember, this is trading not investing and while I preach about investing and that is where the majority of the my money is, I do keep a side pot for trading. This allows me to run (normally) very safe options with the aim to generate a nice return and create cash for future investing. Like I said though and to those who trade options regularly you will know the moment you see a mispriced option spread and the dollar signs pop up in your eyes like the cartooons.

Well, I fell victim and I wanted to take an opportunity to practice something I wrote about previously and analyze the mistake to hopefully allow myself to move on and get back on the horse, albeit wiser. In earlier years I would refer to this as an After Action Review, and I like the format of it for this, so I will utilize it for this for my analysis. There are three questions we ask: What was supposed to happen? What did happen? What are a few positives and negatives we can use to change how we do this in the future?

So I’ll start with the situation and then move on to the analysis. The theory is to mainly stick to monthly options trades with a low percentage chance of coming into the money and you collect the premium. I however in addition take one weekly trade somewhere between the Friday before expiration to Monday before expiration. This is to take advantage of inevitable arbitrage opportunities that occur as the price of options drop and people who look to exit their option.

So let’s turn to analying this opportunity. The first question is, what was supposed to happen? I was supposed to find an opportunity with a high volume, low risk option spread to make a few dollars, from 7-5 days out. I was supposed to take a far out of the money position, set the vertical with a RORC (Return on Risk Capital) of 48% or slightly higher and just daily check to see if it hit the sale threshold.

We always keep a margin of safety in everything we do with our money, a point where we say the risk is too high and it’s time to exit. Sometimes this will be a win, sometimes this will be a loss. Usually the wins FAR FAR outpace the losses. We also choose high volume positions so that we don’t find ourselves in a position where we need to get out of our position and there are no buyers.

Well, that was what was supposed to happen. So what did happen? Okay, on Friday (day of expiration), I saw a massive arbitrage opportunity that would have been about 4x what I normally would have seen in a weekly option. There may have been a reason for that it turned out.

The company has been in the news recently with normal big company problems. I checked boxes, high volume, good return (but much higher than my normal benchmark), but I did not check the box of far out of the money. Instead of losing 3x of return on what would have been a no worry, simple opportunity, I chose an option right at my normal safety zone lower limit. I’ve said it before, pigs get fat, hogs get slaughtered. I got greedy and tried to shortcut my system.

From the start of the trading day I could sense this was not a good situation. Immediately after open it was off by a couple percent from it’s opening price and my percentage OTM (Out of the Money) was cut almost in half. I told myself I had a natural floor between myself and the price and watched for hours as it seesawed close to my strike and then further away. I also lost some visibility for an hour and half in the early afternoon as my internet provider went down.

During this time it continued to seesaw, but what I missed initially was that the low swing of the seesaw kept getting marginally lower. One hour prior to the end of the trading day it crashed through the floor above me and I began getting much more nervous. With a half hour left I was constantly refreshing exit trades, trying to milk any amount of profit from this growing debacle, but never giving up on it expiring OTM. I was at another natural floor, and a strong psychological floor, surely it wouldn’t break through.

Friends, I will tell you it was in the last ten minutes when as I saw the price dropping and I was gathering to take a loss I shouldn’t have even been near, the price dropped to $.30 above my strike. I started frantically trying to get an execution near midpoint, and putting in values farther away. Then, it dropped again, below my strike, and it stayed for a fraction of second, but in that moment I gave up on salvaging a win and took the ask price to get out before I got assigned.

Luckily for me, I got out with a minimal loss and the fact that it closed pennies above my strike didn’t bother me at all. I was just glad I had limited the damage and had learned a powerful lesson in following the rules. They are there for a reason, we should honor that and not let our judgement get clouded by emotion.

On to the final part, Sustains and Improves. Sustaining is where you always start, mainly to generate some positive sentiment before hitting the dreaded improve section. The sustains on this were short, but important, because even in the worst executed situations there is something usually that went right or was well done and we need to acknowledge that.

Sustains. I recognized an opportunity where the market had mispriced an option with a large spread. I got out even though I was hard toeing the line of obliteration.

Improves. I let emotions get the better of me, in particular greed. I gave myself a pass on my rules, even though I am still in my learning phase where following the rules is the most important. I saw the position pass from the safe zone to hazardous and then crash through to dangerous because my ego wouldn’t let me believe I had made that bad a mistake. I essentially played a bluff against an opponent I could not read, in a game where knowing when to fold is sign of excellence.

We usually limit the number of improves because in situation like this it can be overwhelming and give you more more changes than can reasonably be made. It does not mean we don’t consider them, but in the immediate review you limit them. I have done a full analysis on this myself and have many more shortcomings, but this is not about you hearing how I change my strategy, more of a cautionary tale.

Some changes I have made is in checking my emotions and ego at the door. I have a checklist of items before I open a position and I will forever ensure that I am checking ALL of them before making a decision. Learning to trust my gut, when I knew something was up, I should have pulled the trigger and could even have walked away with a small win. When that little voice is telling you something is wrong, you should really listen to it.

Remember, investing is where we should spend the majority of our time and energy, not gambling on trading. Trading like this can be important to generate cash flow for future investing, but it should never be a large part of your portfolio and you MUST make sure you know what you are doing. There was a story recently about a young man who took his life because of not knowing what he was doing with options.

He ran a proper vertical put, and did not have an exit strategy. Essentially he said he would buy 100 shares of this companies stock if the price reached his short strike, with the coverage of an agreement to sell it at a lower price and limit his losses. The long and short of it was that on the day of expiration it hit his short strike, but not his long strike. He saw the debt of six figures on his screen that Saturday when the option settled. Without waiting to find out his options from there he made drastic choice.

I was nearly in the same situation, but I had some knowledge this young man did not, brokerages will not let you owe them large sums of money to keep a position you wagered and lost on. This isn’t the mafia, noone is standing there with a baseball bat telling you to come up with the cash or else. On Monday his broker seeing this situation would have sold the shares at market price for what would have been a much more reasonable loss and would have liquidated other position to cover the difference to the brokerage. Hardly a life ending scenario. He just didn’t know it.

Be careful around options and don’t go in unless you understand the potential ramifications and even if you do have an exit strategy, some trigger that you know to get out at. What might it mean? A small loss, though if done properly you might even keep a small gain. You were wrong and have an opportunity to learn from it. I told the young professionals who worked for me that making mistakes is natural and if you don’t at this stage it means you probably weren’t trying hard enough. The defining moment of make or break is if you know when to seek help and admit you made a mistake. I nearly failed that test.

In the end, even the best investors run options. Warren Buffett certainly does, and I’ll even bet he loses occasionally, but the big difference is he knows when to fold his hand. I bet his track record certainly beats mine and maybe most of yours too. It’s not a matter of doing or not doing, it’s a matter of learning, run some backtests on potential trades. This will provide a large amount of data to you on how to strategize. Also, spend a long time paper trading, it seems useless but I still do it myself and sometimes realize I missed golden opportunities. It’s better to not swing when you question whether the ball is in the strike zone and wait for that fat pitch to hit out of the park. Why? Because there is no one there pushing you to take the swing besides you. Make sure this is in your wheelhouse, that’s what my rules do for me.

At the end of the day though, I still prove to myself that I have a lot of room to grow and refinements to make. So take your time, refine your sweet spot and then go knock one out of the park. Until next time this is Daddicus Rex off to find the next victim.

-Daddicus Rex

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