In this final installment (for now), I’ll share more of my ideas about trading, and options trading in particular.  The purpose is to provide guidance for readers.  I’m not suggesting that you agree with, and adopt, all (or any) of these ideas.  Instead the purpose is to get you thinking about your own philosophy of trading and why my ideas may or may not be appropriate for you.

The bottom line is there’s more to option trading than merely slapping on a position and then waiting for the options to expire.

1) Make the best decision you can at the time the decision must be made.  Do not berate yourself if it turns out not to be the winning decision.

2) Stay within your comfort zone.  Never ‘hate’ any position you own. It’s easy to exit and find a better trade.

3) “It’s not good enough to find winning trading techniques; one has to continually adapt these techniques to an ever-changing environment.” So says, Dr. Brett – and I agree.

4) Don’t depend on ‘hope’ to salvage a bad position.  Use your intelligence to make a good trading/risk management decision.

5) I find that it’s too risky to try to earn every every last nickel from a trade.  Exiting a position early locks in profits and gives you a quiet period with no risk.

6) Don’t sell naked options.  The exception is for investors who want to buy stocks as prices decline.  For those investors only, writing naked puts is a satisfactory strategy.

7) Don’t use options to gamble.

There’s always more to say on any topic.  If you are so inclined, please share any of your basic trading tenets.

This is the “picking up quarters in front of a bulldozer” trade.

Usually, what they are touting is selling far out of the money options. You will be paid a quarter in premium and 95% of the time the stock you are selling the option against does not reach your strike. But 5% of the time it does and all the profits from the 19 successful trades is wiped out by that one bad trade.

Let’s look at an example. We’ll take Baidu, since there is a chance to make more than the transaction cost in that stock.

Baidu

Today is Tuesday, so there are three days to Friday’s close if we put the trade on near today’s close.

The one day one standard deviation move averaged over the last twenty trading days in BIDU is $7.24. To look at the three day one standard deviation price move we multiply this by the square root of three, since price is a random walk. That gives us $12.54 as our one standard deviation move over the next three days. This means that we expect BIDU to end up within $12.54 of its current price 68% of the time after three days. Since it is trading at $173 that means at Friday’s close, we expect BIDU to be between $160.46 and $185.54

If we want a bigger margin of safety, we can go out two standard deviations to plus or minus $25.08. That is, 95% of the time, after three days of trading, a stock with a normal distribution will be within two standard deviations. That gives us a range of $147.92 and $198.08.

Let’s see what we can earn in premium two standard deviations out. The $200 call is selling for $0.05 and the $145 put is selling for $0.25. So if we sold the pair we would be credited with $0.30.

We can do a different analysis and look at the actual tradinig of BIDU, and that way not make any assumptions about its distribution. If we do that, we find that from 31 July 2007 to yesterday, 16th March 2009 there were 410 trading days and 409 price changees.

Looking at those price changes, there were 18 that were bigger than two daily standard deviations and 14 that were smaller than -2 standard deviations (that is, big moves downward). That gives us a probability of 32 / 409 = 7.8% to have a bigger than two standard deviation move in one day. If BIDU’s price changes were normally distributed, that should be 5% so it looks like BIDU has more large moves than the normal distribution and we are closer to 92% safe in this trade than 95% safe.

To give you a fuller picture, of the 18 one day moves that were bigger than two standard deviations, one was a five standard deviation move, two were four standard deviation moves, five were three standard deviation moves, and ten were between two and three standard deviation moves. The downside is safer. Of the 14 big moves there, two were between three and four standard deviations and 12 were between two and three.

So it looks like it is safer to sell the puts. You also make more premium.

Still, it was a mistake because when there is more financial bad news, as there inevitably would be, Wells Fargo will go down with the Citigroups of the world.

So here is how the trade went:  I sold each put for $2.35 on 30th October 2008.  The strike was $32 per share.  At expiration, 21st November, the bottom of the market in 2008, the stock was at $21.76

Result: $21.76 – $32 + 2.35 =  -$7.89

For the December option series, I sold the 24 call on Wells Fargo.  I was paid $2.15 in premium for writing the covered calls.

At expiration, on 20th December 2008, Wells Fargo was called away from me at 24.

Final score: -$7.89 Nov result + $2.15 call premium + $(24 – 21.76) =  -$3.50

General Electric

GE earns half of its profits from GE Credit and so is a large shadow bank.  I sold puts on GE stock on the 3rd of November, 2008, earning $0.85 in premium per share.  The strike was 19 which was just below where GE was trading.

At expiry, GE closed at $14.03 per share so my loss was $19 – $14.03 = $4.97 on the stock softened by the premium received or $0.85 or a net  loss of $4.12.

Since I was put with stock, I turned around and sold the 15 calls on November 26th earning $1.06

At expiration, 20th December 2008, GE was called away and I was paid $15 per share.

Final score: -$4.12 (November) + $1.06 (call premium) + $15 – $14.03 (uplift in the stock) = -$2.09

Moral Of The Story

Don’t trade financial stocks during a financial meltdown.