The Easiest Money And The Dumbest Trade I Ever Made
Here at stock options explained we have covered options trading strategies such as simply buying stock options and also selling options, with the idea that stock options basics could best be conveyed from the standpoint of actual examples behind trading strategies, rather than simply limiting our discussion to theoretical ideas. At any rate, in this vein I thought it might be of interest and helpful to illustrate option trading strategies from a real-life example that’s of particular interest to me. I’ll show how selling options involves more than the risk of having your options exercised so that your stock is called away from you (if you’ve written calls) as it rises well beyond the strike price and you miss out on further gains beyond the strike price. There is an additional danger, one not related to opportunity cost.
In this type of trade, while you will receive some protection from selling options because of the reduced cost basis for your stock (as you receive a premium amount from the option buyer), this lower cost basis might be no match for the amount by which the underlying stock could fall. In other words, using this trading strategy one may sell covered calls against stock he owns and get to keep the premium if those calls expire worthless, but still take a much larger hit because of a drop in the stock price. You might think you’re buying some protection after a run-up, but the market might have much bigger plans!
I would like to illustrate selling options in this context not with call options, but with a trade involving put options. I had a front row seat on this particular trade, as it was I who was doing the trading! The mechanics with selling puts are the same as with selling calls, though your directional preference is reversed with puts. One can write covered, out of the money puts as a way to insure a short position, hoping that the worst that will happen is a drop below the strike price, below which he no longer benefits at expiry as he must cover his short position at the strike. If a trader employs fairly complex option trading strategies of this kind is also fully aware that the stock price could rise, which could easily outweigh that put premium amount that he receives for writing his covered puts. I said “he” but I might just as well have said “I”. Well, here we go.
If you were anywhere near planet Earth during the week ending May 7, 2010, you might remember how quickly the market dropped from above 1200 on the S&P 500 down to a low on the day of the “flash crash” (May 6) of 1056. The market bounced off the flash crash lows, closing the day out at 1128, but the next day, Friday, May 7 was also ugly, with the S&P 500 closing that day at 1110. The reason I remember the events so clearly is that I sold put options a few minutes before the close of trading on that Friday, a move that I have thought of ever since as both the easiest money and possibly the dumbest trade I ever made.
I’ll elaborate a little. For once in my life I had made a correct move and was short SPY from above 120. SPY is a heavily-traded ETF based on the S&P 500, and is a convenient proxy for the overall market. The VIX (a popular volatility indicator) was low and the markets, though they had been grinding higher for months, seemed to me to be ripe for a fall. I decided not to use options for leverage, so I could wait. Well, like everyone else I was stunned by the events of Thursday, May 6, when the Dow Jones Industrial Average fell almost 1000 points. I remember watching CNBC, which had a live feed from Athens, Greece, where there were real tensions over austerity measures imposed by the Greek government. As things appear to start to get out of control there on the streets of Athens, action in the markets worldwide seem to mirror the possibility of real calamity. Even though I was short, the speed of the events unfolding left me utterly flat-footed vis-à-vis my position, and while someone with a clearer head might have chosen to cover his short position when the market was down over 10% in just one day, I did not do so.
The next day I watched again as the bounce that the whole world seemed to be hoping for after the chaos of the “flash crash” did not occur. That Friday was nowhere near as ugly as the previous day but the market was again down nearly 4% intraday.
As the market neared the close on Friday I remember my thought process very clearly: while the market was clearly very oversold it seemed that the upward trend had broken so violently that we were headed dramatically downward again over the next few weeks. Still, with the volatility so high at that moment options premiums were extremely inflated, especially for put options. What this means is that if one were to write put options against an existing short position one would receive, relatively speaking, a very large premium amount simply for promising to buy back shares-or cover his short position-at lower levels, even much lower. One way to look at is is that you could be paid for profiting even further from your short position. Now, there are legitimate option trading strategies for every market situation, and at a time like this capturing volatility is often smart, because even if the market continues down at a slower rate (or stays even) one could see a reduction in the component of the premium that had been inflated due to the volatility (if we are talking out of the money options, that would be 100% of the premium, of course).
On this particular day I was able to sell five SPY May 100 puts against the 500 shares of SPY that I was short, for 1.05. SPY was just a hair over 110 when I wrote these puts, so that means that with only ten trading days left before expiration that SPY would have to go down a full ten points for them to be in the money. After that terrible week it seemed very unlikely that it could happen so quickly, but I told myself that if the overall market experienced another 10% decline during those two weeks I’d be happy to get 20 points on the SPY out of the trade that fast (I was already ten SPY points lower than my entry, remember). The approximately $500 I received from selling options to a trader or traders who were willing to bet $100 per contract that SPY would be over ten points lower in ten days (just to reach the strike price), seemed like the easiest money I’d ever made. Hopefully the puts would expire out of the money, worthless, I would keep the premium and then in the next several weeks I’d eventually see SPY below 100, maybe much lower, with me looking great on my still-intact short position.
Well of course anything might have happened, but what did happen was that the market bounced on the open Monday and into the earlier part of the week. When I covered my short position several points higher I got to keep almost all of the $500 I’d received in premium for selling the puts (yay!). However, my gains from my short position were a few thousand dollars less than what they might have been had I simply covered my short on the preceding Friday, rather than fixating on how likely it was that I’d keep most of the premium!
I don’t fault myself for not being clairvoyant, and I think that the only mistake I really made selling options here was overemphasizing the likelihood that I would keep most or all of the put premiums, relative to the possibility that a violent snapback could occur and quickly negate that $500 position. Still, both trades were profitable, and my actions were in line with the old adage “cut your losses and let your profits run”. Well, they also say that no one ever went broke taking a profit, and might have been was a large one! Maybe I have overemphasized how silly I feel not simply taking a huge, quick profit (heck, I’m sure I’ve made dumber trades) but in any case, for purposes of getting option trading strategies explained to readers of this site, I think this anecdote has value.