Full transcript of January 2022 Boot Camp:
Neal Hamilton
Alright guys next up options mistakes to avoid in 2022. We've been talking about all the great ways that options, create opportunities and markets that are going down sideways and things besides up. But it's not all easy. Let's talk about the stuff not to do. Let's bring on Matthew Timpane.
Matthew Timpane CMT
Hey Neil, Hey Luke.
Neal Hamilton
Yeah, absolutely. It's great to have you back. You're a standard around here. You're a veteran of the boot camps. And we've got we got some new folks or some probably some some some people here that have seen your presentation before. But for those that haven't, would you mind giving yourself a brief introduction, Matthew, and then also letting folks know what they can learn from you here today?
Matthew Timpane CMT
Yeah, so my name is Matthew Timpane, as Neil said, and, you know, our firm is out of Cincinnati, Ohio, Schaeffer's Investment Research, we've been around now for about 40 years, helping retail investors trade the option market, we've been in it basically since the beginning. And we've been here to stay.
So my background, I'm a chartered market technician, so I, you know, deal with technicals on a daily basis. But I also was a partner at a registered investment advisory firm prior to my time at Schaeffer's Investment Research, you know, as a portfolio manager, and a partner. And what you can learn today is we're going to be talking about some option trading mistakes to avoid in 2022. You know, every single year, I kind of like to start out with this presentation, or at least a modified version of it. So some may have seen it before. But I think it is so important for us to just remind ourselves at the beginning of each year of what not to do, or to recognize maybe bad habits that we may have gotten into, while the market was ripping, you know, but we need to fix this because, you know, that won't work in more volatile environments.
I think it's really a good way to start out, especially this year, it's important, because I think there's gonna be a much more difficult market coming up for us here than we've experienced over the last two years. So if you're new to trading, expect it to be much harder to extract capital out of the system. You know, we just had a 16% up move in 2020, 27% move up in 2021. And, you know, my forecast this year on the upside was plus 10%. But, you know, I think there's a lot of potential for, you know, a flat even down year.
So, it's not the same as, as we've had years in the past. And I think a lot of that has to do, obviously, with the Fed moving forward, you know, we should look at environments more like 2011, 2015, maybe 2018, I think 2011 2015 might be better analogies to what we could experience with volatility. But you know, we likely pulled forward some of those returns at least a year or two of returns with the rally the last year or two. So we either need to kind of have like a price or time correction as multiples were starting to get stretched. So, you know, if you're playing, you know, any kind of small cap, you've actually obviously saw that we've had huge rotations out of the market. So as as you know, it can be a difficult environment.
So with that said, let's get going on the presentation itself. Alright, here we go.
And so the first mistakes I kind of want to talk about here is front running your drivers, right? Many traders are impatient, they yearn for action, this can lead to front running drivers on your trade. What do I mean by drivers? I mean, you know, technicals sentiment that you're seeing and reasons why you're getting into this. So for example, you're waiting for a pullback to support at $40 on a stock, but you see that the stock you like is at $41.50. And you go ahead and you buy a head of support that you may have identified correctly. You're only hurting yourself by doing this by creating a sloppy entry.
For one, now you're battling time decay, theta as it tests support. So now your option if you're trading weeklies is potentially even worthless. Otherwise, it's definitely significantly down, you know. Two, you're also battling time because you know, like I said, when you buy an option, you only have a set period of time to be right. So these factors can cause you to be whipsawed a lot in and out of your positions. Because if you're managing you know, risk properly, a small move in the underlying can be a big move in the option causing premature exits and to limit losses, and this will cause lower win rates and average wins. So when you think about it, you know, if you just waited, instead of being impatient, the option you purchased would not only cost less, but your leverage potential would be greater.
So front running drivers leads to sloppy entries that caused lower win rates by premature exits that could have been profitable trades. And it also, like I said, lowers your average wins because the gains will be less when you actually do hit those targets you identified to get out at the only time you really kind of should maybe buy or sell ahead of support or resistance is if you see buyers stepping in on the tape on level two. But that's a whole nother presentation in itself.
The next thing you should do is make sure that you know, you're letting your profits run and cutting your losses. So a lot of traders get into trading stocks and options, because picking stocks is what draws most traders to the markets. But risk management is what separates successful traders from those that are not going to make it. So this is just a healthy reminder that we need to cut losses and let those profits run, especially when trading options. Option traders are battling many things when trading long premium strategies, which I'll go over in the next few slides.
So you should really kind of only expect to be right about 35-45% of the time, I know this sounds low. But when you do get those 45% years or an outlier year where you actually hit 50-55% win rate, you know, those are gonna be huge years for you. So by letting the winners run, this takes advantage also of the power of convexity, and that that you get when you're trading options as well. So as you can see, 40% win rate is easily doable here, you know, with an 80% average win, when you minus a 60% loss rate with average loss of 35%, you're still up plus 11%. So it's much better to let those winners run and cut those losses. You can't have a successful strategy by having a lower average win greater than your average loss, it just isn't going to work unless you have a highly, highly successful win rate, which is really rare in options. And we'll go into why that is here in the next few slides.
So another thing that you want to do and kind of steer away from especially in the volatile markets, is, you know, overcome the greed with target entry and exit points. So before you ever enter a trade, know what your signal is to buy and where your exits will be. Are you you know, taking a risk reward of three to one, five to one? Are you targeting a resistance level or a Fibonacci level maybe to get out at when you do hit that profit target.
At Schaeffer's Investment Research, we typically aim for 100 to 200% profit targets before taking half off to de risked that position. But then you want to let the rest work for you set a stop loss for breakeven at a minimum on the remaining contracts. And then by breakeven, I mean the contract price paid. So if you paid $5, you took half off at $10, you set that breakeven on that contract at $5. This way, you're still able to profit 50% Even if the position moves against you. Or if you're maybe more aggressive and you're looking at the 200% target, you're still gonna walk away with 100% gain.
Set price stops, always, always honor those price stops as well. A good rule of thumb is never to let your losses exceed 50% on an option. And I typically target somewhere between 30% and 50%, depending on the risk of the option and my upside target.
We're targeting, you know, 100% on kind of less aggressive strategies and 200% on more aggressive type strategies. So that's where we kind of get that adjustment between, you know, 30% and 50%. And this is a good way to kind of just control those losses from happening. A time stop is another great way. So a times top is what we usually use that Schaeffer's is called halflife from the date that you purchased the option to expiration.
So if the stock is not doing what you expected at halflife, it's time to get out or roll it if you think it just needs more time to actually hit those targets. So what I mean by that is if you purchase a contract 30 days out, at 15 days if it's not doing what you think you're doing, it's time to get out of that position or roll it if if maybe you're at breakeven and it's you think it's still going to go higher.
So another mistake that we do see is allocating too much capital to a position. We have this chart over here at Schaeffer's. That shows the probability statistic of seeing X number of consecutive losing trades in a row. But first, let's just kind of talk about some other important factors. To know that as an option buyer, you can only expect to really be right, like I said, 35 to 45% of the time, as I showed in that previous slid 40% win rate, you can still definitely be profitable.
Let me explain now, why this is the best traders in the world really only have about an average win rate of 50%. I'm not talking about investors that hold for years, you know, but I'm talking about traders that you know, trade up in and out positions from a few weeks to a few months to maybe a year. What makes these stock traders so good, though, is that they cut those losses, like I said fairly quickly, and let the winners run.
Stock buyers do also have a couple advantages over options traders, because they can hold the stock as long as they want to have that winner, they might have an opportunity cost by doing this. But, unlike an option buyer, they theoretically have an unlimited amount of time, whereas the option buyer is defined by the expiration date and has a window of time to be correct.
The option buyer also has to pay a time premium. So the more time they buy to be correct, the more time premium that is embedded in that option. And time premium decays in a nonlinear fashion as the option approaches expiration. This means that the rate of decay for that time premium increases, the closer we get to expiration. So those are just a couple headwinds that an option buyer faces which causes this lower win rate than stock traders.
Knowing this, you can look at probabilities to try to figure out your chances of being wrong X amount of time. So say your win rate is 40%. As I showed over time, if you look at the probability chart, you can see here you have a 63% chance of being wrong six times in a row.. having six consecutive losing trades. So having the mentality of this next trade has to be profitable, I'm going to double up or triple up can be absolutely disastrous to your P&L.
Even if you pay for a service like ours and you come you in have come to think that hey, these guys are experts in option buying. They've had many big winners before. So this next trade has to be a winner. It's just a fast way to lose your money. Because no it does not absolutely does not, you still have a 42% chance that the seven trade is a loser too. I've been there Heck, I think, you know, over the last year, I went through two periods where this happened, and the market was up 27%.
So this will happen to every trader, at times, it's how you deal with it that matters by controlling your emotions, managing your risk accordingly to preserve your capital, for the next time that you do get into a hot streak. It's really just all about staying alive and surviving through those tough periods. So this is just a chart example to kind of show you quickly of how time decay works for an at the money option. As you can see, the reason why we use those time stops for half life, you know, your slope greatly increases as we approach expiration. So it's just something to keep keep in mind to see, you know, it's a visualization to see how fast this risk can happen to you if the options not working in your favor.
Another mistake that we do see is buying the cheapest options, right? So it's just another allocation factor that we see options traders making better mistakes, they're putting the same amount of money, or percentage of their portfolio to options that have different risk reward characteristics.
So let's go into a little more detail about what I really mean about that. A lot of option buyers, and especially new options, traders will buy the cheapest options, buying the 50 cent options versus the $5 options. People are just naturally programmed to buy cheap and try to sell high. But these options are far out of the money. Therefore, those options likely have anywhere from a 90 to 99% chance of expiring worthless if say you're buying 10 Deltas. You know, with these options, you can be also right in the direction. But if you don't hit your profit targets, you can still have incur that 100% loss, right. So this is something that you need to understand.
You need to understand the difference between out of the money and in the money and you know, yes out of the money gives you a higher profit potential. And we like to all say that, you know, we hit a 10 bagger on this contract. But you also have an extremely high risk for what we like to call a crap out or 100% loss on the premium that you paid. I see people all the time you know also on Twitter want to take that small account challenge, see how much they can grow a tiny account, you know, in a small amount of time, but more often than not, you know those accounts are going to blow up.
Sometimes it's somebody that has extra money throws $5,000 that it sees that they can compound to $100,000. But you know, 99% of the time those things blow up, you know, and the fact of the matter is, you can still achieve that 10 bagger, trading 50 or even 60 Deltas. it's not just going to happen as often. But I do promise you, you will also dramatically reduce your risk.
One of our traders, you know, on our desk even hit, I think it was 2,000% returns on GameStop During the frenzy, right. I think one of them could have even been 2,000%. And he did this by trading deltas that were around 60. So long story short, you need to allocate appropriately, less to out of the money and more to in the money options. You also you want to kind of allocate less money to short term expirations versus long term expirations, because the time decay isn't working against us quickly.
So, this is a chart that kind of shows you you know, buying stock buying short term $100 strike in the money options versus buying maybe two short term 107 strike at the money options, and how it can be different between profit potential, unchanged, and losses. You know, so take a look at this chart.
But real good example, actually, recently, would be Netflix earnings, right? You know, I think at the money options trade about $20. On that option, you would have outlaid, say, $50,000 for the same leverage of those 100 shares, buying stock, where you only put out $2,000 To play at the money options. So those at the money options would have expired worthless with Netflix's earning reaction being down about $100 on that reaction, but if you would have bought stock that you would have been down $10,000. So those are other ways that you can use options, then to maximize potential profit, yet also reduce risk to your portfolio. So this is a good chart to kind of just have an look at and have so that you can make the decision is it more appropriate to buy stock here, buy in the money options or buy at the money options.
Another thing that we like to do over at Schaeffer's. And like any stock portfolio, we think an options portfolio should be diversified, too. A major advantage of trading options is using truncated risk whereby your loss is limited to your initial investment. Your profit is theoretically unlimited. Diversification will allow you to use truncated risk to its maximum advantage. And we believe in a two dimensional diversification system.
See, you know, the key to really kind of achieving profits in options trading is to maximize your chances for very large percentage gains. And this requires the financial and emotional staying power provided by two trading rules that helps assure that you will be able to stay around to achieve huge profits.
So this involves risk reducing and profit maximizing techniques of diversification. First, you should always try to carry several different option positions to maximize your chances and achieve one or more huge winners and minimize your chances of incurring large losses. And these option positions should be established in unrelated industries. As we know trends can change quickly. And this will help eliminate any unforeseen risks that might occur to a certain industry or sector.
So while it's okay to be overweight in certain sectors that are showing relative strength as you want to be where the momentum is, you still need to seek out those opportunities in other sectors, there may always kind of be another opportunity there, you know, in those sectors that are lagging or just starting to strengthen. So you want to have the diversification so if anything happens, like we've seen in tech recently, you know, you're still going to experience you know, upside and keep that portfolio flow. You know, like say you had energy positions on as well, you wouldn't have maybe felt the tech wreck that we've recently experienced as badly.
Second, you need to invest in puts as well as in calls. This will put you in a position to profit regardless of overall market conditions. So that guessing you know wrong on the overall market direction does not severely deplete your trading capital. I get that it is hard to do that in rip roaring bull markets. However, your ratio of calls the puts will vary accordingly to your overall market view to reflect your viewpoint. So you know these steps We'll just kind of help you stay the course by reducing fear and hopefully eliminate some panic selling that many traders often do, where they exit as soon as the position kind of moves against them.
And as you can tell by the market action since November, this would have helped you navigate the volatility we've been experiencing. Even last year, you could have been playing puts on many growth names, while also playing calls in energy or other commodity stocks, financials, or even just large cap Tech because, you know, they were all moving up while you know, some of the higher growth names were, you know, falling. So, this, this can be still done in big bull markets, you just need to be able to pick your positions accordingly.
Other things that we see are, you know, like mismatching drivers with option expiration dates. Traders, you know, optio target drivers that can take time to happen like short interest covering or analysts potential analysts upgrades and downgrades. These drivers, they take time. You know, shorts don't typically run to the exit at the same time. Sometimes that can happen and you can see a massive squeeze. But a lot of the time the unwinding usually takes a period of time and there's peaks and troughs in short interest data, just like price action. Analysts also sometimes take time to upgrade stocks or downgrade stocks because it takes time for them to update their models. And think through how the company updates are going to affect future earnings.
Likewise, short term option indicators like you know, 10 day put call ratios or, like we use a Schaeffer's a proprietary volatility scorecard that we use over here. You know, these are best for short term trades. Because short term dated option expirations, have more leverage power. Sometimes you get lucky, and both the lineup and then you can kind of trade them on multiple timeframes. But make sure your drivers are matching the expiration dates, that you're kind of trading on those options. So if you're looking at something short term, make sure those drivers are supported by short term data. Longer term, obviously, you're going to want to have longer term drivers associated with them.
And then other common mistakes that we see, you know, in trading options, it's typically shorter term. But we're all usually focusing on you know, daily charts or hourly charts or 10 minute charts, or even minute charts. But it's important to zoom out to weekly and monthly charts when you're looking for your trading ideas. Make sure that you're not going to run into resistance on a larger timeframe late level. So you could be seeing a bull flag on a shorter time frame level. But you could have major resistance just ahead. Or maybe it will identify a huge support zone that you didn't realize was there. And instead of just a short term option, you might want to take a longer term approach to the position.
You know, this can save you from a loss, if you were maybe looking at playing puts in there was a major resistance level or maybe even kind of give you like I said that more conviction to buying longer term data calls. Because you think you can see upside over the long term. We see this so often. And I even need to kind of constantly remind myself to to zoom out. And literally, I have a note posted right on my screen on my desk that asks Did you zoom out before entering this position.
Another thing is don't react to the noise immediately. So news trading is great. But first off, you're not faster than the machines Eligos will beat you every time to breaking news trade. Secondly, it's a great way to get whipsawed out of a position. Often you'll get a better entry after that initial volume rush. So my suggestion is stay patient. If you think the news is worthy of a position, even if you're day trading, you will often get a pullback to the 8, 21 or 65 period Moving Averages when trading off of 1, 5, or even 10 minute chart for intraday type trades.
And then finally, trading illiquid options. You know, this doesn't matter as much really when you're trading a few contracts. But as you increase in size, it's gonna matter a lot. Entering into a position with no open interest, or a stock that generally has little open interest sticks out to market makers. We call these Roach motels a lot of the times because you can check in, but we'll never check out. I also kind of like the reference the Eagles song Hotel California is a good analogy since it's very similar.
So you know what they're going to do is they're going to let you in, but when you try to get out to manage risk, because it's at a loss or even a take profit. What's going to happen is you're going to see the bid ask widen on those options. So your exits are going to be extremely inefficient and often cause you to have a much larger loss than you may have had or collect less of a profit.
Here's one chart, I know I usually post a bunch of charts and talk about them and go over some data. This is one I just wanted to kind of throw out here because I wanted to go over mistakes. But what we did see on Friday was an all-time volume record in options. So it was 62.2 million contracts. And that was 69%, above our recent average levels, with puts leading calls 11 to 10. The previous I think 60 million day was the final Friday, last year, in January, it was during the Gamestop frenzy. So putting in this record is really a great thing, I think, for the options industry that showing that we're growing, and we're here to stay. So, you know, we hope that you kind of join the movement and stick with some options trading.
That's it for me today. Thank you for your time, you know, over at Schaeffer's, we'd love to chat with you about your options trading. So feel free to come over to SchaefersResearch.com, feel free to follow us @Schaefers on Twitter, we're always posting good content regarding options market or technical analysis. We have services that you can buy or read Schaeffer's. But also, there's a bunch of free education material free news. So if you want, you can just go over there and check that out. We are options news a little bit different than most places. So maybe you can find some kernels of information that are different, and supports your ideas.
Neal Hamilton
Matthew Timpane! Oh, I love cutting Luke off at the end of the session. Matthew, that was fantastic. As always, I want to get some ones in the chat if you liked those formula slides for looking at your success rate and, and things like that. And let me know also what that one. Did that help you think about how you're actually compiling wealth With options a bit differently. There's a little more to it when you're talking about options trading than just with buying common stock.
Alright, so we got one in the chat. Matthew.
I see folks in the chat asking for a link. I'm going to put it in there in just a second. So I have the link to
Neal Hamilton
Yep. So yeah. So just just keep your seatbelts on. We're going to get you a link over to Shaeffersresearch.com. Really good trade signals with really good contacts. And Matthew, thanks so much. I think that was I think that was the best presentation yet. It's better every time.
Matthew Timpane CMT
Well, thank you. I you know, I think it's just important that people kind of review these things every year because especially coming up this year. I mean, it could be volatile, and I think you need to be able to know what to avoid it and make sure that you're doing the right things when trading options.
Neal Hamilton
Beautifully stated. Matthew Timpane, thank you very much for being with us today and have a great weekend.
Matthew Timpane CMT
Wonderful. Have a great weekend, guys. See you next time.