Last week on Schaeffer's Market Mashup is back, Cboe Global Markets' Henry Schwartz, Senior Director, Head of Product Intelligence, and Robert Hocking, Senior Vice President, Head of Multi-Asset Solutions and Derivatives Strategy, stopped by to discuss the biggest mistakes options traders make when starting out. They discussed the lessons they'd give to their past self, top five mistakes he sees options traders make (4, the broader surge in market participation from retail traders, and how to further educate yourself.
Below is the transcript of the first half of their conversation, on the most common mistakes options traders make while starting out. To listen to the rest, click the Spotify link below.
Let's hop into the DeLorean for a second. What's one thing you'd tell your younger self when starting out trading options?
Robert: Let's hit the flux capacitor! The one piece of advice I'd offer is to just be patient with the learning curve and really immerse yourself in as much education materials as you can find. When I first entered the options world, it was intimidating. Unlike stocks that go up and down, you now have to learn a whole new language of Greeks. Things like gamma, theta, vega, and how each impact your position. It takes time to acclimate to these new inputs and concepts. I found learning went in phases. The first phase taught you the basics of how to communicate. The second phase you can start to anticipate how a position would move given moves in the underlying. The third phase you can begin to actively position yourself, and to take advantage of these anticipated moves. Which leads to the last phase in phase four, and you can start to design specific strategies around your desired outcomes. The process takes time, you can't really rush, and you have to be patient with. Rushing can really lead to undesired outcomes.
Henry: Finding a good mentor and really working hard to surround yourself with people and resources to learn is one of the most important things.
Power ranking any and everything is all the rage on the internet these days. Let's take a stab at power ranking the top five mistakes options traders tend to make.
Robert: I'm definitely guilty of many of these when I started in the business.
#1: I would start with not having a clear entry/exit point for your trade as number one. I would really stress the exit point part. I think it's easy to track different stocks and ones you like, or companies you associate with. But then you have to take that general interest and turn it into clear metrics of where you will get into a trade and then get out. That applies to setting criteria to both winners and losers. Not all trades are winners even though we like to think they are.
#2: Don't let emotions drive your trading decisions. It's helpful to remove all emotion. When emotion is involved, it becomes easier to take your winners off too soon and ride your losers longer than you should. By setting these clear entry and exit points and removing that emotional component from your trading, it helps eliminate second-guessing your decisions in the heat of the moment and playing Monday morning quarterback with your trading decisions. That tends to always be a losing proposition.
#3: I would point to not fully understanding the liquidity of the product you're trading before entering the trade. For some products it can be easier to put on a position than take it off. By understanding the liquidity constraints of each product, it helps you be more realistic about setting those entry and exit points and the associated performance you can expect. You can be realistic about what's possible.
#4: Misunderstanding leverage. Options provide a source of leverage because of their 100 multiplier and appear at times a bit cheaper to purchase in comparison to an actual stock. This can lead investors to having a larger notional options positions than they otherwise would have thought. If they're unfamiliar with this component it can lead to poor decisions.
#5: Not understanding the impact of corporate actions and their impact on options positions. In many situations options have to be adjusted due to stock splits, M&A's, special dividends, reverse splits, etc. For example, when a cash dividend is paid out it typically doesn’t affect the option. But when a stock split happens it can affect the strike price of the option. To understand when and how these events impact your positions becomes extremely important.
Henry: I have also made a lot of mistakes. That's part of learning anything. There's a few tenets that veteran traders have accumulated. It's the kind of stuff guys on the floor would yell out that's catchy and sticks in your brain.
#1: The sizing of positions and trades. You want to be consistent about setting up your trades and how much money you risk, how big you want to be. You can't wing it!
#2: Not being patient and not waiting for the opportunity that you think is coming along because you're impatient. You have to find everything that meets your criteria then you methodically execute a plan.
#3: Illiquid options; they can be a problem the way the market has evolved the last few years. It's a very liquid marketplace in most cases. But you have to understand when liquidity is good and when it might not be good. You have a very different outcome on a trade, or you can get stuck in something that was reasonably tight when you entered and now all of a sudden you're in a bind. What's your Plan B then? Can you manage the trade or offset it in a different way?
#4: Covering shorts. I heard a lot in the pits; when to buy back your short options, don't be a dick for a tick. Which means, if some option that you're short is down two or three cents, you should be covering. There's no reason to leave the risk even if it expires tomorrow. A lot of the brokerage platforms now don't charge commissions at all for options under order, so that makes it a little easier. It's just being disciplined.
#5: Legging into spreads, which is tricky. You have a whole selection problem there. If you're going to do that, you better understand the risk you're taking.
Can you think of a particular moment when having knowing about these mistakes would have been prudent the last two years?
Henry: Just in the last six months we've seen some kind of crazy behavior of some of these meme stocks with things moving faster and further than most people would expect. And that's exactly where sizing comes into play. You can put on a trade and say, "Look, there is no way this stock is going to double by Friday." And most of the time it probably won't. There is that one in a million or one in a thousand chance. Position sizing is just an intelligent way to not blow yourself up. Weird things happen. So, if you're being properly disciplined, and you get some element of diversification by keeping your trades relatively small, it protects you. This year has been a great example with GameStop (GME) and AMC Entertainment (AMC). These stocks have done some really weird moves – very surprising, things that are effectively impossible in your typically probability analysis. And positions sizing is what covers your butt in those cases.
Robert: Understand what you expect and what you want and have that plan going in. Because picking entry and exit points, and really removing emotion from your trading decisions, it's extremely important. And if you don't set those clear boundaries around your trading positions, you could end up chasing positions or, even worse, have your B/D close out your positions for you, which nobody ever wants. But if you go into the trade, and you look at the underlying volatility of the stock, you acclimate yourself to the anticipated moves you could see, and then set clear points to enter and exit, you limit yourself to those defined outcomes, and you're rarely, if ever, caught in a situation where that outcome is unanticipated.
Subscribers to Bernie Schaeffer's Chart of the Week received this commentary on Sunday, June 20.