Using options requires the proper mindset. When recommending an option strategy to a client, it is important that they have realistic expectations. Equipping a client with realistic expectations has three parts, stating the initial intent, having an exit strategy and planning for monitoring the position.
Is your client an investor or a trader? The answer depends on your client’s initial intent, and the answer has implications for the way capital is managed, how an exit strategy is planned and how closely a position is monitored.
Your client’s first decision regards the underlying stock. Is your client’s intent to buy it? If a stock is owned, is your client willing to sell any or all of the position? Generally speaking, investors have a desire to own stock for the “long term,” while traders are interested primarily in short-term profits.
If your client is a buyer of calls and the intent is to acquire the stock, then, sufficient cash, or cash-like securities, should be set aside to purchase the shares if and when the calls are exercised.
If your client’s intent is to earn a short-term profit from a predicted price rise in the calls, then it is not necessary to plan for the purchase of stock. However, a capital-management decision must still be made. Of the total capital available for speculative trading, how much will be committed to this trade? There is no objective to such a question. Every trader must make an individual decision.
Consider a second strategy, selling puts, which involves the obligation to purchase underlying security. An investor who wants to purchase the underlying shares can sell puts that are collateralized by sufficient cash to purchase the shares. This is known as selling “cash-secured” puts.
A speculative trader, in contrast, might sell “naked” puts, which are collateralized by a smaller margin deposit (cash or marginable securities) that is not sufficient to purchase the underlying shares. If assignment of a naked short put occurs, then it is likely that the trader will receive a margin call. Traders who sell puts should know that early assignment is possible, and they should plan accordingly.
Whether your client is an investor or trader, you can help your client develop a plan for the amount of capital and risk that will be committed to each trade. Will your client commit 10% of total capital to each trade, 15%, 20%? The answer is a subjective one and will be different for each client. Part of the answer will involve a decision about the number of positions that can be monitored at one time. Is your client comfortable with three positions, five, ten? Again, the answer will vary from individual to individual.
The issue of capital management is especially important to speculative traders who use margin strategies and thereby get leveraged exposure to price swings in the underlying stock or index. Leveraged profits are terrific, but leveraged losses can have devastating consequences. Consequently, a trader who uses 15% of total capital as the margin deposit for one position could be exposed to a significantly greater percentage risk of total capital. In fact, some options strategies have unlimited risk. This is an important introduction to the next topic, the need for an exit strategy.
When the position is established and the capital management decision has been made, the next step is planning an exit. Both positive and negative outcomes should be anticipated and included in an exit strategy.
Consider first the investor who bought calls and is pleased to see the stock price rise and the calls appreciate. If the goal remains to acquire shares, then exercising the calls is the obvious choice. However, if additional information has changed the original intent, then selling the calls is an alternative. Exercise or sell? How and when is the decision made? You should help your client formulate answers to these questions when the position is established, not on the day before option expiration.
Now consider a negative outcome, when a call buyer has the dismaying experience of watching the stock price decline. For an investor who’s intent is to purchase stock, this may not be such a bad outcome if the goal is kept in mind. Although the value of the call declines, it is now possible to purchase stock at a lower price. The net result may be a net positive.
For a speculative trader, however, there is no way to sugar coat a declining call price. This is a losing trade. Of course, every experienced trader has losing trades, but good traders know the importance of facing a loss and, at the appropriate point, selling the call to close the position and realize the loss. This is never easy, but it is somewhat easier if a loss point is established when a trade is initiated. Some traders, when confronted with a losing trade, will agonize, “Should I hold? Should I sell?” Other traders reduce the negative emotions of a losing trade by having a predetermined stop-loss point. If that point is reached, they exit the position. They can then focus on the productive business of selecting the next trade.
Trading options is about planning trades, managing capital, monitoring positions and sticking to an exit strategy. If you help your clients develop realistic expectations, then you can strengthen your relationships with your clients and make them better options traders as well.
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Options are not suitable for every investor. For more information, consult your investment advisor. Prior to buying and selling options, a person must receive a copy of Characteristics and Risks of Standardized Options which is available from your broker or from The Options Clearing Corporation (OCC) by calling 1-888-OPTIONS, or by writing to OCC at One North Wacker Dr. Suite 500, Chicago, IL 60606.