28 Things I Know For Sure

by Bill Burton on September 16, 2011


I don’t know many things for sure.  Life is uncertain. I find it helpful occasionally to reflect on things I have learned the hard way.  For those navigating the seemingly complex world of options for the first time, here are a few things you can take to the bank:

  1. Ancient Chinese philosophers realized that with great danger often comes great opportunity.   Remember that only those who survive the great danger are in position to profit from great opportunity.  Risk control is paramount.
  2. Conventional wisdom tells us that only death and taxes are certain.  Here is another certainty:  The extrinsic (time) component of the option premium goes to O at options expiration.  Always. 
  3. Although statisticians would argue the point, the probability of occurrence of an extremely unlikely event is made much greater if you “bet the farm” on the event not occurring.  Never forget that black swans do exist and routinely appear at the most inconvenient times.
  4. The human brain is not inherently logical.  It evolved for survival and is prone to make erroneous assumptions and incorrect associations.  The only way to guard against these potentially costly errors is to challenge your assumptions continuously.
  5. Absence of proof does not constitute proof of absence.
  6. Thinly traded options are usually characterized by egregious B/A spreads. You may be able to negotiate acceptable spreads to enter the trade.  You will not be able to do so if you need to exit.  It is usually better to stay away from these pits of quicksand.
  7. Option orders executed as at least a 2 legged spread always receive better fills than individually placed orders.
  8. Failure to consider the current position of IV in an historic framework for the particular underlying in which you are contemplating a trade will usually cost you money.
  9. Failure to follow predicted changes in volatility prior to a known event (e.g. earnings, etc) indicates there is some factor of which you know not.  When discovered, it usually impacts your position negatively.
  10. Failure to use and understand option modeling and option modeling software puts you at a significant competitive disadvantage to other participants in the options market.  The only thing more expensive than having available and using appropriate modeling is not having it.
  11. It is stunningly easy to “roll more than you can smoke”.  It is usually disastrous to attempt to smoke all you have rolled if you find yourself in these circumstances.  This is another reason to model trades and crisply define your risk.
  12. If you create multi legged option beasts by manually entering the orders as opposed to entering from a graphical presentation, you will enter positions incorrectly and end up “upside down” and commit other similar errors more often than you thought possible.
  13. You must monitor the magnitude of extrinsic value when short options are ITM. Failure to do so and to consider your trade plan in light of these developments will result in unanticipated early assignment at the most inopportune times.
  14. Option positions can usually be easily adjusted to improve their structure only before they enter the ICU.
  15. Forgetting to honor time stops when holding certain varieties of option beasts can be as costly as forgetting price and/or P/L stops.
  16. Good traders know what they know; great traders also know what they don’t know.
  17. If you don’t understand the trade and its structure, you will lose money.
  18. Buying OTM options as a single position (as opposed to representing one of several legs of a spread) is almost always a bad idea.  OTM options are usually better to sell than to buy.  Probability of a successful trade is enhanced by selling sizzle and buying steak.
  19. Keep your trade sheets tidy.  Allowing short options with minimal value to remain on your sheets as opposed to closing them for trivial cost is not being frugal; it is denying the existence of unforeseen and unforeseeable risk.  Black swans regularly appear and are never welcome visitors to a portfolio.
  20. In trading options, as in life in general, you will make many errors.  Each mistake contains a lesson.  Study your unsuccessful trades and learn the lessons each teaches.  You have already paid for the instruction. 
  21. Pickpockets prowl the option markets with great regularity.  Their bread and butter trade is buying ITM options for less than the intrinsic value.  Never sell an option for less than intrinsic value.  Be aware that you may have to execute “Plan B” to capture the entirety of the intrinsic value unless you wish to support this unsavory element.  Learn how to implement the various configurations of “Plan B” prior to needing them; the heat of battle is not the time to encounter things with which you are not already familiar.
  22. If all you have is a hammer, everything looks like a nail.  The available option strategies are numerous and designed to accommodate a variety of market conditions. If you limit yourself to only 1 or 2 strategies, you are not taking full advantage of the inherent flexibility of an options approach.  Learn several strategies, their nuances, and indications for their use.
  23. Avoid having option positions open on stocks that will split.  Option trading has adequate complexities without dealing with non standard strikes and changes in contract size that may result from splits.  Your head will explode trying to deal with these complications.  Avoid them like swine flu; spend your energy elsewhere.
  24. Understanding of the various concepts of volatility is essential to the success of all option traders.  Volatility can be considered in light of:

a. What was (SV, statistical vol; HV historical vol; different words and abbreviations for the same thing),
b. What is,
c. What shall be (IV, implied volatility, Market Implied Volatility (MIV); confusingly disparate words and acronyms signifying identical concepts) 

Of these three, IV is by far the most important. The nexus point is right here, right now. The future is unclear and will always be so.  It is essential to understand IV and its various implications.

  1. Be relentless in your pursuit of perfection but accepting of the fact that you are human and will never achieve it.
  2. The first half hour of each day in the option markets is usually quite noisy; the predominant activity is fleecing of the sheep.  Don’t be one. 
  3. Obfuscation of the basic concepts and structure of option strategies is the everyday business of the option community.  The names of the various strategies are multitudinous and confusing.  Understand the concepts and be conversant with the various names of the strategies; success lies in analysis and execution not nomenclature.
  4. Those who do not understand options are unrepentant naysayers to an options based approach to trading.  Realize that these criticisms generally come from those too lazy to make the effort to understand the fundamental concepts.  Do not acquiesce to their seemingly logical but intellectually dishonest bias.

Life is too short to re-invent the wheel.  Incorporate these observations into your trading; focus on the new things to learn.


{ 1 comment… read it below or add one }

Dave Synnott September 18, 2011 at 7:48 pm

Sage advice well received thank you

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