Need help understanding my risks !!!

Discussion in 'Options' started by vedernikov, Jan 27, 2011.

  1. Hi everyone!

    I need some help understanding risks with my strategy with options. First of all, I must say that I am new to this (options) so your advices are extremely valuable to me!!!
    I started trading stocks about two years ago just when marked hit the bottom. Even though I am happy with the returns on my original investments in stocks, getting it was often a very wearisome process and I am trying to secure my gains while still getting some profit.

    As I was educating myself about options I noticed that there are some out-of-money call options (expiring in about a month) which cost about 3% of the current stock price. I like return of 3% a month :cool:. Now my headache is to make sure I understand the risks.

    What I want to do is this: I want to make sure I OWN the stock as soon as its price goes ABOVE the strike AND make sure I DO NOT OWN it when the price is BELOW the strike. In other words I would have my call covered at above strike – in this case it seams like I protect myself when price is going up too much. On the other hand, if I would sell stock as soon as its price falls below strike – when I protect myself from losses due to further decrease in price of the security.

    So, in my naïve mind it looks like a sure deal – collecting premiums and eliminating the risks by buying or selling stock at strike. And this bothers me A LOT! I must be missing something! PLEASE TELL ME WHAT AM I MISSING !!! :confused:

    P.S. : For the sake of argument lets assume: (1) I can write naked calls (2) I have just enough equity to be day-pattern-trader and (3) I have time to stare at the stock the hole day :)

    Thank you all for your help!
  2. Alex,

    You seem to be kind of all around there in your post. You don't make it real clear what you are trying to do. First of all if you are a starter without a large account, you shouldn't assume that you would be able to sell naked calls.

    That being said, you might have a misunderstanding of how calls work in relationship to ownership of a stock - just because a call moves in the money or out of the money doesn't mean you get the stock, or you are forced to sell it (before expiration).

    Let's say there is a fake stock XYZ at $100
    I think maybe you are saying there is a 110 Call worth $300 and you would like to sell it for the premium, but not loose too much by buying the stock if it goes over $110.

    However, if the stock quickly jumped to say $110, the call might now be worth $1000 (for example) against you. You could buy that back and lose the $700. Or, you could buy 100 shares of the stock for $11000 ($110 each). Now you would have covered your call. Of course, now the stock could fall back to $90/share - the 110 call would expire worthless if it was that at expiration, but your shares are now only worth $9000 - you paid $11000 minus $300 premium received.

    Also, if you sell the 110 call, the real risk is a quick, strong upside move - for example, if it went to $140 overnight, the call would be $4,000 against you - or if you wanted to buy the stock, it would now cost you $14,000 for 100 shares - neither would be a good situation to be in.

    For others to help answer your questions better, you might want to describe more exactly what you want to do.

  3. spindr0


    How do you spell W-H-I-P-S-A-W and G-A-P?
  4. Thanks for your reply JJacksET4!

    Here is an idea in more details:

    Let say there is a stock XYZ with current price of $174.5. It's one month call with strike price of $175 goes for $5.

    If I sell one call I collect premium of $500. Since at this moment current price is below strike - I am at no risk of option being called and therefore I dont see the point to buy the stock.

    Now, if I am constantly paying attention to stock price, then I should be able to see when it goes up very close to $175 (strike price). Thereafter, if I see that the price has reached strike than I buy 100 shares - let say for $175.01 each and hold it for as long as price is above the strike. If option holder wants to exercise the option at any time/price - I should be OK with it, since I have stocks on hand to cover the call.

    If later price falls again below the strike - then I sell stock, say for $174.99 and do not buy it for as long as it is below strike price.

    See my point?? Simply following the stock price and buy or sell stock when it crosses strike price.

    The risk I see is that I can miss the moment when stock crossed the strike price and I ended up in situation similar to what you've described - holding the stock when it is falling way below strike (and I am loosing money on "useless" and depreciating stock); or then price is going up way too high and I don't have the stock (I am also loosing money because I must buy stock for much higher price at some point).

    Of course, there is also an expense of trade - each time I buy/sell I must pay a commission to my broker. But it looks like it most cases I should ended up with money on hand.

    What other risks do you see????

    Hope this clears it up :)

    Thanks again for your time!
  5. Two good points spindr0 !

    Regarding WHIPSAW - it only hits me by the small "predictable" amount per each trade. Although I agree it can be some very long and frequent whipsaw ;)))

    Regarding GAP - that is what I am afraid the MOST'!!! As obviously I don't have a control over price when market is close. Do you think I can protect myself form large GAPs by using Straddle strategy overnigt?

    Let say I buy both a Call and a Put at market closing and if gap happens than I should make money to compensate for my loses in stock price. if it doesn't than in the morning I simply sell both call and put for prices about the same what I paid for them.

    Thanks again!
  6. drcha


    Yes, you may find yourself getting batted back and forth by the stock's movement. You may cover by buying the stock, only to have the stock fall again. Watching the stock all day may not help you, because overnight gaps are often larger than intraday movements. Here is my suggestion: try paper trading one or two of these. Then for comparison purposes, you may wish to also paper trade a ratio spread and a straddle. With these types of positions, you are still naked, but at least you are collecting more premium to start with. In most cases, either is better than a naked call, but they are still risky things.

    BTW, I like your thread title. There are few newcomers here who think this way. It bodes well for you.
  7. Whipsaw - if you tried to make your numbers too tight, there would be too much whipsaw - in other words, I think you would want to give some cushion such as at least $1 or $2 in the stock before going in that direction. 1 cent or even 5 cents can happen in a second. You could end up trading dozens of times trying to earn that $500 premium.

    Gap - To me this is the worst part - if you sell options with a month to go, there is no way to avoid this - many stock daytraders don't hold any positions overnight for this reason.

    Buying a straddle everyday would be too much trading again - if the stock doesn't move much, you gain on the original call sale but now you are losing probably $10-$20 plus a commission minimum each straddle - and you might have to do 20+ of them in a month!

    Probably a more realistic thing would be just to buy an OTM call and put and accept a certain maximum loss if the stock moves too far.

  8. spindr0


  9. cvds16


    regarding the buying below and above the level: if it were that simple all the market makers in the world would be filthy rich within a year, it's a full time job that is now arbed to death.
    To make money in options you'll need a view on at least two out of the three following: direction, time and volatility. Preferably three that is to make good money.
  10. Thanks to all for your replies!

    I will surely keep learning about the options before I do anything. And papertrade, papertrade, papertrade!

    But on the personal note I must say: GAP is the BITCH !!! :mad::mad: :mad:

    You guys saved me a lot of money !
    Thanks again!
    #10     Jan 28, 2011