Friday, January 25, 2013

Basic Option Trader Jargon Decoded

Trading jargon is notorious for creating confusion.  Let’s decode 4 critical trading concepts:


Trader explanation:  Imagine a crystal-clear lake. You jump in, you swim with the fishes and you jump out.  But imagine that same lake tarnished with oil.  You jump in, you can hardly move and the fish are especially unhappy.

Trading a liquid product is like swimming in a good lake. You can enter & exit positions quickly.  And with less ‘slippage’!  Slippage is the difference between your trade price, and the average of the bid/ask spread of the stock or option.  But, when you trade a product that isn't liquid, you might get stuck in the trading goo.  You might not be able to execute a trade near its current price, because there aren't enough buyers and sellers. And slippage is potentially higher, because you might have to sell the illiquid product considerably lower, or buy it considerably higher, than its current price.

You can easily identify liquid trading products by high volume, open interest, and bid/ask spreads just a few pennies apart.  Before you place an order, check the liquidity.  If you don't think a product is liquid enough to trade, look for a more liquid stock in the same sector.  Ask your advisor!

Trader explanation:  Volatility (in a sense) “rates” the market's opinion of the range a stock or asset could move in time—say, a day, a week, or a month. Volatility numbers are often expressed as a percentage of the underlying stock price, and are annualized.

Theoretically, a volatility of, say, 30% means that 68 % of the time, the stock could be between + 30 % or -30 % from the current stock price in one year.  But, traders think in dollars and are therefore more likely to care about what the stock might do in the short term—i.e. the next day, week, or month, than one year.  

So how do you convert the “vol” number to a different time frame to dollars?
Monthly: divide by 3.5
Weekly: divide by 7.25
Daily: divide by 16
For example to calculate the range – using the 30% volatility example above for a $50/share stock price – for one month would mean:
(0.30/3.5)* $50            = $4.28
$50 + /- $4.28              = One month range of $45.72 to $54.28

Trader explanation:  Probability is complex math.  Rather than focus on formulas, consider what drives those numbers, namely implied volatility.  All things being equal, the higher an option's price, the higher its implied volatility.  This makes the probability formula generate a higher chance that the out-of-the-money option could be in the money by expiration.

Total market activity – i.e. what traders/investors believe about a given option at its expiration, and how they behave – can drive an option price up or down.  Over time, price fluctuations change the implied volatility, which then affects probabilities.

Probability numbers can't tell you whether a stock is going up or down.  But, they can attach a number to “market expectations” of a price change and/or its potential magnitude.  Although an option might show a low probability of being in the money, it doesn't mean it won't be.

Trader explanation:  To a trader, the cost basis is a position's breakeven price—or the price the stock has to reach for the position to be profitable.  If a trader is long stock, or even long further-expiration calls, often the goal is to reduce the cost basis.  The less a stock has to rise in order for the position to be profitable… the greater the likelihood of making a profit!

One way to reduce the cost basis of long stock is to sell out-of-the-money calls against long stock, or long calls.  You may have heard of a covered-call strategy, where calls are sold against long stock to generate income, and/or to act as a partial hedge.

But traders don't think of it like that.  A stock can't go lower than $0.  So, the lower your cost basis, the less risk.  Also, with a lower cost basis, you can increase the probability of making money on a given position.  To a trader, the credit realized when selling a covered call reduces the cost basis.

This blog strives to educate, and not provide financial advice.  If you need a detailed understanding of some of the terms above, or investment advice, please contact a licensed professional advisor!

Tuesday, January 22, 2013

What is a Trailing Stop?

A trailing stop is an order entered with a stop parameter that creates a trailing or moving activation price.

What does that mean?   

Example # 1:  Let’s say you bought a company’s stock for $10 and that stock is currently trading at $15/share.  If you had entered e.g. a 3% trailing stop sell order, and the stock were to fall in value by 3% or more from its new high at $15/share (about $0.50), the trailing stop order will help prevent you from losing too much of your posted gain.

In a bull market (when stocks are going up)... you effectively will not lose money using this methodology, although it is possible that you may have been able to achieve a greater gain without the trailing stop order executing (commonly aka greed)!  

When the bears pounce (when stocks decline in value)... you limit your losses - if any - within a set percentage or dollar range that you have pre-determined, and are comfortable with!

Example # 2:  As the bid price for the stock moves up, the activation price (for the sell order) trails the new, higher value.  Using my “$10 buy / $15 current” stock price example above, if the stock were to move from $15/share to $20/share over a period, the trailing stop sell order will trail the increased price over that same period, e.g. becoming 3% of $20 (or about $0.60/share).  This means that if the $20/share stock were to lose about $0.60/share in value – having fallen from it’s bid price of $20/share – the trailing stop order will be activated, becoming a market order.

Example # 3:  But stocks also go down in value.  So, conversely, if you had bought the stock at $10/share and this stock is currently trading at $8/share, you could enter e.g. the same 3% trailing stop sell order to mitigate your risk of losing more of your investment.  If the bid price for the $8/share stock then declined by about $0.25, it would trigger the sell and your position will be closed at around $7.75/share, limiting potential further financial loss.

Why should we use a trailing stop sell order?

Firstly, to help manage and control your investor emotion!  Secondly, for long positions (where you intend to own the shares for a while), this technology – provided by your online brokerage account (or broker) – will help maximize and protect your profit in rising markets, and limit your losses in falling markets… and everyone would like to achieve that, right?

Above I’m discussing Trailing Stop Sell Orders, but the same functionality can also be used for buy orders.  When selling short stock positions (when an investor expects the stock price to go down) a Trailing Stop Buy Order can help protect profit in falling markets and limit loss in a rising market.

An illustration, courtesy TD Ameritrade:

Be sure to explore and become familiar with these (and other) technology tools that are often available at no cost to investors… tools that will assist you in managing your investor emotion, and help you in your quest to achieve a maximum return on your investments! 

Best of success with your investment decisions!

Monday, January 21, 2013

Life Sucks!

... or does it? 

Well, I had to try and grab your attention!

Over the past two days, Deb and I have seen a woman, all by herself, screaming at the top of her lungs, her anger somehow directed at the ocean; a homeless man looking for a comfortable piece of concrete so he could take a nap in the middle of the day; a man evicted from a municipal bus for not paying the bus-fare when he had boarded the bus; three females, one 50-something, the next perhaps 20-something, and a young girl maybe aged in single digits begging for money with a hand-written sign saying "please help, we have nothing."  City life... in San Francisco.

Now, most of us have an ability to find a reason to complain about something, right?  I'm too fat, too thin, poor, unhappy with my job, don't have enough money, my dog hates me, the roof leaks, whatever.

It's often very tough to reverse-engineer such thoughts, or to explore some counter-intuitive thinking in order to arrive on the right side of an unhappy/happy equation.  Descartes famously declared "Cogito ergo sum," (translated from the original Latin: "I think, therefore I am"). 

Let's start by flipping his philosophy around and say "I am, therefore I think."

For starters, we can successfully land at the "I am" part of this equation quite easily.  It's true that you are, right...?  Because if this were not true, you wouldn't be reading this blog right now.  Since we should all be able to agree that "I am," let's move onto the second part... "therefore I think."

Have you ever wondered how we are able to create something out of nothing with such incredible ease?  Thinking allows us to do this.  Not deep thinking, just ideas.  Of course, you could have a million ideas and they're all instant because thought is instant, but that doesn't mean that you will necessarily execute on the thoughts (and sometimes you shouldn't anyway).

Let's go back to the second paragraph above... too fat, too thin, etc.  You may have noticed a common thread in the examples I have offered: they're all absolutely within your control.  You determine the outcome and result of most things that impact your life!  There are things that are absolutely outside of your control, but that would be much greater challenges, like life and death.

People constantly search for answers to a better life - or even a life after death - by studying and clinging to philosophies or religion, reading self-help books, paying others to help motivate them, chasing material possessions, buying stuff they don't need, and much more.

Have you even noticed how the best things in life are usually mostly the things that are also "free?"  Sharing a cup of coffee with a loved-one; a walk outside with someone you love, e.g. surrounded by nature & fresh air, or alongside a beach; a hug from someone you love, etc.... these are really the things that cause life not to suck!

There's an adage I learned when I served a few years in the army as a medical orderly, and that was simply that "touch means so much."  I have tried to carry this forward in other areas of my life, enjoying many little moments that can be treasured.

So, the next time you think life sucks, think of this philosophy: The sentence you have just read is in your past and the words that follow are in your future.  That's also how fleeting the suck factor is.  

Simplify your life and remove the elements that cause you stress and/or distress.  If you activate your senses to ensure that your body and mind is exercised and healthy, other life factors - like your job, finances, personal relationships, etc. - will be more rewarding also.

When you feel down, you may realize that you had been happy a short while ago, and you'll look back at your down moment as something that happened in the past, the moment you are feeling happy again!

That's how fleeting our life experiences and thoughts really are.  Now, all you have to do when life sucks, is remember that in a little while - the time required to experience happiness again simply depends on the cause of the unhappiness - your life will be brilliant once more!