It was with a very heavy heart that I chose the topic for Know Your Options this week. We will probably never know for sure what happened, but it appears that a young trader took his own life last week over what appeared to be severe losses in his account – and also that he may have been significantly mistaken about the total amount of those losses.
I certainly can’t blame this young man or the platform he was using to trade options, and I definitely don’t want to make the situation any worse than it already must be for his family and loved ones. My heart goes out to everyone involved. It’s a truly tragic situation.
I do also think this may be an opportunity to discuss the concepts of risk and reward - and also clear up some of the confusing things you might see on a statement if you’re trading actively.
Everyone's Favorite Trade - the Long Call
When I first learned about the concept of an options contract, I was immediately drawn to the concept of buying calls. (I’m guessing this is a pretty common reaction.)
If I had a good feeling about a stock, I could use a relatively small amount of money and get big leverage and unlimited profit potential on my investment - as well as completely limited risk. The worst case scenario was that I wasn’t correct and I might lose the entire amount I paid for the calls.
On the first few trades, I lost the entire premium every time.
My first boss told me that buying options was only for suckers and the only people who made money in the options market were the sellers.
That wasn’t exactly true either. Over the next 26 years, I came to the conclusion that either strategy – or a combination – could be successful. The most important part is having a clear understanding about exactly what your position is, how to mitigate risk as it appears and how to maximize your profits when things go your way.
By design, many of the concepts I discuss in this Know Your Options are pretty straightforward. Especially in the case of spread trades, I generally describe instances when you know exactly what you have at risk and what you stand to gain.
Actually, when I used to train new traders about options theory, I would tell them that no matter how complicated it might seem at first glance, the basic concepts of any trade are:
Who do I definitely have to pay?
What might I have to pay?
What will I definitely get?
What might I get?
When will those payments occur?
Those simple questions will get you to the heart of any options trade or position, but around expiration, you need to be especially careful and fundamentally understand what will happen.
I’ll use a simple spread as an example.
Let’s say you were bearish on the shares of Apple (AAPL - Free Report) . With those shares now trading around $360, you buy the July 340 strike put and sell the July 330 strike put for a net debit of $3.
If the stock is below $330 at expiration, your spread is worth $10. It doesn’t matter whether the shares are trading at $329 or as low as $1, you’ll buy 100 shares of stock at $330 and sell 100 shares at $340. Net of the $3 you paid, you have a $7 profit. Good for you!
If the stock is above $340 at expiration, both puts expire worthless and you lose the entire $3 you spent. Theoretically, that’s the worst case scenario. It’s a pretty simple trade to understand.
There are some pitfalls, however.
The Options Clearing Corporation will automatically exercise any option that’s in-the-money based on the closing price of the stock on the expiration date. You can advise them through your brokerage firm that you don’t want to exercise your long option, but if you’re long the 340 puts, AAPL close at $339/share and they don’t hear from you, you’re going to sell 100 shares of stock.
If Apple were to close at $339 at expiration, you’ll be selling 100 shares at $340 – a profit of $1/share. If you buy 100 shares for $339 right before the close of trading, that dollar is locked in. You still lost a net of $2 on the trade including the premium you paid, but that’s a pretty manageable loss.
If you don’t buy the shares however, you’ll simply be short 100 shares and both options will expire. If something very positive happens over the weekend and by the time you buy back those shares, Apple is trading $345/share, you’ll lose an extra $5/share.
If something really good happens and AAPL opens at $400/share on Monday, you’ll lose $55/share.
The potential losses are theoretically unlimited.
It’s terrifying, right?
It doesn’t have to be.
The way I see it, you have two choices that will both make your life easier. You can close the spread prior to expiration so that you have no risk at all. It might mean selling a spread that’s almost certainly going to be worth exactly $10 for $9.95 or $9.90, but forgoing the last few cents of profit on a winning trade is a small price to pay to sleep easy at night.
If you can’t or don’t want to close the trade, it’s absolutely essential that you pay attention to where the stock price is at expiration and figure out whether you just bought or sold shares – and thus have a position in the underlying.
There’s also a possibility that the shares are below $330 and you’re experiencing the maximum profit, but your brokerage firm might post the share buy and share sell at two different times and your account will temporarily show a big credit or debit.
Here’s the good news. Your brokerage firm has a vested interest in you not losing a large amount of money and they’re going to do everything in their power to prevent it. Mistakes still happen and I wouldn’t recommend leaning on this as a last resort, but if you have big risk, there’s a good chance you’ll be hearing from them!
The best thing you can do is make sure they hear from you first. If you’re at all unsure about what’s happening in your account, please get in touch with an account representative and make sure you know what’s going on. If you’re even a bit unsure, make sure you find out what the exact position in your account is.
Successful trading is extremely gratifying. Losing money is frustrating, but it’s survivable as long as you know what you’re getting into when you make the trade.
Please make sure you totally understand the risks you’re taking and make the smartest decisions you can.
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