Timing is really everything.

Blow-off Top or Pull-Back?

Most traders I talk to are in one of two schools of thought right now. Either you think this is the best shorting opportunity for the next 2 years or you are convinced that we are now in a new bull trend that could take the S&P 500 well above 1,500. It’s pretty much split down the middle honestly.

Whatever camp you are in there are some key stats that are glaring and cannot be brushed under the rug:

1) The VIX closed the week below 20 for the first time since last July.

2) S&P 500 is three standard deviation points above its 20-day moving average.

3) AAII Sentiment is near extreme levels at 47% Bullish compared to 29% Neutral and 23% Bearish.

4) S&P 500 contract short interest has declined nearly 32% – no more short squeeze?

Stick to Your Guns (And Indicators)

Will a top come soon? Maybe (hopefully) but who the heck knows right. I know I have been getting itchy to trade more as I’ve been mostly in cash for nearly a month now. Not that I don’t want to trade, but I think that better risk/reward ratios will come soon and I’d rather have cash on hand to make those trades.

During bull market trend’s like this I find that keeping an eye on the indicators is best. They can and often stay over-bought for weeks but eventually they do break and divergence will be the early warning signals. Look for momentum indicators to drift lower even though the market will continue to move higher.

A key part of a financial education is understanding the basics of risk management with respect to your entire portfolio; specifically how your income capabilities and your risk tolerance level should determine the allocation to options.

The Importance of an Emergency Fund

Before you even think about trading options (or any other investing for that matter) it is essential that you have set aside an adequate emergency fund to prepare yourself for the unexpected events. Although many experts may debate the actual amount of money needed in such a fund, the general consensus is that you should be able to support yourself for three to six months from your emergency fund.

Since an emergency fund is designed to protect yourself in case of an emergency, that cash should be easily accessible in a highly-liquid savings account or money market fund. Check out our post on the top 8 places to park your cash for ideas.

Under no circumstances should you think about investing these funds in options; given the risk management characteristics of emergency funds, this cash should only be placed in accounts that have very little risk attached to them. And never make any excuses as to why you “need” to take money out of it. It shouldn’t be used for a new car purchase or a new iPad.

Finding Cash to Invest in Options

Once your emergency fund is fully funded, you can start to think about the cash that is available to you for options trading. If you have any additional savings that is not a part of your emergency fund, this cash could conceivably be used as part of your allocation towards options trading.

In addition, I would make it a point to include or at least allocate any future income that you earn from your current job to grow your portfolio. Budget out your monthly expenses and include a line item for the “trading fund.” At least that’s why my wife and I do each month.

5 Things to Consider Before Investing

Although such a broad-based education in personal finance could take a lifetime to learn, a few key lessons that I have learned along the way and wanted to share are as follows:

• Always have an adequate emergency fund of at least 3-6 months.
• Do not invest in anything you don’t understand. Hence why we offer free education.
• Diversify your investments among asset classes, strategies, and timelines.
• Never invest money you can’t afford to lose (beginners pay attention here!)
• If you worry about risk management first, the profits will take care of themselves.

Options trading is an inherently risky financial activity that should only be pursued by those people who have developed effective risk management and asset allocation strategies. However, if you are willing to obtain the education and perform the hard work necessary to make money at it, options trading can be a very rewarding and profitable.

How Casino’s Make Money

In very simple and easy to understand terms casinos make money by slightly tilting the odds and chances in their favor. Every game you gamble on in a casino has a built in statistical advantage in favor of the house. That edge can be extremely small (as low as 2% sometimes), but millions of bets with that edge started to add up.

The casino owner’s could care less about any but getting as many people through the doors as possible to gamble. Hence why they offer free drinks, food, great shows and amazing hotels. The more people gamble the more the casino makes.

Casinos know the odds and stick to a very strict risk management plan.

Probabilities and Odds When Trading

It’s fairly easy to find odds data on a particular stock, ETF or index that can transform your trading. By knowing how to analyze historical probabilities you can quickly narrow down your strategy list and choose option strategies that are more likely to make you money over time.

Just like the casino, the concept of trading professionally is knowing up front that you are going to have both winning and losing trades. The key to success is to make sure that the winners outperform the losers on a consistent basis – not just once in a while. Tilt the odds in your favor by making smarter decisions up front and managing risk along the way.

In this video I’ll show you how to find, analyze and choose an options trading strategy using thinkorswim’s desktop platform tools.

Differences Between Weekly & Monthly Options

Before discussing the various trading strategies that can be build with weekly options, it is important to go back and review some of the more important trading terms. Remember that weekly options are different in that they have a much shorter lifespan. Most of these weekly options start trading on Thursday and expire the following Friday. This provides uniformity and also allows traders to easily “roll” weekly options from one expiration to another.

Four Strategies You Can Use

1) An investor can use weeklies as a pure play. Because they do not remain open as long, the may involve somewhat less risk, but it is important to consider liquidity constraints, as many weeklies have smaller markets. The lower risk of a shorter holding period is lost if the instrument is illiquid and the investor cannot trade the position when needed.

2) Offsetting positions can be taken at certain times during the month between weeklies and monthlies. When the options expiration of the monthly contract is nearly identical to the expiration of the weekly option, there may be a price difference that can be captured between the two.

3) You could take a position in the monthly contract and take rolling positions in the weekly contract in the opposite direction. The idea is to establish a consistent hedge against short term market volatility but make sure that you factor in the higher transaction costs for getting in and out of the market more often.

4) The last approach to using weekly options is to use them to supplement income from an underlying position. This is often called a call writing strategy because the investor who owns the underlying instrument writes calls on that position and collects the premium. If the underlying remains static or falls, the investors makes a profit or mitigates losses. If the underlying rises, he or she may miss some of the profit, but the downside protection is used to justify this risk.

What About Trading Daily Options?

Rumors have been floating around the web about the possibility of daily options as the next logical product for traders. We already had monthly options and weekly option popularity is growing fast. Add your comments below and let me know if you would ever trade a daily option that started trading in the morning and expired that same afternoon.

The wording is subtle yet there is a powerful difference between return on capital and return of capital. The first is the return on the money you invest. For example, if you made $8 on $100 of invested money you would have an 8% return on capital. The later is the ability to at least get your $100 back at the end of the day and not lose any money.

Success Is Measured By How Much You Keep

I firmly believe we are entering another very tough and potentially devastating year for stocks. It feels oddly similar to the same market sentiment just before the crash in 2008 – just a new catalyst to trigger the fall (i.e. sovereign debt).

Back at the start of 2009 the best money manager and investors weren’t those who earned the highest return in 2008 but rather those who lost less than everyone else. Being a “smart” investor then meant having money left after the shit hits the fan and the same is going to be true of those investors in the coming years.

Looking back at my trading journal (and this blog’s archives) I know that what was so successful for me trading during 2008 was that I had small positions and a lot of put protection. Moreover, I stayed mostly in cash and waited for the best opportunities to come out before I put money at risk. Living through that time and surviving taught me to focus my attention on return of capital.

From $20/share to Bankrupt In Just 5 Days

Above my computer in my office is a picture of the October 1929 crash newspaper front page. It’s there to constantly remind me of what can happen seemingly overnight. The systematic risk factor that is prevalent in all markets.

Lehman Brothers is also a classic example and still recent enough to remember the pain of a market crash. Keep in mind that it took just 5 days for Lehman to go from a $5 stock and still worth millions of dollars to bankruptcy. And even 9 months before the crash Lehman was a $60 stock. Always remember how quickly things can turn!

Add your thoughts below in the comments section about the top strategy you are going to use to protect your portfolio this year?

Including dividends, the S&P 500 total return index (which is what we track against) returned 2.11% for 2011. Better but still poor performance. Think about it this way; even including dividends you lost money after inflation, which is running at 3.4% trailing 12 months.

Slow & Steady Wins Again!

Each year it amazes me how conservative trading with options out-performs when used with proper risk management. I never had shot for unrealistic returns that cannot be duplicated month after month – and this has been very profitable for me.

This year all 3 Option Alpha portfolios beat the major index by a large margin. Funny how consistently making 1-3% each month really adds up at the end of the year and in my opinion is much safer than blindly putting money into the stock market and praying for returns.

Doing a quick review of the year this week, I have some general comments that I thought might be interesting to share…

1) Notice that you don’t have to trade each month to have amazing performance. Notice that we did NO trading for the Iron Condor portfolio in the 2nd half of the year and yet still made 26%+. Lesson: wait for the right time to trade and don’t force trades into the market.

2) Trading was much more profitable on a monthly basis early in the year. During the 2nd half of the year we scaled back our positions and focused more on risk management and rolling trades to protect against the summer sell-off. Although we sacrificed  some income, I feel the added risk aversion was a big winner for us this year. It’s how I got through the 2008 crash profitable. If it works don’t fix it right?

3) I still believe that we report earnings better than anyone else. We have a model portfolio which includes cash allocations and only report on trades actually filled. More often than not other sites will say they make 40% or more when in fact they just made 40% on 1 small trade and left the rest in cash. This is NOT an accurate description of their returns. They should factor in the amount of money left in cash earning 0%, and thus their returns should be much lower.

How Was 2011 For Your Portfolio?

Add your comments below and share the “ups and downs” of trading in 2011. What worked and what didn’t? What are you going to change in the coming year to make yourself a more profitable trader? Can’t wait to hear from you all!

So this past summer while on vacation with my wife and her family I came up with the idea to launch a completely FREE video platform for options trading education. And it took me the better part of 6 months to put together more than 126 videos (71 of which are live right now).

The whole idea was to make information easy to find and accessible by anyone. Our Dashboard page is easy to navigate and can direct you exactly where you need to go to learn more about anything from the expiration process to technical indicators and so much more.

Plus we added some more awesome tools including a interactive Amazon bookshelf of the top options trading books and a full Stock Broker Review section. It’s really everything you need to be successful trading and then some.

As I’ve said before and I’ll say it again, I started this “adventure” with the goal to help and educate people on options trading. And unlike other websites and services out there, I refuse to charge you a FEE for access to these video tutorials and education. All I ask is that you willingly share the information and provide feedback on what you like (and don’t like).

This project has been a long road and I’m still not sure how it will be received by everyone. I guess that is the risk I run with 6 months of development and no “real testing.” But I have confidence in what I have put together and I strongly believe it’s some of the best content out there.

As always, please share your comments below and enjoy!

If stocks have a good week, we’ll end the year higher overall. Anything less than a 4% return overall YTD is big loss for investors in my book. With investing expenses, taxes, and inflation a return under 4% to me would be a flat and inefficient use of money. If you aren’t moving forward, you are moving back.

Above are the statistics for the last trading week since 1928. Generally speaking the market has seen gains more than 60% of the time. With the VIX as low as it’s been in recent weeks I’d be wildly surprised to see a sell-off at this point (next year is a whole different story).

Cheap Compared To What?

When someone says they buy cheap options they typically mean that the absolute price is low. They will buy options around $25 each for example and think they are just “stealing money” somehow from the market. But in reality this option below on has a 20% chance of making money at expiration.

You see they are not comparing the pricing to any historical guide or point or reference. Just because an option is priced low doesn’t mean that it’s cheap. And likewise, just because an option is expensive doesn’t mean that it a great investment either.

How To Evaluate Option Pricing

As you start to plan out your next options strategy, there is one main factors you should evaluate before making the trade. Again it’s important to have a frame of reference before you go blindly buying options all over the place that are $25 each and wasting your hard earned money.

Implied vs. Historical Volatility

As option traders we measure how expensive or cheap options are using a parameter called implied volatility, or IV for short. All the data point shows is what the market is pricing in for future volatility of a particular stock.

High IV is synonymous with expensive options and thus shows that there is a lot of fear in the market which is driving up prices due to increased risk. Low IV is synonymous with cheap options and shows either complacency and/or greed in the market.

The implied volatility of the option will indicate the market’s expected trading range for the stock going forward. Since historical volatility can be plotted on the charts you can see how it compares to current implied volatility levels.

Remember, this doesn’t mean that the market will always do what you want it too just because the historical trends are in your favor. It’s all about odds and probabilities. Over time, making the right trade and managing risk will lead to profits.

Spend Your Time Analyzing The Stock

The reality is that the market is going to sniff out any easy profits (always has and always will). There are big banks and large traders who have much more time and money to spend searching for these little pricing inequalities than you or I do.

I suggest you spend your precious time looking at the technical indicators and analyzing the underlying stock.  Timing your trade properly is much easier than digging for a mispricing in the options market.