We continue our series on Options Blunders today, discussing the huge opportunity that options traders miss because they are reluctant to buy long options to protect their short options positions. This video provides a vivid example of how much opportunity is lost by refusing to protect your options positions.
View Video Transcriptokay so today’s video is the seventh in
our series that we’ve entitled huge
options trading blunders
we’ve decided to produce this series for
traders who are serious about trading
options for a living and badly want to
succeed but they keep getting
sidetracked by pursuing strategies with
huge flaws in them instead of taking the
proper steps to excel and improve as an
options trader
I’m the head trader of SMB capitals
options trading desk and I can tell you
for many years of experience that I’ve
seen every one of the mistakes that were
describing in these videos and some of
them I fell for myself when I first
started trading they’re real and if
you’re serious about trading for a
living you really need to pay close
attention to these videos so that you
can avoid serious problems and
unnecessary detours in your trading
journey so if you’re committed to
trading full-time as an option trader
then I urge you to watch this video and
the rest of the videos in this series so
that you don’t fall by the wayside like
so many aspiring traders who don’t want
to spend the time to learn the actual
truth about the rewards and challenges
of options trading and the skills you’ll
need to develop to succeed we want you
to take a realistic path to your trading
goals which are attainable if you’re
serious and willing to put in the work
to succeed
[Music]
hi I’m Seth Freudberg and I’m the head
trader of SMB capitals options trading
desk SMB capital is a proprietary
trading firm located in midtown
Manhattan and we provide capital for
options and equity traders from all over
the world trading both remotely and in
our offices here in New York City now
I’d like to suggest that you click on
our subscribe button right now so that
you don’t miss any of our free trading
videos that we produce for traders and
investors all over the world they’re
really very valuable ok so today we’re
going to be looking at options trading
blunder number seven in our series on
options misconceptions and huge mistakes
that you can make in your journey
towards becoming a full time options
trader so to understand options trading
blunder number seven I need to make sure
that you are familiar with the basics of
how index options work and if you know
something about options don’t worry this
is going to be quick and then we’re
gonna jump into the main part of a
lesson now almost all of you are
probably familiar with equity options
where a call buys you the right to buy
100 shares of a stock at the strike
price of that option any time before the
option expires and a put option entitles
you to sell 100 shares at the strike
price of the put before that option
expires but there are also index options
which work similarly to equity options
except there’s no such thing as 100
shares of an index like the S&P 500 you
can’t really buy or sell 100 shares of
an index but what you can do is to get
paid in cash $100 per point if the index
expires above the strike price of an
index call that you buy or alternatively
you’d be paid $100 per point for each
point the index drops below the strike
price of your index put so for example
if an index is trading at 1,400 and you
buy the 1410 call if the index goes to
1415 you were to receive $500 in your
account if the index closes at 1410 or
lower your call expires worthless on the
other side of the ledger if you buy an a
13 85-foot and the market sells off to
1375 you’d make $1,000 but if the market
just sold off to 13 85 or higher the put
would expire worthless so those are the
basics of index options and
or you can buy options but your broker
will also allow you to sell options and
your broker will allow you to put
together combinations of options in
other words options strategies that
involve both short and long options
purchased in a way that is advantageous
to you as a trader okay so now armed
with that knowledge let’s dig into
options blunder number seven so one of
the core strategies for options traders
is known as the strangle yes I know
that’s a gruesome name and lots of
options trading strategies have these
strange names but suffice it to say that
the strangle is at the core of many of
the top strategies for professional
options traders so a strangle is
actually a very simple trade on its
surface for example let’s say that
someone was interested in trading a
strangle on the NDX
index so on this particular day in
August of 2019 suppose that you decided
you wanted to make a straddle trade on
the NDX
which is the Nasdaq 100 index by the way
companies like Apple Amazon Google
Microsoft and other top tech names of
the major components of the Nasdaq 100
index and it’s a very popular trading
vehicle for options income traders now
on this particular day the ndx index was
trading at 79 66 as you can see so what
some traders like to do is sell a call
way above the price that the index is
selling at and at the same time sell a
put way below the money we can discuss
another time how you would make the
decision as to which short call and
short put to place but for now let’s
just say that this trader decided to
sell the call for options expiring in 29
days at about 350 points above the index
price up at 83 25 for $14.80 and at the
same time sell a put 600 points below
the market price of index down at 70 350
for price of twenty three dollars and
sixty cents now I’d also like you to
notice that your broker would require
you to put up 83,000 dollars in capital
to make this trade please make note of
that because that’s gonna be a very
important fact shortly now putting this
into perspective as you can see on that
day
the 83 25 strike prices well above the
all times highs of the nd accent
furthermore the index had not been as
low as 73 50 strike for several months
so the trader might be thinking hey
there’s a pretty good chance the index
will not rally more than 350 points
above its all-time highs nor is it
likely to drop 600 points from here to a
price that it hasn’t been to in a few
months over the next 25 days so if the
trader believes that the nd ndx will
stay somewhere inside that range between
the short put at 70 350 and the short
call at 80 325 then this triangle would
be a very logical trade for him to make
now we’re about to move forward to the
day that these options expire on August
30th but before we get into that which
will explain how this trade worked out
and more importantly why this trader
completely missed the opportunity to
make a much better trade I wanted to let
you know that there really are sound
viable long-term techniques for trading
options for income and in fact we’re
currently running a to our free
intensive workshop at the moment where
we’ll be teaching you three of those
strategies that real professional
options traders use including a really
simple but incredibly effective strategy
that some of the greatest investors in
the world like Warren Buffett use all
the time plus an options trading
strategy that has a statistical 80
percent probability of profit month in
and month out plus an option strategy
that you can employ with a stock that
you like where you’ll make your target
profit whether the stock goes up goes
nowhere or even goes down a small
percentage so if those strategies would
be of interest to you then you should
check out the free options class that
we’re currently running right now just
go ahead and click the link that should
be appearing now at the top right corner
of your screen that will open the free
registration page in a new window so
don’t worry you won’t lose this video or
you can just go ahead on over to options
class com to register for this free
intensive workshop it’s a rare
opportunity for retail traders and
investors to learn directly from Wall
Street traders but that’s exactly what
you’ll be getting through this free
online workshop so click the link to
sign up now and don’t miss it okay so
now
moving forward to expiration day on
August 30th as you can see the India ndx
index closed its 7677 now being 2:00 in
the afternoon on this day in just a few
hours from the when the options expire
the call option has dropped from $14.80
down to 25 cents because now the market
is close to 600 points from that call
and there’s only a few hours left for it
to get there so that obviously has very
little value and the put has actually
dropped to 17 cents because the market
again in less than two hours has to drop
more than 300 points for that put to
have any value at all now what that
means is that if you wanted to close the
trade at that moment and pocket your
profits those profits would have come in
at 39 48 so let’s analyze why that’s the
case well when we first enter the trade
we received cash into our account for
selling the call and the put as you can
see so for the call we received 14
dollars and 80 cents but that represents
100 dollars per point so you multiply
that by a hundred and you see that we
receive 1480 for the call and for the
put the same calculation you multiplied
the 25 30 we received by a hundred and
you’ll see that we receive 2530 dollars
for that call now to close the trade
we’re gonna need to buy back the call
and the put that we sold to close out
the trade so that’s not going to cost
this much because the calls dropped to
25 cents so that would cost us only 25
dollars in the put has dropped to 70
cents so that will only cost this 17
dollars and so when you do the math the
total profit comes to three thousand
nine hundred sixty-eight dollars on the
transaction okay so you’re probably
thinking how is that exactly an options
trading blunder if you’ve made more than
39 hundred dollars and the answer is
it’s a blunder because you could have
made so much more money out of the trade
with half the capital and half the risk
if you were willing to buy long options
to protect your short options you see
that formation that we just discussed
selling the strangle well you’ll recall
that I told you that we’ll need over
83,000 dollars for that trade and you
may have been wondering hey
if we just sell one call and one put why
do we need eighty-three thousand dollars
in capital for that trade and the answer
is that even though we sold just a one
lot strangle the risk once the market
gets past those options if that were to
happen is substantial why because of the
market were to really sell off very hard
or if it were to really rally very hard
then the risk is enormous because you
have to keep paying $100 more per point
of the index as we discussed before
regardless of how high that index goes
and so your broker recognizes that
you’re basically taking unlimited risk
and they’re going to require you to put
up a huge amount of capital make sure
that you’ve got enough money in your
account to pay off on that option in an
extreme market move well as it turns out
given that you made about thirty nine
hundred dollars on that trade and your
broker margin you about eighty-three
thousand dollars on the trade your
return on the trade was actually four
point seven percent well you’re probably
saying that’s not bad at all for a month
but you’re missing when you say that
that there was a much safer way to
construct the trade where your potential
for return is much greater but it
involves you buying a long haul above
your short call and a long put below
your short put into what is known in the
options world as an iron condor okay so
let’s take a look at what it would have
meant to our position if we had bought
the long call directly above the short
call and a long put directly below the
short put okay so now let’s carefully
break down what’s going on here you see
just like before we’re selling that
eighty-three twenty-five call and the
seventy three fifty puts like we showed
you before but this time we’re buying
the 38 50 call and also buying the
seventy three twenty-five puts now let’s
break down what that means well just
like before we’re gonna receive 14 84
selling the call and 25 34 selling the
put but this time we’re spending eleven
hundred seventy-five dollars to buy the
call right above the short call the 8350
call and we’re also spending twenty
three sixty on that long put at seventy
three twenty five and if you net it all
down you get a credit
of $475 so you’re probably saying
yourself how dumb is that
why would you spend so much money and
end up with a little more than 10% of
the clash flow you were getting if you
didn’t buy the long call and the long
put and the answer is that you’re asking
that question because you have fallen
into options trading blunder number
seven I’m not gonna waste my money
buying long options to protect my short
options now why am I saying that
receiving less cash is an option trading
blunder the most important reason is
that with a short strangle you’ve got
unlimited risk as we discussed but with
an iron condor there’s an absolute limit
to how much you can lose and in fact
your broker knows that and that’s why
the broker margins you so much less in
fact in these two examples as you can
see your broker would have margined you
your account eighty-three six for the
shorts triangles as we mentioned before
but for the iron condor he would have
only margined you 2025 dollars and why
is he margining you so much less well
that’s because the long put protects the
short put so if the market really tanks
the long put starts having value and it
is an increasing value at that point at
about the same rate as the short put is
costing you so the long put effectively
puts a stop on your trade it stops the
bleeding if the market really takes off
to the downside and the same for that
long call if the market blows past your
short call to the upside then in 25
points your long call will kick in and
that will stop the bleeding on the short
call and so your broker knows all this
and only charges you two thousand and
twenty five dollars per option because
you have built in protection into your
trade and the broker knows how that’s
going to work well this fact is actually
huge why because the return on your iron
Condor is way higher than the return on
your short strangle if you think about
it why well let’s take a look at an
example and this will become quite clear
to you so let’s say that on the same day
that we entered into the one lot shorts
triangle trade suppose that instead we
entered into 20 iron condors with the
same short strikes
eighty-three 25 on the calls and 73 50
on the puts like last time but this time
we buy the protective call and puts just
like we showed you on that one lot
example except this time we execute 20
of them now let’s break down what
happens in this case well as you can see
from the calculation if you get $475 for
just one of those condors you get $9,500
for 20 of them you get 20 times the cash
from the options you sold although you
paid 20 times that amount for the
options you buy incidentally yet and
here’s the great part you’re using less
than half of the capital and so if we
move forward to the day they expire you
can see that the short calls and the
short puts have shrunk to almost no
value because again the MDX is trading
at 76 77 and those short calls and those
short puts are just too far away from
the market for them to be in any real
danger with two hours left before they
expire and the same is true for the
protective long call above the short
call and the protective long put below
that they’re even farther from the
market and so obviously they’re going to
have even less value so if we just go
ahead and close the iron Condor at that
point by the time you actually get it
executed it will look like this you’ll
have to pay to close the short the two
short options and you’ll receive cash
back from selling the long options and
the result is that you’ll end up with
9,000 $360 profit from the whole
transaction now just to drive this point
home let’s take a look at the comparison
between these two approaches using the
single short strangle we make a little
less than $4,000 on more than 83,000
dollars in capital but with the 20 lot
iron Condor with around 40,000 of
capital less than half of the amount
your broker will require for the one
short strangle you’d make ninety three
hundred dollars that’s a return of
twenty three percent versus about five
percent with half the risk if that isn’t
enough reason to convince you that this
is a blunder then you should consider
one more thing and that is the short
strangle has unlimited risk
unlimited that’s a lot infinities a lot
okay and so even though your broker will
margin you a finite amount eighty-three
thousand dollars it could theoretically
get worse than that yes you will spend
money on the long call and money on the
long put but the results of using these
Long’s
is so dramatic on your capital
utilization that it’s not even close as
I hope this example made clear so please
don’t fall for options blunder number
seven you obviously get a much higher
return with protected positions like
iron condors as opposed to what are
known as naked positions like strangles
with unlimited risk and massive capital
requirements now just to remind you as I
said earlier if you enjoyed this video
and learned something valuable from it
would like to learn the details of three
real-world option strategies that
professional options traders use all the
time then you should check out the free
options class that we’re currently
running just go ahead and click the link
that should be appearing now at the top
right corner of your screen that will
open the free registration page in a new
window so you won’t lose this video
don’t worry
or you can just head on over to options
class com to register for this free
intensive workshop it really is a rare
opportunity for retail traders investors
to learn directly from Wall Street
traders but that’s exactly what you’ll
be getting through this trio online
workshops so click the link to sign up
now and don’t miss it and please don’t
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* no relevant positions
