This video is the first of a series of ten videos that we’ll be producing as cautionary warnings about the largest mistakes that options traders make and how they can rectify those mistakes. The first Options blunder we’ll cover in this video is about the disastrous consequences of getting cocky and sizing up too quickly as an options income trader.
View Video Transcriptokay so today’s video is the second in
our 10 part series entitled huge options
trading blunders we decided to produce
this series for traders who are really
serious about trading options for a
living and taking the proper steps to
excel as an options trader as opposed to
fooling around with ridiculous trading
ideas that have giant hidden risks that
are often overlooked
I’m the head trader of SMB capitals
option trading desk and I can tell you
for many years of experience that the
pitfalls were going to be describing in
these videos are real and if you’re
serious about trading for a living you
really need to pay close attention to
these videos so you can avoid serious
problems in your trading journey so if
you’re committed to changing careers and
trading full-time as an options 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 challenges and rewards
of options trading
[Music]
hi I’m Seth Freuburg I’m the head trader
of SMB capitals options trading desk SMB
capital is a proprietary trading firm
located in midtown Manhattan whom 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 continue our series
of options blunders and myths that we’re
trying to debunk and warn you about so
that you can avoid dangerous options
trading situations so in today’s video
we’ll be talking about this crazy myth
about options trading that somehow is
circulating around the trading world and
it goes like this
I bought a call option on Facebook right
before earnings and I sold a Facebook
put option for the same price so I own
the call for free now we need to break
down exactly what that statement means
and then we’ll delve into why that
concept is so insane and dangerous now
most of you probably know something
about options but just for a quick
review and this will be fast what is
known as a call option on a stock
entitles the buyer of that option to
purchase 100 shares of that stock at a
certain price called
the strike price of that option
regardless of what the stock is actually
trading at what’s called a put option on
the other hand entitles the buyer of
that put to sell 100 shares of a stock
he owns at the strike price of that put
again regardless of what price the stock
is trading the buyer of the option pays
what’s called a premium to the seller of
the option because the seller of the
option is taking the risk this stock
will go past the strike price of the
option in which case the buyer can
exercise his options so in the case of a
call even if the stock has gone way
above the strike price of the call the
call buyer can exercise his right to buy
100 shares at that strike price in other
words he’s entitled to buy the shares
way below market he could flip them the
next minute and make a huge profit on
those share
or conversely on the put option if the
market goes way below the strike price
of the put option the buyer of that put
option has the right to sell his shares
of that stock at the strike price of the
put option that he’s bought even if the
stock price has gone way below the
strike price of the put which of course
saves him a lot of money compared to
where he did not own the put and he
stuck suffering a much larger loss on
his shares because their prices gone way
below what they were worth before he had
no protection against that happening so
those are the basics of call and put
options okay so let’s look at an example
now of a real-life situation that you
could have gotten yourself into if you
didn’t know better here’s Facebook
trading at 217 a few years back at that
time that was an all-time high and so
let’s say you were bullish on this stock
and felt there was more upside so on
this day as you can see you could have
bought Facebook 220 calls for two
dollars and 80 cents and if you look
down on the put side you’ll see that the
210 put happens to be priced for exactly
the same price two dollars and 80 cents
so you figured hey I’m bullish on
Facebook and I can buy that call for 280
so since each of these call options
represents my right to buy a hundred
shares of Facebook at 220 I’ll pay two
hundred eighty dollars which is what the
two dollars and 80 cents represents at
the same time though I’m selling the 210
put option which happens to be at the
exact same price as the 220 call on this
day and so in this case I’m gonna
receive two dollars and 80 cents times
100 for the hundred shares that each
option represents and so I’m gonna
receive two hundred eighty dollars for
selling that foot so the cost of the
call was offset by the cash we received
for selling the put so we own the call
for free right I mean after all there
was no cash flowing out of my account
after this transaction right I mean
everyone loves stuff for free right but
this is a ridiculous concept that
misleads people and we’ve got to work
through why this concept is very very
misleading well first of all you could
say that there are a lot of things you
can get for free
for example suppose I have a ticking
time bomb in my hands I could give that
to you for free right so
now you have something for free
something for free that could blow you
into the next county but still it’s for
free so it’s not necessarily good to
have something for free but just because
something is free of cash flow doesn’t
mean it’s free of risk and that’s the
fallacy of this concept that you’re
about to see a vivid example now before
we get into why it can sometimes be a
very bad idea to own an option for free
I wanted to let you know that there
really are sound techniques for trading
options for income and in fact we’re
currently running a two our free
intensive workshop at the moment where
we’ll be teaching you three of the
strategies that real professional
options traders use including our 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 the stock that
you like where you’ll make your target
profit whether this stock goes up goes
nowhere or even goes down a small
percentage so if those are strategies
that would be of interest to you 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 right now at the top right
corner of your screen that will open a
free registration page in a new window
so don’t worry you won’t lose this video
or you could just head 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 here’s the thing traders find
the idea of buying a call very
attractive because it helps them to
control the risk of a trade so when you
buy the call for two dollars and 80
cents here in other words you spend 280
and if Facebook doesn’t get beyond the
strike price of the call by expiration
day then the call just expires worthless
and you’ve lost $280 and no more now I
know you don’t get into trades to lose
money
but the fact is that the worse they can
get for you is the loss of $280 which is
what you originally put up to buy the
call but then when you try to get cute
and you don’t even want to pay $280 for
the call you want to pay nothing for the
call and have it for what you’re calling
free and here’s the important part so
please focus on this at that point
you’ve completely changed the
risk/reward
dynamic of the trade now why do I say
that well that goes to the fundamental
nature of options a call option is a
right to buy shares so the worst that
happens is that you don’t exercise that
right because Facebook never gets beyond
225 and the call never has any value
because you’re not going to exercise
your right to buy shares at 225 when the
stock is trading for less than that
obviously so you don’t exercise that
right and therefore you just blew $280
but if you’ve also sold that put then
while you may feel better because there
was no cash outlay for the call and you
could make a lot of money at Facebook
rally quite a bit you inadvertently took
on a huge risk that you weren’t thinking
about all because you were trying to
avoid shelling out $280 for the call so
let’s take a look at what actually did
happen on this trade so as it turns out
Facebook sold off badly and on the day
the option expired Facebook closed at
170 489 about 43 points below where
Facebook was trading when you enter the
trade and worse 35 points below the
strike price of the foot we sold so
let’s break down how this trade ended so
remember we started out with zero cash
outlay because the price of the put we
sold offset the cost of the call we
bought well that was where the good news
ended because with the stock selling off
to 170 489 the owner of that put is
obviously going to exercise that put at
210 because the shares he has which are
now worth 170 489 he can sell them to
you for $35 per share higher than
they’re worth so he can dump his shares
on you for 210 and you’ll be the proud
owner of a hundred shares of Facebook
stock for 210 when they’re trading at
174 so you immediately take a loss of
$35 per share the crucial takeaway here
is that the trader did not at all
appreciate that by being a
go go around bragging to his friends
that he was able to structure a trade
where he bought a call for free he put
himself into an incredibly dangerous
position because he didn’t think through
the fact that he had completely altered
the risk/reward nature of the trade by
selling that put in other words to save
himself a lousy $280 on the call he put
himself into a position where he lost
over 3500 bucks in other words he took a
limited risk situation and turn it into
an extremely risky situation by virtue
of the fact that he didn’t realize that
the risk of selling the put was in a
sense the cost of owning the call for
free he was trading upfront cost for a
huge risk and all he was thinking about
was how he drove his upfront cost down
to zero look I used to be in the
insurance business and we insured
people’s houses for fire insurance so
suppose someone asked me to insure their
house which let’s say it’s worth
$100,000 and they wanted me to insure
for five hundred bucks and I took that
cash and I bought a lawn mower for five
hundred dollars with that cash then I
just buy a lawn mower for free well kind
of I got cash from you and bought the
lawn mower and ended up with the same
amount of cash as I had before you gave
me the $500 yet I’m up one lawn mower
but I’m on the hook for $100,000 if your
house burns down so did I get that lawn
mower for free this is the same thing
when you sell an option you’re entering
into an obligation if you don’t
understand that obligation you have no
business trading options what was really
wrong here was not that the trader made
the trade the problem was that he didn’t
understand the implications of the risk
of the trade which he had no business
doing because he didn’t understand what
he was doing so the moral of the story
is that you have to look at the full
risk reward picture of every options
trade you can’t just look at the upfront
cash flow of the trade without
understanding the risks of that position
in this case you took a $280 risk and
turn it into a risk more than ten times
greater than that because you didn’t
understand the ramifications of selling
that put to put yourself into a cash
flow free position just looking at the
cash
is extremely foolish and it’s a really
good way to turn a large fortune into a
small fortune professional traders the
ones who do this for a living
hardly even acknowledge the cash flow
aspect of an options trade they focus on
the full risk reward trade offs of the
option strategy that they’re
implementing and then take sensible
steps based on that risk reward profile
if you want to become a professional
trader that’s how you’ll need to think
also so by now I hope that you see why
we call this an options trading blunder
and to be clear it’s only a blunder if
you don’t understand the risks you’re
taking on if you’re bragging about the
zero cash flow of owning the call then
you are most likely not understanding
the risk you’ve taken on and you
shouldn’t be in the trade at all so
don’t fall into this trap it would be a
sign of unprofessional trading now just
to remind you as I said earlier if you
enjoyed this video and learn something
valuable from it and you’d like to learn
the details of three real-world option
strategies the 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’s really 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 and please don’t
forget to click on the subscribe button
right now so you won’t miss the next
episode of huge options trading blunders
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as an options trader
* no relevant positions
