The "Daily Call" From Option Alpha

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#420 - Should You Consider Trading Pot Stocks With Options? Nov 16, 2018

Show notes

Hey everyone. This is Kirk here again at Option Alpha and welcome back to the daily call. Today, we're going to try to answer the question, "Should you consider trading pot stocks with options?" I think that the rise in popularity of pot stocks or marijuana companies I think is very interesting to watch. Now, whether you are on one side of for legalization or not for legalization of marijuana is not something obviously we discuss in this podcast because we don't get into the politics or to the legislation side of any of this, but it does present potentially an opportunity in the future to trade some of these companies with option contracts.

Now, the one caveat that I have to this is that as we start to see the rise of both recreational and of medical marijuana in this country and we're starting to see this not only just recently in the last couple of months with more country or more States legalizing marijuana in one form or another, medical or recreation like Oklahoma did earlier this year in 2018, but also as we start to see it rise globally like Canada legalizing it on October 17th, 2018, we are starting to see more and more company start to pop-up. Now, while there are a few companies that are already starting to trade options, my biggest caveat with this is that we don't yet know what the history or the liquidity of these types of option contracts or even companies that they're based on is moving forward. And so, while we have a lot of companies that are starting to trade and starting to trade a lot of option contracts like Tilray, we don't yet have a solid foundation of understanding how the company reacts to different market news, we don't have a solid understanding of how the option contracts are really being priced based on implied volatility and expectation and therefore, I think as an option seller, it may not be a good opportunity to trade in these. Now, does this mean that you should be an option buyer in these contracts because of such huge potential swings in volatility? Maybe if you wanted to. Just again, always allocate a little bit of your account towards these types of trades because what I saw a lot of people do especially with the rise and collapse of say Tilray, was that a lot of people allocated a lot of money towards call option contracts at the height of the market with implied volatility very high and super spiked up and a lot of people got burned and crushed when Tilray basically collapsed in a matter of two weeks.

And so, that type of movement is what I would expect is going to happen going forward in the future, a lot of run-ups and a lot of collapses based on news and expectation and legislation as this entire market continues to evolve and develop. And this is really like an emerging market basically for US industry. We do not yet have great data to understand how well these things perform during different market environments, during recessions, during expansion periods, during high interest rates or low interest rates, during all the things that might impact potentially trading pot stocks and therefore, trading their underlying option contracts. Again, not necessarily saying that I agree with pot stock trading or not, so the underlying fundamentals of whether we should have legalization or not. When it comes to option contracts, what I'm concerned about is history and liquidity and what we haven't seen yet in this market is either of those things. It's so new. It's so fresh. It's so infancy in its stage that we have not yet seen enough liquidity and enough history to know if we are actually in a relatively high or low implied volatility market, so for that case or for that matter, I'm going to be sticking away from trading these things until we get a lot more data on this. As always, hopefully this helps out. If you guys have any questions, let me know and until next time, happy trading.

#419 - Are Covered Calls Safe For Investors To Trade? Nov 15, 2018

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to be answering the question, "Are covered calls safe for investors to trade?" Now, covered calls being safe for investors to trade is a relative question. Safe compared to what? Say at not trading at all? Safe compared to a credit spread, compared to an iron condor? What are we basing this off of? I want to start this podcast by saying that I think we should base this particular question off of just trading regular long stock. Should we trade a covered call or should we trade regular stock and not include the option contract? What we know from a lot of research that using covered calls is a great way to reduce the cost basis of stock ownership. You've often seen this in CBOE studies, as well as the studies that we've put out here at Option Alpha and we do have some new research that shows that in some cases, using covered calls actually might not be the best use of your capital and you might (using a covered call) give yourself an opportunity to actually reduce the overall returns from the underlying security, basically choking or strangling the security from potentially making a nice run higher. Now, of course, we've been in a huge cyclical bull market for a long time, so this could be potentially part of the reason why we see covered calls not being as effective or productive as they have been in the past, but our research has gone back more than 15 years, so we do have a lot of data that can show that potentially, covered calls do not work as well as people think they do in some particular markets.

Now, as far as the alternative which is just trading regular long stock, I think that for many investors, using a covered call is something that could help curb some of the risk in the position by reducing cost basis. However, the biggest risk to a covered call position is the underlying stock itself. My biggest drawback with trading covered calls and one of the reasons why I do not trade covered calls is because of the underlying risk that the stock or the underlying ETF itself goes down in value. Covered calls are not going to curb that potential black swan one-sided risk in the underlying security. As either a covered call trader or as a regular stock trader, you still are carrying the full position and capital investment of that underlying security and you carry the full risk that that security goes down in value and that to me is too much risk to potentially hold in my portfolio for a small position in a single ticker symbol. What we like to do is trade more spread type trades and spread the risk across multiple tickers and smaller positions. Are covered calls safe for investors to trade against the alternative which could be stock? Potentially. Potentially could be good alternatives in certain market situations. Otherwise, we suggest not trading the underlying stock because stock is inefficient and capital-intensive and we would prefer that people start gravitating more towards spread style trading with just option contracts. As always, if you have any questions, let me know and until next time, happy trading.

#418 - How To Manage Options Spreads? Nov 14, 2018

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question, "How to manage options spreads?" The root of this question in managing options spreads comes from the assumption that in order to be profitable trading, we need to be very active or super active in managing options spreads, either managing potential profitable positions or on the other hand, managing potential losing positions. I take maybe an alternative approach to managing spreads in that if you are trading a spread option strategy which would include credit spreads, iron butterflies, iron condors, etcetera, you are defining your risk on that trade by the width of the spreads that you're trading. When you enter a credit spread or an iron condor trade, you can define how wide that options spread trade is going to be and therefore, you are defining whether you know it or not, the amount of risk that you are willing to take on that position.

Now, since we know from our research and back-testing data that using stop-loss orders is never the best strategy overall, we are definitely fans of letting options spreads go all the way to expiration unless they hit our profit targets first. If a potential spread trade hits our profit target, say at 25% or 50% of the credit received, then we will take off the trade, but if it does not hit that profit target, we are fans of letting the trade go all the way to expiration. Yes, that means no stop-loss for the trading that we're doing because we know research wise and back-testing wise, this ends up generating higher expected returns than using a stop-loss order. While many people want to manage option spreads by using stops and by using orders that would potentially limit risk or so-called risk in the position, we have found that managing spreads actually is much more of a game of patience and letting the position run all the way to expiration unless it hits its profit target first. Hopefully this helps out. As always, if you have any questions, let me know and until next time. happy trading.

#417 - Fundamental Analysis vs Technical Analysis Nov 13, 2018

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to be talking about the difference between fundamental analysis versus technical analysis. Whatever analysis camp you come from, you do have to understand the difference between fundamental versus technical analysis and hopefully what we can do here is just quickly go over the highlights of these different types of analysis when it comes to stock and ETF and index trading. Fundamental analysis is the understanding or the analysis of the company itself, the industry, the macro or microeconomics of the market and how it relates to the value of the stock at the current price. A lot of fundamental analysis investors or fundamental investors will look at the difference between where the stock is priced now and maybe some projections on where the fundamental value of the company is moving forward in the future and they try to buy based on these fundamentals. If the stock is basically underpriced and has an intrinsic value that they perceive as potentially higher than where the stock is trading, there's an opportunity to make some money.

On the other hand, you have technical analysis which is basically just the understanding and the research around the price history and the momentum and the charting of the stock itself. With technical analysis, many traders look to use technical indicators, things like moving average, stochastics, MACD, Bollinger bands, etcetera to give them an estimation or an assumption of where the stock is trading in a relative range based on its historical patterns going back in the past. Technical analysis investors have no regard officially for where a stock is valued fundamentally, nor do they care about the stock's expectations of earnings, the sales growth, the EPS growth, the price to earnings ratio, nothing. What a technical analysis trader's solely focused on is just the charting and the technical indicators that are showing for that particular stock. Now, in either camp, no matter which one you kind of lean towards, there's obviously benefits and drawbacks to each and my opinion is that I think that there's value to maybe using a little bit of both of these in understanding a potential setup or a trade that you're getting into especially if you're going to be allocating a significant portion of your account to that type of position. Hopefully this helps out. As always, if you have any questions, let me know and until next time, happy trading.

#416 - Can You Generate An Instant Profit Buying ITM Call Options? Nov 12, 2018

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question, "Can you generate an instant profit buying in the money call options?" Many new traders and many experienced traders as well wrongly assume that you can generate an instant profit buying in the money call options. The reason that they assume this is they attribute most of the value to these call options as just the difference between the strike price or the in the money strike price and the market price of the stock and they think that you could buy the call option and resell the call option back to the market for a quick profit or buy the call option, exercise your call option which would purchase stock at the strike price and then resell the stock back to the market at the current underlying stock price conceivably much higher than where you bought the in money call option. But in either of these cases, what they fail to recognize is the premium and the extrinsic value of the option contract. For example, if we have a stock that's trading at $100, we might assume that we could buy the 95 call option which is in the money by $5 and make a quick instant profit exercising our call option at 95, so effectively, buying stock at $95 and selling it back to the market at the $100 price that it's currently trading at.

But the assumption here would be wrong because the value of that option contract might be $5.10. The value of the option contract at $5.10 accounts for the intrinsic value, the value of exercising the contract right now which is $5, so that's the $5 difference between the stock price and the strike price and then it has a little bit of extrinsic value baked in which is about $.10 or so, so that potentially, there's some time value left in the contracts, there's some volatility value left in the contracts and so, therefore, you could not immediately generate an instant profit by buying these in the money call options. Now, this extrinsic value could be very small like our example right now, if you're close to expiration or it could be very large. Sometimes the extrinsic value could be double what the intrinsic value or more of the contracts are. Again, it's a wrong assumption to assume that there's a free opportunity or an arbitrage opportunity just buying in the money call options. Hopefully we've clearly explained it. As always, if you guys have any questions, let me know and until next time, happy trading.

#415 - Do I Receive Dividends When Selling Call Options? Nov 11, 2018

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question, "Do I receive dividends when selling call options?" There's two parts to this that I think we really have to dissect in order to understand if we are able to receive dividends when selling call options. The first thing is just to understand that when we are selling a call option, we have the obligation to sell stock at that strike price in the future to the call option buyer. We have to sell stock to them at that strike price which means that if they were to exercise that contract, as the short option contract seller, we would be in a position where we are actually short shares of the underlying security versus long shares of the underlying security. And so, therefore, if we are short underlying stock, we would, of course, not get paid the dividend. In fact, we might actually have to pay out the dividend to a potential call option buyer if they were to exercise that contract.

This is where we often see people get really confused when we talk about short call dividend assignment risk, this risk that is present when a short call option goes in the money and the corresponding put option is worth less than the dividend being paid. When this happens, you are at risk of having your short call option assigned. The call option buyer would then buy stock from you at the strike price and then collect the dividend. The only way to collect a dividend then would be to be an owner of stock. And so, you can be an owner of a stock if you have a short put and you assign the short put and then you go through a dividend scenario where you collect the dividend or if you're a call option buyer and then you exercise your call option and again, take delivery of the stock and then as a stock owner, you can receive the dividend. Again, there's two parts here, one is being a short call option seller and then two is if you're a short call option seller, do you get any chance at the dividend and the answer is no because you'd be short stock. You'd actually have to pay out the dividend if you went through that scenario. Hopefully this helps out. As always, if you have any questions, let me know and until next time, happy trading.

#414 - What Is The Difference Between Speculating And Hedging? Nov 10, 2018

Show notes

Hey everyone. This is Kirk here again from Option Alpha. Welcome back to the daily call. Today, we're going to answer the question, "What is the difference between speculating and hedging?" I often hear the terms, speculating and hedging thrown about in forums and in emails and people assume that both of these things are the same. And while they might perform potentially the same types of trades, the psychology of the investor going into a speculation trade versus a hedge trade could be completely different. For me, speculating is the assumption that you're getting into a trade with huge potential risk reward payoffs. And so, this speculation is built up by the trade that you're getting into in the sense that you're building an option strategy or a stock strategy or a combined option stock strategy with the purpose of generating positive expected returns. Now, you assume that this is going to happen and that's the part of the speculating. You're speculating that this is going to happen though you don't know for sure. But the assumption with the speculator is that they're generating money with their trades. All of their trades are focused or at least, the trades that they're speculating on are focused towards generating a positive expected outcome, generating Alpha or superior returns with their trades.

If you take the other side of the coin, a hedge trade would be a trade that is looked to minimize the risk or reduce the risk of other trades in the portfolio. The reason that we call hedge funds, hedge funds is because they have the ability to trade both sides of the markets versus say a regular mutual fund which only has the ability to basically buy. And so, hedge funds were created basically, so that there was an opportunity or an alternative where you could actually use a long position in the market, but then use a long put option contract to hedge that position in the market or you could short some sectors or industries of the market to hedge your long position in the market. Hedge trading to me could perform the same thing. You could actually be buying the same contracts as a speculator or hedger, but again, the underlying assumption is with someone who's hedging a position, they might understand that that hedge trade is solely for the purposes of protecting themselves in case the worst happens. And so, for that reason, they might already assume going into the contract that they plan on losing that money, but they're okay losing that money because of the amount of risk reduction that they received during the contract time period.

To use an analogy with insurance, if you have a house that you own and you buy insurance in case it burns down, the premium that you pay to the insurance company, you're basically planning to lose. You are hoping that your house does not burn down to the ground. You don't ever want to make a claim that your house has burned down to the ground. You'd be happy at the end of the year paying that premium to the insurance company in exchange for the reduction in risk should your house burn to the ground and that's the same thing that hedgers do. Hedgers will pay a premium. That doesn't necessarily mean that they think or that they speculate that the market will go down or a stock will go down, but they're basically covering themselves by using a hedge technique, whether it's long put options, whether it's call options, a combination of options, but that's what they're doing. Again, speculators are really looking for these options to create potentially an asymmetrical risk reward scenario with a low probability of success. Hedgers are taking the other side of it and looking for a potential trade that could hedge and reduce some of the risk of another position. Hopefully this helps out. As always, if you have any questions, let me know and until next time, happy trading.

#413 - The "Endowment Effect" And Why It Cripples Investors Nov 09, 2018

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to be talking about the endowment effect and why it cripples investors. My understanding and belief in these different psychological effects or barriers that we have to our potential to be great traders is that we can't overcome these necessarily. But the more that we understand them, the greater the possibility that we have an opportunity to recognize when we are being manipulated by some degree to these different psychological barriers or effects that happen in our mind. And so, this is not to say that we can overcome these by any stretch because it'll always potentially happen to us, but again, it's the understanding and the recognition of them I think that will enable us to make potentially better decisions or smarter trades.

The endowment effect is a really interesting one and I see this all the time and you've probably felt this before and now, retroactively, you might go back and think to yourself, "Yes. I've felt the endowment effect before. I know when I was feeling that and I shouldn't have been feeling that." But it's only after the fact that you realize you're feeling this. But it's this bias that occurs when we overvalue something that we own and it's regardless of the objective market value of the underlying thing that we own. If we buy a t-shirt and later on, we value that t-shirt because there's some sentimental or nonphysical meaning to the value of that t-shirt to us, we just overvalue how much that t-shirt is really worth. It might have been $5 when we bought it, but it's worth a lot to us because it has some brand logo or some affinity or you bought it during a certain time in your life. And so, that's the same thing that can happen in investing. When we go into a potential trade or you make a trade in the market, you overvalue potentially something that maybe doesn't have that much value at all. And so, this was proven back in some research back around I think like 1990, 1991. They proved this in research that people do this all the time. And it's evident that people become relatively reluctant to part with something good that they own for its cash equivalent and again, it's because people are not willing to give up the sentimental value or the extrinsic or kind of non-tangible value of this thing and again, it could be a physical object like a t-shirt like what we're using in our example or it could be something like an option contract where you think it has more value, but the market is telling you that it does not have more value and you're putting on this value that could be greater than what actual market value might be.

Put more simply, look. People place a greater value on things once they've established ownership and that's really what it comes down to. When you own it, you immediately (no matter what happens) put a ton of emphasis on value because now, you have owned it and this is especially true for things that we would normally have bought or sold during the market and it's usually like I said, symbolic or experimental or emotional significance, something out there that basically forces you to take a stand and say, "No. I believe in this." And we see this previously and we talked about kind of this bias around trading, but the endowment effect can impact you because what if you, let's say, made a trade in Tesla or Facebook or Twitter and now that you've made a trade in there, maybe you've even told people you've made a trade. You've publicly declared to other people that you've made a trade. Now, you have more of this endowment effect, this more weight on the value of that trade even though that the trade value hasn't really changed. It's still the same trade. Nothing's really changed other than the fact that now, you're part of it and you've maybe told somebody, but now, there's immediately more emphasis in value placed on the trade which might actually lead you to holding the position longer if it's a loser, to maybe not getting out of it as quickly if it's a winner, wanting to be right, wanting to be correct, not wanting to look stupid or like an idiot in trading and that can really mess with your mind. And I've seen this time and time again with traders, is that they have this ego about them that they want to be right. And again, it's not a conscious thing. It's more of a subconscious thing. People don't even know that they're doing this. But this is one of those major things that could affect it, is the endowment effect.

My hope today is that you understand, first of all, what this is and I think we've done a good job on that, but two is just to understand when this is happening. Set your ego aside for all of the trading that you do because there's no place for it. The market does not care who is the owner and who is selling. The market does not care about that type of stuff. You got to set your ego aside and just realize that the most important thing is generating money and reducing risk and increasing the probability of success of your overall positions. Everything else doesn't really matter as much. Hopefully this helps out. As always, if you guys have any questions, let me know and until next time, happy trading.

#412 - What Is The Difference Between Volume And Volatility? Nov 08, 2018

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to answer the question, "What's the difference between volume and volatility?" This is another member question. Somebody sent me a question and basically, it was this. It was, "Some places are saying that if a stock has high volume, then it might also have high volatility or I see that people are mentioning that a stock is moving really high in volume and volatility, but can it really be both? What's the difference between volume and volatility?" The simple answer to this is that volume tells you how much of something is being traded. Volume in the sense of either stocks or options tells you how much of that stock or option contract is being traded. If there's a lot of volume, that means that there's a lot of trading that's occurring, there's a spike in trading activity. Now, this doesn't always mean anything for direction. A high spike in volume for call options could be a hedge and doesn't necessarily mean that somebody is expecting the stock to make a big move higher. But all we know is that there's a lot of volume that's now coming into the market, there's a lot of activity in the market.

On the other hand, volatility tells us how much expected volatility or actual volatility the contracts themselves are seeing that day. If we have, for example, a stock that is making huge moves during the day, it's up $10, then down $20, then back up $10, that's a lot of volatility for that stock price. Now, the stock could also have high volume for that day, meaning that in addition to the huge swings that it's having in the price, it's also a record-breaking day for the number of people who are trading contracts and that, most of the time, is the case. When you have a lot of volume, it's also followed by a lot of high volatility. In the world of options, what we typically associate with volatility is implied volatility or expected volatility. You could have a stock that has a lot of volume, option contracts that have a lot of volume, people are expecting the options to behave or move in a certain fashion in the future and that increases the volume or number of people who are trading, but it also increases the expected volatility of the stock. Now, this doesn't mean that the stock actually is going to make a move. We see this a lot with earnings trades where right before a stock announces earnings, the option contracts have huge volume, lots of people are trading them, the stock is not moving, however, but implied volatility, the expectation of a move in the actual option contracts is being bid up. People are expecting a big move at some point in the future. It just hasn't happened yet.

Understanding these two differences I think is obviously important and it definitely helps you decipher what people are trying to say online. If you're reading a forum post or somebody's article or their tweet about volume and volatility, just really understand what they're kind of talking about and what that means in the grand scheme of options trading. As always, hopefully this helps out. If you guys have any questions, let me know and until next time, happy trading.

#411 - The 80/20 Rule Applied To Options Trading Nov 07, 2018

Show notes

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we're going to be talking about the 80/20 rule, but applied to options trading. We all have heard the 80/20 rule in some form or fashion basically that 20% of your inputs is responsible for 80% of the output or 20% of the population holds 80% of the wealth. Whatever discipline or vertical it's applied to, we all know the general concept. Well, I want to put a little bit of a twist and spin on that and tell you that in trading, I think the 80/20 rule applies as following. 80% of trading is psychology, 20% is mechanics and that's the twist that I think you should really hone in on here today and think about over the next couple of days, is that trading is really a mental game. In fact, it's the most mental game that you could possibly be in because you have money, you have moving numbers and charts, you have geopolitical issues, you have consumer issues, global issues, country risk, company risk. There are so many moving parts, it becomes an entire game of just mastering your mind and mastering your psychology, controlling or removing your emotions from the decision, so that you can focus all of your attention on just the things that actually drive results which in many cases is just this 20% mentally is the mechanics.

Most of trading is not a mechanical game. It's very few mechanics. The actual process of entering trades and closing trades and looking at positions, that's the small side of trading, in my opinion. That's frankly the easiest side of trading. The hard part is getting over the psychology, holding through a losing trade and not using a stop loss, taking profits early in the expiration cycle and not being greedy to hold potentially all the way through expiration. A lot of those psychology things, you have to get over and that in some cases, comes with time or could be used… You could use technology to do that. Hopefully, we'll have the ability for you to do that with our auto-trading platform here in the near future. But I think that this concept, the 80/20 rule is really, really interesting if you look at it in a different light for options trading. That's what I want to leave you guys with today. As always, if you guys have any opinions or thoughts, let me know. Hit me up on Twitter, Facebook, wherever you guys can find us. Shoot me an email. I'd love to know what you guys think about this and until next time, happy trading.

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