Freddy Krueger
It is almost Halloween and with that come ghosts, goblins and tricks proving things may not always be what they seem. In that spirit, let's step outside of our normal options strategies like condors and butterflies to cover something even more basic, and I believe even more important. Do you know who you're trading with? Who is the “Oz” on the other side of the curtain and “why are they out to get you?”
Trading can be hard enough for folks without the extra fear that they are absolutely doomed from the start because of who is on the other side of the trade. Let’s face it, the hardest thing for many traders to do is to click that mouse for the first time and buy or sell. In theory, using fake money should be no problem, and buying 1,000 shares of AAPL and selling it later that day would not evoke any fear.
Then it comes time for real money and you have to make that trade. You look at the universe of stocks you want to trade and realize that trading AAPL takes up too much of your capital so you look for something more reasonable. You do your research and decide to purchase 100 shares of CSCO on the offer at $18.55.
Click to enlarge. TD Ameritrade’s thinkorswim trading platform. For illustrative purposes only.
So you click the button and buy the stock. The crazy thing about doing so is that you immediately have buyer’s remorse. Those of you that are new to trading, do not worry, we have all gone through it. Your first thought is, why would they sell it to me? “They” must know something about the stock that I do not. Even though you have done hours of research, looked at chart after chart in time frames from 1 minute to 15 years, now that you have actually taken action based on research, you are more afraid than if you had just seen the original “Nightmare on Elm Street” for the very first time and Freddy Krueger is standing in your kitchen.
Calm your nerves and take a breath. The first thing you have to realize is that buyers and sellers make the market. You need a person on the other side willing to sell those shares to you or there is not a trade. Did it occur to you that they may be having the same thoughts? In someone else’s eyes you are the almighty Oz pulling the strings and you must know something.
You make some trades, get comfortable and now you are about to trade options. This is where many people often start to get into this same pattern again. Perhaps it is because the average investor has more experience trading stocks or because options are a derivative product, but the worry about who you are trading with becomes even more pronounced here. Let’s take this from the point of a covered call, a first foray in to the options market for many.
A covered call involves buying a stock and selling a call against it. Let’s say you owned a more blue chip stock such as XOM. So you have your XOM stock and in this example (from Oct. 11, 2012) it is trading at $91.53, so you decide you want to sell a call against it. Again, you go out and do your research and decide that a good candidate would be the Nov. 92.5 call. You see the Nov. 92.5 call has a theoretical price of $1.10.
At this point, the big question you should be asking yourself is am I comfortable with the fact that I may have to deliver stock to someone at an effective price of $93.60 (92.50 strike plus $1.10 premium received) in 36 calendar days? Instead, the thought process for too many folks is why would someone buy that call from me? “They” must know the stock is going higher. Again, take a step back and think this through. Yes, someone could be buying these calls speculatively, but they could be buying this call with a put and hoping for movement. Or maybe they purchased this call to protect a short stock position rather than putting in a stop.
Click to enlarge. TD Ameritrade’s thinkorswim trading platform. For illustrative purposes only.
Just like the monster under the bed or the plastic ghost in your neighbor’s front yard there are many things that can scare you if you let them. Experience shows you that if you understand what is really happening and determine what is just your imagination versus reality, you’ll find most of these fears are unfounded and at the end of the day rather silly.
Happy Halloween!!!!
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Options. Commentary and examples provided for educational purposes only and should not be considered a recommendation for any specific security or strategy. Supporting documentation for any claims, comparison, statistics, or other technical data will be supplied upon request.
Kinahan, a 26-year trading veteran, is a CNBC “Fast Money” Trader and is frequently quoted in the Wall Street Journal, Financial Times and Reuters News, along with many other respected media outlets. He is also a member of the Board of Directors at NYSE ARCA and is a member of the Arbitration Committee at the CBOE. His licenses include the 3, 4, 7, 24 and 66.
