In the past 7 months, I have gained a lot of exposure to trading options. I started getting my feet wet when I started this blog. But now, I have tested with and tried to understand the price movements of options in relation to the movements of underlying stock, and how it ties together with the time value, etc.
I studied various strategies that are to be employed in bull, neutral or bear market for maximum returns. However, I have realized that these sound very solid on paper and in hindsight, but, can be difficult in practice. They do not take into account the commission and are very tightly bound to the direction of the underlying stock. If anything goes wrong, huge losses follow. I will summarize a few things I learned from couple stock option strategies that I employed in the past 7 months. I will not be going into details about the strategies, that is covered in a separate post, just my learnings.
Covered Calls
This is something I really liked. The idea was to hold a stock, sell a call option. Wait for it to expire and repeat. There are 2 scenarios:
Stock appreciates in value, this means the stocks owned will be assigned and you keep premium paid. Stock falls, call expires, you keep the premium and repeat. I got caught off-guard twice in this strategy. Once, when I had an early assignment of AAPL. I lost some decent dividend. But, that was alright. At least, I did not suffer losses. The second one was a little more drastic. I was writing calls when BABA fell from ~$105 to ~$85. I lost about 15% on that trade. Real losses were more, but writing covered calls reduced my cost basis. I soon realized that I was playing catch up and was risking $10K to write one covered call worth $100 and a lot of time $50. To sum it up, following were the reasons I stopped and started looking beyond the covered calls.
- It tied up too much capital for the returns I was getting
- I paid short-term capital gain taxes on the premium when my stock was running in loss
- I got stuck with a position that I was playing catch-up by selling covered calls
Iron Condors
When I came across this strategy, this looked very promising. Of course, there is a catch, and experienced traders know what that is.
In this strategy, you work out a range and "bet" on the stock staying within that range at the end of a set time period. For example, if AAPL is trading at $120, you can "bet" on it staying in the range of 10%, or between $108-$132 for a fixed time, say 3 weeks.
Sounds simple. More or less. Traders use statistical analysis like standard deviation to decide the range. The problem is all the analysis is based on past data and stocks, usually, do not honor that. What results, is a "black swan" event. Where, a trader finds himself/herself in a situation where the market does not behave as expected.
I had been following AAPL since a log time and realized decent profits on it writing covered calls. So, I decided to make an Iron Condor on AAPL. I was naive to try it out with an individual stock, instead of trading an index fund like SPY. I set up a trade where, if the stock stayed in my range, I would have made $200 and if the stock broke out of my range, I loose $2000. I actually ended up losing on this trade. My first Iron Condor trade. Looking back, I could have tried to fix it when I realized it was not going my way. I could have gotten out of it for 50% less than what I actually lost. I also noticed the commission was pretty high for it because this strategy uses 4 option legs. I use Interactive brokers and they are one of the lowest commission brokers. Later on, I did 2 trades on SPY with this strategy that I ended up winning. But, I was always checking the stock to see if it stayed in my range, I wanted something that did not require constant attention.
To sum it up, following is my experience with Iron Condor:
- You have to be really sure about the strike price
- Never do it with individual stock, always go for index fund
- High commissions per dollar of profit
- High risk (as per my taste)