s

Mastering Your Mind

Five Steps to Champion Options Trading Psychology

ABOUT THE AUTHOR

Hi-- my name is Steve Place. I trade options for a living. I am the founder and head trader of InvestingWithOptions.com, an options analytics and advisory website. I believe that anyone can become a great trader, with the right training and outlook. If you need help becoming a better options trader, let me know how I can help. My email is steven@iwomail.com

WHY PSYCHOLOGY MATTERS

Believe it or not, this is how financial speculation works.

No matter what system you trade, you will always be a part of it. How your mind interacts with the system will affect how your performance will be. If I gave people a profitable trading system with rules for entries and exits, only 50% would make money. Why? Because they would not understand how the trading system works, and how they should respond to it. I am a believer that anybody, regardless of background, can become successful at trading the markets. We live in a time where information arbitrage no longer exists and you are now on the same level as all the big banks and firms. Information size and speed has put nearly everyone on the same playing field. So does that mean markets are now super efficient and we can't time them? Nope-- because it's still a market of humans. Even the HFT robots have someone on the backend that can turn them off if losses get too bad or they think the system is broken.

Because of this psychological standpoint-- it becomes critically important to understand how different biases and behaviors can affect your trades and other traders' trades. This is where the edge lies.

STEP UP TO THE TABLE

When it all comes down to it... It's gambling. Financial speculation is the attempt to gain returns from risking capital in the financial markets. So yes, we could view it as gambling-- but it may have a positive outcome if you're good enough. But when we see how it differs from gambling, we gain insights into why options are different from other instruments. When you walk into a casino, with all the bright lights, secondhand smoke, and retirees gambling away their pensions-- there is a very specific way you can put money at risk. There is always an endgame-- there is always an outcome. Let's take roulette-- you've got red, black, and green. You also have different numbers, combinations, and other methods to put your money at risk. So they say "last call," you plunk your money down, and they spin the wheel. After the ball strikes its target, the "game" is over. It's a fixed bet, with a time-based outcome, and you can choose whether or not to play again. This is completely different than financial speculation. Traditional gambling is what we know as a "discrete outcome" event. The implied odds, risk and reward, and your overall expectancy are easily determined. But what of stocks? Of forex, or futures or commodities or bonds? These are not discrete events... these are continuous events. This makes the game completely different when considering how to define your odds and how to manage your psychology. There is no fixed risk, there is no distinct outcome-- it is a series of price fluctuations driven by market participants over an indefinite amount of time. If you know anything about statistics, the way we have to approach discrete events vs. continuous events is completely different. It also matters because it opens us up to a set of psychology known as behavioral finance, which is what I call "how to lose money because the monkey brain inside you doesn't know what it's doing." But then options come along.

Option trading has a time component-- these assets have an "expiration date." So we are stepping back up to the table. And now we've got this bastardization of a discrete event derived from a continuous event. And it can be complex if you don't understand it. Even worse-- if you don't know how your own mind is affected by options, you can lose money even faster. We're going to step through what I consider 4 Unique Psychological Issues that option traders face, and 5 steps you can take to solve them. I'm a fan of the Pareto Principle. 80% OF YOUR TRADING LOSSES COME FROM 20% OF YOUR TRADING MISTAKES. And trader psychology is a huge driver of new trader's losses. Let's try to fix that.

THE SUPER ANCHOR

Anchoring bias is a term in behavioral finance that tells us humans have a tendency to "anchor" to a single piece of information when making a decision. This makes sense from an evolutionary standpoint-- if there is a very large tiger in your proximity, you're anchored to that fact you need to get the heck out of dodge. But now that we don't have to worry about immediate threats (most of the time), it can be a detriment. Marketing and advertising attempt to get you to anchor to facts that cause you to buy. The diamond industry is particularly good at that-- they talk about the 4 "C's" -- Cut, Clarity, Color, and Carat Weight. Notice two things: 3 of those are fuzzy, subjective terms there isn't any discussion about "P" - Price!

Anchoring bias in financial speculation comes in many forms. We may have heard someone on CNBC randomly say how they are bearish a particular stock, and even if you don't know why or their timeframe, you "anchor" to the fact that the stock is a short, regardless of company fundamentals or technical analysis. We can see this on a macro level as well. The market crash in 2008 has left many investors incredibly skeptical of upside price action in equities, even though the economy changed or fund managers are forced to get into stocks again. The anchoring of bad experiences is known as "disaster imprinting." On a more quantifiable level, we see this when someone enters into a trade or investment and the price of their entry becomes a very significant anchor. If you buy a stock at $98, you are now keenly aware of price action above or below that level. You find pleasure as price moves above $98 and pain when it moves below.

In terms of market structure, it may mean very little to anyone else. Perhaps the institutional buyers have been defending the stock at $95, or maybe they've been slowly selling the stock at $97.25. Too many people focus on the entry point of their trade when that price is probably not a key piece of information that is important. WITH OPTIONS, IT GETS MAGNIFIED. IT'S THE SUPER ANCHOR. Every single stock option has 4 unique traits: the underlying stock the expiration month the strike price whether it's a call or a put

The strike price is the component of the option that tells you at what price you would transact with the underlying provided the option was exercised. Sounds like a mouthful, right? Let's take an example... If you own an IBM 200 call, and you exercise the option, you would buy 100 shares of IBM at 200. Sounds better, right? Because if it is advantageous to exercise the option, the option is "in-the-money." If it is not advantageous to exercise, it is "out-of-the-money." Well, that strike price is now something you will obsessively monitor. Whether your position is ITM or OTM is very important because how the option behaves can change as the option greeks change. It's an anchoring bias, but it's amplified to a super anchor because of the transactional nature of options. And you'll sit there, not only figuring out whether your position is at a profit, but also where the underlying stock is relative to your options' strike price. And the implied odds set by the market will not matter to you, because you think this trade will be "the one."

BUT THE OPTION IS CHEAP!

Say you've got your eye on this sweet new ride. It's a 2010 BMW M3. It's fast, sexy, and everyone at the office already has one. So you walk into the auto dealership to shop around. The smell of new tires and stale coffee hit your nose. Soon enough, a man with too-white teeth and slicked back hair greets you. He's a nice guy though, and wants to show you around all the offerings in the showcase room. And there it is. Your dream car. And you look at the price tag: $60,000.

Whoa. "Fret not," says the auto dealer. "It can all be yours for a low monthly payment of $600 per month." 600 bucks? That doesn't seem so bad. Sign the papers! And that's the denomination effect. It can be disastrous in your personal finance. IT'S WORSE IN OPTIONS TRADING. Options are a transactional contract. That means there is a size and a price of the underlying tied to the option. In other parts of finance you have other options-- real estate options are a great example, where you can have the ability to purchase the house at a given price by a given time. But to make things simple, US-based options are standardized to 100 shares. So when we talk about options, we generally divide the cost of the option per 100 shares. For example, if there is an XOM 87.5 Call going for 1.40, we generally just say "a dollar and forty cents." But the actual cash to buy this option is going to be $140. Sure, we know that the value is 100x more than what we say... But still, how we verbalize the cost can have serious psychological implications. You could start viewing it to be "play money" rather than serious capital being put at risk. Sounds bad? It gets worse. Many traders get into the options market because it offers a fair amount of leverage. There's nothing wrong with that, provided you are an excellent market timer. But if you don't understand how options are priced, you can get into some serious trouble. There are a few components to the options price. Without getting too complicated, we can split it up into a few factors: time value - how long the option has left in its life implied volatility - how fast the underlying moves moneyness - how close the underlying strike price is to the current price of the stock

Now when you say an option is "cheap"-- well, relative to what? A current at-the-money call for PFE is currently going for 0.36. A similar at-the-money call for BIDU is going for 6.70. Does that mean the PFE call is "cheaper" than the BIDU call? Nope-- because BIDU is a very volatile stock relative to PFE, it will have a higher implied volatility, and the premiums available are much higher... justifiably so! Another example: AAPL is currently trading around 600 bucks (getting frothy much?). A 615 call with 20 days to expiration currently has a value of $10.40.

A 660 call on the same duration has a value of $2.00. You may think the 660 has the better potential for profits, but remember: THERE IS ALWAYS A TRADEOFF BETWEEN RISK, REWARD AND ODDS. You can't really compare the "cheapness" of different options because each option is unique. There are some fixes to properly viewing options-- that will be discussed in the solutions section

OVER-ENDOWED
You've probably got that crazy aunt out there who collects something weird. Beanie babies, antique clocks, or mismatched socks. You think it's stupid and rather gross that she holds onto them. But to her, they are priceless. This is a magnified example of what's known as endowment effect. The endowment effect is a fancy term for saying that your perceived value of something is much, much higher when you are the owner. This may be relatively harmless with your crazy aunt and her beanie babies as she would never sell her preciouses. But in assets that are easily tradeable (fungible) it can get ugly. THE ONLY PRICE FOR A FUNGIBLE ASSET IS WHAT IS SET BY THE MARKET. And if you value something more than what it's currently worth on the market then you've got issues as you won't be able to manage risk properly. This gets even worse when you trade options, because the value of an option is set by other variables besides the underlying price. Let's say you have a sold put option that you sold for 5.00, and it's now worth 6.00. That means you're down $100 bucks (remember to multiply by 100!) and are suffering a loss. But with sold put options, you have the benefit of time decay. Eventually, provided your option stays out-of-the-money, it will eventually be worthless. So you sit, believing that your current position is much more valuable than what it is currently worth on the market. We could take the other side, where you may be long that put option for 5.00 but the market value is currently worth 4.00. You tell yourself that you have plenty of time left and that your risk is "capped." You value your position much more than what the market does-- this could change you tell yourself; only if the stock would come back to your freaking level (see that anchoring bias?).

Have you ever heard of the phrase "cut your losers and let your winners run?" The opposite of that is a result of the Endowment effect. Too many losing traders tend to cut their profits all too quickly and hold onto their losses because the perceived pain/pleasure comparison is different in our minds relative to what we should do.

MEAN-REVERSION BIAS
Smart people often make the worst traders. Because they believe being right is much more important than making money. That somehow all the fancy math and economics they learned tells them that they are better than the market, and when the market disagrees with them, they continue to be right. I see this happen time and time again with traders I work with, but it is amplified with option traders. There is a lot of fancy math involved with options trading. You've got volatility surfaces, heteroskedacity, geometric brownian motion... the list goes on and on. But if you focus too much on the math, you forget about the art of trading and recognizing trends. It gets worse with those who are primarily option sellers. Options have a pricing component called gamma. This is a 2nd derivative greek, meaning that it doesn't directly affect the price but affects something else that has to do with the price. In this case, gamma is how the delta (directional exposure) changes as the underlying moves. You can view it as the "acceleration" of the position. If you are long gamma, that means the more right you are the "righter" you become. If you are short gamma, the more wrong you are the "wronger" you become-- this is what I call "gamma heartburn." The exchange for gamma is theta-- which is the decay of the option price over time. If you have short gamma then you have long theta. Nothing wrong with that-- but it can have disastrous consequences to your mentality. Let's take an example of a put credit spread, also known as a bull put spread. This is a bullish position with limited risk and limited reward. The trade makes money as long as the underlying stock stays above the short strike. It also has short gamma and long theta. This example is a put credit spread in BIDU, specifically the May 135/130 put credit spread. Notice that as long as we stay above 135 the trade makes money into options expiration, but if there is a move lower in the short term the trade will be at a drawdown.

So you will have this psychological issue-- do you hold onto the trade in a drawdown knowing that the time decay will eventually catch up to it, or do you cut for a loss? For those with no good answer to this because they think they are right in the trade, they will say: "It'll come back. Don't worry." I've said it before. And it sucks when it comes back to bite you. We can take the flipside of the trade as well-- if you are in a position that is long gamma and short theta. If the underlying market hasn't moved at all or hasn't moved in your favor, you will be in a drawdown as the time decay wears on your position. But you have faith in the long gamma of your trade, thinking "it'll come back, don't worry." You may even add unplanned risk to the trade to help reduce your breakeven. It may work for a few trades, but when it doesn't, you're hosed. If you think that the time component of your trade will help you even if you are in a drawdown, you are suffering from a conflagration of the SuperAnchor, Endowment Effect, and prospect theory. That's why you'll see many derivatives traders stay stubbornly against the trend in the market. They want to be right, they know the odds from the fancy maths of their positions, and they know that there's no way the market can move any higher or lower.

THE SOLUTIONS
KNOWING IS HALF THE BATTLE. So what's the other half? You need to develop systems and tactics to help reduce losses as a result of these psychological roadblocks. Let's look at 5 things you can do to fix it

1. DEFINE YOUR RISK BEFOREHAND

This may seem obvious, but it isn't when trading options. With stocks, futures, forex, or bonds-- you have a "stop-loss" level that you follow. From there you know how to manage your risk and position size appropriately. With options since there are other risks, then you have to plan for those as well. Sure, if you are trading strictly directionally you can use underlying price stops as a way to manage your risk and size up-- but there are other considerations. A major risk that options have is the time decay in the value-- also known as theta.

This time decay is actually exponential-- so the options that have the highest theta risk are those with less than 2 weeks to expiration. Using time stops on positions is very appropriate for option longs-- you can also consider a tactic called rolling out, where you move your position further out in time to reduce the theta risk. Another major risk is on the option short side, and that's the gamma risk. If your delta changes too quickly then you may be exposed to much more directional exposure than you planned. That can lead to larger losses than planned. A simple solution would be to roll your position to different strikes or months that will soften the delta. Another tactic is to trade stock or deep in-the-money options to reduce directional exposure-- this is a tactic known as delta hedging.

2. SYSTEMIZE YOUR ENTRIES

A big issue with the Super-Anchor bias is that you believe the strike price of the option you're trading somehow was a good decision on your part-- but if you are picking an option according to what "feels right," then you are overexposed to this bias. A solution to this is to use the delta of the options board to choose your strike. The beauty of the delta is that it is directly set by the implied volatility and time. In other words, delta is directly tied to the odds of the option. A .50 delta option will have about a 50% chance of expiring in the money. A .30 delta option-- about 30%. When you know the implied odds in a trade, you can then go on to make much better decisions on defining your trading system.

3. HAVE A WELL-DEFINED COUNTERTREND STRATEGY

Sure, it's sexy to go to all your cocktail parties and tell your friends and coworkers about why you're going against the market. And there's nothing wrong with countertrend strategies-- but you have to do them right. Saying a company is overvalued or a market is "stretched" implies very little. It's not actionable, not quantifiable, and leads you into that ugly mean-reversion bias that can wipe out a good portion of your portfolio. A great tactic I like to use on a market I think is running too hot is the failed break strategy. Essentially, if a market is at a key level of support or resistance breaks it and then fails back through the key level that tells you the countertrend play could work out very nicely. Another shorting tactic is to use the Bollinger Bands as a technical indicator, as they adapt for the volatility and trend. When we see a market truly go parabolic, it will stretch above the Bollinger Band to show us a statistically significant overbought signal. And when the market goes red, that's when it is a great time to take advantage of the short side.

4. USE IMPLIED VOLATILITY SMARTLY

If you think an option is cheap, you must ask yourself "relative to what?"

The best way to do that is to use the Implied Volatility (IV) to tell when an option is cheap or expensive. The IV is derived from the extrinsic value of the option-- also known as risk premium. If people are scared of a sharp move in a market, they will use options to protect themselves. That will drive up the extrinsic, which will boost IV. If people are complacent and there is a ton of supply on the market as option sellers step in, IV will lower.

Each stock has its own distinct IV. So the IV of BIDU and the IV of PFE will be drastically different because they are different stocks with different realized volatilies. The way to measured realized volatility is to look at the Historical Volatility (HV) of the stock. This can be done using any charting software. And comparing the current HV in the market to the forward-looking IV is a great way to get an edge in the options market.

5. BE AN ASSET SPECIALIST
I know it sounds fun to go all Gordon Gekko on your trading account. You're in and out of eurodollar futures, trading VIX options, short some TLT puts and are playing a dispersion trade between the SPX and AAPL. If you're reading this, odds are you don't have the trading staff or capitalization to really care about this. But if you spend all your time looking for ways to time every market and trade every option, you will become mentally fatigued. And that will open you up to a host of psychological issues. Become a specialist.

That can mean different things. I know traders who only trade SPX options. That's it. And they stick to the same option trading strategy all the time. They know what works for them, and they stick with it. Now I personally will never go that far-- I believe that I can time the markets to reasonable accuracy and I can structure my risk to take advantage of those trades. When you are dedicated to developing a single system and becoming really good at it, you have a much stronger capability to see how your personal psychology will interact with that system. When you know how you can sabotage the trade, you can set barriers up so you are not able to do that.

WHAT TO DO NEXT
I'm a huge believer that personal performance is not improved through sheer willpower. Take weightloss for example-- sure you have all the books and videos... you've got a personal trainer and a diet all lined up. You don't get results, but you believe if you can just work a little harder then your results will come through. This is not the case-- you need to have systems in place to remove the psychological component out of the equation. Things like having a training partner or cooking all your meals for the week on Sunday can have much better effects than just blindly "working harder." The same can be said of trading. You know these psychological issues exist, but no matter how hard you try, you will still be susceptible to the losses generated by them. You need to get better systems in place. Here's a series of questions that you can use to help improve your trading systems.

IS THERE ANY WAY THAT I CAN MANGE MY TRADE THROUGH THE OPTION GREEKS INSTEAD OF THE CHART? HOW CAN I BETTER USE THE DELTAS OF AN OPTION TO DEFINE MY STRIKE SELECTION? WHAT WOULD HAPPEN IF I OPENED TRADES 1 MONTH FURTHER OUT? WHAT WOULD HAPPEN IF I OPENED ONLY 1/2 OF A POSITION IN MY COUNTER TREND TRADES? HOW WOULD MY PERFORMANCE LOOK IF I ONLY SOLD OPTIONS? IF I ONLY BOUGHT OPTIONS?