SIZZLE Mailbag No.1 Unusual Options

Activity Part I

Not sure if you’ve heard, but I’ve been asking members of the OptionSIZZLE community to send me their hard-hitting questions pertaining to options.

Let’s face it, many of us our going through some of the same issues when it comes to options investing.

With that said, I thought by sharing these responses with you here, we all could get something out of it.

Let’s get started with the first question.

Hi Joshua,

I found your report on unusual options to be very helpful, especially the part about following a successful roll.

I have some questions for you, hopefully you can provide answers. I am a novice trader and don’t plan on becoming a professional. So I don’t have access to the same tools as you.

However, I usually follow the options flow posted on Twitter or Stocktwits. Now, when I followed some of these trades, they ended up moving in the wrong direction and I took a big loss.

Question 1: How do I decide when it’s time to stop out of a trade and take a loss?In the past two months, I won some, but lost more.

The most painful part, is taking a loss and then seeing the trade becoming profitable without me.

For example, I followed FSLR April 70 Calls, it dropped sharply, I got out. A few weeks later, news was released and it rose sharply and traded above 75!

Response:

First, let me say that I’ve experienced what you’re going through. And to be honest, there’s nothing more frustrating than getting out of a position for a loss…only to see it rebound and come back. Of course, not every trade is going be a winner and there is nothing wrong with getting out once your pain threshold is met.

However, it makes a lot of sense to evaluate your losing trades and ask yourself if there was anything you could have done differently.

Here are my thoughts:

We never know if an unusual options trade is done for speculative or hedging purposes. However, that shouldn’t stop us from trying to be inner detectives.

That’s why I constantly ask myself:

Is this order done for technical reasons (bullish or bearish chart patterns, breakout or breakdown etc.)?

Is there an event coming up (analyst day, earnings, conferences, pending legal announcement, FDA release etc.)?

Is this company a potential acquisition or involved in one (M&A rumors)?

Is there an activist hedge fund manager involved with the stock (Carl Icahn. Daniel Loeb etc.)?

Is this sector getting bought? For example, are we seeing strength in all solar names or is this isolated.

Is this stock vulnerable to economic news or highly correlated to the broad market?

If you go through the report again, you’ll notice there are even more questions for you to consider.

But I think you get the picture. The goal is really to try to figure out what the potential catalyst might be.

Of course, sometimes we can be completely blind-sided, only finding out what the catalyst was after the fact.

In this case, First Solar, Inc. (FSLR) had an analyst day on 3/19/14. Typically, analyst notes are followed after an event like this.

An analyst note is simply a report on the company along with a price target and their justification for that price target.

Now, it turned out that almost every analyst on the street upgraded their price target on FSLR after the analyst day.

UBS $55 to $72Deutsche Bank $50 to $70JP Morgan $31 to $51RBC $67 to $87So on and so forth…

If I were to guess, the order flow you saw was a speculative bet that FSLR would have a positive analyst day. In fact, that week, the stock price jumped 32.91% to $73.37.

OK, so we just identified the potential catalyst. And you didn’t need any fancy software or analytics to figure out. In fact, YAHOO! Finance has a pretty good news service (that’s free). You can check it out here:

Moving on.

You mentioned that the position moved against you so much that you had to bail out.

Here are two things to consider:

It boils down to position sizing. If this is a bet on an event, we have to treat it like a binary trade. This simply means that it’s going to be a winner or a loser.

For example, if I decide to trade binary events, I size accordingly. If my max loss on a trade is $1000 and the contracts are priced at $0.50.

I will only buy 20 contracts, with the idea that there is a good chance of losing it all. If I’m wrong and the event passes, I’ll try to salvage any premium that’s left.

To put it into context, if I normally risk 3% of my account size on any given trade. On binary trades, I’ll risk 1 to 1.5%.

Why?

Because they’re super risky and if I’m right the stock should really pop…so there is no reason to have a lot on.

Also, these are near term contracts, the premiums have the potential to move very quickly.

I don’t want to be in a position, where I have too many contracts on and I am forced to get out before the event occurs (because the losses are too big).

By keeping your position size small, you have the ability to see the trade play out. It seems like you had too many positions on.

Now, let’s assume we don’t know what the potential catalyst is. I’ll then look at the option volatility. What does this mean? Well, I will look at the implied volatility of the options.

Let’s say the at-the-money options have an implied volatility of 60%. Implied volatility is expressed in annualized terms.

However, most investors have a greater feel for volatility in daily terms. With that said, I would take that .60 and divide it by 16 (rounded off, it’s the square root of the number of trading days in a year).

You don’t have to get caught up in the jargon…just know that if you take the implied volatility and divide it by 16, you’ll convert annualized volatility to daily volatility.

.60/16 = .0375 or 3.75%

This means that the option market is implying that the stock could move +/- 3.75%.

For example, if the stock price moved 3% today that would be considered a normal move. In other words, that 3.75% is a one standard deviation move.

Bottom line, if the stock experiences a lot of price volatility and it’s a near term option…I want to trade small because I don’t want to get stopped out.

As you can see, the way you size your position should vary based on the time frame of the options, the potential catalyst and structure of the trade.

If you read, “The Ugly Truth About Buying Options” you’ll recall how quickly extrinsic value gets sucked out of options as they near expiration.

Bottom line, this was a trade that was based on upcoming event and you were not sized correctly.

It’s also worth considering other trade structures in the future. For example, if you’ve read, “How to Underperform the Market and Get Paid Like a Rock Star” you’ll know that I’m a huge fan of structured option positions.

In addition, if you read, “Why You Should Avoid Trading Options All Together” you’ll know that I like to sell puts vs. buying stock or calls if I have a bullish bias on a stock.

In Part II I’ll be going over a position management question. If you’d like to get involved with the action, just send me an email, message on Twitter orFacebook.

Of course, you could always share your thoughts in the comments section below.

I’d love to hear from you.