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Option trading can sometimes be very complex; some positions may be constructed using a couple of different instrumentsAVOIDING COSTLY ORDERING MISTAKES Option trading can sometimes be very complex; some positions may be constructed using a couple of different instruments. If adjustments are added to an existing position, then the complexity of the matter can become even greater. Even seasoned traders can become confused when dealing with the trades that they have created. Its just the nature of the beast. But confusion can lead to placing a trade incorrectly. You may end up putting yourself in a position where you are exposed to a greater amount of risk than what you originally intended. The severity of the mistake will determine the course of action that is required to fix it. This topic really hits home with me since I just went through an experience of confusing strike prices, which caused me to make a mistake on the long and short options that I wanted to trade. If I had followed the advice in this chapter, perhaps the mistake could have been avoided completely. Lets go through a couple of different scenarios. Lets say you receive the confirmation from your brokerage firm and then realize that you placed the wrong trade. Unfortunately, in this business you cant go back and say, Hey, I really didnt mean to place the trade this way. However, if you are able to call your broker immediately after the trade was executed and tell him or her that you need to bust the trade, then they may be able to accommodate you; but that certainly is not the norm. Fortunately, I was able to have my trade busted and I certainly learned my lesson! Scenario #1 Lets say that you intended to get into a Cisco Systems (CSCO) bull call spread using the 20/40 strike prices for a small debit. However, the symbols that you gave your broker were incorrect and you ended up with the 20/30 bull call spread for that same debit. This is not a complete disaster because the risk profile is going to be similar to what you originally wanted. You have a couple of different actions that you can take in this situation. First, you can just sit with the trade and see what happens. If your original assumptions were correct and the stock moves higher, then you should be okay. The position just wont move as quickly as the intended trade. Another alternative is just to exit the trade immediately and realize the loss that you will incur because of the bid-ask spread. All other things being equal, I would probably stick with the erroneous trade, since there is plenty of time for the trade to work out. Scenario #2 Now lets look at a situation thats a little more serious that requires immediate attention. Lets say that you had a synthetic straddle on Best Buy (BBY), and you have been trading it very aggressivelyas the stock moves, you are buying and selling off shares in order to lock in profits and remain delta neutral. Another adjustment that you could make to the position is to sell calls against the long stock. In the process of doing this, you neglect to double-check the number of shares that you were long. You end up selling more calls than you have long stock. This is a very serious situation, because the position now has an unlimited amount of risk due to the greater number of short calls compared to the number of long shares available to hedge the trade. The reason to trade a synthetic straddle is to limit risk, not create an unlimited liability. The action to take here is to immediately buy back the appropriate number of calls that were sold short. This action eliminates the unlimited risk that became part of the position, which is exactly the goal when dealing with this type of scenario. As you can imagine, there are many different types of mistakes that can be made when placing orders; some mistakes are more serious than others. It is up to the trader to discern what has happened and determine how the risk characteristics of the position have changed, and then act accordingly. Maybe you will just stick with the trade or maybe something will need to be done immediately. The best way to keep yourself from getting into these problem situations is to be well prepared when you trade. There are five steps that I always go through before placing a trade. This process should help you catch any of the possible mistakes that are easy to make. 1. Write out the trade exactly that you want to place, including the ap propriate actions (buy/sell), the number of contracts, the months, the strike prices, the appropriate option symbols, as well as the net price for the overall trade. 2. Write out the various characteristics of the trade. Know and under stand the margin requirements that the brokerage firm is going to require once youre in the trade. 3. Use an options analysis software package to view the risk profile. 4. Know your exit strategy or at what point the next adjustment will need to be made. 5. Place the trade with confidence. Hopefully, some of these ideas will help you to avoid panicking if you realize that a mistake has been made with one of your trades, as well as to provide some ideas on how to prevent mistakes from occurring. POINTS TO REMEMBER The typical brokerage firm ticket has the buy side of the trade on the left and the sell on the right. Generally, we would always start from left to right, writing down your buy side first. You would say, I have a straddle order. I am going to buy three of the June XYZ 45 calls and buy three June XYZ 45 puts at ______ at the market or as a limit order with a certain number of points to the buy side. With a spread order, always give the quantity, the month, the underlying instrument, the price, and the strategy: I am buying three [quantity] June [month] XYZ (stock) 45 [strike price] straddles [strategy]. The other half of the order would be, I am buying three June XYZ 45 puts. I am buying three June XYZ 45 calls. Now we have to calculate the cost. It is either a debit, a credit, or at even. If it is at even, you do not want to receive a debit or a credit. You want to stay at net cost of zero. I prefer to do my trades at even or better. However, a straddle is a debit strategy because you are buying both legs. If you are not comfortable with the specific language of straddles and spreads, then state each part of the trade instead. Tell your broker, I want to buy three of the June XYZ 45 puts. I want to buy three of the June XYZ 45 calls. Spell out the whole thing if you are more comfortable doing it that way. In fact, you dont even have to say straddle and strangle if you are not comfortable with those terms. In the beginning, it is a good idea to be specific about each leg to make sure you get it right. Once you have experience in these types of trades, it will become second nature to properly state your orders correctly. If you are trying to get a credit, do not state the credit as a dollar value. You do not say, I want $200. You specify the credit, if that is what you desire, at the point level you want. So $200 is actually 2 points. You need to specify the trade in the terminology used by the floor. Most importantly, it has to always be in tick values or point values, not in dollar terms of how much you want to spend or take in. You can go into any market at whatever price you want. The floor will either execute the trade at that price or it wont. You could say that you want the trade at even, but if the market is not at even, your order will not get filled. At one point during the day, perhaps the market does get to even and you finally get what you want. Bottom line: If you dont enter, you cant win. If you want it at a certain price, put the order in as a limit order. Then wait to see if you get the trade filled. If you do not get your credit price or at even, try the trade at some other time. Do not chase the trade. The more volatile the market is, the wider the bid-ask spread will be. If the market is pretty quiet that day, the bid-ask spread will be smaller. The bid-ask will be smaller for the at-the-money (ATM) options and for the body of the trade and greater for the wings. Floor prices primarily depend on volatility and liquidity. In addition, the longer the time your options have until expiration, the wider the spread. Floor traders will widen the spread when there is a greater chance of their being wrong due to time, volatility, and volume. CONCLUSION The progression of an order through the trading system is a fascinating process. It has come a long way from the days in the late 1700s when traders met under a buttonwood tree on Wall Street. Todays floor traders run an average of 12 miles each trading day just to get the job done. Although many traders never set foot in an exchange, it is important to understand the process your order goes through before returning to you as a profit or a loss. As we progress further into the twenty-first century, this process will undoubtedly become even more electronically synchronized. As the information superhighway speeds up, it will be very interesting to see how it changes and if the nature of the game itself remains the same. |
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