What is the biggest difference between an option trader and investor?
I spent 15 years of my life and 25 years total as an option trader and investor. One thing I have noticed is that students in Option Pit, and myself sometimes for that matter, get confused on what is a “trade” and what is an “investment”. The easiest way to separate the two has to do with how you can deal with the delivery of the underlying security. If the expectation is no delivery then that is a trade. If the trade results in delivery and is kept, that is an investment. The trouble comes when the two issues get confused.
Making a short-term trade into a long term (bad) investment
As a floor trader I saw all kinds of things go down. I must have traded 6 or 7 million contracts over that 15 years and really enjoyed every minute of it. Ultimately floor trading was not investing but was a way to try and make money day in and day out. It was not passive and the last thing I wanted was to take delivery of a stock I did not want. A mistake trader’s can make is let their long-term assumption of a stock affect their short term trade. They might end up with massive losses they cannot handle for margin reasons only to be right much later after the cycle is over. An adage I like “it is ok to be short term wrong as long as long you can afford to be long term right.” If the short-term wrong wipes out an account, it does not do any good no matter the long-term thesis. This is the same for rolling a loss if that idea consumes all the capital in the account. It is much better in a trade to take a quick small loss early and rethink it.
Time and Volatility are related
The reality was floor option trading taught me a lot of things on how to be a better option investor. The most important thing was time. Time has a crazy variation of values when trading options because the market can value volatility differently at any point during the expiration cycle. Time can get interchanged with volatility. Time to expiration for the cycle is known at the outset but volatility is not. The opportunities at a 20 VIX are different than a 12 VIX. Right now I am most buying option volatility with VIX at lower levels. The reason is lower volatility decays at a much lower rate than higher volatility options. Bull markets tend to trend and long options do better in that environment. Longer time frames help too since options 3 to 6 months out don’t decay very much. A trader is almost an option investor at that point, except they are investing in “low volatility.” Now there is a mind bending concept.
Combining Trading and Investing
I keep a watch list of stocks I am interested in. TWTR is one of those stocks. When it pulls back big I get interested again as I see it as a perennial undervalued property. I wont sell puts in it at $40 but I will in the $20’s . The IV is so low I am just buying options in the Jan cycle. I will keep the risk to 20% of premium paid before I check my long term view with my short term account.
Disclosure: TWTR, VIX and SPX positions
Follow Andrew@optionvol You can hear Andrew on Option Block every week.
Follow Mark@optionpit You can hear Mark on Volatility Views every week. Volatility View’s Crystal Ball is on Friday’s.