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Index Trading vs Individual Stocks

Posted by Pete Stolcers on June 14, 2006

Option Trading Question

Today Lloyd R. asks "I understand why someone would want to be long options, but why not use indexes for credit spreads? Stocks are so unpredictable and a news event (takeover, earnings pre-announcement, law suit...) can come at any time. The penalties are extreme"

Option Trading Answer

Great question. Stocks do carry a surprise component and obviously, when you are long premium you want that to a degree. You don’t want random surprises where you are continually blindsided. Indexes are diversified and consequently they do not have “unsystemic risk”. They only have “market risk”. There is a statistical advantage to selling out of the money put spreads, on indexes and I do like that trade under the right circumstances. With the market near a seven month low and the implied volatilities (IV’s) spiking - that trade is setting up.

As you know from my prior blogs, I do not advocate Iron Condors or neutral trading strategies. There is too much slippage and one big market move can strip away half a year’s profits. These are very popular “seminar” strategies and they are typically index based. At $3000 per seminar, they’re the ones making the money.

On the topic of index call credit spreads, I do not feel I’m properly being compensated for the risk. As the market rallies, the IVs collapse and you have to get too close to the money to get any premium. Look at the OEX July 600 calls and the 530 puts. Both are 35 points out-of-the-money (OTM) and one trades for $.70 and the other trades for $4.40. The risk reward ratio is not there on the call side.

Indexes have so many eyes focused on them that I don’t feel I have an edge. Every large institution is analyzing the SPY, OEX, SPX and they are executing baskets of stocks and futures against their option positions. I won’t pretend that I know more than Goldman Sachs and its 50 Floor Traders. There is no edge for me. I could tell you stories about the sophisticated trading tactics I witnessed in the OEX pit 15 years ago. If ever there was “fair value” it’s the exact price of that product at any moment. In the end, when I trade indexes I’m forced to predict what the market is/isn’t going to do.

My edge lies in my ability to find relative strength and weakness within the market and I have a proprietary program that helps me find that. There are opportunities that large institutions are not interested in. They can’t get the size done to justify trading it. There is a large advantage to trading a balanced long/short portfolio of stocks with relative strength/weakness. Choose well and the strong stocks gain more than the weak stocks lose when the market goes up and vice versa. This strategy helps me reduce my market risk. I also feel that I can identify supply/demand imbalances in a stock and I know when someone is trying to move “size”. That comes from my chart reading skills and I like to shadow them. In a crowded arena like an index, that trail is masked by “noise”.

I have found that careful research and selection can help me navigate news events. For instance, I don’t do credit spreads on biotech stocks. The chance of a material, unscheduled news event is too high. When all of my research has been conducted only a quarter of my trades translate into option trades for liquidity reasons.

Getting back to selling options, when the stock or the market are uncertain, the IVs are high and I’m rewarded for selling premium. The credit helps me distance myself from the trade and I can keep my objectivity. The key is to watch for upcoming news events and to get intimate with the stock. Know what’s driving it. Just as I would go long or short a stock, the credit spreads are no more than a directional trade with a built-in buffer. Another way to throttle risk is to size the position accordingly.

Never start your search by looking for stocks with high IVs. That is suicide. Those big premiums are there for a reason. There’s a very high likelihood that a lightly publicized event is forthcoming.

Option Trading Comments

  • On 07/16, Tanady said:

    Great observation !

    My name is Cornel Tanady, and have been doing some research about futures trading. Recently I’ve discovered some tips when entering the options/futures market.

    Please kindly visit and comments if interested.

    Cheers,
    Tanady

  • On 07/16, Pete Stolcers said:

    I was not overly impressed by the depth of the article, but I do know Options University. I have reviewed parts of their curriculum and I have found the instruction to be accurate. Before you start trading options or futures you must have a basic understanding. I advise starting with small stock positions to get your feet wet. The key to becoming a good option trader is to identify the right stocks. Once you become comfortable investing you can gradually advance to more speculative activity.

  • On 07/16, Tanady said:

    Thanks Pete for the information.

    You are right. I’m still a beginner in trading stocks etc. That’s one of the purpose I do research. Hope to learn from you all folks.

    Cheers.

  • On 03/10, Starting a small business said:

    I would love to be able to do some more investing without getting taken to the cleaners by my broker. I can’t seem to find anyone honest. I guess my only option is to do research myself. Thanks for the site and the info.

  • On 03/11, Pete Stolcers said:

    I believe that there are so many sources of information that with some training and discipline, you can do better than most brokers. You will also know why you entered the trade and you will be able to refine your approach based on your results. When a broker calls with a great “idea”, you never know where it came from or why he is peddling it.

  • On 09/14, jim byrnes said:

    when trading put and call spreads on the S&P;EMINI,I MUST PAY VERY HIGH COMMISSIONS WHICH DIMINISH MY PROFITS CONSIDERLY.OPTIOXPRESS IS MY CURRENT BROKER ,DO YOU KNOW ANY BROKERS WHO ARE MORE REASONABLE.EX:if itrade 3 eminis on both sides of spread my commision is 77 bucks,way to much......

  • On 11/02, ninan said:

    Assuming I want to short a stock, is it better to buy a deep ITM Put provided there is enough liquidity, say > 200 contracts per day. It avoids borrowing costs and also I can do that for an IRA account. What are the drawbacks, if any?

  • On 11/03, Pete Stolcers said:

    If you want to short a stock in an IRA, buying a put is the only way. The strike price, expiration month and size are determined by your opinion.

    For the most part, bearish strategies are discouraged in IRA accounts (unless they are intended as a hedge). Over decades, the market has a long term up trend. IRA accounts are intended for long term investments. I realize that there are many traders and I will assume that you are seasoned.

    The current risk is that you get caught in a bear market rally and your put losses value. You are paying a ton for puts and implied violatilities (IV) are at HISTORIC HIGHS. You also have the risk that a stock will be takenover or receive good news (FDA approval, favorable litigation outcome). Deep ITM options normally don’t carry much IV, but that is not the case now.

    Any time you are trying to time the market, you have risks. Buying deep puts that are trading near parity is mo more risky than shorting the stock. I just don’t know that either is suitablke for an IRA account. Only you can determine that.

  • On 07/17, Ken Lessin said:

    Hi - I’ve recently decided to trade options.  This came due to the hundred thousand I made (virtually), buying BP puts after the oil spill.  It seemed like a no brainer, and I was right.  Now, I’m looking for an analyst to subscribe to to guide me as I begin trading options in earnest.  But here’s my problem (question).  Seems that none of the multitude of professional stock pickers would have recommended buying puts on BP while it was pluging from 60 to 30 over a couple of months.  I guess if you just use technical and fundamental guidelines, you miss the huge moves driven by big news events.  Did you recommend BP?  Is this question relevant?  I’ve looked at many analyst subscriptions like yours, and very much like your intelligent and intelligable advice and thoughts in the newsletter.  But will you recommend the next BP like event?  Thanks much, Ken

  • On 07/20, Pete Stolcers said:

    BP was not the no brainer you think it was. From a trading standpoint, the stock sold off dramatically from the onset and the option impplied volatilies spiked making put purchases very dangerous from a risk/reward standpoint.

    The well could have been capped in a week or they could have run into a multitude of problems with equal probability. The extreme option implied volatiliies were pricing a big move in one direction or the other. I viewed this as a crap shoot and decided to look for higher probability opportunities.

    Congratulations on taking the right side.

    I’ve never met anyone who lost money paper trading. When real cash is on the line, everything changes. You can stick with a paper trade that loses money and turns around, but that is not reality. When hard earned money is on the line, you sweat out every tick and a disciplined trader will stop himself out.

    The more certain you are about a trade, the more dangerous it can be because you are likely to leverage up. Only the school of hard knocks can temper your confidence.

    It’s nice to start off on a positive note, but only after years of trading do you know if you really have what it takes.

    Option trading is exciting and rewarding. Learn as much as you can before you begin and the journey will be much easier. Good luck with your trading!

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