Growth of an Elite Option Trader

7 minutes to read

November 7 2018

by John Ferraro, CIO of Longhouse Investments

☠☠☠WARNING: This story recommends trading processes that are meant for advanced trader/investors only. Follow any of these recommendations at your own risk. Discuss with your financial advisor/planner before implementing any of this advice.☠☠☠

How I Got Started in Option Trading

Welcome to my story, my name is John and I am a former Option trader and double-black diamond skier (I miss my old Rossignol Freestyles).

I still trade options but as an investor now, not as a trader.

I call myself elite because I ‘ve made thousands of options trades and experimented with almost all of the well known strategies.

I made even more trades in a paper trade account while experimenting with a wide variety of option strategies, before putting real money to work.

So I’m certainly not reckless with regards to trading.

I am a retired Senior Principal Scientist Engineer at a large aerospace company that I worked at and retired from after 36 years.

My first exposure to options was way back in the 1990s.

I was called into my department manager’s office one day and you could imagine what was going through my mind.

"Am I about to get a good talking to for bad behavior, complaints about me, poor performance complaints or even worse getting laid off ...Gulp."

After my initial anxiety, I thought to myself, hey I’m doing great here at work with great yearly performance reviews and increasing level of project responsibility year over year.

So after my initial apprehension, I went in.

To my surprise my manager had a big smile on his face and he preceded to hand me a folder with something called ISO Options.

My response was,

"What are these?"

I had already been very familiar with stocks, ETFs, CITs, Mutual funds and other run of the mill investment products, but I had never looked into options. After a little research I realized that these were special options called Incentive Stock Options, were created at a local brokerage near my company and were designed to keep me working there. With these I had a reason to not jump ship to competitors like Northup Grumman or Boeing which had buildings within a short walking distance from ours.

This process was repeated over the next five or so years and I ended up with a fairly large chunk of long call options at varying strike prices and expirations.

When I investigated retail option chains they did contain LEAPs that expire 1 or 2 years from purchase but I didn’t see anything 10 years out. This let me know these were special broker created option contracts.

There were also tax penalties and lengths of time from when they were given to me that I could not exercise them.

All of this designed to keep me at the company and not jump ship.


Down the Rabbit Hole

So now my curiosity was on fire about these ISO options.

When I looked at 2 year LEAPs At The Money(ATM) call premiums, they were really cheap compared to just buying the stock.

Then I realized those cheap bastards had bought long calls for a small percentage of the stock price and had roped me into staying for many years until I could exercise them.

Then I thought , "Wow that was brilliant, I’d like to meet the guy in finance that pitched that idea to upper management!"

I later learned that several of my high performance friends had been getting the same ISOs.

So rather than awarding the high performers stock which we could then sell and leave, they gave us financial hooks, ISO options to keep us in house.

After a couple of years I was able to exercise a few thousand options that had gone beyond their strike price and cleared their ISO restrictions and pocketed a quick twenty grand.

I remember thinking, "Hey there might be something to these options."


Going to Options School

So I proceeded to learn everything I could about options.

I quickly learned about this strange phenomenon called time decay.

I heard time decay described one day as like buying a melting ice cube. So buying options seemed dicey but selling them and watching all of those melting ice cubes making me money looked pretty good.

At that point my curiosity was hooked on the money making potential of these suckers.

Then when I learned about the huge percentage gain on a single trade, I thought I may have found the mother load.

At that point I had been focused on the potential gain. As far as the potential risk I’ll worry about later. (a common mistake)

The engineer in me made me learn about all option strategies with interesting names like:

Strangles, straddles, iron condors, butterflies, bull/bear call spreads, bull/bear put spreads, outright call/put purchases, naked put/call sells.

Oh, and there was the more mundane covered call and cash secured put options sells.

I focused on mechanical strategies that you can trade week after week without really following the current market conditions.

This made the most sense since I had a full time job.

These are market neutral volatility plays.

That’s their allure, it didn’t matter if the market went up or down, only that it moved or didn’t move.

This also brought timing into the trade being right or wrong on volatility.

With a straddle or butterfly you need the price to break out of a price window within a certain amount of time, with a strangle or Iron Condor you need the price to stay within a price window within a certain amount of time.

I did pretty well with these trades but noticed I would have several successful trades and then one losing trade and be even after winning three and losing once.


Paying My Tuition

Having several successful trades and then one losing trade and be even after winning three and losing once was happening pretty regularly.

This led me to the concept of win/loss ratio.

To solve this problem I decided I needed a really accurate window analysis tool to gauge the probability of a stock breaking out or staying in a fixed window before expiration and do this with such high probability that I could overcome the W/L ratio.

Some of the brokerage firms had a similar tool but they usually couldn’t do want I wanted and were not flexible enough to satisfy my needs.

I ended up designing the requirements for the tool and hired a software developer to code it.

It cost me a couple of grand and worked like a charm.

I did have better results using the tool but I still could not escape that nasty win loss ratio that I thought the tool would help me overcome.

Without being able to overcome this ratio I could never go into putting big money on these volatility strategies.

So on to the next strategy I went because my real goal was being able to go big on a strategy that I had a high confidence in.

I still use the tool but I’ll discuss that later.


Blindly Following the Pros?

If you’ve ever watched CNBC they have a program on every Friday afternoon called Options Action.

These are supposedly options experts and they give you ideas for bull and bear put and call options spreads designed to take advantage of current market conditions or technical analysis of their technical analysis guru.

These guys are really in tune with the current market conditions but their trade recommendations only do slightly better than average and again these are multi-month speculative trades that you really cannot go big on.

I must admit now and then if I see the market or something going really hard in one direction I’ll pop one of these spreads on it just for fun and a few quick bucks(i.e. Oil price crash in 2016, Bull put spreads on XLE).

The main advantage of these spreads is you reverse the win/loss ratio in your favor(i.e. risk a buck to make 3), but you know have several things that have to go right before expiration (price direction, size of the move, and time duration.

This makes it tough to do without being tuned into the market very closely. If even the pros were right only slightly better than half the time, I had little chance of regular success.

So I don’t do volatility spreads anymore, I rarely use spread trades unless I see an obvious trend that will take some time to reverse.

So what do I do?

After all of these quick action options trades I finally figured out there was real money in those mundane, slow moving long term strategies (covered calls and cash secured puts). These reduce your leverage substantially but with high leverage comes high risk.

Summing up this progression,

here’s what I’ve learned...


Lesson Learned from Trading Options

  • The market goes up and the market goes down, but the big money is in the long game.
  • If you want to end up like bank think like a bank, slow steady low risk.
  • NEVER SELL PUTS AGAINST A STOCK THAT YOU DON”T WANT TO OWN.
  • Learn how to select the highest quality stocks. See “The Story of a Young Cattle Rancher
  • Note: Buying individual stock while possibly very rewarding is also very dangerous. A major index correction is usually down 20%, how many times have you seen good stocks down 50% or more.
  • Go long and stay long, don’t get shaken out easily.
  • Use cash secured puts to pick up your highest quality stocks.
  • Build a long term cache of the highest quality stocks.
  • Once you’ve built up your stocks, sell covered calls against them to generate monthly income.
  • If they get called away sell more puts.
  • Repeat as necessary.
  • Slow down on covered calls if the market is moving up quickly, just sit back and enjoy your stock capital appreciation.
  • Don’t JUST trade a stock, create a trading thread for each stock (see below).

Creating a Trading Thread

Here’s a hypothetical example trying to buy Apple priced at 100 and creating a Trading Thread. This also works for index ETFs (SPY) for example.


Month 1 Sell 95 strike cash secured Put 2 bucks- expires worthless apple ends 102 profit 2

Each time you sell a put and it expires worthless you get paid to not buy it!!

Month 2 sell 97 put 2 bucks – expires worthless apple 102 profit 4 total

Month 3 sell 97 put 2 bucks – expires worthless apple 105 profit 6

Month 4 sell 100 put 2 bucks – apple dips to 99and it gets put to you at 100

100-6=94 is your Breakeven point

Month 5 sell 105 covered call 1 buck expires worthless 101 BE 93

Each time you sell a covered call and it expires worthless you get paid to not sell it!!

Month 6 sell 106 call 1 buck- expires worthless 103 BE 92

Month 7 sell 107 call 1 buck – APPL rallies to 108 called away at 107 BE 91

Profit 107- 91=16


END THREAD HERE AFTER STOCK GETS CALLED AWAY OR CONTINUE AND

MONTH 8 SELL PUT 100 2 BUCKS

ETC...

ETC...

ETC...


So just buying the stock outright would have earned you 108-100=8 or using these techniques you would have made 16.


John’s Custom stock ETF with Options

The investment model I’ve described here on a collection of high quality stocks is what I call John’s Custom stock ETF with Options improvement, or My ETF for short.

The down side is even though it’s a long strategy, it still requires weekly and sometimes daily monitoring to optimize performance.

I describe it to non-investor types as launching ten to twenty sail boats into the ocean and doing slight course corrections as they stray off course or to make them go faster.

As I stated at the beginning of this story, this is for advanced traders/investors only.

A high degree of skill is required to implement this strategy successfully and based on market conditions, no guaranteed of profit is expressed.

The interesting thing about the market is knowing what not to do can be as important as what to do in the market.


Here's My List of Things I’ve Learned NOT TO DO.

  • Trying to time the market.
  • Day Trading stocks.
  • Short term option trading(Day or Weekly).
  • Buying individual stocks with out 1) having a really disciplined buying checklist 2) enough money to buy enough individual stocks to create a diversified portfolio.
  • Buying Annuities (this is a whole other discussion).
  • Buying expensive Mutual funds (high expense ratio A,B, or C shares).
  • Buying expensive CITs and low yielding UITs.
  • Investing in private placements or other little known about securities offered.
  • Falling for can’t miss, guaranteed security offerings.
  • Investing in derivatives of weak credit offerings.

There's a Lot More to Talk About

I hope you enjoyed my post on my options trading journey is you have any questions or comments, leave a comment below and let's get a lively discussion going.

I'm working on creating a bunch of posts detailing what I do and how you can glean some wisdom from mistakes I've made.

Me and my sons call those mistakes, "paying tuition".

Our friend from hockey calls it the "stupid tax"! Whatever you call it, hopefully we'll be able to teach you a few tips to avoid paying too much.

Options Disclosure

Options are not suitable for all investors. There are risks involved in any option strategy. Individuals should not enter into option transactions until they have read and understood the option disclosure document titled "Characteristics and Risks of Standardized Options," which outlines the purposes and risks of option transactions. This booklet is available from Longhouse Investments or at OCC - Characteristics & Risks of Standardized Options.