Core Market Knowledge for Options Traders

By Martha Stokes, C.M.T. © copyright 2007 all rights reserved.

Any time leverage is used in trading, it creates inherently higher risk. Therefore, it becomes even more critical for options players to have a foundation of knowledge that goes beyond the extremely narrow scope of “options strategies”. An option strategy is the last thing an options player needs to learn. What they need to learn first is: Core Market Knowledge.

Core Market Knowledge is at the bottom of the Trading Pyramid because it represents the largest body of information all traders must learn. Once they have this knowledge then they are able to develop their own unique trading style, they can then study the market condition and choose the right trading system, and then apply the appropriate strategy based on all these previous criteria. It may sound complicated but in practice, it makes trading infinitely easier and more reliable.

Let’s examine a few areas of Core Market Knowledge.

One of the first areas that should be studied is History. Just the word, “History” makes most people cringe. How can history be important and why does it matter?

Here’s an example:

Most everyone knows that Candlestick charting, which is frequently taught alongside of options strategies was first developed in Japan over 2000 years ago for their Rice Commodities Exchange. This is important because the Rice Commodities Exchange of ancient Japan was the first futures market in the world. Immediately any well educated trader knows that this is an important fact.

There are innumerable critical differences between futures markets and stock markets.

The first difference is seen in chart analysis and interpretation because a stock market has far more levels of market participants than a futures market. The reasons for buying stocks are not the same as traders who buy futures contracts. Some people invest in stocks for the long term, whereas futures traders only buy and sell short term contracts. Futures are speculative as the commodity doesn’t usually exist at the moment of sale but is a future event. The stock market however, shifts from value-oriented to speculative during the life of a major bull run based on the growth and development of products and services by a company.

Futures are a time limited contract that obligates the buyer to take possession of a certain commodity (seldom done by futures traders but non-the-less an impact on price action) whereas stock purchases are an outright ownership albeit nowadays frequently for the short term. The buying mentality of a futures trader is quite different from the buying mentality of a stock trader.

This difference in attitude, intentions for the trade, and time constraints, can and do alter candlestick patterns. Understanding the many differences between a future commodity market of ancient Japan and the current stock market enables an options player to read candlestick charts with greater accuracy and insight.

Options are a secondary market mostly used to leverage stock buying and selling. Options markets are therefore different from stock markets in many ways. Understanding the history behind options, why they were created, when and how, and the implications for options trading today all are part of core market knowledge.

The Dutch invented options during the 1600’s Dutch Tulip Bulb Mania speculative market bubble. Actually options came just as that market was about to implode due to extreme buying frenzies and prices that had skyrocketed into thousands of dollars for one tulip bulb—the equivalent of spending hundreds of thousands of dollars today for just one bulb. The Dutch Tulip Mania market was one of the earliest examples of a great market crash. In this heated, extremely emotional market, options were born. The poorer families of the region had been caught up in the greed of the moment and were eager to join the ranks of the ‘get rich quick’ and become wealthy overnight with no effort or knowledge of the commodity market of tulip bulbs. Needless to say, all of those who bought options on tulip bulbs lost everything.

Why is this important for options players of today?

Options appeal to many kinds of traders but in particular, they draw the small capital base trader with the allure of leverage. The theory of options is that with even a hundred dollars you can leverage large numbers of shares to make huge profits quickly.

The downside to options is something no one talks about: the smaller your capital base the more inherent risk for any kind of investment. The reason risk increases the smaller the capital base is because most of the time, this is money these individuals really can’t afford to lose. Unlike large capital base traders who can set aside a portion of their savings to put at risk and still have money in the bank for unexpected catastrophes, the small capital base trader is often putting everything they have on the line.

Despite the fact that options players have access to vast numbers of optionable stocks, chains, software to analyze implied volatility, numerous seminars, news, and gurus to help them, the statistical success of the small capital base options player remains as dismal as it was in the 1600’s. So despite the advances in technology, the average options player still is struggling to become successful. This should be a big warning flag to would-be options players that something is wrong with how people learn to trade options.

When you understand the history of something, you are better able to see the inherent benefits and flaws of the concept. Yes, options can be a powerful leveraging tool and yes, small capital base traders can succeed, but before any level of experienced trader can use an options strategy, they have to develop their own individual trading style, then understand what the current market condition is to select the correct trading system for that market condition so they can select the best strategy that will work based on all of those factors. And that leads into another part of core market knowledge.

Let’s look at an example:

Straddles are popular options strategies because they offer the promise of a “sure thing”. An option straddle strategy is one where you are both buying and selling at the same time. In theory, this strategy implies that it doesn’t matter what the stock does, the options player will make money. If the stock moves up then the sell options expires worthless but the buy option makes money and vice versa. Sounds like a bullet proof strategy, but it is not.

Here’s why: Stocks selected for this purpose are often in a consolidation or tight sideways pattern. The options player often lacks technical skills and so buying and selling at the same time seems to be a solution because the options player can’t tell if the stock will move up or move down out of that sideways action. But that is not the worst of it. They also don’t know how to determine the duration of that sideways pattern and more importantly, the velocity and point potential of that move. All of these are critical to the success of the option trade. The option player is trading the market blindfolded.

Whereas a position trader who trades stocks and has this knowledge can actually determine the duration of the consolidation, the probably direction of the move either up or down out of the consolidation, the velocity or momentum of that move, and the potential point gain. Position traders know that platform building phases are continuation patterns of the original trend and can quickly determine the direction the stock will take. The position trader learns all of this from stock chart analysis, both the current price action and the recent HISTORICAL price action of the stock. The position trader knows the duration of the consolidation based on technical patterns as well as certain financial cycle patterns. The position trader knows when to enter the position trade to get into the trade prior to the move and to reap the benefits of gaps and sudden explosive runs.

Most traders don’t know anything about trading styles. Therefore they don’t know that options are a position trader strategy due to the duration of the normal contract time frame. This means options players should be proficient at position trading before they ever buy an option.

Unfortunately most options players only learn strategies and do not know how to position trade. If they did, they would seldom use straddles because they would know the impending direction the stock would take based on chart and indicator analysis. They would know when the stock would most likely break out of that sideways pattern and they would know how much that stock was expected to move. With this information, the options player could quickly discard weaker picks and select only the optimal stocks in consolidation patterns that were poised to move shortly after the contracts were purchased.

Another area that causes options traders’ problems due to lack of core market knowledge is the analysis of implied volatility. In recent years implied volatility has become the “holy grail” for options players. The concept was that if one understood volatility options trading would be easy. Unfortunately despite numerous books and seminars on the subject of implied volatility, the profitability of the average options player has not improved.

Let’s examine why:

Implied volatility is the analysis of interest rates, expiration date, and strike price to calculate if the option premium is a good price or not. It is an analysis that takes into consideration only the option market or secondary market without consideration of the primary or stock market from which the option contract is irrevocably tied. Implied volatility focuses on what other options players feel is going to happen with the option contract. Options players focus solely on this aspect of options playing and ignore the underlying stock analysis.

And that is the inherent flaw. Although the demand, expiration date, and strike price for a certain option impact option profits, the ultimate control of profits for the option contract lies not with options players but with those who are actually trading the stock. Options depend upon not only other options players but the complex realm of stock traders.

Here is an analogy to help with this concept:

Retail stores are actually a secondary marketplace to manufacturers of products. Retail stores are tied to those who create products. Many people see retail stores as independent and self-contained. Retail can, after all, discount prices to sell items and controls its own destiny. That is not exactly how it works. Manufacturing actually controls prices by setting certain levels of price that Retail must pay for a product. That price fluctuates based on cost of materials, production costs, and demand for the product. Retail has no control over a manufacturer’s price structure. Manufacturing actually dictates what price Retail will pay which determines how much profit Retail can make on that product. To be successful at Retail, a business owner must understand what will impact manufacturing prices and adjust and adapt to consider what product to buy from what manufacturer. If a Retail store owner doesn’t understand the manufacturing aspect of product pricing, then they are likely to have lower profits or worse, no profits.

Now switch the terms: ‘retail’ to options and ‘manufacturing’ to stock traders. A similar relationship applies as we study implied volatility.

Implied volatility fails to consider the primary market from which stock options are derived. It fails to consider the various levels stock traders and investors and their impact on near-future price action. It fails to consider which of the 8 levels of market participants are currently buying that stock, where in the ‘cycle of market participants’ the stock is currently trading, and who is dominating or controlling price action at that time. Regardless of whether or not the option premium is a “good deal” or not, how the stock moves is controlled not by options players but by stock traders. Therefore, part of the core market knowledge all options players must have to be consistently successful is an understanding of the various levels of market participants and why they buy or sell stocks.

The old saying: where the stock goes, so goes the option—is a truth that many options players simply forget to consider.

Summary:

Options can be a wonderful strategy for low capital base traders if they have a complete foundation of Core Market Knowledge and have learned to Position Trade stocks. Option strategies are only as good as the foundation of knowledge the options trader has at the time they implement that strategy.

Martha Stokes, C.M.T. is the Senior Technical Analyst and co-instructor for TechniTrader, the educational division of Decisions Unlimited. Stokes’ courses teach swing, position, options, intermediate, and long term trading and investing. In her 25 years of teaching and trading, Stokes has developed all of the material featured in this series and writes for various paper and internet publications. She also authors daily and weekly newsletters for all of her students on market condition and in-depth analysis of stocks, trading techniques, and strategies. For more information on TechniTrader’s courses, go to www.TechniTrader.com or call 888-846-5577.