Trading Options:  The Importance of Discipline

By:  Jon Najarian

The following is an excerpt from Jon Najarian’s How I Trade Options

I believe discipline is the number one factor any trader – be it a professional or a retail investor – must have.  It may be fairly easy to get into a trade, particularly if you’re a buyer and the market moves in your direction.  But getting out with a profit once your target is hit can require a lot of discipline.  And if it turns out that you left some money on the table, you can’t fault yourself.  Constantly ask yourself those crucial questions that all disciplined traders must pose: “Would I buy this option here? If not, then why would I hold it at this price?”

Admittedly, there are times when it’s boring to be disciplined.  But even if you’re the luckiest person alive, you’re not going to keep your profits if you’re not disciplined.  It also helps to have a disciplined mind that can do research on a company or industry and then apply what you’ve learned.  This kind of research is even more critical for investors who have a longer term timeframe than a trader who might be scalping during the day.  In fact, the closer you move to a floor trader-style on trading, the less you have to care about what a company does or any other fundamental factors.  All you’re looking for is price opportunity and opportunities to exploit volatility swings.

As a professional off-the-floor trader, I take a hybrid view.  I do make scalp trades when opportunities arise.  But at the same time, I do plenty of research – something which I enjoy – to find trading opportunities.  For example, if I see oil prices rallying, I like to short the airline stocks either by buying puts or by selling calls. (Remember fuel is the second only to labor as the biggest direct costs for airlines.) Or if bonds are up or down 12 or 14 ticks, then I have to evaluate the financial stocks.  Or you watch the market sectors and look for stock opportunities among stocks that are not moving in step with the others.  Here’s an example.  I noticed that while drug stocks, in general, were lower, Johnson & Johnson had not declined as much.  When I determined that it was not event-related (none of the drug companies had just reported earnings or finished a new product introduction, for example) I decided that it was only a matter of time before Johnson & Johnson declined.  So, I started accumulating a short position in Johnson & Johnson by buying put options when the stock was trading at $97 a share.  We began buying $95 put options over a three-day period.  Over the next three months, the stock was down nearly $25 a share.  Through that decline, we sold puts into the slide, taking profits and establishing put spreads to further profit from a continued slide.

At year end, we typically look for stocks that might come under some pressure because of tax concerns.  Investors might take a loss now for this tax year and then buy shares back 30 days later (to avoid the IRS’s washed sale rule) for anticipated gains for next year.  As we look for these opportunities, we might be short a particular stock in the last two weeks of the year, and then trade from the long-side for the first two to three months of the new year.  With options, it takes a relatively small amount of risk and capital to get into these opportunistic positions. 

Stocks in late 1999 that fit that description included Waste Management, Xerox, and BancOne.  All of them were beat up and underperformed over the year, and as a result saw some aggressive selling for tax losses. As the year came to a close, we established an April call spread to own them on the cheap if the stock had a rebound.  That worked two years ago in Apple and Oracle, which were both under $20 a share at the time.  Apple went from about $16 a share to $150 in two years.  Oracle, which was once $18, traded up to around $90.

In these instances, it all came down to having a plan and the discipline to carry it out.  Further, if you are going to trade options, even as a retail investor using spreads, you must be able to deal with risk.  With options, the best way to control risk is to buy options, because you then control your future.  The option buyer can only lose the premium paid.  Or, you can use a spread, which also limits the risk potential.