How Can You Lose Money Trading Options

"This one time, at band camp…" Everyone knows that you do embarrassing things at "band camp" so the analogy seems fitting. A long time ago, I did something really dumb with my options trading, and I lost a significant amount of money because of it. In this article, I am going to share with you my story along with the lessons to be learned so that you can avoid unnecessary pain and loss in your own trading. The article includes real numbers and calculations because you have to be able to understand and calculate your costs and gains if you want to be a successful options trader. After the wonky stuff, I include some advice for how to avoid making the type of mistake that I did, as well as some advice on how to approach mistakes that inevitably happen anyway.

Prologue — The Background

My investing philosophy has almost always been long-term buy-and-hold or LTBH: buy stock in solid, high-performing companies with strong leadership and a deep competitive moat, and then hold the stock for years if not decades. Note thatinvestingis not the same astrading. The difference between the two is a topic for another article, but essentially, the equity in my long-term investments is the foundation for my options trading.

As part of my LTBH investing, I bought Starbucks (SBUX) about twenty years ago. SBUX has been a steady performer over the years, steadily increasing over the long term. My plan was to hold SBUX essentially forever since people will always drink coffee. So this is where our story begins.

Act 1 — The Setup

Around 2012–2013, SBUX traded mostly within a band as shown in this graph:

SBUX Stock Chart Jan, 2012 — Apr, 2013 — SBUX stock chart for 14 months prior to open options trade

SBUX split 2:1 in October, 2005 so the prices shown in the chart are half of what SBUX was actually trading for in that time frame. Aside from a couple of drops and one spike, SBUX had mostly been chugging along between 50-58/share (25-29 in the chart). So without much thought and just a touch of frustration that SBUX wasn't going higher, faster, I had the brilliant idea to generate some cash off a position that appeared to be neutral or only slowly rising.

There is a stock options trading strategy known as a covered call in which you sell one call option for each 100 shares of an underlying stock that you already own (or which you buy concurrently with selling the call). At market close on the call's expiration date, if the underlying equity's price is below the call's strike price, even by just a penny, then the call expires worthless and you get to keep all of the premium that you were paid when you originally sold-to-open the option. Seems like a pretty easy way to get rich with options, right?

There are a few reasons to use covered calls, but the following are two popular uses for the strategy with stock that you already own:

You want to earn income on a stock that is neutral or moving slowly in either direction (up or down, but usually up). You should choose a high enough strike price to make it unlikely that your underlying stock is called away from you, because you do not intend to sell your stock.
You want get a higher price for a stock that you wish to sell. You should choose a strike price that is close to the stock's price so that the call is likely to expire in-the-money, thus calling away (or selling) your stock. In addition, at-the-money (ATM) options have moretime valuethan do options with strikes that are further away from the stock's current price. ATM options therefore pay a higher premium and you get a better overall price (the strike price plus the premium) for your sold stock.

My objective was to supplement my returns on SBUX but in keeping with my LTBH mindset, I had no desire to sell my SBUX shares. I actually thought (for probably about ten seconds) about the risk of losing one of my best long-term performers, but the idea of that juicy premium not going into my wallet got the better of me. To that end, in March, 2013 with SBUX trading at about 56.60, I made the following trade:

3/27/2013 Sell to open SBUX 07/20/2013 57.50 C 2.46

And then the fun began.

Act 2 — Drowning Underwater

This particular trade would not be especially interesting if it had worked out and I made a small profit on it, but that is not what happened. My first mistake was that I chose a strike price (57.50) that was way too close to the underlying's current trading price. If SBUX moved up by only .90, or roughly 1.6% in the next three months, then my calls would be in-the-money (ITM) and my SBUX stock would be at risk for being called away.

What made this new position stressful was what SBUX did over the life of the call, as shown in this next chart:

SBUX stock chart for life of initial call

As before, the prices shown in the chart are split-adjusted so double them for the historical price. On 3/28/2013, the day after I sold the calls, SBUX closed up a bit at 56.96. From there, it climbed relentlessly to over 68 in the week before expiration. Which is great if you own SBUX outright, but not so great if you foolishly covered SBUX at 57.50. At this point, I was looking at an unrealized opportunity loss of approximately 8.04/share (68.00 – 57.50 – 2.46).

Act 3 — Staying Afloat (Barely)

Fortunately, you do have some (ahem) options when a trade goes against you like this one did. I could just accept the lower gain and let my SBUX shares go, but there were two big problems with that: first, I would have a huge capital gains tax bill, since I had bought SBUX many years before for a split-adjusted price of roughly $9/share. That meant that I was sitting on a very large, unrealized profit that would turn into a taxable profit of nearly $51/share (57.50 + 2.46 – 9) if my calls were assigned and my shares were called away. Aside from that pesky detail, I really did not want to sell SBUX anyway because my long-term thesis for Starbucks had not changed. It was an investment that I wanted to continue for many years to come. (Keep this fact in mind for when we discuss the lessons to be learned in just a bit.)

Since I was not willing to sell SBUX, a second possibility would be to buy-to-close the July-2013 57.50 calls. At the time, they were trading at 11.80 so that would result in a net loss of 9.34 (11.80 – 2.46), or $934/contract. Not an ideal outcome.

Finally, I had the option to roll the calls out and up. Rolling an option means to close the current contract and simultaneously open a new contract with a later expiration (rolling out) and possibly with a higher strike (rolling out and up). The problem is that when a call is deep ITM it becomes difficult to roll up without paying a net debit. That is, you have to spend real cash to roll it out and up. Nevertheless, rolling the covered calls gave me a chance to keep my SBUX shares and avoid a large tax bill so that is the path I took.

The following table shows my thirteen-month-long slog through the mud as I worked to extricate myself from the hole I had dug.

Table displaying my SBUX call options trades from July, 2013 to closing the position in April, 2014. — SBUX Covered Call Trade Log

Each BTC/STO pair in the table represents a single transaction in which I bought back the current calls and sold new calls to maintain the position. Since I was rolling up, I essentially was buying back either 2.50 or 5.00 dollars of strike-price gain for the cost of the roll. For example, the first rolling transaction cost 4.20 (11.80 – 7.20) which bought me a five-dollar higher strike price (62.50 instead of 57.50).

Capital gains taxes aside, was that first roll a good investment? At the risk of getting too math-geeky, let's calculate the return on investment (ROI) for that first roll. ROI is defined as follows:

The cost of the roll was 4.20 and I gained 5.00 from the increased strike price:

In this case, the ROI was 19% in just over two months, which makes the annualized ROI just over 163%. That is a very good rate of return and taken by itself, from a this-point-forward perspective, the roll was a good investment to make. Likewise, you can calculate the ROI for each additional rolling transaction over the lifetime of the position.

Thirteen months later, after three more rolling transactions, my call's strike price caught up to and surpassed SBUX's then-current price. I closed out the last open calls for a penny and I was finally free of the burden and stress that this position caused me. All told, this ill-advised covered call on SBUX cost me $7.00/share when you take into account commissions ($.10/share over the lifetime of the position).

Lessons That Became Rules (or the Good Part of the Story)

Everyone makes mistakes, whether in life or investing or trading. If you aren't able to accept and learn from your mistakes, then for sure do not start trading or doing anything else with the stock market, because you will be very unhappy a lot of the time. The best traders embrace their mistakes. Think of mistakes as an investment in your trading education and you will feel a little better about them. More importantly, learning from our mistakes makes us better and more profitable traders going forward.

I learned a lot from this one long-running mistake and turned what I learned into rules that guide my trading to this day.

Rule #1:Do not ever write calls on stock that you are not willing to sell. And when I say "willing," I mean that you absolutely, positively must be really and truly willing to let that stock go. If there is even a tiny bit of doubt or if you will have any regret if your call options are assigned and you lose the underlying equity position, then step away. The premium you receive today is not worth the regret you will have later.

Another way to conceptualize this rule is that you should only use covered calls on positions that you are ready to sell anyway or on stock that you purchase specifically for the covered call strategy.

Rule #1(a):Ignore what could have been; be happy when you close a successful trade with a profit . Let's say that instead of using existing Starbucks stock, I bought 100 shares of SBUX for 56.90 back in March of 2013, and I simultaneously sold one 57.50 call for 2.46. My cost basis would have been 54.44 and about four months later, the 100 shares would have been called away at 57.50. The profit for this hypothetical position would be 3.06 and I would be perfectly happy with that. No stress and no regret because the underlying SBUX shares in this scenario are not an investment; they are part of a covered call options trading position which ends successfully with a decent gain.

Since I know you want to know, the ROI for this trade is 5.62% and the annualized ROI is 18.64%. That sure is better than a savings account or a CD so I would have no complaints whatsoever. I do not care that I could have sold the 100 shares of SBUX for 68 in July, if only I had not covered them (oh woe is me, I'm so dumb!). Buying SBUX stock and then selling it later was not this hypothetical position's strategy so any alternate trade has absolutely no bearing on my actual trade. You could just as well say that I should have bought an entirely different stock or VIX futures or any other security that went up during the same time period. Not relevant, don't care, no regrets.

Rule #2:Strictly follow your own guidelines, rules or system. Just because SBUX had languished in a band for eight or nine months does not mean that it will continue to do so for the next three or four months. I did very little analysis of using a covered call on SBUX before I dived in. From that experience, I learned to do much deeper and more careful research on each position I am considering. Develop a system or process for evaluating each trading strategy that you use, and then apply your system diligently and thoroughly to each potential position. Do not let yourself be rushed. Trading is not, and should not, be the same as gambling. If you feel emotionally like you're gambling with your positions, then you are. Step away and reevaluate what you are doing.

Rule #3:Look at each trade as if the position is starting today. Do not worry about or consider what happened in the past. Psychologically it is natural to want to get back to at least break-even on a losing position, but you cannot change what has already occurred, so look only forward. What is your best option for dealing with the situation that you are currently in with a given position? Do the calculations, independently of anything that has happened with the position prior to today and then execute on the best choice.

For example, what was the best option in my SBUX story? Let my shares get called away and take the 9.34 loss or try to reduce the amount of that loss by rolling out? Think of each step in terms of the ROI, as if it's a new position. Sure, overall, I put myself in a hole with the SBUX covered call, but on the other hand, going forward, I could get a 163% annualized ROI for that first roll. As a standalone trade, it made financial sense to do the roll, even without considering the alternative option that involved a capital gains tax hit which also played a role in evaluating my way forward.

It can be very hard to psychologically let go of the fact that you are negative in a position because you want each and every one to be a winner. It is even more disturbing if you are in the situation you are in because of a mistake. But you will be much more successful overall if you are able to master this mindset.

Am I Still Embarrassed?

Sure, kind of. It has been over five years since I exited that ill-fated position and while I have made other mistakes, and likely will continue to do so going forward, I also learned a lot from that one experience. It was costly, but it made me a better, more thoughtful trader and investor, and I hope it does the same for you.