Just as the game plan may change depending on which team you are playing, so it may change for a trader. The markets change, so the game plan has to be adjusted accordingly. If a change is anticipated instinctively before it occurs, then the game plan can be far more effective. This takes a high level of skill and instinct.
With trading the mindset for the market behaviour is always ‘anything can happen’. Within this framework the trader is always prepared to apply their defence strategy should a trade turn against them.
Let me explain …
The market moves in 3 directions and 3 directions only – up, down or sideways. Now it can do a number of things while an option is waiting for its expiry date. However, a smart trader can develop a game plan for each scenario while in the trade.
It’s like the game of chess. You are moving in on your opponent’s king with the rook. If you place two squares forward and put them in a position of check what will your opponent do? Will they defend in such a way that it will force you to make the choice of sacrificing that rook or can you counter attack? Anticipating what may be the next move and the consequence of that move is part of the art. At the same time it’s important to not get too far ahead of yourself, second guessing your opponent’s next moves and missing what’s staring you right in the face. It is similar with options trading. Yes, option’s trading is about strategy!
THE CHALLENGES OF OPTIONS TRADES
The challenge any new trader has when it comes to trading is which options strategy they should use. There are so many it can be overwhelming. Sometimes the names can appear a little differently from trading platform to trading platform so you also need to ensure you are on the same page with the broker particularly when you are selecting a strategy.
In fact, spelling it out is sometimes a must. One of my mentors emails his trades to the broker to ensure accuracy. A good lesson learned in the financial game is to never assume!
In fact here’s a list of options trades I’ve come up with that exist …
- Covered calls
- Naked puts
- Reverse Spread Ratios
- Straddles
- Strangles
- Condors
- Butterflies
- Option Spreads
- Bull Call Spread
- Bear Put Spread
- Bull Put Spread
- Bear Call Spread
- Ratio Spreads
- Calendar Spreads
- Time Diagonal Spread
- Long Straddle
- Short Straddle
- Long Strangle
- Short Strangle
- Reversals
- Conversions
- Index Options
The reality is that it is very unlikely that a trader will use all of these. In fact, I remember one individual telling me he knew of a case where a few traders blew $65,000 simply testing all of these strategies in an effort to discover which ones were the most effective! Now that’s research!
We will discuss the more common ones. For the sake of paced learning and avoiding information overload we will restrict the number of options trades in this part of the course. However, you are free to explore the various ones at a later time. I always try to be pragmatic when it comes to trading. Theory is one thing, reality is another.
As one of my mentors once put it some trades are just rubbish! They are designed to allow the broker to charge lots of brokerage for the multiple legs involved in the set up. (This was said in the context where a broker sent out a release one time recommending a particular trade.)
You will discover there are indeed many “options” within options!
THE VARIETY – SELLING VS BUYING OPTIONS
So let’s start with some real basics.
A trader needs to determine whether they are dealing with calls, puts or both in their strategy.
And within that they need decide whether they are buying options or selling them, or a combination of both.
What we have to recognise is what the trader is using the options for. Is it protection, cash flow or capital growth?
Some traders may use stock in their trades. Some may want to protect this portfolio and may elect to use puts to insure they hold their value.
So let’s say there were 100 contracts of ABC shares trading at $30. This totals a stock value on the US market of $300,000. ($30 x 100 units x 100 contracts) The trader believes the stock may go up and wants to insure them against any downside. They may be prepared to risk a $1 drop in value of this (total $10,000) and want to insure them at $29.
Let’s say the option premium for a $20 share for the next 38 days is $0.80. So it is a high beta stock paying health premiums with plenty of high risk in terms of losing funds but big potential for upside.
This trader may spend $8,000 to protect the portfolio of $300,000 over the next 38 days. ($0.80 x 100 units x 100 contracts.)
In this example the trader gets the benefit of sleeping better at night. If the stock goes up, the value of the portfolio is increased. If it stays stagnant, the trader has protected the downside but will have to insure for the following months if they want protection for that time period. However, if the portfolio drops by $0.50, no option can be exercised and the value of the portfolio has dropped by 0.50 x 100 units x 100 contracts in capital + $8,000 in puts purchase = $5,000 + $8,000 Total expenditure $12,000.
In some instances you can buy long options to expiry – up to 2 years on some occasions which of course you pay higher premiums for the time value involved.
It is often quoted that statistically 80% of options expire worthless. More accurately according to the ASX around 55% of options are closed out before expiry, around 15% are exercised, and around 30% expire worthless.
What this says statistically is that the odds of options closing with intrinsic value are low. My mentors taught me the odds are better statistically if you sell options in terms of making a profit rather than buying them.
A trader who sells options is going for the options premium to create cash flow. They are paid upfront at the cost of having a liability until expiry.
Now this doesn’t mean they have to wait until expiry and we’ll deal with this a bit later in the Strategy Course.
However, they are writing a contract that says no matter what the stock does, we will come up with the capital if the stock exceeds this certain strike price.
So in the case of puts, the trader who sells them is saying I will pay the stock price at this agreed value no matter how low the stock gets, even if is worth $0 at the time of expiry.
Conversely, a trader who sells a call option is saying they will pay the stock price at this agreed value no matter how high the stock goes, even to the point of infinity at the time of expiry.
This is called trading naked. There is no covering in terms of the liability.
Which one is more dangerous? Well a naked call is treated as a greater liability by a broker than a naked put. At least with a put we know the stock stops at $0 in value. In a bullish market there can be no telling for a call. Remember there is the agreed strike price, times the number of contracts, over the unit of shares. The numbers can really start to stack up! (Please note: I never trade a naked call as I deem it far too risky for these reasons.)
So understanding what you are writing and agreeing to when you sell options is absolute key! You are accepting a liability in exchange for an upfront premium.
Managing that liability is paramount, and this is where the strategies play out.
We will look specifically how this is done for covered calls, naked puts, and spreads.
HOW DOES A TRADER SELECT THE RIGHT ONE FOR THEM?
Determining the right strategy for a trader comes down to a number of factors.
What are their objectives? What is their risk profile and attitude to risk? What is their knowledge base? What is their skill base? What works for them?
In my experience as a consultant I’ve seen a number of strategies. I’ve also heard traders argue which is more dangerous and which isn’t. At the end of the day if it works for a trader it works. There are various risks involved, and I’ve seen people also report on how they were wiped out.
Losing confidence is the worst thing that can happen, so this must be protected at all times.
As for me I am very conservative when it comes to risk and how aggressively I trade. My mentors and colleagues tend to be more aggressive than I. That works for them, and it is not right for me to say they are wrong. What is right for one trader will be different for another.
Be aware that someone’s risk profile can change too. It can grow as confidence increases, or decrease, depending also on what is happening in a trader’s personal life. There have been times in my life when I have deliberately reduced my trading or stopped for a short while. This can be because of sickness, death in the family, travel, holidays, or perhaps a career change. Not having a trade is a trade! A trader must recognise that not trading for a period of time is ok. As a trader you are very often your own worse boss!
In terms of picking the right strategy I can only speak from my experience. I started with a conservative strategy, and then discovered another trade that in my view was even more conservative, and gave me better leverage than the first. Then I came across a trade that had the same leverage, better protection if it went against me, and could potentially work in every market directional. In some ways you can say I started conservative and became even more conservative as I progressed!
This may sound odd to the novice but to the experienced it makes sense. We all know what the upside can be on a trade; it’s the downside that gets you!
In fact, in my own journey I experimented with about four trades while settling for my favourite which is a Reverse Spread Ratio. Even within the Reverse Spread Ratio trades I have a couple of variations which are explored in other courses we do. And sometimes I apply the strategy theory of strangles and straddles to a reverse spread ratio which is even more advanced. This application is demonstrated in the 12 Month Premium Classroom – Advanced Options Trading Course 201 which Trading Institute conduct.
I’ve always tried to refine and improve what I do, without digressing too far from what works.
I’ve found when a trader takes on a new strategy what is key is having a very clear understanding of the strengths and weaknesses of the trade, including the risks and rewards involved, deciding whether it is right for you, systemising it with exit strategies if it goes against you, testing it in small samples with limited risk, proving to oneself it works, and then reassessing whether you want to continue in it.
Additionally, keeping it simple is critical! Options can quickly become complex. There are some trades I won’t engage in for this very reason. They are just too complicated to calculate, let alone execute.
Once a strategy has been developed what occurs is a trader tests it, develops it, and ensures it works for them. Once it is getting them consistent results they tend to stick with their system. The danger for creative people is they get bored easily. And it is important to recognise that if that is your temperament. I fall within this category and have found I need to find other outlets to express this. I don’t want to bring this into my own trading. In fact, my goal is always to make trading boring. This takes out any thrill seeking tendencies, reducing the risk.
Self-discipline is also of critical importance. The moment you let go of the reigns, is the moment the market can sting. Sticking to your strategy once committed is a must no matter what occurs, and what emotions play in out in your mind.
Regardless of which strategy/ies a trader settles for as their favourite, each will have strengths and weaknesses. For me it was a case of starting with the most common, I paper-traded how it worked, (i.e. tested on real trades without money), and then concluded there was a different trade that was better. I experimented with the second strategy, found a flaw in it, and discovered a patch to fix it with a simple variation of what I was doing.
For the trader their craft is a case of refining their skill set as they learn, grow, practice.
One of my mentors used the analogy trading is like being a tradie. You live with mum and dad for four years before you make any money.
And this is where many give up, especially if they haven’t had the tutelage, guidance, and persistence.