How to Invest in Options: Selecting the Best Options Strategies to Trade
In order to be consistent, and make the best decisions about what to trade, it is important to understand when to use each of the options trading setups. By understanding how these options set ups work in reality you can effectively learn how to invest in options. Every trader looks at the market slightly differently and each has their own perspective of what will happen to the price of a specific stock. Even if these traders have a common belief in the direction of the market they may pick different options strategies to try and profit from a up, down or sideways move in a stock. This begs the question, are there better setups that consistently deliver higher profitability? If we compare strategies side by side, can we determine an optimal strategy for specific market conditions?
If one trader trades by selling a put or put credit spread and another trader buys a call option will one strategy always come out ahead? Both strategies allow the trader to make money on the trade if the price of the stock increase in value. While you might assume that the trader who trades by buying a call in AAPL would make more money versus someone selling credit in AAPL, over time the probability of success of each of these trades will be different. Probability of success becomes an important component of trading options. There is the potential for Apple AAPL stock to move from $150 to $400 by the end of the year but what is the probability of this happening? Just because buying a put or call has the potential to make very large profits doesn’t mean that it will happen very often. You have lots of options with options so consider your options, don't get stuck trading the same strategy over and over again. Look at different trade setups that might provide an edge in the given market environment. Just as the name suggests, take advantage of your options.
Before you decide what option strategy you will trade, you will need to weigh:
- What is your directional assumption of the stock based on your chart analysis?
- What is the price of the option you want to trade?
- How much premium vs intrinsic value is in the price of the option?
- How much has the stock moved in the past? Is it a big mover or does it usually steadily move in one direction or the other?
- What is your risk in the trade?
The answers to each of these questions will be influential to help you decide whether you will be selling options or buying options, and whether you want to use put option strategies or a call options strategies, what strikes to trade, and where to trade them (either at, in or out of the money).
Since option strategies will carry different risk and reward profiles, understanding some of the benefits and disadvantages to trading each option strategy can help you decide what to trade. Traders who sell puts or trade credit spreads out of the money (away from where price is trading with options that have little value) may feel a sense of security by trading at these levels because it is statistically low that the price of the underlying will get to the strike you trade. But is this a false sense of security?
Mathematically speaking, a trade that is placed out of the money two standard deviations away has around a 95% chance of expiring worthless, and thus making money. Traders believe that because of the mathematical odds of this working out, that they can place this trade without worrying about risk, as in their minds the trade will never lose money. However, this is a perfect example of how important it is to consider the amount of money a trade can make versus how much the trade can lose. The options trader taking a 2 standard deviation trade might be tempted to take less credit in exchange for a 95% mathematical advantage but when the combined profits of most trades don’t cover the cost of one losing trade (and even at 95%, you will still have some losing trades), your risk/reward ratio will prevent you from being profitable over time, it’s simple math. All it takes is one trade (that small % of the time) to wipe out all of the profits from the previous winning trades. This is especially important when trading strategies that have virtually unlimited maximum losses such as selling puts.
Let’s look at an example, if you take a 1 standard deviation trade which has approximately a 68% chance of success then you have to make sure that the credit you receive over your sample set of trades is at least 68% of max loss. Put simply, this means that you must take in an average of at least $1.21 (approximately per trade) if the width of the strike is $5.00 and around $0.24 on a trade with a strike that is $1 wide. Over the short term you may beat the probabilities, but over the long term, the probabilities will set in and have a direct effect on your profit and losses. If you trade at 2 standard deviations out you must take in at least a $0.24 credit of a $5 wide strike and $0.05 on a $1 wide strike.
Keep in mind that standard deviations in options are a rough guide, and inevitably, nothing will ever be 100%.
Long Put and Call Options Strategies
Now the opposite of trading by selling options is generally to look for trades that involve buying options, with the assumption that the stock is either going up or down, you are placing the options trade with a directional assumption. The purpose of buying options directionally is to participate in a move made by the underlying trading instrument. The trader expects that the price of the underlying stock will move in the anticipated direction before or at expiry. This will cause the price of the option to increase and lead to a profitable trade. Directional trades have the potential to be more lucrative than credit spreads providing they move far enough and fast enough in the intended direction of the trade. The intended direction would be down for a put options strategy and up for a call option strategy. Buying a call or put in a stock that inevitably moves sideways or worse, the opposite direction can mean a potential loss on the trade.
The increase in premium imbedded in the options price, specifically related to the increased implied volatility in the price of an option at times can also mean that an options buyer is paying for an anticipated large move in the price of the stock which may not happen. The more premium in the price of the option the more potential for the options price to decrease rapidly if the stock does not move in your intended direction or if price does not move in any direction. Because of this expense, there will be times that a trader might not want to buy a put or call, but rather sell the corresponding options strategy taking advantage of the higher premium imbedded in the option.
Even though it might seem enticing to always trade directionally because of the potential to make more money per trade, if the trade moves in the opposite direction that was anticipated, the maximum loss can also be higher than other trade strategies. Most traders think of potential profits not the potential for profits, a very subtle but important distinction.
Reasons to trade directionally vs. spreads
Depending on your risk/reward parameters, the momentum of the trading instrument and the implied volatility ( higher premium ) in the price of the option will influence whether you choose to trade directionally or with spreads. In my opinion, it makes more sense to place a directional trade when you believe there is about to be a big move in the trading instrument. Typically, when a stock is in a strong trend on a daily chart without any major resistance to price increasing or decreasing, I will prefer to buy the option once the stock has pulled back to support or resistance, to avoid over paying for the option.
In a market that is range bound, or if you think there will be a slow grinding move in a stock, then selling options may be more favourable. I am especially happy to see a grinding move in a stock after it has just hard a large move. This type of change in a market favours selling options to rely more on premium decay to generate profits in the trade versus relying on the direction of the stock.
By analysing the movements of the underlying stock to determine whether it is moving in a clear direction, or just moving sideways is probably the biggest influencer to help make the decision to either sell options or buy options.
Reasons to trade by selling options if....
- A stock is in a slow grinding move. Since the time decay will impact your profits, a directional trade may not move far enough before expiry to increase the price of the option.
- When volatility is high. Since volatility will increase the price of the trading instrument, it might be better to sell a spread and collect premium rather than buying a put or call at an inflated price.
- A big move has already happened. It will be beneficial to trade using a spread out of the money if a trader feels a big move has already occurred and/or there is not a lot of time before the contract expires.
Considerations to buy a call or put if....
- You believe there is good momentum.
- A trading instrument is in a strong trend .
- You do not want to limit you profits.
There is risk in any trade. Remember that the risk/reward ratio is not the only measure that should determine your trades, looking at the probability of success is also an important factor when trading options. Always be mindful of the cost and benefits of each trade strategy as it pertains to the markets that day. Risk is always relative and ever changing.
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