Option Trading Strategies
This page was created to give prospective members
a better feel for the option trades I make.
What strategy I choose depends on what the market
is doing. If the market is flat and not moving
much we do certain types of trades more, and
if the market is flying in one direction either
up or down, we concentrate more on other types
of trades.
Volatility is an option trader's friend and
nemesis. High volatility is great because it
raises the prices of all options. As sellers,
this means options are pricier and the seller
gets paid more when he sells them than under
normal conditions. But high volatility can also
hurt us because the market can move quickly.
Here are the option trading strategies I use
and a short decription of them.
The credit spread is one of my favorite
option strategies. This is a trade which results
in a credit (money given to you at the beginning
of the trade). It consists of two different options
(legs).
You buy an out of the money option
at a certain strike price and then you sell an
out of the money option at a different strike
price of the same month.
For example, if IBM stock is selling
at $50. You sell the $75 January Call option for
$2. Then you buy the $80 January Call option for
$1.50. You get a credit of 50 cents. As long as
IBM stays below $75 at expiration you get to keep
the credit. As time goes on the options will decay
in value. This strategy allows you to win if IBM
goes down, stays where it is, or goes up until
$75.50. You start to lose money above $75.50.
Since each option is for 100 shares,
the maximum potential gain on the above trade
would be $50. (50 cents x 100 shares). The maximum
loss would be $450. (Difference in strikes minus
the credit: 80-75-.5) The return on investment
would be 11.11% I like to place credit spread
close to expiration so this return for would for
a one or two month time frame.
Buying the second option does two
things:
1. If protects you from a large loss if IBM shoots
above $75.
2. It allows you to do the trade with less margin.
So even though you have to pay for
the second option, it is a conservative strategy
to employ it.
You can also do credit spreads with
Put options if you think a stock is going up.
Which option strike you decide to
sell depends on how aggressive you want to be.
My style is conservative so I choose options that
have a very low probability of expiring with any
value. If you use this strategy with At the Money
or In the Money options you can make a lot more
money, but have a higher risk of loss.
Iron
Condor Option Trading
Strategy
Another of my favorite option strategies
is the Iron Condor.
An Iron
Condor is simply two credit spreads, calls
and puts, used together. This way you get a larger
credit. Most stocks stay within a range. And using
statistics we can tell with a high degree of confidence
exactly what that range will be. We then sell
options above and below this range. As long as
the stock stays in the range, we win.
If the stock threatens to break
our range, we have to adjust our range or adjust
the trade to account for the movement.
If you subscribe to my Free Options
Course, I will show you exactly how we put on
an Iron Condor trade, a real trade that we did,
and the adjustments that we made to the trade
when it got into trouble.
For more details click here: Iron
Condors
The butterfly is a neutral position
that is a combination of a bull spread and a bear
spread.
Let's look at an example using calls.
IBM price: 60
July 50 Call: 12
July 60 Call 6
July 70 Call 3
Butterfly:
Buy 1 July 50 Call $1,200 Debit
Sell 2 July 60 Call $1,200 Credit
Buy 1 July 70 Call $300 Debit
$300 Debit to place the trade
Our maximum loss is our debit of
$300.
The Maximum potential gain is the difference between
strikes minus the debit (10-3=7)
So our Max gain is $700.
Results of butterfly spread at expiration
| Price at Expiration |
July 50 Profit |
July 60 Profit |
July 70 profit |
Total Profit |
| 40 |
-1200 |
1200 |
-300 |
-300 |
| 50 |
-1200 |
1200 |
-300 |
-300 |
| 53 |
-900 |
1200 |
-300 |
0 |
| 56 |
-600 |
1200 |
-300 |
300 |
| 60 |
-200 |
1200 |
-300 |
700 |
| 64 |
200 |
400 |
-300 |
300 |
| 67 |
500 |
-200 |
-300 |
0 |
| 70 |
800 |
-800 |
-300 |
-300 |
| 80 |
1800 |
-2800 |
700 |
-300 |
As you can see our breakeven points
are 53 and 67. As long as IBM stays between those
strikes we make money.
While the covered call is considered
a conservative option strategy it can be very
risky.
Basically you buy 100 shares of stock and you
write a call against that stock.
So for example, you buy 100 shares
of IBM at 100 and you sell the 100 Call for 2.00.
At expiration if IBM is above 100, your call will
be exercised and they will take your 100 shares.
But you get to keep the 2.00.
Writing calls against stock you
already own and want to keep long term is a neat
way to make some extra money for holding the stock.
Where you can get into trouble is
when the stock drops in price. If you want to
hold it, do so. But if you were in for a quick
trade, you are in trouble. If that is a risk,
you can do a covered call that is already in the
money. So buy IBM at 100 and sell the 90 Call.
We do not use this technique much.
But it comes in handy in times of very high volatility.
When volatility is high, options are more expensive
and so the premiums we get by selling options
are larger than normal. We can use covered calls
to take advantage of this volatility.
Here's a real trade that we did
on November 26, 2008.
Stock Symbol: C
Buy 200 shares at 7.00
Sell 2 Dec 5 Calls at 2.31 for a Debit of 4.69
I chose to illustrate the trade
with 200 shares, but members are free to trade
as much or as little as they want.
In this trade we paid $7 each for
200 shares = $1,400. We then got a credit of $462
for selling 2 calls that were set to expire in
25 days on December 20. Notice that we sold In
the Money Calls. So if C is above $5 on expiration
day we will get called and our stock will be taken
away from us which results in a maximum gain.
We stand to make 31 cents per share
or $62 max. That is a 6.6% return in only 25 days.
If you use margin the return is 13.2%.
On expiration day C was at 7.02.
Our stock got called away and we made the max
on the trade..
A Calendar is also called a Time
Spread. I know some traders that do nothing but
Calendars. They put on the trades every month,
and get out when the trade gets close to breakeven.
They win enough times to make a very nice living.
The Calendar is a spread that is
a relatively cheap trade but has a large profit
potential. It is created by selling one option
and buying a more distant option with the same
strike price. When we use it as a neutral trade,
we benefit from the time decay because the near
term option will decay and lose value faster than
the farther out option that we bought. When enough
decay has occurred we exit the trade.
The risk in a Calendar is the debit
required to put on the trade.
Check out this link for more on
Calendar
Spreads
Double
Diagonal Option Trading Strategy
A Double Diagonal is two diagonals,
Puts and Calls put together. First, let's discuss
the regular diagonal trade. The diagonal spread
is created by buying a longer term call at a higher
strike price and selling a near term call at a
lower strike price.
So if IBM was at 100, we would sell
the January 110 Call and Buy the February 120
Call. In this case we want IBM to stay below 100
at expiration in January.
To make it a Double, you do the
same on the Put side.
So we would sell the January 90 Put and buy the
February 80 Put.
This gives us a range of 110-90
that IBM can play in. If it stays in that range
we make our max profit. If it gets out, we need
to make adjustments. The Double Diagonal is a
good trade because with adjustments you can still
make money even if the stock goes well out of
the range.
|
