Putting Context Behind Your Options Strategy

Putting Context Behind Your Options Strategy

One my favorite parts of running OptionSizzle is engaging and interacting with all the different types of investors from all over the world. It brings a lot of joy to me to be able to help them in their quest to build wealth.

However, sometimes I feel when they reach out, they’ve got so many preconceived notions about how options should be traded…along with a list of Do’s and Don’ts, that aren’t always logical.

For example, I get a ton of responses on social media whenever I discuss the topic of selling option premium. For whatever reason, they believe that selling premium is a widow maker. I’m not sure where this belief stems from…but it’s pretty silly.

Let me show you why.

On October 3, 2014, Tesla Motors closed at $255.21. Let’s say you had a bullish bias on the stock over the next 5 weeks and wanted to express that by buying a call spread, the November $265/$275 call spread.

Using mid-price (average between the bid and ask price), these were the values:

NOV $265 calls: $12.90

NOV $275 calls: $9.30

So if you bought the NOV $265 call and sold the NOV $275 call for $9.30, the spread would cost $3.60.

(Note: This is not a trade recommendation and in a live market it’s unlikely that you’d get filled at the mid price…this is just an example)

What is your belief with owning this spread?

Well, to break even on the trade at expiration, we would need Tesla to close at least $3.65 above $265, which is $268.60.

Since this is spread was purchased, the maximum risk is $3.60 per contract.

The trade is risking $3.60 to make $6.40. This is derived by taking the max value of the spread, $10, and subtracting the premium spent on the trade.

Makes sense?

Good…Moving On

I know that some savvy option investors already know this…but what if I were to tell you that you could replicate this same position by selling premium…here’s how:

By selling the NOV $275/$265 put spread.

The mid-price for the NOV $275 put is $29.13

The mid-price for the Nov $265 put is $22.73

By selling this ITM put spread, you’d receive a premium of $6.40.

So what is this spread saying?

In order to break even on the trade at expiration, we would need Tesla to close $6.40 below the $275 calls that were sold, which gives a price of $268.60.

In this example, $6.40 were collected on a $10 spread…which means the max risk is $3.60.

Now, if you look at both examples again, you’ll notice something very interesting…

They are both the same trade in respect to break even points, risk and reward. One is done through buying an OTM call spread, while the other is done by selling an ITM put spread.

This isn’t magic…this is how options work. After all, if one was more expensive than the other…you’d simply sell the more expensive spread and buy the cheaper spread for an instant profit.

In options jargon these are called “synthetics” or replication.

Here are some more examples:

A long stock position: Has “undefined” profit potential on the upside and defined risk on the downside (a stock can only go to zero).

How do we do achieve this with options? Well, a long call option has “undefined” profit potential…but what about the defined risk on the downside? That can be achieved by selling a put.

Going back to Tesla, if you were long stock at $255…the synthetic equivalent would be long the $255 call and short the $255 put.

A short stock position: Has defined profit potential towards the downside and “undefined” risk towards the upside. To replicate this with options we would just using a combination of calls and puts that have this same risk profile.

For example, if you’re short Tesla at $255…the synthetic equivalent would be long the $255 put and short the $255 call.

Long Stock Long Call + Short PutShort Stock Long Put + Short Call

By using the above table, we can mix and match stock and options to create other replications.

For example, long stock and a short call is known as a covered call…or synthetic put.

Long Stock + Short Call

Long Call + Short Put (the embedded long call is canceled by the short call)

I could keep going…but I think you get the picture.

You see, there is a relationship between stocks and options…longs and shorts…calls and puts…they can all be replicated. This ideology that you’ve got to stick to only buying premium is silly once you understand these relationships. With that said, being solely a premium seller is also silly.

Professional traders understand this…for the most part, they don’t care if a stock is moving higher or lower…all they want is increased volatility…because that’s what creates opportunities in their eyes.

With that said, your focus should be on the opportunities in front of you. Too many people are focused the premium buying vs. premium selling debate. It’s like democrat vs. republican…the reality is it’s all the same.

Unfortunately, we as people sometimes put our attention on the wrong things.

So What’s important then?

Idea Generation: This can be driven by fundamental, technical, unusual options activity, event-driven and from views on volatility to name a few. If you’re having difficulty generating ideas, I suggest you check out my free report on unusual options activity.

Options Landscape: Are the bid/ask spreads competitive? Are options relatively cheap or expensive? After addressing these questions, then you can start thinking about an options strategy.

Identify The Type of Trade: Is this a binary event? A technical play? A long term or near term play? An earnings play? By answering this question you’ll get a better feel for what you should be risking, time needed and how you should be sizing the position.

Risk & Position Management: Now, if you’ve sized the position correctly, a lot of the hard work is out of the way in regards to handling losses. For many option investors, handling winning trades is a lot harder. I have different approaches, depending on whether I sold or bought premium.

As I’ve mentioned before, options are just a vehicle and an options strategy is an expression of a trade idea. As you gain more experience, you’ll learn what works best for you and what doesn’t.

You’ll want to focus on your A+ setups as much as possible…and have the discipline to not overtrade or put on trades out of boredom. There are periods where trading options can be full of excitement…others where there isn’t much going on and you’ll need to be patient.

Remember, cash is also a position and a luxury when you manage money for yourself.

Choosing when to be more active or less active comes with understanding opportunities when they do or do not arise.

It’s a myth that you have to be fully invested at all times and something financial professionals have told you for many years because they only get paid if your money is invested.

With that said, you’ve got to put everything into context. Although I’m an advocate about selling premium, certain conditions apply. The same can be said about being long premium. They both can work if the right conditions are met.

For example, when I’m selling premium…I’m look for options that are relatively rich, the stock options need to offer good liquidity so I’m not chopped up in the entry and exit.

Also, I take into account the price of the underlying stock and the type of risk I’m willing to expose myself in. Sometimes short strangles can be justified…other times I’ll use a structure a trade to define my overall risk.

In fact, The SPX Method is a detailed course that teaches you a step by step blueprint on how to make the market beat you. By following specific parameters you’ll be provided with the best chances to create profits on a weekly basis.

However, certain conditions need to be met. For example, if the VIX is above 15…we’ll look to entering one of our trades on Wednesday morning…but it’s near 17.50…we’ll put it on Wednesday afternoon…if it’s near 20, we’ll wait a day and put in on Thursday.

Bottom line, the opportunities must fit the parameters.

In conclusion, the premium buying vs. premium selling debate is futile context. My belief and my approach is to utilize both. Money can be made and lost in both fashions. What’s important is your process and execution.

Too many times investors get caught up in “strategies” and options marketing jargon…most strategies are just way to define risk. A strategy will only work if the right conditions are met…that’s what OptionSIZZLE tries to teach you.

I believe that selling premium provides the best probabilities of success. However, I understand that buying options offer that potential for a home run trade, and that you should have some of these type of plays on as well.

Focus on what’s in front of you and you’ll never look back.

What are your thoughts on this great debate? I’d love to hear from you in the comments section below.

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