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Trader Notes: Tips for Trading Options



As you know, the US main brokers (Ameritrade, Fidelity, Charles Schwab, eTrade) are now offering zero-commission in stocks, ETFs and options trading. A piece of great news, by far the best this year for retail traders.  It's a great opportunity to start trading options more aggressively, creating an options-based portfolio as now commissions are no longer cutting our profits.


1. Options as a substitute for Stocks: Delta > 0.80


Substituting stocks with options has two unique advantages: only options bring leverage and protection.

- Options provide tremendous financial leverage to users when they are used in a conservative way: you can control the same amount of shares with less money, and mainly, the % returns are much higher when you trade with options. This carries another advantage: with more money available you can diversify better your portfolio.

- And provide protection: with the appropriate strategy, in case of devastating fall of the stock, your maximum loss is always limited to the amount of the call purchase.  The use of stop-loss in stock trading works reasonably well but not always prevent losses due to frequently morning gaps. Stop-loss orders offer protection that is path-dependent (depends on the "path" the stock takes), while options offer time-dependent protection (and never trigger you out of the position just because of the path the stock, as stop-loss did).

Options are two-dimensional assets: you must guess correctly the direction and the speed of the underlying stock. When a stock-trader becomes an option-trader they often buy at-the-money call options (since they are cheaper) as a substitute for the stock. Doing so subjects them to a two-dimensional asset when they are used to trading stocks, a one-dimensional asset. When you starting out, buy short-term options in-the-money (ITM), calls with relatively high deltas in the 0.80-0.85 range and you will have an asset that behaves similar to the stock you are trading. They are more expensive but less risky.

The reason is that a call option with a delta of 1.0 is no longer considered an option, it's a perfect stock substitute. There is no time-premium there, and a lot of intrinsic value that we would rather not pay for. So you don't need to find a delta of 1.0 but should get close, and the 0.80-0.85 range will suit your needs. On the other side, if you buy a higher strike, there is too much time premium in the option and it may not respond to smaller changes in the stock price.







2. Use Credit Put Spreads


As you know, trade options are more complicated than with stocks. You need to guess not only the direction of the stock but also how quickly the stock's price will get there (the speed). We can combine two concepts for a solution, selling puts and the vertical spreads, to create a great strategy, the credit put spread.

- You can create a bullish trade not only by buying calls: you can sell puts. A short put, being on the opposite side of a trade of a long put, is bullish. Most traders, who are bullish, tempted to immediately reach for the long calls, also due to its unlimited gains, but they need the stock to move. A short put also makes money if the stock rises. And more important, also make money if the stock standstill. It's a big difference: by selling puts you don´t need the stock rise for us to make money; you just can't have it fall. You eliminated the speed component of the option.

- Sell puts creates an unlimited downside risk that you could control by creating an option spread, that's combining two different option strikes as part of a limited-risk strategy.  This called vertical spread, consider buying and selling a call, a call spread, or buying and selling a put, a put spread, of the same expiration but different strikes Essentially, trading put credit spreads is very similar to the short put. Preserves its advantages, but without its dangerous downside risk. And that's great!

A vertical spread can be bullish or bearish and can be for a debit or a credit. Let's review my favorite of all, due to its many great features, the credit put spread.

Click to enlarge.

Typical P/L (profit/loss) chart of a credit put spread. This month I'm bullish in silver (follow by the ETF SLV), now trading at $16.77. The spread was created with two legs: sell put 17 and buy put 16, for a net credit of $0.49. If SLV rallies, the put credit will decrease in value and result in a profit. Conversely, a sell-off results in a loss. As max-gain is similar to max-loss ($500), we had a good risk/reward ratio of 1. When the expiration date is near, the spread will benefit from theta decay, unless legs are completely ITM. 


As you verify in the chart above, a credit put spread has important features advantages against other option strategies. Let's summary them:

- Maximum profit: limited, and is the credit or premium received.
- Maximum loss: limited, and is the difference between the two strikes minus the premium received.
- Risk Level: low, if you use a Risk/Reward ratio near 1.0 or less. You could get it with ATM legs (that's one ITM and the other slightly OTM).
- Break-Even: is the strike price of the short pull minus the premium received.
- Environment: ideal when you have a bullish, neutral or slightly bearish position and don´t need a great move in the stock price.
- Legs: two, a bullish short put (the main) and, further away, a bearish long put (the protection).
- Goal: receive credit and hope both legs expired worthless, or the same, the stock price stays above the short put strike, as you can review in the chart above.
- Stock Volatility: as it affects both legs at the same time, its effect is mitigated.
- Implied Volatility: in terms of cost, for high IV, use the spread Buy OTM Put/Sell ATM Put. For low IV use the spread Buy ATM Put/Sell ITM Put.
- Time decay: acts in favor of a put credit spread, as short put gains with the passage of time, and its theta offsets the long option theta.
- Close Position: as other options, a spread could be closed at any moment, better prior to expiration if it reached its max profit. Sometimes you only need to close the short put since it can't gain more and leave the long put in case it rises. And if you reach the max loss, wait: always there's a chance that the position turn in your favor.
- Expiration Risk: be careful if the underlying expires within the short and long strikes, or the short ITM and the long OTM. You have the obligation to buy 100 shares of stock for each short put. If buying power isn't enough it will activate a margin call from your broker.

Selling options strategies with a favorable risk-reward and a high probability of success is the way an Income Trader works. Think like them and treat your portfolio as an insurance company: they live selling policies (options) for a premium, a successful business. The goal is to do the same: collect as much premium income as possible and never pay out the policies. So, maximize the number of credit trades, diversifying between index, ETFs and stocks, in different sectors, through bull or bear market conditions, analyzing only the stock direction. Now that brokers offer commission-free trades, it's perfectly possible.

In the next Trader Notes, we take a step forward with another popular risk-defined option strategy, the iron condor, that combines two verticals (a call credit spread and a put credit spread), for use when you have a neutral bias in the underlying.

This practical chart summarizes what options strategies work better depending on market direction and implied volatility size. Straddle, Strangles, Butterflies, and Calendars are not treated in this post, but in some next.





3. Best Options for Earnings Play


Buy a stock just before its earnings report is a bet: it can be highly profitable or devastating for your portfolio. You decide the risk you face. I always prefer to wait for the report, to compare their numbers with the estimates in EPS, sales, and guidance, review the conference call for some additional data and see the next day analyst's ratings, which usually increases or decreases their weighting and price target. Also, high-volume transactions with price and implied volatility moves, are guaranteed before and after the earnings date.

And, of course, you can use specific options strategies during these events. Let's overview some ideas as to choose the right strategy. You need to know the following principles:

-  A strategy that involves long options (been calls or puts) will typically gain value as IV increases and lose value quickly with IV decreases.
- On the contrary, a strategy that involves short options (been calls or puts) will typically gain value quickly with IV decreases and lose value as IV increases.
- During an earnings event, the implied volatility IV of the underlying usually increases some days before the report (due to typical great attention given by traders, creating orders like bets). And when the report was released it drops sharply.


Click to enlarge.

Thinkorswim includes this great feature in its platform, in which, at a glance, you could review the latest earnings of any stock, in this case, Disney DIS (my favorite 2019 stock), showing its price move and implied volatility before and after the event. 
Here is an example of what usually happens during an earnings event: despite the result (if the stock beats or miss EPS, sales or guidance), the implied volatility increases before the earnings date, and decreases quickly after it, the next day, hurting the premium. The goal is to take advantage of this movement.


If you decide your directional bias in the underlying near the earnings report, buy OTM calls (or OTM puts, depending on the direction) just before it, with cheaper premiums, looking for a big profit if the stock explodes after the report. It also works with spreads (OTM credit puts or OTM credit calls) for bullish or bearish bias, respectively. Traders love this simple strategy (really, it's a bet): low-cost, minimum risk but also very little profit probabilities in your favor. But it's valid: sometimes works.

If you have a neutral position or presume the underlying wouldn't have a sharp move before/after the earnings report, you could consider taking advantage just from volatility changes:

- Before earnings: entry long positions (long calls, long puts or ATM debit spreads) one or two weeks before earnings day, and then closing the position the day before the event, so to take advantage of the volatility increase mentioned above.

- After earnings: entry short positions (short calls, short puts, or ATM credit spreads) just before earnings, to take advantage of the volatility decrease mentioned above. The position could be closed just after the report.

As you see in the three option "tips" mentioned in this post, risk management is the main factor I consider in all of them.  Protect your portfolio and protect your gains is the key to become a profitable trader.