Three-dimensional trading for options

Most casual retail option traders not only believe that they have the ability to pick the correct direction of the underlying security, but they also think they can get the timing right as well. Unfortunately, many options bought under such circumstances expire worthless, leaving the investor dejected and slimmer in the wallet. It’s hard enough to get the direction right, but the timing too? The main culprit to the failure of these option players is that they concentrate on buying the wrong options.

Trading options is different than trading stocks or futures. With stocks and futures, direction is the only factor. You either get the direction right or you don’t. Options trading, however, involves direction, timing and volatility. Not only do you have to get the direction right, but you also need the move to happen before the option expires. In addition, volatility can cause option prices to swing up or down, even if the underlying security doesn’t move at all.

Most option investors concentrate on buying out-of-the-money (OTM) options with a short shelf life or expiration date. OTM options represent those that have strike prices that are far away from the current price of the underlying security. For call options, the OTM strikes are higher than the current price of the underlying security, while OTM put options have their strikes sitting below the current price of the underlying security.

These relatively cheap options are considered lottery plays with nearly limitless upside but an extremely low cost of entry. Unfortunately, just like the lottery, these options have a miniscule probability of being profitable.

REALLY WIN THE LOTTERY

If the majority flock to low-priced, low-probability options that rarely profit, then the better trade should be obvious: Take the other side. By being the option seller and collecting the money from the option buyer, you can take advantage of less-sophisticated market participants looking for the cheap, easy payoff.

One technique for doing so is called the option credit spread. The biggest benefit of the strategy is that picking the correct direction of the market is not the driving force behind being profitable. In fact, being wrong on the direction can still yield profitable results.

The option credit spread involves two options of the same expiration month, the same type (both calls or both puts), but of different strike prices. The trade calls for the more expensive OTM option to be sold and then offset by buying the cheaper, further out OTM option. Because we are selling the more expensive option, we will be taking into our account a cash credit.

Even though getting the direction right isn’t imperative when initiating an option credit spread, you still need to have a general idea of where you think the market may be headed. That said, you won’t have to be totally correct on the direction, but you must have an initial prediction about your chosen market.

“Sleek as silver” (below) shows the nasty sell-off in silver at the beginning of March 2007. Because silver had been in an uptrend, it seemed likely to bounce off the blue 200-day moving average line and continue its uptrend. This bounce played out on March 5, setting the trade up for step two.

With the directional call in place, the next step is to turn the directional call into an option spread. The plan is not to try and predict how high or far silver might go by option expiration, but to predict where it likely would not go to by expiration. There’s a huge difference in those two approaches. Silver was likely to go higher, but we don’t necessarily need to know how high and how soon.

A great thing about this type of trade is the huge margin for directional error. At the time of execution on March 5, 2007, May silver futures were trading at $12.50 per ounce (12500 on the chart). Our danger zone — where we would begin to lose money — was down at the $11 per ounce level, $1.50 lower than current prices.

Because we were assuming that silver wasn’t going lower than $11, we wanted to sell an OTM bullish put option credit spread. This is a limited risk/limited reward trade that is initiated from the sell-side. The options should correspond to support levels, so we sold a May 2007 silver $11 put and bought a May 2007 silver $10.75 put, collecting a premium of 3¢ per spread. In silver options, 1¢ equals $50, so we collected $150 for every spread we sold.

LIMITED PROFITS, LIMITED RISK

As the seller of the option spread, the most we could make on the trade is $150. As the option seller, you are not positioned for unlimited profits. The option credit spread is a slow, steady gainer with a high probability of profit. That is why we execute it so much — because the probabilities of winning are so high (see “Probability calculator,” below).

The probability calculator will tell you what your chances are of having a successful trade at time of execution. We use it to tell us the probability of the underlying security reaching our breakeven point. In the case of option credit spreads, the breakeven point is where you would begin to lose money, so we want to avoid that.

The probability of being successful on the silver trade is 87%. With this specific option credit spread we did not want silver to trade lower than our breakeven price of $10.97. We calculated our breakeven by subtracting the spread price of $0.03 from the short strike of $11 ($11 - $0.03 = $10.97). The current price of silver was at $12.50 and so we didn’t want it to retrace back down to the $10.97 level because that’s where we would start to lose money. However, we started with a huge cushion. Silver was $1.50 above our danger zone. As long as silver didn’t go back down there by option expiration, we’d get to keep the whole $150 per spread. The probability calculator showed there was an 87% chance that silver would not go below the breakeven price of $10.97.

The key is not trying to figure out where silver might go. We just want to figure out where it likely won’t go. Because we’re selling OTM options, we have a huge margin for error. Silver could move higher, and we win. Silver could do nothing, and we win. Silver could move lower, and as long as it doesn’t go lower than $10.97, we win. And you don’t need to wait until the end to take a profit.

The point is to get out of the mindset of needing to know where the market is headed.

Give yourself a higher probability for profit and figure out where the market is not headed.

Once you’ve done that, you can sell OTM option spreads and reap many small winners through time.

Lee Lowell is editor of The Delta Force Trader (www.mtvernonresearch.com), author of Get Rich with Options: Four Winning Strategies Straight From The Exchange Floor and a former Nymex options market maker. He can be reached at editor@mtvernonresearch.com.

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