OptioNewton

Selecting a Strategy

When selecting a strategy the goal is to maximize profits and/or minimize losses, but how is a strategy selected? We might hear one or more of the traders on CNBC say, for example, "I'm bearish on the stock, if you own it, buy the put spread" only to have the next one say "I'm bullish on it, buy the put spread". Two completely opposite opinions saying implement the same strategy? Or "we think the stock is going higher, but if you buy it here, buy a protective put" or "we think it could pull back, if you've got a profit, sell the calls" or "if you've got a profit in this stock, collar it up for protection".  What option or combination should be used? What strike prices? What expiration month? How and when are the pieces executed? When is the profit taken? How to exit? It can get expensive buying options only to watch the Time Value decay eat away at the investment. Pick the wrong strategy and it may hurt more than help.

Sentiment -

The first step in choosing a strategy is to select a general market and/or stock sentiment. Sentiment can be influenced by many factors including economic, company specific, technical and then the options cycle itself.

Economic Cycles and Trends

The economy and therefore the stockmarket is cyclical. Over a period of years there are bull markets and bear markets. The previous tab discussed the probability of success assuming a completely random market. That is, the market or a stock movement as a fair coin toss, meaning 50 50 chance of heads or tails or up or down. And a stock's price movements can be modeled fairly accurately with a random number generator with two possible equal outcomes over a short period of time. However, the randomness of the market or a stock is not always 50 50. There are times, although a short term component of randomness may still exist, when the coin is weighted to the upside and times when it's weighted to the down side. In other words, heads may show up more than 50% of the time and tails less than 50% of the time or vice versa. Although buying a call in a completely random market may have a 33% chance of success (ie a three sided coin), in an uptrending market, that 33% chance side may show up more often than not. 

Government monetary and fiscal policy drives (or better reacts) to the cyclical nature of the economy by adjusting interest rates, the amount of dollars or liquidity in the economy, and government spending. The government does this as an attempt to moderate booms and busts that may occur in an otherwise free market. As the economy heats up or accelerates as measured generally by GDP, the Fed may start a period of raising interest rates incrementally. This has the effect of applying the brakes to the economy to certain degrees. Lowering interest rates in a recession has the effect of either taking the foot of the brakes or applying pressure to the accelerator. Government fiscal policy attempts to regulate the economy by increasing or decreasing monetary supply or increasing or decreasing gov't spending. The stockmarket's cycle reacts to this, but generally looks ahead or anticipates what the economy will be 6 months into the future based on policy. So they're not in phase. 

Weekly or monthly economic metrics reported by the government, such as unemployment rate and situation, inflation, housing sales etc can move the market in the shorter term.

Company Specific

Fundamental Analysis 

The financial health of a sector or a specific stock, obviously, will drive stock prices. Fundamental analysis involves a study of a company's income statement, balance sheet, cash flow and the future trends or projections of them. Each industry has it's own financial metrics. For example, banks profits are driven by deposits, interest rates, loan loss provisions. Oil refinery profits are driven by production capacity, production utilization, crack spreads, etc. Fundamental analysis requires a lot of homework or due diligence. A sector may have a good outlike, but some companies within a sector are better managed and have better financial strength than some of it's comptetitors. But financial information on publicly traded companies is reported quarterly in SEC filings and throughout the quarter, they generally release news that may impact the results of the next quarter's results and all of this is easily accessible on the internet.

Tecnical Analysis 

Technical analysis (TA) has less to do with economic or company specific fundamentals and more to do with the historic price movement of a specific stock or index and the near term projection of them into the future. Generally, it is assumed that if a stock price has fluctuated a certain amount in a previous period of time, that it will continue do so in the near term future as well. It also assumes that if a stock's price has a trend in a certain direction (ie up, sideways or down), that the trend will continue into the future. There are many TA metrics for indications of continuance or reversal of these trends, either by moving averages, MACD's, Bollinger Bands, etc or certain chart (bullish or bearish) candle patterns. If enough traders follow the patterns, then there is some validity to it. However, unanticipated news, good or bad, or anticipated news with unanticipated results, such as quarterly earnings announcements, can completely change stock price direction and dynamics without warning from TA.

Options Cycles, Put Call Ratio & Max Pain

As we've already alluded to previously, options have time limits and therefore are decaying assets. The previous tab discussed options expiration day being a reasonable point to evaluate risk and potential profit. So selecting a successful options strategy may simply boil down to trying to predict whether a stock price will be above or below a single strike price on opex. 

In addition to the premiums, most options chain tables show each option's volume for the day as well as the open interest volume. Open interest refers to all of the net open contracts on a specific option. This number goes up as options contracts are opened and down as open contracts are closed. Remember options can be opened to buy and they can be opened to sell. Both of these add to open interest. Similarly, options contracts can be sold to close and bought to close. Both of these reduce the open interest. At first glance it might be thought volume and open interest might provide an indication of what the market thinks the trend of the stock price is. And that may be the case, but it should also be understood, however, that high volume on a certain call, for example, doesn't necessarily indicate the stock price will go to that strike. There are many traders who don't mind gambling for the relatively small price of an OTM call for the chance the stock might rise above that price. On the otherhand there are many traders who use the OTM calls as a hedge for a stock position. As mentioned previously, there are always two sides to every trade and both sides have different motives. 

The put call (volume) ratio can be an indication of the trend, but it is often used as a contrarian indicator. There is an average put call ratio on the order of about 70%. That is the volume on the put side is usually 70% of the volume on the call side. If the put volume is much higher than 70%, which means the market sentiment is very bearish, some traders take this as a sign to start being bullish.  If the put call ration is much lower than 70%, which is very bullish, some traders take this as a sign it's time to get bearish.

Max pain is another indicator. The theory being that the price of a stock price will gravitate to a point that will cause the most pain for the most option purchasers on opex day. For example if there is a high open interest in calls at the strike price of 25 and a high open interest in the puts at 25, then the theory claims the stock price will probably be in the 25 range on opex. This means the calls above and the puts below this price will all be OTM and expire worthless, causing the most pain to purchasers of those. The mathematical process for determining max pain is actually the open interest volume times the difference between a selected strike and the ITM strikes for the respective open interest. This has to be done on both the call side and the put side and then the 2 are added together. The max pain would be when the previous sum is at a minimal point. A good indication of max pain can be seen by looking at the option chain table in straddle view. 

In reality the distribution of the open interest on options prices will appear to be bell shaped with the max open interest being the center of the bell curve and the open interests falling off in either direction from the max open interest strike. If the bell curve for the call and put volumes don't coincide on a common strike, then the strike between the call bell curve and the put bell curve is likely the max pain. The max pain theory works best in months that don't include any market or stock moving news, such as earnings announcements.

Bullish, Neutral or Bearish Sentiment

In summary, there are 3 basic sentiments for the general market or a stock's price direction; Bullish, Neutral and Bearish. And each of these can be subdivided into two levels based on volatiltiy.

Bullish - or bull means the market and/or a stock is anticipated to be in an up trend and should move higher for a period of time. The two levels of bullisness include modestly bullish and very bullish.

Neutral - means the market and/or a stock is anticipated to stay about where it is or within a certain range for a period of time or make a large move in either direction with no idea which. This situation can occur when publicly traded companies announce quarterly earnings and it is uncertain if the news will be good or bad or how the market will react to it. Less than bad news can be interpretted as good news and then sometimes the market buys on the rumor and sells on the news. The two levels of neutrality include high volatility and low volatilty. High volatiltiy is the neutral sentiment that expects a large move up or down but uncertainty with which direction. Low volatility is the neutral sentiment that expects the stock price to remain within a certain range.

Bearish - or bear means the market and/or a stock is anticipated to move in a downward trend for a period of time. "Short" is another term that refers to a position in a stock (as in a short sell) or option (as in a write) in anticipation of a bearish or counter move. The two levels of bearishness include modestly bearish and very bearish.

Protection - or protective is a bearish option trade either simultaneously with or sometime after the initiation of the purchase of stock or an option trade. If it's implemented simultaneously with a stock purchase it provides a more conservative position than owning the stock alone because it limts the downside, but also limits the upside. If implemented after a gain in a stock or an option position it is intended to counter an anticipated downward or bearish movement in the stock or option to protect profits without having to sell the original stock or option. Protection may be implemented before market moving news such as economic metrics or earnings announcements are released.

Strategy Alternatives

Option strategies can be categorized as; Spreads, Combinations, Calendar (or Horizontal) Spreads, Diagonals and Synthetic. When evaluating specific options strategies the Call Put Chart and the Time Value Decay Chart can be a useful tool in understanding and optimizing the various alternatives for a specific option strategy. 

Spreads

Leg - is one of the options in a strategy that involves more than one option. A trade on a spread or combination can be executed all at one time or they can be legged in using limit orders taking advantage of short term fluctuations in the stock price to get a better option price. 

Vertical Spread - is an option strategy that involves 2 call or 2 put options of the same expiration month, but different strike prices. One option is bought (or long) and the other is written (sold or shorted). Spreads can be bullish or bearish and intended as a way to lower the cost and therefore the potential loss of an option trade. For instance, when buying a call, the premium is a debit to the account. A portion of this will be time premium that will decay over time. To counter this, when the initial call desired is bought, the premium can be offset some by writing a higher strike call. The net premium paid is the cost of the purchased call minus the credit from the written call. So they are considered modestly bullish or modestly bearish. They can also provide some protection against a movement in the direction opposite of that anticipated.

Combinations

Combinations - are trades involving 2 or more options, one being a call and one being a put.

Common ombinations

Straddle -  is a neutral combination that expects a large move in one direction or the other. An ATM call and an ATM put of the same strike and expiration month are bought. The strikes can be below or above the current stock price, but usually near the current stock price. The premium is a debit.

Strangle -  is a neutral combination that expects a large move in one direction or another. An OTM call and an OTM put, both with the same expiration month, are bought. The premium is a debit, but less than for a straddle.

Iron Condor - is similar to a strangle, but includes selling upper strike calls and lower strike puts to lower the cost of the premium. It has 4 legs and involves buying an OTM call, selling a higher stirke call, buying an OTM put and selling a lower strike put. The premium is a net debit.

Iron Butterfly - is a bull call spread and a bear put spread.

Reverse Iron Condor - as implied is the oppsite of the iron condor.

Reverse Iron Butterfly -  as implied is the oppsite of the iron butterfly.

Collar - is a protective combination consisting of a long position in a stock and a vertical spread. Ie, an OTM call is written and an OTM put is bought. A no cost collar is one in which the cost of the put is equal or less than the premium recieved for writing the call.

Calendar Spreads

Calendar Spread - is a combination involving 2 options of the same strike, but different expiration months. It usually involves writing one option and buying the other. This strategy anticipates a movement in one direction or the other in the stock in the short term, and a movement in the opposite direction in the longer run.

Diagonals

Diagonals - as the name implies are a combination of options with different strikes and different expiration months.

Synthetic Strategies

Synthetic Combinations - a position in a stock can replace the long call portion of an option combination. When the stock is used as such it creates a synthetic option combination. Likewise an options spread or combination can be used to simulate a stock position. Because the loss on a long option is limited to the option premium, this can be more conservative than owning a stock. On the otherhand options have a time limit on them. 

If a trader's account is not set up to write naked options in many of the strategies, no need for dissappointment. There are many strategies involving covered writes (or stock and options combinations) to create synthetic combinations that can minimize the downside and maintain a large percentage of the potential upside.

Debit, Net Debit, Net Credit or Credit

Since option premiums generally have a considerable amount of time value that decays over time, selecting strategies that reduce the cost of the premium can increase the probablility of success (or reduce the risk of failure). On the other hand, the less risk in a trade, the lower the profit potential. So there is a balance that can be chosen between risk and reward and probability of success. As mentioned above, strategies where one option is bought and one is sold help reduce the cost of the premium and can even provide a net credit. These help to increase the chance of success, but also reduce the profit potential. All strategies can be subdivided into whether the premium is an initial Debit, Net Debit, Net Credit or Credit to the account and therefore varying degrees of risk/reward and probaility of success.

Debit trades - a debit trade is generally a combination in which options are only bought, ie no options are sold. The entire purchase of the options is a debit to the account. They are generally limited loss and unlimited profit risk/reward profile strategies.

Net Debit trades - a net debit trade is a spread or combination where one or more options are bought and one or more options are sold. It occurs when the value of the options bought exceeds the value of the options sold. These are generally limited loss and limited profit risk/reward profile strategies.

Net Credit trades - a net credit trade is a spread or combination where one or more options are bought and one or more options are sold, but the value of the options sold exceeds the value of the options bought. These are also generally limited loss and limited profit risk/reward profile strategies.

Credit trades - a credit trade is generally a combination in which options are only sold, ie no options are bought. These are generally unlimited loss and limted profit risk/reward profile stategies.

Strategy Selection Steps

The next tabs provide details for some of the basic strategies.  There are many others and the minor twists on these by the trader can generate an infinite number of possible strategies. Too many to cover all in a website. But in general, in order to select the proper strategy and not be overwhelmed by the choices, the number must be narrowed down by a logical thought process in order of priority. This might include;

Step 1 - selecting a sentiment - Bull, Neutral or Bearish.

Step 2 - selecting a sentiment volatility - High or Low

Step 3 - selecting the duration to options expiration and/or planned exit, long or short term. 

Step 3 - selecting a risk/reward profile which determines Debit, Net Debit, Net Credit or Credit.

Step 4 - selecting an option, combination or spread, or nothing, 

Step 5 - selecting the strategy, noting the associated probability of success.

The process to this point might be illustrated with the following matrix;

 And there may be others the investor may have investigated. Then 

Step 6 - select specific options from options chain table,

Step 7 - check strategy current asks and projected premiums based on the anticipated price movement with a Call Put Chart and/or options calculator. It is very important that before investing in a strategy, the investor understand all possible outcomes and especially the risk of loss and the possible profit to establish a risk-reward profile. A good simulator to do this can be found here.

Step 8 - select order type and bids and place the order.

It is highly recommended that the first time options trader use a virtual trading tool to do real life testing of strategies without investing in money first. One can be found here here.