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 up trending 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 outlook, but some companies within a sector are better
managed and have better financial strength than some of it's competitors. 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.

Technical 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 volatilty.

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 bullishness 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 interpreted 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 volatility. High volatilty 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 limits 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

Spread
- generally means the difference between two things. With regard to stocks and options it is
the difference in value, prices, expiration months, strike prices and/or premiums.

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 combinations

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 opposite of the iron condor.

Reverse Iron Butterfly -  as implied is the opposite 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 received 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
disappointment. 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 probability 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
probability 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 limited profit risk/reward profile strategies.


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;

(Click on the image to enlarge, click on the back arrow to return to this page.)








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.

This simulator allows the investor to see what the strategy net profits or losses might be as the stock
price moves up or down any amount and at any time between the current time and opex as specified
by the user. Note, the projected options premiums in this simulator are based on the Black Scholes
theory and the variables entered by the user. This provides a good indicator, but actual values will
vary to some degree.

Also note, with multileg spreads and combinations, one leg will have a profit and one will have a
loss. What's important is that the profit exceed the loss. However, if the options are traded properly,
as the stock price moves in one direction and a profit is made on one leg, that leg can be traded and
the profit locked in with the other leg being held until or in case  the stock price reverses, possibly
generating a profit in it as well.

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

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