In my experience as a trader and fund manager, I have found options to be a truly amazing set of financial instruments. The flexibility of options and the numerous ways where they can be applied provide excellent opportunities for traders employing various strategies: portfolio insurance, income generation, arbitrage or just outright speculation. These styles all have their merits and are exceedingly profitable when applied in proper market context. Today I’d like to focus on the style most often used by the average trader and the one that happens to be my personal favorite: speculation.

I must warn you, though, that while pure speculation is a very lucrative trading style, it is not the staple in the overall activities of our fund. We use it judiciously when just the right sort of opportunity arises in the overall market context. Regardless of the relative infrequency of its application the profits generated by this trading style contribute greatly to the bottom line. The very reason they do is that we are extremely selective when it comes to making speculative bets and when we do make a bet a significant portion of our capital gets committed to it.

The strategy that is described below isn’t difficult to execute but its biggest caveat is the trader’s ability to stick with it. That is why it is fundamental for the opportunity to be just right -- only then will the trader have the necessary level of confidence to stay in the trade long enough to capitalize on the expected outcome of the strategy.

The idea behind the strategy is fairly simple and it was born out of a more complex income generation approach that I use with great consistency. As the story goes, for some time our fund has been shorting call and put options with the intent of collecting premium. We’ve perfected our option selling methods to the point where obtaining a pre-determined monthly return has become highly probable. The problem was that while it was nice to be generating consistent returns, we had a very tightly capped upside. We needed a strategy that would give us that occasional high multiple on an investment and add some positive non-linearity to our equity curve.

Basically, we wanted a consistent, repeatable way to make a quick, blatant hit and walk away with a bag of money.

So, it was back to the drawing board time. As we started digging through our past trades an interesting fact emerged: some of our short premium collapsed quicker then we had been projecting due to a simultaneous implosion in implied volatility and a directional move of the underlying stock. Nothing really new here except that after defining the actual context surrounding these occurrences it became clear that we would have done a lot better if we augmented our short selling strategy with buying long premium against our short options. An observant reader here will ask, “but doesn’t the long premium get completely obliterated due to the very vol implosion you had observed?” Good question and here is an answer: of course it does, but it’s a matter of timing of that implosion versus the directional move in the stock that precedes it.

We’ll discuss this strategy in detail shortly. Before we do, let’s define some criteria. First of all, we must understand risk. There are two types that we’ll need to worry about: directional risk and volatility risk. There is also a small issue of time decay, but since this strategy stays in a trade for only a few days (sometimes slightly over a week), this particular risk is minor. Consider it “rent” for owning the option.

Directional risk has everything to do with the stock and nothing with the option itself so we can define it in terms of the underlying price. In contrast, the volatility risk is all about the option and we’ll need a way to either hedge it or limit the duration of the position in order to mitigate the exposure of the premium to (an almost inevitable) implosion in vol.

Having highlighted the risk involved, let’s now focus on the risk/reward equation. How much do we want to make? When researching this strategy the answer we came up with was “at least double the money”. The reason for this was that the mere infrequency of trading using this approach dictates that the opportunity would allow for a high-multiple return. In other words, when all the stars align and we actually get filled the way we want (all of which happens relatively rarely), we stand to make a lot of money. It is important to realize is that since we are expecting at least a 100% return, the risk can be commensurate and as such, gives us plenty of leeway to stay in the trade.

In short, we can bet $100 for “double or nothing”. That itself is sufficient to make money as long as we’re right more than half the time. However, the really good news is that we don’t have to lose all of $100 when we’re wrong. In practice, we’ll risk $100 in order to either lose $50-$60 or make $100. Do the math to find the expectation of returns even if the strategy is “wrong” half the time, and you’ll have a nebulous vision of a money minting press.

Now, let’s move on to the actual trading approach. The approach has two parts: a strategic identification of the trading opportunity, and a tactical entry. Both parts must be fulfilled in order to the overall strategy to work well (and, most importantly, to enable you to stay in the trade).

Strategically, the following criteria will capture the opportunity:

1. The stock of choice must have a steady short-term downtrend consisting of a series of non-stop, down-down-down price action.
2. The downtrend must be followed by a down trading day accompanied by extremely high trading volume (at least double of 20-30 day moving average)
3. The price of the stock during this last trading day must get to (or preferably exceed) an important level established sometime in the past. This can be a support level or a prior breakout point.
4. The price should have traded through a near round number (5’s are considered round)
5. The implied volatility of the ATM option must have spiked to a new level or at least has approached a previous high.

Now, it is obvious from the above that if the stock price meets the above criteria, there is going to be a severely oversold situation. In order to make this situation “better”, or more oversold, a tactical approach for the entry follows the following two rules:

1. The stock must make an intraday low during the first 1.5 hours of trading or the last hour before the close.
2. The low must be accompanied by an intraday spike in volume (again, above some average)

These entry rules can be applied on the same day when the strategic criteria have been met (the position would be taken on during the second half of the day) or the following day (a trader would look for en entry in the morning).

Now, the expected result would be a strong bounce in the stock resulting in at least a 10% move. Translated into options terms, the result is at least a 100% return or more, depending on the levels of implied volatility and the chosen strike price.

Let’s look at a concrete example. On 5/22 we bought BTU Jun 60 Calls for $1.40. We then sold half of them the following day for $3.10 and the rest a few days later for $3.00. Below are two charts depicting the trade:



On 4/18/06 BTU broke out of a range on high volume and proceeded to rally. After reaching the top, a vicious downtrend followed, characterized by the sort of down-down-down action we would look for. On 5/19/06 it traded in the vicinity of the 4/18 level on double the normal volume. In addition, the implied volatility skyrocketed to 61% - far above its average. Our strategic criteria were nearly fulfilled. We then needed to stock to trade through a whole number (55) and get down to 52.50, which was the root of the 4/18/06 breakout.



The following day opened down and the rest of our strategic criteria were fulfilled simultaneously with tactical ones:



After trading right through 55, by 10 a.m. the stock traded near the key 52.50 level set on 4/18/06 and bottomed on high intraday volume. That was the perfect time to enter the trade.

The implied vol was still high (61%) and we chose the 60 strikes as the option with the highest probability to double. We could have chosen the 55 strikes, but we’d have to commit more capital and while we’d make more in the end, we wouldn’t double our money. And we like to double! On a serious note, 55’s would be fine as well, but being right at the money they carried more vol risk than the 60’s.

Now, with this strategy, exiting the trade is much simpler than entering. In essence, double your money and get out. In our case we sold half the position the next day (the morning’s rally on high volume gave us a tactical exit along with the options having already doubled). We kept the other half to “test” the strategy and see whether it was likely to get a 200% return. That was indeed possible but after two additional holding days we decided to sell out the rest of the position at the same price. The ensuing action did take the stock to 65 within the next four days and would have actually quadrupled the return. Lucrative as it may sound, we would never wait that long (and don’t recommend that you do) for two reasons:

1. The vol implosion took place within 2-3 days after the initiating trade. Had you waited longer and the stock hadn’t rallied any higher, you’d give up a lot of your options premium. That’s vol risk for you.
2. The probability of the stock rallying higher after the initial bounce gets highly diluted. So, keep the options if you wish, but realize that at that point you’re gambling.

An observant reader would now ask the question: “why not just trade the stock? After all, you’re using options just for leverage, right?

Good question. And, no, we don’t use options for leverage. Here are the reasons for options being the instrument of choice for this strategy:

1. When we purchase options, our risk is only the premium. So, if we invest $20K into a position, that’s all we can lose.
2. More importantly, when we buy options we own gamma, which means that the position loses money slower when the stock goes against us. Inversely, the position makes money faster when it goes in our favor.
3. Additionally, we own vega, which means that when the stock decides to go lower the implied volatility is likely to rise, which offsets some of our directional losses.
4. Finally, our dollar outlay is just the cost of the option. With the stock we’d have to maintain a margin requirement, which would cost a lot more.

Let’s go through a quick exercise: Let’s assume that in the above scenario I bought 100 June 60 calls at $1.40. They cost me $14,000. Let’s also assume that a trader next to me decided to capitalize on the opportunity by buying an equivalent measure of stock.

Since the option’s delta at the time was about 26, he would have to buy 2600 shares (100 calls * 26 delta) in stock to simulate my position. This would cost him $137,800 ($53 * 2600 shares) and entail a margin requirement of $68,900.

Now, let’s look at the risk: imagine that the stock plummets three points from the level where I bought the options ($53). With the stock at $50, our calls would be worth $0.65 resulting in a loss of $7,500. At the same time, the equivalent position in stock would lose $7,800. Not much difference? Take the stock down another two points and we have losses of $10,000 and $13,000 respectively. At that moment our stock trader is a lot unhappier than I am.

On the profit side, a 5-point move up puts the options at $3.10 and a corresponding profit of $17,000 as compared to a $13,000 profit generated by an equivalent position in stock. Again, my smile is bigger than the stock trader’s smirk.

So, the options made more money and, adding insult to injury, the stock trader didn’t double his money. Now, that’s a real bummer!

So, what’s the take away from this trading approach? Can you make money using it? Honestly, I don’t know, as it really depends on your patience, ability to handle risk and the stomach to take losses. You also have to really want to win, but that’s a topic for an entirely different article.

If you have learned anything today, it’s this: Take the time to find a rare, unique, concrete opportunity that makes the world of sense to you and trade it to make serious money. Do it just a couple of times a month and eventually you’ll realize that the less you trade, the better you’ll do in the long run.

And the long run is what matters.

Dmitry Babayev is a portfolio manager and derivatives strategist at Cadence Capital Group, LLC, a Manhattan based money management firm. His main focus at the firm is on premium selling, aggressive long/short and delta-neutral strategies. He also maintains a blog, Live Options Trading (with corresponding coverage of stocks, ETFs and futures) reflecting the actual activities of Cadence Capital Group.