Today's Trading Lesson From TradingMarkets

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Each night we feature a different lesson from TM University. I hope you enjoy and profit from these. E-mail me if you have any questions. Also, if you trade options, be sure and check out the brand new TradingMarkets Options College, with Joe Corona.
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How To Use TradersWire Interactive To Identify Options Setups
By Duke Heberlein

While it is a fact that we focus on setups in the majority of instances to be taken advantage of by stock traders, the setups we profile are easily utilized by options traders. Some are even better suited for options strategies. 

While it is true that options can limit risk to only the premium paid when buying puts or calls, they are not a low-risk strategy. Trading options must be understood before you use them as a tool in your trading. For those of you who wish to familiarize yourselves with options I would suggest also taking a look at salibaoptions.com.

The Options Advantage

Options are an element to consider due to several advantages:

• You don't need a large account. The advantage of leverage allows traders of call and put options the luxury of not laying out a large amount of cash to open a position. Since options contracts are sold in lots of 100, you can leverage the premium paid on in-the-money options and catch a 1 point move per contract for every point the underlying stock moves. When you consider that you will pay in the range of $600-1000 per contract for a deep in the money option, if you predict the correct direction of the move and the stock moves 4 points in your favor, for example, you will realize a profit of $400 per contract. This is a 40%-66% return per contract! Catch enough of these and your account starts to add up very quickly.
• Flexibility and versatility. With stock, traders can be either bullish or bearish. With options, traders can be bullish, bearish or neutral. Options can be used by themselves or in conjunction with stock. Options can also be used in combination with other options to create many different risk/reward scenarios.
• Predetermined risks. For option buyers, the most you can ever lose is the amount paid for the option. You know in advance how much you can lose.

There are many different ways to utilize options strategies in trading. In this lesson I am going to focus on a couple of rudimentary methods for taking advantage of swing trading setups. These methods are a good start to enable you to become familiar with keying off action in the underlying stock to spot options scenarios from which you can profit.

I have heard figures quoted that state some 80%-90% of options traders end up losing money. If this is true, it is because they make a few cardinal mistakes. Many who do so have no strategy in place, and therefore end up taking shots in the dark and depending on luck. This is the farthest thing from intelligent speculation. Trading options, just like equities and futures, entails having a plan of attack and adherence to sound principles of money management. When attempting to make a trade based on a setup you determine to fit into your style of trading and risk tolerance, here are some guidelines to keep in mind.

By far, the best way to trade options is through use of option spread strategies. According Tony Saliba, "staying spread is staying alive." His success and longevity in the business as a professional option trader is direct evidence of the credibility of this statement. Contrast this with the typical short-lived durations of the vast majority options traders' careers and you know that ultimately spreads are the strategies you should gravitate to if you want long-term success in this business. Keep in mind that teaching spreads is beyond the scope of this lesson, and my focus is how to coordinate the application of the options strategy of your choice with the movement of an underlying stock. For the sake of illustration I will be focusing on simpler strategies.

"Cheap" vs. Expensive Options

One mistake I see many new options traders make is succumbing to the temptation to purchase "cheap" out-of-the-money options, going on the theory that if they are right, they can increase the amount of their returns. While this may allow them to hit the proverbial home run once in a while, the number of times they will be wrong will cost them dearly. Keep in mind that using a swing trading style when playing options means we are only looking to hold the option for two to five days on average, although some trades may dictate we hold them for a few more days. A system I have used, which allows me to get the same 1 point move in the option for each 1 point move in the underlying is this:

• If you are more than two weeks away from expiration, use the front month option. Since we are not looking to hold the position for a long period of time, we don't need to go out two months or more and expose ourselves to higher premiums and time decay of that price. Therefore outside of two weeks until expiration, use the front month's options. If inside of the two-week window until expiration, I will often go to the following month's options.
• Try to find an option one to two strikes in the money that is trading as close as possible to parity.  This again protects against time decay from eroding into a potentially profitable position. "Parity" means trading as close to its intrinsic value as possible. For example, if our entry in a theoretical position is $50 in the stock, if we are going to purchase the front month, 45 strike calls, we would prefer them to be trading as close to $5 as possible ($45 for the stock plus $5 for the option = 50). If they are more than $6 for the call, we would go down to the 40 strike calls. Usually it is not recommended to go more than two strikes into the money, as at those levels the spreads widen and volatility gets much higher. Most of the time you will find a suitable option at one to two strikes in the money. If you don't, this may not be a setup that makes options the best plan of attack. Using in the money options also gives us a delta of 1.00 (or close to it) meaning that for every point the stock moves in our favor, the value of the options position increases accordingly.
• Wait for entry in the underlying before putting on the options position. As Dave Landry says "no tickie, no tradie." If you are going to trade a pullback from high setup, you normally will wait for the stock to trade over the previous day's high to signal a valid entry. The same goes for putting on the trade with options. Wait for a trigger in the stock before you enter in the options. Following this simple rule will help you avoid several losers.
• Manage the options in the same manner you would if you were trading the underlying. Key off the stock to put stops in place, and honor them just as if you were managing a position in the stock. You can do this by putting in physical stops with your options broker, or by using mental stops if you are able to manage the position during the day. The important thing is to use stops and protect yourself from large losses. Many of those who lose money in options do so because they let them expire worthless, where if they had used stops and taken small losses, they may have been able to stay in the game.

Some Examples of Possible Trades

Here is a recent swing trade we profiled in Nvidia (NVDA). The underlying stock in December had set up as a basic pullback from high on the daily chart.

Looking at how to play it using options, we first have to determine entry. This is at 65.05, .05 above the high on Dec. 21. A look at the January 60 calls shows they are priced outside our preferable range, so we go down to the 57 1/2 calls, which are more to our liking at 8.70. The following day when the stock follows through (A) we can put on an options position.

After the stock triggers out of the pullback, it rises nearly 5 points in the next four days. On day four, when it gaps slightly and runs to 70, a good move at this point would be to sell half the position if you purchased more than one contract. You can then lock in a profit on that half of the options, and possibly place a two-bar trailing stop on the remaining contracts, which is hit two days later (B). This is one example of how to manage the position, and lends itself to taking advantage of a larger move with a looser stop. Other traders may protect profits more closely by exiting on the first new low, which will lead to smaller profits and possibly a greater win ratio with more stop outs.

Another recent example from the Insights From The War Room was a breakdown from a slanted triple bottom in Mercury Computer (MRCY).

Waiting for an entry under the low of the breakdown day at 42.09, it occurs the following day, and when the stock hits 42.04 we put a position on with the February 50 puts, which are trading at 8.20, only .20 from parity. The stock continues to break down and the options premium rises in conjunction with the move.

The February 50 puts rise in value to nearly $16 at the December low in MYGN. Again, if multiple contracts were purchased, prudent money management would dictate selling off a portion of the position to lock in profits as the move went in your favor. Even a stop placed 5% away from the close of the low on Dec. 18 locks in nearly a 4 point gain, or almost 50% on the position. 

Other times TradersWire will spot a setup in which a major move is likely on the horizon, but the direction is difficult to ascertain based on the pattern. This is normally in a situation where the volatility has contracted price into a pattern that could break either to the upside or downside. In this situation a straddle would be a good way to play it. In a straddle, a call and a put of the same strike and expiration are purchased, so that whichever direction the pattern resolves itself will result in a profit if the move is large enough.

Autozone (AZO) is setting up in a triangle at its highs during December with earnings due to come out. Before the actual announcement comes out, a straddle using the 65 strike in the calls and puts is put on. For this strategy sometimes it is wise to go out at least one month or two, because sometimes these types of setups can take longer to play out, however since earnings are going to be announced soon it is not necessary in this case. The position is in place with the December 65 call at 3.70 and the 65 put at 2.35, for a cost of $605 per straddle.

When a telephone conference with analysts before the earnings announcement leaks news of a substantial increase in profits compared to the previous quarter, the stock explodes to the upside, giving us the large move we need to profit from the straddle.

The 65 puts rise in value to more than $13, while the puts become basically worthless and fall to .20, as they are now far out of the money. This results in a profit of around $750 per straddle when we subtract the loss of the puts from our profit on the calls.

Using Advanced Strategies

The examples above show a couple of simple ways to play options in ways I feel is the best way to approach them, by way of the underlying stock. Whether you use these approaches or more advanced strategies like spreading, the way to avoid a guessing game is to key off the price and patterns that are exhibited in the moves of the stock. In using advanced strategies in this manner, you can often limit risk, but limit the profits you can realize on particular positions. While these strategies are by no means risk-free, they are certainly worth learning if you want to become a complete trader in the arena of options. I would suggest reading the following lessons from Tony Saliba and Len Yates on TM University to further your education:

Introduction To Options Spreading

An In-Depth Look At Vertical Option Spreads, Part I

An In-Depth Look At Vertical Option Spreads, Part II

A Directional Strategy That Costs You Nothing If You Are Wrong

I hope that this will at least get you interested in learning the basics, then going further to learn the intricacies and nuances of options trading. This will enable you to posses another tool to attack the markets in search of profitable trading. Best of luck!

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