In this final installment of How to Trade Options we’ll look at a break-even trade and analyze the results, and then touch on what we’ve learned to reiterate the key things you should take away from the series. Our final trade entered on Nov. 21, 2011 and exited 4 trading days later on Nov. 28, 2011.
This was essentially a break-even trade if using SPY stock. Below we see the results if Dec. 2011 monthly options had been used instead:
These results once again reflect using 1 option contract as a replacement for 100 shares of SPY. The results are mixed. The long calls have lost money, suffering from time decay. The short puts have made money, collecting the time decay (an example of not being wrong). The bull spreads have done a little worse than SPY stock, but still essentially break-even, again in between long calls and short puts.
If the market exposure is increased to that of the SPY trade, the results are similar, just bigger because of the extra contracts.
The first two trades showed the use of options at their best, avoiding a very large loss on a very bad trade, and participating significantly on a quick sharp move up. The last trade was an example of when using options was a bad choice (in hindsight that is). Most options trades will have results somewhere in-between the examples.
Each of the 3 basic strategies has a best/worst scenario relative to trading SPY stock:
- The long call’s best scenario is an immediate sharp move up, while the worst scenario is a slow grind to the strike price.
- The short put’s best is a slow grind to the strike price, while the worst is an immediate sharp move down.
- The bull spread does best with a slow grind to the short option strike price, while the worst is a slow grind to the long option strike price.
If you’ve already been trading options and use only one of the 3 basic strategies presented, you might consider when to use one of the others. If you normally buy calls, but find the implied volatility (premium) too high, you could sell a higher strike call and try a bull spread instead, or sell a naked put. If you normally sell puts, but you think the implied volatility is too low, you could buy calls or do a bull spread instead. If your M.O. is to put on bull spreads, but you think you’re not getting enough for the short option, maybe trading long calls becomes appropriate.
With all these complicated choices, why even bother with using options instead? One reason is for risk control, taking advantage of limited risk to help smooth the equity curve. Another, more subtle reason is to take advantage of the leverage to allow for participation in an infrequent trade opportunity without tying up capital during idle periods. For instance, let’s say you trade equities on a swing basis, but also use a strategy like we were using in the examples — a strategy that triggers once a month on average. Instead of keeping a large amount of cash on the sidelines waiting for the infrequent trade, you could decide ahead of time how much you were willing to lose when that trade came around and keep that amount of cash available instead to buy calls, and free up the rest for the swing trades.
We can’t leave without at least a brief discussion of ITM, ATM, or OTM options.
Deep ITM options are basically stock, although still affording some limited risk and reduced capital use. Far OTM options are often called lottery tickets, they are almost always 100% losers, and their payoff comes with an extremely large and immediate move (something like a takeover — hard to imagine a SPY takeover).
I’d suggest that options between 70 and 30 deltas are more what we are considering. I will point out that if an OTM call makes money, then so will an ATM or ITM. Likewise if an ATM call makes money, so will the ITM. The same cannot be said in reverse, if an ITM is profitable, the others may or may not be profitable. On the other hand, if an ITM call loses, so will the ATM and ITM; if an ATM call loses, so will the OTM. The reverse is not true, if an OTM is unprofitable, that doesn’t mean the ATM and ITM is also unprofitable. If the same number of contracts is being used, ITM clearly has the advantage, a higher chance of success, and a higher amount of profit if right, but a larger loss exposure. If different number of contracts are used (either based on deltas or option price), while it is possible for the OTM to have a higher amount of profit (on a very large move), the ITM will always have a higher chance of success and will always be profitable–if any are profitable.
Let’s review what has been presented throughout this series.
- We defined calls and puts, and identified the factors that go into determining an option’s price.
- We showed the relationship between stock, call, and put and showed how each can be expressed in terms of the others.
- We defined the Greeks, the language used to talk about and to measure the pricing factors.
- We identified three basic strategies to use options as a replacement for stock and graphically showed how the P&L developed through expiration.
- We then showed how the three strategies would have compared to using stock across three extremes of trades to get an idea of what to expect.
- We briefly explored the best and worse scenarios for each strategy.
- Finally, we talked about how using options for infrequent trades allows participation while freeing capital for trades that happen more often.
Maybe the most important point made was that options do not eliminate risk, they just redistribute it. If you buy calls for the downside protection, you give up some of the upside, and lose on sideways action. If you short puts for the premium, you cap the upside, get only limited protection to the downside, and gain if very little happens. If you put on bull spreads, you cap both the downside and the upside, and have less market exposure that takes longer to mature.
Whatever you choose to do, you should now have an idea of what to expect. It is fine to be disappointed or pleased with the outcome, but you shouldn’t be surprised.