Today’s Trading Lesson From TradingMarkes

  • June 30, 2005
  • TradingMarkets Editors



Editor’s Note:

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.

Brice

The Beauty Of Combinational Strategies


By Len Yates

I have written about all the main option strategies. And many of
those articles have been about combinational strategies — trades involving two
or more options simultaneously.

The
reason I’ve sought to bring your attention to the various strategies is to show
how each strategy is such a unique tool. Much like hydrogen and oxygen combine
to form a unique substance (water), putting options together into various
combinations results in some amazingly unique risk/reward profiles.

For
example, the sale of a naked at-the-money option is a very risky strategy. And
the purchase of an out-of-the-money option is costly and has a poor probability
of success. However, do both of these trades together and (provided the two
options are of the same type and in the same expiration month) you form a credit
spread — one of the safest and most successful strategies there is.

For
another example, buy an at-the-money call or a put, and the chances are good
that you will lose all your money (stops notwithstanding). However, buy a
straddle (both a call and a put at the same strike price and expiration month)
and the possibility of losing all your money is practically nil (the underlying
would have to finish precisely on the strike price).

“Since no particular
strategy is good to use at all times, the trader needs to be able to apply
the best strategy in any given situation. This requires familiarity with the
various strategies and how they perform.”

Note
that no strategy automatically makes money. I once thought that there might be a
magical combination that would usually produce positive returns. Then I realized
that since each (fairly valued) option is a net zero expected return item, no
matter how many of them you put together, you still have a net zero expected
return.

Any
combination of fairly valued options is a fairly valued combination. And by
definition, “fair valued” means there is no advantage to the buyer nor to the
seller. So to make money, either your model must say that options are currently
mispriced (which happens pretty often), or you have a directional prediction
that comes true. Note that your directional prediction might be complicated. For
example, “The stock will either break out strongly to the upside or drift
lower”. (Can you remember the best strategy for this kind of prediction?  That’s
right, a

call backspread.)

Since no
particular strategy is good to use at all times, the trader needs to be able to
apply the best strategy in any given situation. This requires familiarity with
the various strategies and how they perform. Tables and diagrams have been
constructed to show which option strategies are bullish, bearish, aggressive,
moderate, or neutral. Such tables and diagrams are somewhat useful, but often
fail to take into account all three primary considerations: price direction,
time frame, and volatility. Another difficulty is the fact that many strategies
overlap with other strategies in their applicability.

So a
feel for how the various strategies perform is best gained through experience,
and may be accelerated by the use of software that can simulate the performance
of any given strategy in all three dimensions (price direction, time frame and
volatility).

By the way, when I say options
are mispriced fairly often, I am mostly referring to the concept that all the
options of a given asset are sometimes priced too expensive, or too cheap — not
so much to the idea that one individual option is mispriced. It is rare that one
individual option is mispriced, and if it happens, it would probably be so
short-lived that you would never catch it.
 

However,
it is easy to find situations when all the options of an asset are collectively
expensive or cheap. Buying cheap options and/or selling expensive options is
called “volatility trading,” and I have written much about this reliable
approach to options trading. This approach requires sophisticated tools, and
naturally I recommend that all options traders use software to assist them in
decision-making and record-keeping.

Many people who know about
options but are not truly familiar with them, believe that options are
inherently risky. While options allow you, and even tempt you, to take
speculative risk, it is not true that options are inherently risky. Options are
enormously flexible in the ways you can use them, not only to speculate, but
also to hedge or even simulate a portfolio, and through combinational
strategies, to construct a position that closely fits your goals, price
predictions, time frame, and the current volatility environment.
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