THE OPTIONS COURSE- Basic Trading Strategies

THE OPTIONS COURSE


Basic Trading Strategies

Trading is a diverse activity that encompasses a wide variety of analysis techniques and innovative approaches. The optimal approach for you requires an assessment of both your time availability and your risk tolerance. Once these factors are determined, you’re ready to specialize in those techniques that fit your parameters. There are three fundamental approaches on which all trading strategies are based: strategic trades, long-term trades, and delta neutral trades. Each has its own set of conditions and rules that foster a unique trading style.

Strategic trades are typically short-term trading opportunities geared especially for day traders and short-term traders who have the opportunity to monitor the markets very closely each day. Strategic trades are specific to certain markets and may be driven by economic data or events. Many strategic traders use the Standard & Poor’s 500 as the key index on which they focus their attention when trading market-related instruments. The Dow Jones Industrial Average (the Dow) is also watched closely to tip off certain bond and currency trades. 

As a trader, you need to develop your own personal trading style based on the patterns you encounter in the markets. Consistently applying the use of a strategic trading approach fosters success. Long-term trading methodologies differ greatly from strategic trades. Long-term traders do not look at trades from a second-to-second perspective. Instead, they approach trades from the perspective of a couple of days to a few months, or even into the next year. These trades are based more on market trends and seasonal factors. 

They take a while to blossom and bear fruit, which gives the long-term trader more time to develop the art of patience. Delta neutral trades make up the third kind of trades, and probably the most complex. These strategies create hedged trades in which the overall position delta equals zero. As the market rises and falls, the overall position delta moves away from zero. Adjustments can then be made by purchasing or selling instruments in such a way as to bring the overall position delta back to zero. Each adjustment has profit-making potential.

Most delta neutral trades can be structured in such a way that your total cost and risk are minimized. Delta neutral trading strategies and longer-term trading opportunities are better suited for traders who are not able to sit in front of their computers all day watching the markets move. Successful delta neutral traders create a trading system with a time frame they feel comfortable working in. You can create trades that are three months out, two months out, one month out, or even only one day out. 

If you are the type of person who does not want to think about your trading every single day, simply take a longer-term approach. Delta neutral strategies can be applied to any market. It can be advantageous to learn to trade both stocks and futures. Even if you think you want to trade just futures, you can make just as much money trading stocks if you use delta neutral strategies. In either case, the options strategies outlined in this book can be applied using stocks or futures. As you read about them, think about the ones that make the most sense to you and then specialize in those strategies.

RISK PROFILES

Before launching into our discussion of specific strategies, let’s discuss one of the most important tools for viewing the profit and loss potential of any options strategy: the risk profile. Understanding and managing risk is the critical task of all traders. Very experienced traders and the mathematically adept may be able to intuitively understand what risk is being assumed by a given trade, but the rest of us work best with a visual picture of the risk we are taking. For that reason, the drawing and understanding of risk curves is an essential part of daily trading activities.

A risk profile is a graphic representation of the profit/loss of a position in relation to price changes in the underlying asset. The horizontal numbers at the bottom of the graph—from left to right—show the underlying stock prices. The vertical numbers from top to bottom show a trade’s potential profit and loss. The sloping graph line indicates the theoretical profit and loss of the position at expiration as it corresponds to the price of the underlying shares. The zero line on the chart shows the trade’s breakeven. By looking at any given market price, you can determine its corresponding profit or loss. 

Risk profiles enable traders to get a feel for the trade’s probability for making a profit. In order to get a better handle on what a risk curve is, let’s use a hypothetical example. The first thing to understand is that the risk graph depicts the value an option or an options position in relation to changes in the underlying asset’s price. As an example, let’s consider call options on Wal-Mart Stores (WMT). Here, WMT is the underlying asset. Assume shares of Wal-Mart are trading for $60 each and one January 70 call can be purchased for $2.50 (or $250 per contract). Therefore, the underlying as-set is Wal-Mart Stores and the option is the WMT January 70 call.

Table shows the risk and reward of holding the WMT January 70 call. The prices are hypothetical prices that might exist at expiration on the third Friday in January. Notice that if the stock doesn’t rise above $70 a share, the position loses $250 because the option expires worthless at or below $70 a share and yields no profit. If the stock climbs to $75, the options are worth $5 and the profit totals $250: [(75 – 70) – 2.50] × 100. At $80 a share, the profit equals $7.50 ($10 – $2.50). Notice that the position breaks even at $72.50 because $2.50 was the initial cost of the call when purchased.

Rather than creating a table for the risk/reward profile of the WMT January 70 call, we can create a risk graph. It plots the profit from the option (on the vertical axis) along with the price of the stock (along the horizontal axis). The potential profit from the call is plotted along the vertical axis. The lowest of the four lines on the graph considers the potential profit and loss of the WMT January 70 call at expiration and contains the same information as the table. Just as we saw on the table, the profits begin to accrue when WMT hits $72.50 a share.

TABLE  Risk/Reward Profile of WMT January 70 Call 


FIGURE  Standard Risk Graph for 1 Long WMT January 70 Call @ 2.50

The breakeven point (at expiration) occurs where the straight black diagonal line intersects with the zero profit line. The other lines reflect the risk/reward with a specific number of days (as shown in the upper left-hand corner) remaining before expiration. The position of the profit/loss lines at various time intervals is based on the model’s assumption that implied volatility remains constant. While this assumption doesn’t reflect reality, it must still be made in order to produce the chart.

You can also use other options pricing software or compute the graph manually. To actually draw the risk curve, your tools can be anything from a pencil and piece of graph paper to a computerized spreadsheet program such as Lotus 123 or Microsoft Excel. The steps will be the same. Drawing a risk curve for any trade, regardless of its complexity, consists of five basic steps:

1. Determine the stock prices for which you will have to calculate values of your trade at expiration.
2. Calculate the profit (or loss) at each of those points, and determine the breakeven level.
3. Sketch the two axes of your risk curve—the vertical axis will delineate the profit (or loss) of the trade, while the horizontal axis will depict the price of the underlying for which you have determined a profit or loss.
4. Actually plot the points that you calculated in step 2 onto the graph set up in step 3.
5. Draw lines connecting each point plotted in step 4.

This simple five-step process will permit you to calculate a risk curve (even without a computer), detailing the actual profit or loss that can be expected at any stock price upon expiration. Granted, you cannot estimate potential profit or loss prior to expiration, but a basic rule of thumb is that the profits will not be as high, nor the losses as great, at any time prior to expiration. If you don’t have a sophisticated risk-graphing program available, this process will give you the basic outline of what your trade will look like. 

As you gain experience and your trading becomes more refined, you will find yourself needing the power of the packaged programs. However, for the beginning trader, a simple risk curve at expiration like this one will help explain where profits can be made or lost. If you graph out the risk curve on every trade you are contemplating, the visual recognition of the risk will soon improve your trading in countless ways.

FIGURE  Wal-Mart January 70 Call Risk Curve 

FIGURE  Risk Graph Framework for 1 Long WMT 70 Call @ 2.50

Skill Builder

Now it’s your turn. Follow the five steps to see if you can manually create a risk graph for 1 Long WMT 70 Call @ 2.50. The complete risk graph can be found if you want to check your work.

           Breakeven                                   72.50
           Maximum loss                    –$250
           Price at maximum loss             70
           Profit @ 75                             $250
           Profit @ 80                            $750

LONG STOCK

While the term going long might have you envisioning a football player going deep for a pass, in the financial markets going long is one of the most common investing techniques. It consists of buying stock, futures, or options in anticipation of a rise in the market price (or, in the case of a long put, a drop in the price). An increase in the price of the stock obviously adds value to a stock holding. To close this long position, a trader would sell the stock at the current price. A profit is derived from the difference between the initial investment and the closing price. A long stock position is completely at the mercy of market direction to make a profit.

Long Stock Mechanics

In this example, the trader is long 100 shares of XYZ (currently trading at $50). Remember, shares of stock do not have premium or time decay. Long stock has a one-to-one risk/reward ratio. This means that for every point higher the shares move, you will make $100. Conversely, for every point the shares fall below the purchase price, you will lose $100.

Figure shows the risk profile of this long stock example. As you can see, when the share price rises, you make money; when it falls, you lose money. Notice how the profit/loss line for the stock position shows a 1-to-1 movement in price versus risk and reward. This means that the stock trade has an unlimited profit potential and limited risk as the price of the stock can fall only as far as zero.

FIGURE  Long 100 Shares XYZ @ 50

Exiting the Position

When you purchase a stock, the only way to exit the position (without exercising options) is to simply sell the shares at the current market price. If the price of the stock rises, the trader makes a profit; if the price falls, then a loss is incurred. Thus, if XYZ rises to 60, 100 shares will yield a profit of $1,000: (60 – 50) × 100 = $1,000. If XYZ declines to 40, 100 shares create a loss of $1,000: (50 – 40) × 100 = $1,000.

Long Stock Case Study

Buying, or going long, stock is the easiest and most straightforward trading strategy available. However, this doesn’t mean it is the best strategy to use. Going long stock consists of buying shares of a company outright and holding onto them as they (hopefully) gain in value. The positives to this strategy are that it is easy and figuring your profits and losses is straight forward. The stock can also be held forever, as long as the company remains a valid corporation and does not declare bankruptcy. 

However, the costs can be expensive, making it difficult to diversify. There are many different ideas on how to pick a good stock, depending on your time frame. Technical analysis is often used for short-term trading decisions, while fundamental analysis is the main discipline for buying stocks over the long term. As with any trading strategy, it still is a good idea to have exit points set up in advance so that you aren’t swayed by emotion.

A risk graph for a long stock trade is very easy to create, even by hand. It is a straight line, which shows that for every dollar gained in the security, you profit a dollar per share. The same holds true to the downside. It shows the dollar-for-dollar profit/loss that comes with this basic strategy. Let’s say we saw the Nasdaq 100 Trust (QQQ) break above resistance on May 1, 2004, and decided to buy 100 shares at $27.69.

This trade proved to be a good investment decision, with the Qs moving higher right into 2004. We might have held onto this trade until the Qs started a downtrend in early 2004. Let’s assume we got out at 36, when the Qs made a lower high and a lower low. By getting out at 36, we would have made $8.31 per share, or $831 overall. Not bad, but we had to invest $2,769 (or half this amount if we used margin)—a 30 percent return on investment. Of course, if the Qs had lost ground, we would have lost a dollar per share for each point the Qs fell.

FIGURE  Risk Graph of Long 100 Shares of Stock on QQQ

SHORT STOCK

Traders can take advantage of a falling market by selling, or shorting, shares of stock. Initially, this process can be quite confusing. After all, most investors want to buy a stock at a lower price and sell it for a profit at a higher price. Short selling reverses this process. With short sales, the trader actually sells the stock first and hopes that it will decline in value, so that it can be bought back at a lower price. The difference between the selling price and the purchase price represents the profit or loss.

In order to sell a stock short, traders must first borrow the shares from their broker. This is not always going to be possible and will depend on the specific stock and the brokerage firm. In some cases, it might not be possible to find the stock. This is especially true of less liquid or actively traded shares. Generally, a broker will look in one of four places for the shares to lend to the short seller. The most common source is from other customers who are long the stock in their margin accounts. Alternatively, the firm might look to one of three other places:

1. Its own inventory.
2. Securities borrowed from another brokerage firm.
3. Securities borrowed from institutional investors.

If the firm has exhausted these options and come up empty, the short seller will not be able to borrow and short that particular stock. Once the stock is sold, the trader will profit if the stock moves lower. Keep in mind, however, that if any dividends are paid by the stock, then the lender, not the short seller, is entitled to them. The person holding an open short position must pay the amount of the dividend to the lender. 

In addition, the margin requirements call for a 150 percent deposit of the net proceeds from the short sale. Also, importantly, the lender generally retains the right to demand that the stock be returned to him or her at any time. So, one risk to short selling is that the lender may demand that the shares be returned before the stock has made a move lower. Undoubtedly, short selling stock comes with a variety of risks.

Short Stock Mechanics

An investor believes that the price of XYZ is too high and expects the stock to move southward. It is currently trading for $20 share. So, she instructs her broker to sell short 1,000 shares of XYZ at $20. The brokerage firm then lends the investor the securities and they are sold in the market for $20. The total credit received from the short sale equals $20,000. Now the money is in the account, but the customer owes the brokerage firm the 1,000 shares. If XYZ falls, the trader can book a profit. For example, let’s say XYZ drops to $10 a share and the short seller instructs the broker to buy back 1,000 shares to close the position. 

The stock is purchased for $10 a share and the cost of the trade is $10,000 (plus commissions). She then returns the borrowed shares and closes the trade. The profit is equal to the difference between the purchase price and the selling price, or $10,000 (minus commissions). Suppose, though, XYZ appreciates to $30 a share and the trader decides that it’s time to cut her losses. In this case, she must buy XYZ back for $30 per share, or $30,000, and return the borrowed stock to her brokerage. The loss is equal to the purchase price minus the sale price, or $10,000 (plus commissions).


FIGURE  Short Stock Risk Graph

Exiting the Position

When you sell shares short, the only way to exit the position (without applying options) is to buy back the shares at the current market price. In order to do so, you must instruct your broker to close the trade or to “buy to cover.” Then, once the stock is purchased, the borrowed shares are moved out of the account and returned to the original owner.

Short Stock Case Study

Outside of trading options, there is only one method a trader has to make a profit during a downtrend in stocks: short selling stock. As previously discussed, going short is the process of borrowing shares from your broker and then replacing these shares at a future date when the stock has lost ground. If this occurs, a trader can profit on the decrease in price. However, shorting stock is extremely dangerous and cannot be done on all stocks and at all times. It’s vital to keep in mind that shorting stock requires a large amount of margin. 

This is because the risk is unlimited to the upside. If you borrow a stock from your broker at $50, expecting it to decline, but it instead moves higher, you are at risk the whole way up. If the stock hits $75, you have lost $25 for each share you are short. This means that a margin call would have occurred several times on this move up. A margin call is a Federal Reserve requirement that a customer deposit a specified amount of money or securities to keep a trade open when a sale or purchase is made in a margin account; the amount is expressed as a percentage of the  market value of the securities at the time of purchase. 

The deposit must be made within one payment period. Another negative to shorting stock is that it can only be done on stocks that have large volume. Also, a stock can not be shorted on a downtick. This means that if the market is falling hard and you want to short a stock, it can’t be done until the stock has traded at the same price or higher. Let’s take a look at the risk, which depicts going short 100 shares of the Nasdaq 100 Trust (QQQ) at $82.44 on November 6, 2000. 

The short sale of 100 shares produces a credit of $8,244. As you can see, the risk graph for a short stock is the exact opposite of a risk graph for a long stock. Although the trade profits dollar-for-dollar as the stock moves lower, it is also at risk dollar-for-dollar if the stock price increases. Keep in mind that your broker will require a rather large sum of capital to cover the margin requirement with the firm—usually 150 percent.

FIGURE  Risk Graph of Short 100 Shares of Nasdaq 100 Trust (QQQ) @ 82.44

Luckily, this trade proved to be a good investment decision, with the Qs moving lower and then sharply lower. If a trader had stayed short until the 200-day moving average was broken near 40, he or she would have made a significant profit. The Qs fell that year from 82.44 to 40 in about a 12-month period, which would have created a healthy profit for the savvy short seller!

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