THE OPTIONS COURSE- STRATEGY ROAD MAPS

THE OPTIONS COURSE





STRATEGY ROAD MAPS

Long Butterfly Spread Road Map

In order to place a long butterfly spread, the following 14 guidelines should be observed:

1. Look for a sideways-moving market that is expected to remain within the breakeven points.

2. Check to see if this stock has options available.

3. Review options premiums per expiration dates and strike prices. Make sure you have enough option premium to make the trade worth-while, especially considering the commission fees of a multicontract spread.

4. Investigate implied volatility values to see if the options are overpriced or undervalued.

5. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

6. A long butterfly is composed of all calls or all puts with the same expiration. Buy a lower strike option (at the support level), sell two higher strike options (at the equilibrium point), and buy one even higher option (at the resistance level).

7. Look at options with 45 days or less until expiration.

8. Determine the best possible spread to place by calculating:

• Limited Risk: Limited to the net debit paid on the options.
• Limited Reward: Difference between highest strike and the short strike minus the net debit. Maximum profit is realized when the stock price equals the short strike.
• Upside Breakeven: Highest strike price – net debit paid.
• Downside Breakeven: Lowest strike price + net debit paid.
• Return on Investment: Reward/risk ratio.

9. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. The risk curve of a long butterfly shows a limited reward inside the breakevens and limited risk outside the breakevens.

10. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. Make an exit plan before you place the trade. For example, if the stock begins to move outside the breakevens, consider cutting your losses. You want the stock price to stay within a range so that you get to keep most or all of the credit.

12. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net debit of the trade.

13. Watch the market closely as it fluctuates. The profit on this strategy is limited—a loss occurs if the underlying stock closes outside the breakeven points.

14. Choose an exit strategy based on the price movement of the underlying stock:

• XYZ falls below the downside breakeven: Let your position expire worthless. The cost for this trade will be the net premium paid (plus commissions).
• XYZ falls within the downside and upside breakevens: This is the range of profitability. Ideally you want to sell the long options and let the short options expire worthless. The maximum profit occurs when the underlying stock is equal to the short strike price.
• XYZ rises above the upside breakeven: Either exit the trade or if you are assigned the short options, exercise your long options to counter.

Long Condor Spread Road Map

In order to place a long condor spread, the following 14 guidelines should be observed:

1. Look for a sideways-moving market that is expected to remain within the breakeven points.

2. Check to see if this stock has options available.

3. Review options premiums per expiration dates and strike prices. Make sure you have enough option premium to make the trade worthwhile, especially considering the commission fees of a multicontract spread.

4. Investigate implied volatility values to see if the options are overpriced or undervalued.

5. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

6. A long condor is composed of all calls or all puts with the same expiration. Buy a lower strike option (at the support level), sell one higher strike option, sell a higher strike option, and buy one even higher option (at the resistance level).

7. Look at options with 45 days or less until expiration.

8. Determine the best possible spread to place by calculating:

• Limited Risk: Limited to the net debit when the position is placed.
• Limited Reward: Difference in strike prices minus the net debit × 100. The profit range is between the breakevens.
• Upside Breakeven: Highest strike price – net debit paid.
• Downside Breakeven: Lowest strike price + net debit paid.
• Return on Investment: Reward/risk ratio.

9. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. The risk curve of a long condor is similar to the long iron butterfly; the limited profit zone exists between the breakevens and the limited risk occurs outside of the breakevens.

10. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. Make an exit plan before you place the trade. For example, if the stock begins to move outside the breakevens, consider cutting your losses. You want the stock price to stay within a range so that you get to keep most or all of the credit.

12. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net debit of the trade.

13. Watch the market closely as it fluctuates. The profit on this strategy is limited—a loss occurs if the underlying stock closes outside the breakeven points.

14. Choose an exit strategy based on the price movement of the underlying stock:

• XYZ falls below the downside breakeven: This is in the maximum risk range. Let the options expire worthless.
• XYZ falls within the downside and upside breakevens: This is your profit zone with maximum profit being at the short strikes.
• XYZ rises above the upside breakeven: You will need to close out the position to ensure you are not assigned.

Long Iron Butterfly Spread Road Map

In order to place a long iron butterfly spread, the following 14 guidelines should be observed:

1. Look for a sideways-moving market that is expected to remain within the breakeven points.

2. Check to see if this stock has options available.

3. Review options premiums per expiration dates and strike prices. Make sure you have enough option premium to make the trade worthwhile, especially considering the commission fees of a multicontract spread.

4. Investigate implied volatility values to see if the options are overpriced or undervalued.

5. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

6. A long iron butterfly is composed of four options with the same expiration. Buy one higher strike OTM call (at the resistance level), sell one ATM lower strike call, sell one slightly OTM lower strike put, and buy one even lower strike put (at the support level).

7. Look at options with 45 days or less until expiration.

8. Determine the best possible spread to place by calculating:

• Limited Risk: The difference in strikes minus the net credit received for placing the position. This is usually a small value and is the reason why this trade is attractive. Realize that commissions are not calculated in this example and can really eat into the profits.
• Limited Reward: Net credit received on placing the position. The profit range occurs between the breakevens.
• Upside Breakeven: Middle short call strike price + net credit.
• Downside Breakeven: Middle short put strike price – net credit.
• Return on Investment: Reward/risk ratio.

9. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. A risk graph for a long iron butterfly is very similar to the risk curve of a long butterfly, once again showing a limited reward inside of the breakevens and a limited
risk outside the breakevens.

10. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. Make an exit plan before you place the trade. For example, if the stock begins to move outside the breakevens, consider cutting your losses. You want the stock to stay within a range so that you get to keep most or all of the credit.

12. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net debit of the trade.

13. Watch the market closely as it fluctuates. The profit on this strategy is limited—a loss occurs if the underlying stock closes outside the breakeven points.

14. Choose an exit strategy based on the price movement of the underlying stock:

• XYZ falls below the downside breakeven: You should exit the trade to make sure you are not assigned the put side of your position. The calls can expire worthless. You’re in the maximum risk range.
• XYZ falls within the downside and upside breakevens: This is the profit range and ideally the position expires near the short strike prices.
• XYZ rises above the upside breakeven: Similar to the lower breakeven, you should exit the trade to make sure you are not assigned the call side of your position. The put options can expire worthless.

Calendar Spread Road Map

In order to place a calendar spread, the following 14 guidelines should be observed:

1. Look for a market that has been range-trading for at least three months and is expected to remain within a range for an extended period of time. A dramatic move by the underlying shares in either direction could unbalance the spread, causing it to widen.

2. Check to see if this stock has options available.

3. Review options premiums per expiration dates and strike prices.

4. Investigate implied volatility to look for a time volatility skew where short-term options have a higher volatility (causing you to receive higher premiums) than the longer-term options (the ones you will purchase).

5. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

6. A calendar spread can be bullish or bearish in bias.

• A slightly bullish calendar spread employs an ATM long call with a distant expiration date and an ATM short call with a closer expiration date.
• A slightly bearish calendar spread combines an ATM long put with a distant expiration date and an ATM short put with a closer expiration date.

7. Look at a variety of options with at least 90 days until expiration for the long option and less than 45 days for the short option.

8. Determine the best possible spread to place by calculating:

• Limited Risk: Limited to the net debit when the position is placed. If you replay the long leg, then your limited risk continues to decrease because you take in additional credit for replaying this strategy.
• Limited Reward: Use options software for calculation. The reward is limited but the exact maximum potential varies based on several factors including volatility, expiration months, and stock prices.
• Breakevens: Since this is a more complex trade you must have an options software package available to calculate your maximum risk, breakevens, and your return on investment.

9. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. A calendar spread has limited risk and limited reward. Since it is a complicated strategy, a computerized risk graph is necessary to determine the needed variables of maximum profit and breakevens.

10. Write the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. Make an exit plan before establishing a calendar spread. If the stock makes a dramatic move in the wrong direction, consider cutting your losses rather than hoping for a turnaround. If the stock goes through the short option’s strike price sooner than expected, close the trade to avoid assignment. Ideally, the stock will make a gradual move in the appropriate direction and the short option will expire worthless. Then another short option can be sold against the long option or the trade can be closed for a profit.

12. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net debit of the trade.

13. Watch the market closely as it fluctuates. The profit on this strategy is limited—a loss occurs if the underlying stock makes a dramatic move higher or lower.

14. Choose an exit strategy based on the price movement of the underlying stock and the effects of changes in implied volatility on the prices of the options.

For a bearish calendar spread:

• The underlying stock falls sharply to the downside: Both puts would increase in value one-for-one so they would offset each other. The most you would lose is the net debit.
• The underlying stock stays within a trading range: If the shares fall within the desired range, you will make a profit. The largest profit potential occurs if the shares expire at the ATM strike price. You can then sell another short-term put option.
• The underlying stock makes a significant move higher: Both puts would expire worthless and you would lose the premium paid.

For a bullish calendar spread:

• The underlying stock makes a significant move to the downside: You are in the maximum risk range. Exit the position for the loss on the short call and hold the long call in case of a reversal.
• The underlying stock stays within the desired trading range: If the stock falls within a range as expected, you will make a profit. The largest profit potential occurs if the shares expire at the ATM strike price.
• The underlying stock rises above the desired trading range: Your short call is in-the-money and possibly subject to assignment. Close the trade by purchasing the short-term call.

Diagonal Spread Road Map

In order to place a diagonal spread, the following 14 guidelines should be observed:

1. Look for a market that has been range-bound for at least three months and is expected to remain within a range or move modestly higher or lower over an extended period of time. A dramatic move by the underlying shares in either direction could unbalance the spread, causing it to widen.

2. Check to see whether this stock has options available.

3. Review the option premiums for different expiration dates and strike prices.

4. Investigate implied volatility to look for short-term options with a higher volatility (causing you to receive higher premiums) than the longer-term options (the ones you will purchase). Unlike the calendar spread, look for different strike prices between the long-term option and the short-term option.

5. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

6. A diagonal spread can be bullish or bearish in bias.

• A bullish diagonal spread employs a long call with a distant expiration and a lower strike price, along with a short call with a closer expiration date and higher strike price.
• A bearish diagonal spread combines a long put with a distant expiration date and a higher strike price along with a short put with a closer expiration date and lower strike price.

7. Look at a variety of options with at least 90 days until expiration for the long option and less than 45 days for the short option.

8. Determine the best possible spread to place. To do this, look at:

• Limited Risk: Limited to the net debit when the position is placed. If you sell more than one short option then your limited risk continues to decrease because you take in additional credit for replaying this strategy.
• Limited Reward: Use software for calculation. The reward is limited but the exact maximum potential varies based on several factors including volatility, expiration months, and stock price.
• Breakevens and Return on Investment: Since this is a more complex trade you should have a software package available to calculate your maximum risk, breakevens, and return on investment.

9. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. A diagonal spread has limited risk and limited reward. It is a more complicated strategy, so a computerized risk graph is required to determine the maximum profit and breakevens.

10. Write the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. In most cases, the srategist wants to see the underlying asset make a gradual move higher or lower when using the diagonal spread. If the stock makes a dramatic move in the wrong direction, consider cutting losses rather than hoping for a reversal. If the stock goes through the short option’s strike price sooner than expected, close the trade to avoid assignment. Ideally, the stock will make a gradual move in the appropriate direction and another short option can be sold against the long option or the trade can be closed at a profit.

12. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net debit of the trade.

13. Watch the market closely as it fluctuates. The profit on this strategy is limited—a loss occurs if the underlying stock moves too far in one direction or the other.

14. Choose an exit strategy based on the price movement of the underlying stock and the effects of changes in implied volatility on the prices of the options.

For a bearish diagonal spread:

• The underlying stock falls below the lower strike: Both puts will increase in value and offset each other. The most you would lose is the premium. Avoid assignment by closing the trade.
• The underlying stock falls between the two strike prices: If the shares fall within this range, you will make a profit. The largest profit occurs if the shares fall to the lower strike price (but not below) and the short put expires worthless. At that point, the long put will still have intrinsic and time value. Close the position, or sell another short-term put. Check the implied volatility first.
• The underlying stock rises above the higher strike: Both puts could expire worthless and you would lose the premium paid. For a bullish diagonal spread:
• The underlying stock falls below the short strike: You are in the maximum risk range. Exit the position for the loss.
• The underlying stock falls between the two strike prices: If the shares trade at the higher of the two strikes at expiration, then the maximum profit is attained. In that case, the long call retains most of its value, but the short-term option expires worthless. At that point, the position should be closed or another call can be sold.
• The underlying stock rises above the higher strike: You are at risk of assignment on the short call. Close the trade for a loss.

Collar Spread Road Map

In order to place a collar spread, the following 13 guidelines should be observed:

1. A collar is utilized to protect a stock holding against market declines for a specific period of time and still participate in a modest increase in the stock price.

2. Check to see if this stock has options.

3. Review out-of-the-money LEAPS call and at-the-money LEAPS put premiums at various strike prices.

4. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

5. Investigate implied volatility values to see if the options are overpriced or undervalued.

6. This strategy is created by purchasing an ATM put and selling an OTM call against 100 shares of stock. The idea is to provide protection for the long shares and to offset the cost of the put with the premium from the short call.

7. Determine the best possible trade to place. To do this, calculate the following:

• Limited Risk: [(Initial stock price – put strike price) + net debit (or – net credit)]  100.
• Limited Profit: [(Call strike price – initial stock price) – net debit (or + net credit)]  100.
• Breakeven: Initial stock price + [(put premium – call premium) ÷ total number of shares (100)].

8. Risk is limited to the downside by the long put. Upside reward is also limited by the short call. Create a risk profile for the trade to graphically determine the trade’s feasibility.

9. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

10. The collar is known as a vacation trade. It is designed to provide low-cost protection when the strategist expects a gradual move in the underlying asset. If the stock trades sideways, do nothing and let the options expire or roll out to a more distant expiration month. If the stock makes a considerable move lower and is trading below the put strike price at expiration, exercise the put option and sell the stock at the strike price. If it makes a sharp move higher, do nothing and the call option will be assigned. To avoid assignment, buy back the call to close.

11. Contact your broker to buy the put and sell the call. Choose the most appropriate type of order (market order, limit order, etc.).

12. Watch the market closely as it fluctuates. The profit and loss on this strategy is limited.

13. Choose an exit strategy based on price movement of the underlying stock and the effects of changes in implied volatility on option prices.

• The underlying stock falls below the put strike price: Do nothing. The shares are covered by the long put. If you exercise the put and sell the stock, also sell the call to close because it is no longer covered once the stock is sold. If you hold the short call without owning the stock, you are naked a call and are exposed to unlimited risk to the upside.
• The underlying stock rises above the short call strike price: Do nothing. If the calls are assigned to an option holder, when exercised the shares will have to be delivered to the option holder to fulfill the obligation that comes with the short call. Hold the put and let it expire worthless or try to sell it for any remaining value.
• The underlying stock closes at the initial stock price: Call and put expire worthless. Sell the stock or create a new collar.

CONCLUSION

When trading stocks, we can profit in two kinds of markets: when stocks move up or when they move down. However, with options, we can also profit in sideways-trading markets that occur quite often.  Just take a look at a long-term chart of a stock or index and notice how many times they see little net movement over time. Instead of sitting out during times of consolidation, you may want to look at sideways-trading strategies like calendar and diagonal spreads, butterflies and condors, and collars. These strategies take advantage of sideways trading in different ways, with each having its place. Regardless of the market environment, there are always numerous stocks trading in a channel. 

These are quickly recognized when viewing charts, as they have distinct support and resistance points. We can also use ascending or descending channels by extrapolating where the stock will be by expiration. However, we have a dilemma when looking for good butterfly and condor candidates. This dilemma develops because we want high IV to get a better entry price, but IV is normally low on stocks in a trading range. However, when a stock is making numerous sharp moves within its channel, we can get a high IV reading even though a trading range has developed. A drop in IV helps our trade, so we would like to use options that are showing relatively high IV, which is expected to drop. 

One way to find these trades is to look at a list of the largest declining stocks during a trading session. When a stock drops dramatically in one or two sessions, it often enters a consolidation phase. This is the best of both worlds: First we have a stock that has had a spike in its options’ IV, but IV should fall sharply as the stock consolidates. Another way to find candidates for this strategy is to get a list of high-IV stocks and look at their charts. The easiest chart pattern to see is a stock in a trading range. By eyeballing dozens of stocks that have high-IV options, we can often find great candidates to use for a butterfly strategy. 

When looking at a chart with moving average convergence/divergence (MACD), look for a MACD pattern that is moving sideways near the zero line. This is also a sign of a consolidating stock. As with any strategy, there are ways to make a butterfly more profitable, albeit with higher risk. The one thing to remember when trading a butterfly is that it is hard to make a profit until expiration or near it. Thus, be aware when entering long-term butterfly trades that it will be tough to see a profit in the short term. Nonetheless, a butterfly spread is an excellent strategy for making a profit in a sideways-trading market, but make sure you understand the risks and are willing to accept the possible consequences if the stock does not stay within your channel.

These versatile spreads can be constructed using calls or puts. I usually base my selections by calculating the best possible reward-to-risk ratios. To accurately assess the situation, you have to be willing to do the calculations. The same holds true for collars. I look for the right market by scanning charts until I locate one with strong support and resistance levels. Collars, or hedge wrappers, can be used either to hedge a stock you already own or to enter a new strategy, looking to profit from the move of an underlying security. The strategy consists of buying actual stock (we’ll assume 100 shares), buying a put, and selling a call. This combines the effects of a covered call with a protective put kicker. Depending on what strikes a trader uses, a collar can be neutral, bearish, or bullish. 

When I see a market with strong support and resistance levels, I take a ruler and draw the lines before choosing which options to buy and sell. In many cases, I am willing to accept a lower profit potential for an expanded profit zone. Although you can calculate these risk/reward scenarios by hand, a good options analysis program is worth the investment. It will save you a great deal of time and avoid costly errors. Besides, one good trade could certainly pay for the software. These strategies can be exited by simply doing the opposite of the original trade. If you bought options, you sell them; and if you sold options, you buy them back. If you are exiting at expiration, then you can let the short options that are worthless simply expire. 

If any of the short options have value, you can buy them back for a profit. Try to limit your commissions when you are placing and exiting these trades, as commissions can be a big part of the cost of trading. Trading sideways markets can be a very conservative specialty. If you decide to trade markets that have established strong support and resistance levels, never forget that markets can change erratically. Always be vigilant to the changing nature of the markets you are trading. If the market starts to move above the option strikes you purchased, make a bullish adjustment. If the market appears to be making a real move downward, make a bearish adjustment. Learning to be flexible in your trading approach will lead to longer-term success.

Share:

No comments:

Post a Comment