Trading Options
It is important to grasp the foundation of options logic past the basic miser of “what is a call” or “what is a put.” This blog post lists some of the topics I believe are crucial to an options traders understanding and development.
With options, we can trade every type of price action; directional trades for a large move in the market, non-directional trades for a ranged market, earnings trades, “mechanical” trades, hedging, and investing (through the use of options for stock accumulation and stock distribution).
Do we need to grasp all these topics to be a consistently profitable trader? No! But, the more understanding we have about options the more choices we have; options provide exposure to risk on a sliding scale that provides every level of trader and every account size an opportunity to participate.
Non Directional Options Trading
Non directional options trading focuses on the ability to profit from factors other than price action – the market does not need to make a move for the trade to be successful. The price of an option is effected by three aspects: price action of the underlying market, by Theta decay and from changes in Implied Volatility. Non-directional trade strategies are designed to profit from Theta decay or from changes in volatility rather than from a move in price.
To become an options trader with a bias towards non-directional options trading logic, there has to be an understanding of the “moneyness” that an options spread offers; a trader must have the ability to articulate and define what the trade is attempting to accomplish while also manage the risk within that trade through common trade management conditions.
- Understanding the logic of probability and statistical trading
- Constructing and Buying verticals with probability logic
- Constructing and Selling verticals with probability logic
- Broken Wing Butterfly (BWB) development and analysis
- Ratio Backspreads (a vertical with an additional option)
- Ratio Butterfly (a butterfly with a vertical added)
- Building / Analyzing / Trading complex spreads
Analysis Tab
The analysis tab (or a risk graph if using a broker other than ThinkOrSwim) is where a trader can evaluate the option trade constructed and visually inspect the shape of the profile, the risk and reward of the trade, the probability of touching, the breakeven, and so much more.
Common options trades have common risk profiles that become a staple and a consistent image to an options trader as they settle into a consistent pattern of trading. While a professional options trader may not have a need to constantly evaluate each position – professionals and beginner options traders will benefit greatly from an understanding of what the risk profile has to offer.
- Trade Comparison
- Day Step
- Volatility Step
- Think-Back
- Plotting the analysis onto a chart
- Beta Weight
Options Pricing
Recognizing “fair” options prices really has to start with an understanding of intrinsic value, the bid / ask spread, and the reasoning behind the current options value. To better manage an options position we need to grasp what the trade “could be” and what the trade “should be” versus what the trade actually is right now.
Nothing on the market to date offers insight towards the future price of an option or an options spread before expiration; we can measure where it “could go” and we can compare that with options prices at the destination location but extrinsic value comes from a variety of sources that are beyond anticipatory measurements (such as the aggressiveness of the traders – if they are hitting “above the ask” (AA) or “below the bid” (BB) then this can drastically alter the cost of the option far beyond its value).
- Recognizing “fair market value”
- Collecting enough credit for the current risk
- 1:1 Risk Reward Ratio and probability
- Development of the choice selection
- Skew Evaluation
Weekly Mechanical Options Trading
In late 2019 I was discussing DOW theory and market logic with a group of traders who argued that such “simplistic” logic like DOW theory is false or mis-leading and this discussion prompted me to develop mechanical options trades. My intention was to prove that trading in the indexes does not have to be complex and that DOW theory is still true in our modern world.
The DOW theory we were discussing was simple: the market indexes go up; that is their default behavior when there are no external forces pushing it down. These “external forces” can be interest rates, negative news, a mega-market cap company with bad earnings, or other extraneous forces.
To prove the logic, I developed various mechanical strategies that would be activated without user input (mechanical) and would be “long options” positions. (I had no idea that COVID would hit the world in late Feb 2020 but I had already committed money and trades to the mechanical system and did not want to abandon the strategies). The results were impressive and profitable but the learning behind the entire operation was even more impressive; I gained so much insight and understanding about the impact of volatility within our trading systems and how our own internal bias can cause us to make well intentioned mistakes.
- Weekly Expected Move Trading Strategies
- Puts / Calls
- Iron Condors
- Back Ratio Plays
- Credit Fades
- Butterfly and Double Butterfly
Mechanical Hedge Trading
Hedging is a concept or logic to trading that seems to confound traders of all skill levels; “mechanical” hedging was developed to consistently protect the portfolio from excessive positioning. The logic is simple; maintain protection or “insurance” at all times to avoid disaster.
Dealer Gamma Heading is another tangent within the hedging space; we will cover these topics more to provide depth and background in the process.
- Risk Twist Spread
- VIX Volatility Spreads
- Back Ratio
- Unbalanced Butterfly
Earnings Play
Every new options trader gets “pulled” into the promise of a drastic earnings report; every quarter there is a blow-out trade that sucks in new traders with a promise of making extra ordinary profits from a relatively minor position (when looking at the risk versus the reward).
But in the “real world” where reality is painful, new “earnings traders” find out that the siren song of “easy wins” and big returns from playing an earnings report is tainted with losses; without a statistical edge behind the trade logic, any approach to trading earnings is likely to produce only consistent losses.
There are earnings trades that provide edge; this is important to understand. We can trade earnings with an expectation of profit commiserate with our risks but to achieve this we need to grasp the finer points of options Greeks impact and the “real” distance of the expected move (EM). There is also the “pre-earnings” and “post earnings” plays that provide additional opportunities.
- Iron Condor
- Calendars
- “Best Practices” – Do’s & Don’t of Earning Plays
- “After Earnings” trades
Market Bias
On their own, options can give you access to the market without any concern for the chart. In the right market, the price does not matter at all. But, not all options trades can be traded that way. Understanding when to apply iron condors or when to take a debit rather than a credit or understanding when to buy a call option rather than sell a put option can be all the difference between winning or losing a trade.
If you have skills recognizing the direction of the market, you want to maximize that skill and trade options with that edge in your favor. If you are a newer trader & you lack the ability to determine market direction, then an options trade that leans on probability may be a better choice for you. Every type of trader can take advantage of options trading to increase their exposure to the market – so instead of learning options with a focus on “some new thing” you could look at options as an enhancement to your current trading strategy.
Portfolio
If you have already been trading and own stock- options trades can be a great way to protect that investment. This type of options trading is a good place to start – and a way to transition into options trading. A lot of people start a career in options trading by working on their portfolio. “Covered Calls” are useful when your stock is just not moving all that much and “Covered Puts” are a great way of targeting a stock price you would like to buy into. Beta Weight analysis used with investment enhancement can help a lagging company stock generate income – between the dividends and the selling of calls, you can use those “stalled” stocks to bring in residual income.
Unusual Options Activity
Unusual Options Activity (UOA) focuses on options flow and seeks to take advantage of the opportunity identified; there are a number of directions that UOA trade logic can take us; from short duration scalping against a single strike to a longer duration trade based on identifying a large institution building a position.
UOA trading is a very popular trade concept but it is really new to the options world (considering that standard options as we know them today began in the 70’s) and is little understood by most traders in the options community. We have a LOT of ground to cover for UOA trading but depending on your trading style and personality, this path is a consistently profitable one.
One thing about UOA trading that I do not like is the lack of UOA tools on most brokers; options flow data is costly enough, having a platform that can analyze that data and provide inside or direction is an even more costly program or application; if you are looking to become a UOA trader you will want to consider investing in an application that offers community, educational resources, and review of past trades for examples.
GEX
Options Gamma Flow analysis is a modern concept that came with our ability to gather and transmit data and our ability to parse that data with various programs. As options traders, we can utilize GEX for day trading and swing trading; for index analysis and market structure; when we narrow the whole of options data down to its core components we can maintain a narrative of the money flow by the institutions
Options Coaching
The topics listed above are a small example of the options trading material that is covered at the OEC Coaching Service. There are specific trades and specific strategies and specific trade logic – then there is just plain options education. No matter what type of options trader you are (or want to be) you can do any of these once you understand options and how they work. You do not need to have a full grasp of every part of options before trading them – you need to understand how to apply every part.
From Earnings plays to Insurance on a portfolio – from income trading to intraday scalping – there is something for everyone in the options market place. Your Playbook is like a tool-box, offering you the equipment needed. The more plays you have – the more choices you have.
