Twenty-five hundred years ago, General Sun Tzu, a famous general and military strategist in China, wrote a book he called The Art Of War. After many years winning battles, he summed up wisdom such as :
- "No long war ever profited any country."
- "100 victories in 100 battles is simply ridiculous."
- "A wise general responds quickly to changing circumstances."
- "By thinking, assessing and comparing points, a commander can calculate his chances of victory."
As a wise man, Sun Tzu emphasized the importance of having a method for success. You must do things in a systematic and organized way. You must also be consistent, following your method relentlessly. Most unsuccessful traders, naturally, do not have a trading system. They cannot tell you what works best. Sun Tzu did not expect to win every battle, but to win the decisive ones.
There is no perfect trading system, of course, but if yours works 80% of the time, you are doing very well. If your win/loss ratio is 50/50 or worse, then you do not have a successful method. If you don't even keep track of wins and losses, then it is just a game to you.
For Sun Tzu, the most important trait in his commanders was recognizing strategic opportunities. The key to success in warfare was to have the right strategy for the current conditions: sometimes you surround your enemy, sometimes you divide them, sometimes you siege a city, sometimes you retreat.
What is strategy?
The Dictionary says, it is "a plan of action or policy designed to achieve a major or overall aim." The synonyms are "master plan, grand design, game plan, plan (of action), action plan, policy, program." Taken from military language, it means "the art of planning and directing overall military operations and movements in a war or battle."
People who lack strategy end up making many irrational decisions and are doomed to failure from the start. If you don't plan, then are subject to the emotions of fear and greed. When the market goes up, you will start buying just when the market is about to drop. Similarly, fear of loss causes many traders to sell at the bottom of a market move--just when they should be buying! Your emotions are not a good trading guide!
Two Basic Types of Strategies
1. Directional
As we recently discussed, a major purpose in reading charts is to determine trend or direction. If the recent history of a stock shows a clear trend, either bullish or bearish, we trade with the trend and choose option plays that take advantage of that trend.
If I am LONG the position, I want the option to increase in value. If I am SHORT the position, I want the option value to decrease. So if I expect the stock to go up, I could buy a long Call, place a covered Call, or use Bull Put Spreads. Here are some directional strategies
Bullish--Long Calls, Covered Calls, Bull Put Spreads (credit), Bull Call Spreads (debit)
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Bearish--Long Puts, Covered Puts, Bear Call Spreads (credit), Bear Put Spreads (debit)
Consult The Bible of Options Strategies for full descriptions of these strategies.
In trading options, remember that what is good for one position will be bad for its opposite. What is good for Puts is always bad for Calls, and vice-versa. If Puts decrease in value as the market goes up, then Puts increase in value as the market goes down. But there are many other examples: If buying Calls is bad, because of time decay, then selling them must be good. If the stock price moving away from my long Put or Call is good, then moving toward them is bad. There are many examples. You should also think through the effect of various actions on your position by looking at the charts.
Long Puts and Long Calls
If you expect a stock to go up, then you buy Calls. If you expect a stock to go down, you buy Puts. These simple facts rule whenever a speculator locks in the price of stock for purchase in the future (using Calls) or a retiree buys a Put to protect the value of her 401(k). The profit or protection could be unlimited, and the risk of loss is limited to the cost of the option (plus commissions). The art of strategy, then, is knowing which strike to buy, how much money to spend.
Credit Spreads
One of the most popular trades is the credit spread. In this trade, you receive money and assume the risk of loss. It works by selling one strike and buying another for a net credit. Your brokerage also put a "hold" on any potential loss in the trade. Money comes into your account but the amount available to trade is reduced by the amount of potential loss. More on this below.
Here is a chart of AAPL [click to enlarge] showing two Bull Put Spreads we placed after the stock gapped up (green blocks). Red lines represents the short or sold put, and green lines represents the long or insurance Put. (These colors match the thinkorswim pink and green orders.) As AAPL price moved up, it moved away from the sold strikes, making them less valuable. For sellers of premium, this results in net profit because we buy back what we sold at a cheaper price. If the options worthless, then you simply keep the profit and do it again. This is directional strategy because it works when the price moves in one direction--away from the price.
The Covered Call
A favorite of stock holders, the CC consists of a short call held alongside 100 shares of stock. The strategy usually consist of selling a Call at or above the current price. This strategy enables the stock holder to receive additional premium while holding the stock. If the stock value is at or above the short Call when it expires, the stock will be called away (or sold) at the sold strike. If the stock price is below the sold strike, the Call seller simply keeps the premium and Sells another Call. This is directional strategy because it works when the price moves up or sideways.
This trade is directional, and works best when market is inching up. Many people simply trade this strategy and collect about 4% per month on large stock portfolios. Its an art worth learning, and will pay well your investment in time and study.
See the chapter on Covered Calls in The Bible of Options Strategies.
MORE EXAMPLES
- You are bullish on AMZN and expect the price to go up. Current price is $950. You can buy Call options, or sell Put options.
- You are bearish on TSLA. You expect the price to drop over the next few weeks. You can buy a Put, or sell a Call Spread.
- You are moderately bullish on AAPL, expecting it to go up from 105 to about 110 but no higher. You buy an AAPL 105 Call and sell the 115 Call. When the stock hits 117.5 you close them both out as a pair for a nice profit.
2. Non-directional
Sometimes a stock appears to be simply moving sideways. The range of its movement may be large or small, but the effect on its price minimal.
Everything depends on what the trader expects to happen next. If a stock is moving sideways, with a balance of supply and demand, and we expect the situation to continue, then we can adopt non-directional strategies.
Neutral implies you don't expect the stock to move much. You must employ a strategy that makes money when the stock doesn't move much, or stays within a defined range.
Iron Condor--combination of two credit spreads
Short Straddle, Short Strangle, Iron Fly-- selling both Put and Calls (with insurance!)
Butterfly--when you expect the stock to fix to a strike
Calendar Spreads--selling the closest expiration for income
Bi-directional means you expect the stock to become bullish or bearish, but you don't care which. You may beare anticipating upcoming volatility or stock movement, but don't know which way it will go, so you consider placing bets each way. These strategies work well for stocks that have been moving sideways for some time--but do you expect them to keep going sideways forever? If you think it is time for them to break the sideways pattern, but you don't know which way the stock will go, then buying a Straddle or Strangle might be profitable. Strategies include
Long Straddle-- placing bets both ways. By buying a Put and Call together, you stand to win whether the stock goes up or down. But it must increase in value enough to give you profit.
EXAMPLE: The 160 AAPL straddle for 60 day expiration is $4.40 (the Call is worth 1.80 and the Put is worth 2.60). We buy 60 days away in order 1) minimize time decay, 2) to give enough time for the stock to move. Don't get greedy and expect the straddle to double in value.
HOMEWORK: Buy the ATM AAPL straddle for this month's expiration and place an order to sell it for 20% profit.
Long Strangle--you also don't care which way the stock goes, as long as it moves fare enough to be profitable. These are cheaper than straddles, and are usually bought OTM when a big moment is expected.
Short Straddle/Strangle If you think the sideways pattern will continue, then you could sell Strangles and Straddles, and buy them back cheaper--for a profit. The trade tool we use on thinkorswim is the Iron Condor, selling with insurance both sides.
EXAMPLE Here is a chart of MA which remained in place for about 9 months
in 2014. Notice how the stock stayed within a range. Short Straddles, sold near the middle of the range, would have been profitable during this period. Iron Condors, selling Calls placed near the top and Puts near the bottom of this range, would also have been very profitable. (For more on Iron Condors, see Basic Strategies 2)
HOMEWORK: Sell an ATM straddle for this coming Friday on your favorite index such as SPX, SPY, RUT or QQQ, When filled, place orders to buy it back at 50% of your credit.
How to Calculate Margin on Credit Spreads
When you place a credit spread, your broker will ask you to put up all the money that could be lost in such a trade. Remember, this sounds unfair, but it isn't, since as a seller of options you agree to take on a defined risk. This amount is called "margin" and is segregated within your account but not taken out of your account as it would be if you were purchasing an option or stock. Once the trade is closed, a calculation is made and you may need to give back some of the credit you collected, or pay up even more from your account. The margin requirement [M] is the difference [D] between the strikes less any credit [C] you receive. Here is the formula...
D - C = M
[Strike1 - Strike2] minus credit = margin
EXAMPLE: Lela places a credit spread on TSLA using a Put spread such as 200/190. She receives a credit of $2.20. As the strikes are $10, she still has $7.80 that must be covered by money segregated for that purpose in her account.
[200-190] - 2.20 = 7.80 margin per contract
For Iron Condors, the margin requirement is not doubled, as the price at expiration cannot be both on the Put and Call sides.
D - C = M
[Strike1 - Strike2] minus [credit 1 + credit 2] = margin
EXAMPLE: Leith wants to put an Iron Condor on AMZN at 900 and 890, using $10 wide strikes. He sells the 900/890 Put strikes for a credit 1 of $1.95 and the 1000/1010 Call strikes for credit 2 of $1.40, for a total of $3.35. Thus his margin will be
[10] - 3.35 = 6.65 margin per contract
For credit spreads: the more credit you collect, the less your overall risk. The less you are willing to risk, the less credit you will get. The art is in finding the sweet spot in the middle. Many traders this is around the 30% mark as per the example.
For debits and debit spreads, there is no margin requirement. Whatever you spend is the amount risked. 70% of long options expire worthless.
Despite Your Best Efforts, Your Strategy Will Sometimes Fail . . .
Here is an article which talks about how strategic plans might still fail. Do you see anything here that might be important for traders to remember?
http://www.forbes.com/sites/aileron/2011/11/30/10-reasons-why-strategic-plans-fail/
As traders, we can learn much from Sun Tzu's ideas. In them we see the ideas of a winning percentage, adaptability to market conditions, and the use of probability, and the choose of correct strategy. Most importantly,
- "If you fail to plan , you are planning to fail."
Are you methodical, or are you just hopeful? Keep up the study and practice, practice, practice!
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Homework:
1. In your thinkorswim PaperMoney account, go through ten or twenty stock charts of stocks over $100 and identify suitable strategies for each one. Which stocks look bearish right now? Which look bullish? Which are just going sideways?
2. Review the pages in the The Bible of Options Strategies, Options Trading for Dummies or How We Trade Options for each of the following strategies:
- Covered Call,
- Straddle
- Strangle
- Bull Put Spread
- Bear Call Spread
- Iron Condor
Which ones are bearish? Which are neutral? Which should be used in volatile markets? Which should be used in stable markets?
3. Enter these orders in your PaperMoney account:
- Close any trades left from the first few weeks of class.
- Buy a Covered Call or Synthetic Covered Call on SPY by selling the next month 250 Call. (That is either buy 100 shares of SPY or a Call, and then sell the front month 240 Call.)
- Buy an ITM Put for two months out on a stock which is trending downward.
- Buy an ITM Call for next month a stock which is trending upward.
- Buy a Straddle on any stock and place an order to close at 20% higher. Do not use this week's expiration.
- Buy an ATM Strangle on a tech or biotech stock which has earnings coming up. When filled, place a closing order for 10% more.
When filled, place order to CLOSE all these trades at a profit.
4. Complete the quiz below.
Ask for help if you need it!
Good trading!
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