Sun Tzu, the famous Chinese general whose book "The Art of War" has guided strategists for over 2,500 years, made this famous statement about good strategy:
“Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win.”
How do we as traders "go to war first" ? Here are some basic rules, and their military counterparts:
1) Sell rather than buy. If you collect a credit first, victory is already in your hands. You need only protect your income and stay out of trouble. This means that on spreads we seek NET CREDIT. (Put time on your side!)
2) Collect enough credit. The higher the net credit the less the risk. If you only collect 5% of the width of the strikes in a credit, you have 95% exposure. A better proportion would be 15-50%. (Proportion your troops to assure victory.)
3) Limit the risk, even if it means limiting your profits. The truth is, every trade is in fact limited by the stock price. If you see "unlimited profits" it means very little, because no stock yet has reached infinity. Use the ANALYZE TOOL to determine the exact possible loss on a trade. (A handful of small battles is easier to manage than one large one.)
What really counts is the probability of being profitable. It is much better to go for $100 with a 90% chance of winning than to be offered $1000 with a 5% chance of winning.
4) Give money back only as your last resort. This means using every opportunity to keep adding credits to your trade. (A warrior would say, don't surrender unless death is the only other option!)
5) Find more money to replace any money you have to give back. Go and bring in another credit. Its out there somewhere! (Keep your supply line full!)
Now let's take a look at some popular trading strategies. We find these listed on our thinkorswim platform under the "Trade" tab.
Simple Strategies
So let's first review the simple strategies we learn as traders. By this time, you should be able to do all of these on TOS.
- BUY stock to OPEN
- SELL stock to CLOSE
- BUY a Call to OPEN
- SELL a Call to CLOSE
- BUY a Put to OPEN
- SELL a Put to CLOSE
There are several other trades which you can also probably do as a Level One trader such as . . .
- BUY a Covered Call
BUY stock to OPEN
SELL Call to OPEN
SELL stock to CLOSE
BUY Call to CLOSE
- BUY Married Puts
Buy Stock to OPEN
Buy Put to OPEN
Sell stock to CLOSE
Sell Put to Close
- SELL a Cash Covered Put
SELL a Put to OPEN
Requires sufficient cash to cover any potential purchase of stock
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What Level will my account be approved for? 
Each brokerage firm sets its own standards, so you need to discuss your experience with them. HOT can write a letter by request in support of your application. For the purpose of this class, you will need Level Two in PaperMoney.
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More detail on each strategy is found in the Bible of Options Strategies. See the link to the PDF in the Vault.
Vertical Spreads
The simple combination of two Puts or two Calls at different strikes but with the same expiration is known as a "vertical spreads." However, many strategies use vertical spreads. Here are some popular ones.
DEBIT spreads
- directional strategy
- long and short versions
- place order all at once
- money leaves your account
- no margin required
- loss is limited to
- TOS order ticket is green
CREDIT spreads
- directional strategy
- all at once
- short and long versions
- money goes into your account
- margin calculation
- TDA order ticket is pink
Bullish or Bearish?
The most basic decision every trader makes before constructing a trade is whether she expects the price to go up or down, or remain where it is. Once you've made that decision, then you can choose an appropriate strategy.
Bullish Strategies BULL Call Spread BULL Put Spread
Bearish Strategies BEAR Call Spread BEAR Put Spread
Do you know which of these are debit spreads, and which are credit spreads? Make sure you read about these strategies in your Bible of Options Strategies and understand them. Now go to thinkorswim and construct lots of them! Practice, practice, practice.
What is your risk?
The second question to answer is, how do I know my risk? For debit spreads, the potential loss is limited to your initial investment. That's it. For credit spreads, risk is more complicated and is assessed by a formula.
How to Calculate Margin on a Credit Spread
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 (your "risk"). Remember, this sounds unfair, but it isn't since as a seller of options you agree to take risk that others will not. This amount is initially 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). Here is the formula.
[Strike1 - Strike2] minus credit = margin
IOW, the margin requirement is the difference between the strikes less any credit you receive.
EXAMPLE: Lela places a credit spread on TSLA using a Put spread such as 180/170. 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.
Neutral Strategies
Iron Condors
IC are a neutral strategy that combines both Call and Put spreads, and popular among traders of all levels. More commonly sold than bought, they take advantage of a stock's lack of movement by selling premium on both sides of the current price. The margin requirements for IC are reduced, as they combine the credits from both spreads, and the stock cannot end up in two places at once.
- neutral strategy
- 2 verticals, one Puts, one Calls (4 legs)
- one vertical each side of current price
- makes money using theta decay
- only one margin requirement
EXAMPLE: AMZN Here is a standard IC generating $2.10 credit. Notice the "iron bridge" shape and how the sold legs are closer to the current price. This is found in the Analyze tab under Risk Profile.
For more on ICs, see Bible of Options Strategies and www.theoptionsguide.com/iron-condor.aspx
Straddle
This "both ways" strategy takes advantage of patterns in potential price movement.
- Put and Call share same strike
- directional for buyers, non-directional for sellers
- depends on price movement for buyers, that decay for sellers
- no margin requirement for buyers, as loss is limited to purchase price
- large margin for sellers, as loss can be unlimited in two directions
- Buyers and Sellers should close the trade whenever profitable
- works well for buyers in run up to earnings, or whenever large movement is expected
- works well for sellers when price is static and premiums are dropping
Strangle
Similar to a strangle, except the Put and Call are at different strikes.
- Put and Call not sharing same strike
- can be long or short, and options can face inward or outward
- a long straddle expects price to move either up or down beyond the strikes
- a short straddle expects price to remain between the strikes
- builds in intrinsic value to reduce potential total loss of premium
- premium gain or loss an important consideration
Calendar Spreads
Calendars share the same strike but trade different months. The most common or Long Calendar sells the nearest month, as premiums disappear fast, and while buying a further out month. In this way, the CS acts like a Covered Call or Covered Put.
- takes advantage of faster premium decay in front month
- can use either Put or Call, or both
Condors
A condor takes advantage of premium decay by selling either all Puts or all Calls, with protection.
- contains 4 legs, two short, two long
Ratio Spreads
Buyers of options can reduce cost by selling more options than they purchase, even covering the entire cost. When traders sell an option, they can also reduce the amount of protection they think they will need by reducing the "insurance". A typical ratio might be selling 3 OTM Calls while simultaneously buying 2 ATM Calls, for a ration of 2/3.
- For mildly bullish or bearish trade.
- Used to reduce insurance costs on an iron condor
- can also describe a trade with an uneven number and puts and calls, e.g. a straddle with 5 Puts and 10 Calls
Butterfly
The amazing butterfly spread is a complicated arrangement with lots of flexibility. The "wings" can be moved or "broken" to adjust the investment.
- 3 legs
- pick your strike
- put or call
- short or long
- broken wings
This is an advanced topic, and will be covered in depth in the next series of classes.
Thinking about Strategy
Every strategy has advantages and disadvantages, and so the trick is matching the strategy to the opportunity. Momentum plays would prefer a straight Single option, or possibly a Vertical Spread. A stock that is very stable-- that is, zero momentum--would attract short straddles. As Sun Tzu says, "just as water does not retain its shape, so in warfare there are no constant conditions. He who can modify his tactics in relation to his opponent can thereby succeed in winning, may be called a heaven-born captain."
Combining these two ideas--collecting rather than spending money, and using the right strategy--we can enhance basic strategies and make more profit. To a long Put or Call, we can add a short Put or Call, increasing income and protecting against loss. We can also turn a credit spread into a ratio spread by selling some insurance. You should practice doing these trades many times on paper until you develop a confident ability to choose the best action.
HOMEWORK
Review
1. Do the short quiz below to make sure you understand the concepts.
2. Make up a sheet and list the strengths and weaknesses of each strategy. 
Use the one at right. Check with The Bible of Options Strategies to get a description of each type and see the diagrams revealing the risk profile for each.
Trading
1. Look at the PCLN chart. Place the following trades:
- Buy a deep ITM Put on PCLN. Then Sell an ATM Put. You now have a Debit Spread. Is it bullish or bearish?
- Sell an OTM Call spread using the front month at 30% probability of being ITM. You now have a Credit Spread. Is it bullish or bearish?
- Look at the PCLN chart again. Place an OTM Bearish Put spread just above when you find support.
- Use the "Vertical" drop-down and adjust the strikes on the order as necessary.
2. Put closing orders on each Spread that will give you some profit. On the long ITM Put Spread, place a closing order for a 20% profit. On the spreads where one leg is ATM, expect a 40% profit. On the OTM Put spread, place order to sell at 60% profit. On the Bear Call Spread, place a CLOSING order at .10 or at 90% profit. On the Bear Put spread, place order to sell at 100% gain.
Here's the quiz....