Constructing Low-Risk Trades

At our recent Summer Trading Intensive, I asked the participants to help me construct an ideal trade. Here's what they came up with.

• low- or no-risk of loss
• very high probability of success
• very liquid market
• using other people's money
• high profit potential
• minimal management
• fast closure
• repeatable at will

Those are eight excellent points, starting with attention to risk. But such trades are not easy to find! Today we examine ways to construct such trades. Maybe we can even put together a trade with zero practical risk?

First, I assume that you know the basic and advanced trading strategies such as credit spreads, iron condors, straddles--and how to examine their risk profiles using thinkorswim. Some of these trades are "combo trades," meaning they combine different strategies. Not for newbies!

Next, it is important to realize that "low-risk" sometimes means that there is risk of loss somewhere, but probably not near the current price. Other times it means that a small loss will occur, but if it hits, it will hit big! So let's not confuse risk of loss with probability of loss.

Let's start with low-risk trades, and then see if we can get to no-risk trades.

1. Wide-Wing Iron Condors

The first strategy to think about is selling options a long, long way from the current price. On the probability scale, these would have at least 90% chance of expiring out-of-the-money. If we sell options when they first appear (new series appear on the first Monday after each monthly expiration) they are usually at their highest price. By selling products that expire several months down the road, traders can get a nice fat premium. Buy back whenever you satisfied with the profit.

If you take the Iron Condor, and push its strikes very far to the right and left, you end up with a high probability trade with reduced risk. The greatest risk to an option occurs close to the money; the further away from the current price that an option sits, the less risk it entails. This is obvious if we consider AAPL (currently $115). Selling a 120 Call entails some risk, a $130 a little less risk, and $150 Call a lot less. If I sell a $150 Call, or a $80 Put, then I am a long, long way from the current price, and hence the probability of success is very high. If I sell both, adding insurance strikes even further out, I have a WWIC.

But what about the risk? The amount of possible loss is limited by the insurance strike on any Iron Condor. The closer your insurance strike to the sold strike, the less risk. However, the probability of loss is measured by the distance from the current price, not the distance between the strikes. The amount of loss is a different matter.

RISK: We control the probability of loss by the strike placement, and the amount of loss by the number of contracts.

ACTION: Construct an Iron Condor on any stock that has recently announced earnings. Place the strikes where there is about 92% chance of expiring OTM. Decide how much money you want to risk, and then select the appropriate number of contracts. 

 2. The Deep-in-the Money Trade

DITM trades employ deep short positions with insurance, and are traded as verticals. A DITM Call spread would be bearish, and a DITM Put spread would be bullish. A vertical is formed by adding an insurance strike to the deep strike. The P/L curve should show large potential profit and minimal loss. The amount of loss is related to the cost of the insurance strike--which is a combination of strike placement and time premium. This strategy works best on pivoting stocks, swing trades and earnings announcements.

The DITM leg of the spread is your money maker, and should have a delta of at least .9.  It should be placed beyond were you expect the stock to go. The insurance leg can be placed OTM, ATM or ITM. ITM placement reduces overall risk, but the stock has to move further to exhibit a profit. If placed OTM, the amount of potential loss increases (if the stock goes the wrong way), but the spread becomes profitable more quickly. If you buy an ATM strike, you are paying high premium for insurance, and so the risk of loss from time decay can eat into your profits if the stock does not move as expected.

I most often use a close expiration, as the money spent on insurance is reduced. A potential risk/reward ratio of 1/10 is attractive.

RISK: Total risk can be easily controlled by the placement of the insurance option and the number of contracts.

ACTION: Construct a directional DITM trade on a stock you think is ready to change direction or pivot. 

3. Insect Trade

By adding a DITM spread to an Iron Condor, we can end up with a six- or eight-legged trade (insects and spiders). This elaborate strategy brings in money from its OTM positions to pay for the premium on the insurance for its DITM positions. The strategy then pays for itself, with little or no risk to the trader.

I sometimes place this trade when I want to protect my Iron Condor. Once the IC has achieved 30% profit, I can place a protective or speculative DITM Call or Put spread.

RISK is reduced by bringing in more premium via a DITM position. The DITM position acts as insurance.

ACTION: Study this six-legged SPY spread and duplicate it in your TOS. It uses a four-legged Iron Condor (actually a short straddle using the 214 strike) with insurance options of 217 Call and 212 Put. To that is added the DITM Call credit spread, with a ration of 10 IC to 2 DITM legs. Notice where the insurance strike is placed and its effect on the overall profitability of the trade. As you can see, this insect will make good money no matter where the SPY price moves, as long as it stays under about 215.5.

However, there is a problem with this complex trade. If the index shoots up, then the trade could lose money. Knowing what you know, how could you protect the overall construction against loss? 

As you see, each trade we have constructed uses elements of the ideal trade, but not all elements. We will continue with low-risk trade construction with Butterflies!

4. Long Butterfly (3-legged Debit Spreads)

A butterfly is named after the center of three strikes. So a 135 butterfly could be long 134 Call, short 135 Call, long 136 Call. It is called Long because the purchase will be a debit to the account. When you buy a Butterfly spread, you risk is limited to the amount you spend.

ATM butterflies are always the most expensive, so we rarely buy. Profit comes from decaying theta on the last day or two of the option, and usually depends on picking the right strike. You want the price to stay where it is, and settle close to the short strike.

BEST STRATEGY: On Tuesday, place orders to purchase several butterflies around where you expect the price to settle on Friday. Choose stocks with limited range and don't pay more than .10 for the spread. Sell on Thursday if you are at 50% profit at any strike. As prices move on Friday, try to sell more than one butterfly at 50% profit or more.

ACTION: Construct a butterfly trap using GOOGL that will expire this coming Friday. Manage it and close with overall profit  by expiration.  

5. Short Butterfly (3-legged Credit Spreads)

By selling a Butterfly ATM, receiving a credit, and then buying it back cheaper, we can pocket fast profits. This strategy works well for stocks which move moderately at earnings, or at least far enough away to remove the threat of loss. One thing is fairly certain: if a stock usually moves on earnings, then it will not be tomorrow where it is today! This provides an opportunity to make some money with limited risk.

The good news with this trade is that we can use it every week, assuming that the stock moves from week to week. The secret is to simply sell wherever the credit is the highest, and whenever stock is most likely to move--usually during periods of higher volatility-- and buy back or close whenever it is profitable.

EXAMPLE: Here we have a NFLX Butterfly credit, only sold about 3 days before weekly expiration, at the 118 strike. You can see that the potential profit is about $200 and potential loss is about $800. If the price goes $1 either way, we get out of danger and make money, but it must move.

Here are the secrets to this trade:

• pick a stock that moves a lot, or with a high ATR, with good volume in the options
• choose a narrow range of strikes, such as $1 or $2.50 wide
• when filled, place a closing or buy back order
• watch this position on expiration day and close when highly profitable
• consider trading the SPY on the strike with less Open Interest, when the price is ATM. You can be pretty sure price will move within a day or so.

This strategy works by stock movement, either up or down, taking the trader out of the risk zone.

My favorite way to trade this credit butterfly is on expiration day . . .

The Last-Minute Butterfly

This technique can also be used very close to expiration, but only with stocks that have very close strikes--on expiration day. By selling whenever the option is almost expired--perhaps a hour before expiration--large credits can be received. If the stock moves enough in the last hour of trading, then you will able to buy the Butterfly back at a cheaper price. Use the Risk Profile to determine the amount of credit. The secret is to place the trade when your Butterfly is deep in the "loss" part of the profile, where it has over 80%  credit, and placing a closing order at 50-100% of available profit.

RISK: Total risk can be easily controlled 1) using close strikes, 2) maximizing the credit you receive for the trade.

EXAMPLE: Review this trade carefully. Notice it is placed with no possibility of loss! The amount of profit is a function of how far the price moves. If I can start with a credit of as much as $2.30, then any price at I buy it back will result in price. Maximum profit will be achieved if the underlying index moves at least $2.50. This scenario only occurs in the last hour or so of trading on expiration day.

ACTION: Construct a Credit Butterfly by selling ATM five of your favorite hi-beta stocks, and buy back when profitable, or waiting until expiration. Remember to sell as narrow a range as possible, and use stocks with Beta over 1.0.

Copyright 2016 Honolulu Options Traders, LLC

All rights reserved.