Options Trading: What Kind of Player Are You?

By Steve Smith  FEB 21, 2014 9:42 AM

It's time to think about your identity as an investor.

 




The market is near all-time highs, but recent volatility has pushed plenty of investors into wondering whether it's time to jump in or head to the sidelines.

Was the recent 6% decline and subsequent bounce back an opportunity or a warning?

An educated options trader can profit from either perspective.

However, you must identify your goals in terms of time and profit expectations, and apply acceptable risk-to-reward rules within those parameters.

This earnings season stands as exhibit A of the confusion investors are facing.

Well-known stocks like Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Apple (NASDAQ:AAPL), and VF Corp (NYSE:VFC) have tumbled, soared, then returned to prior levels in the days surrounding their earnings reports. When a year's worth of price change can happen in a few days, and when a lifetime of profits can be made or lost in one year, how can one rationally participate in this random (if ultimately efficient) walk?

Many people view options as a complication to an already confusing situation. However, they can provide a great deal of clarity to your trading and investment decisions.

Slowing the Game Down

When performing at their peaks, great athletes have been known to describe the action as occurring in slow motion, and in a general expansion of time and space. For example, the best basketball players are able to predict where teammates will be before they get there, or imagine a hoop seemingly expanding in size.

And in the trading game, we can use options to expand our own fields of view in a way we never can with the actual underlying stocks and indices.

"I spent 20 years in the S&P 500 (INDEXSP:.INX) futures pit; now I focus on both individual and equity options, and I feel like I have time to think things through," says Philip Yarsley, a Chicago-based independent trader. Yarsley also says options allow him to see the bigger picture and make more objective decisions. This of course, is the opposite of what can happen in a panic situation, when everything rushes by in a blur.

The trade-off is that with options, there are more components to manage, such as all those "Greeks." For example, you must determine what impact an increase in delta will have on your position.

But having to take these factors into consideration helps you take a more analytic approach to trading, because you're forced to think about things like the rate at which a stock may go up, and the possible magnitude of news events.

Trading rules are good and necessary, and there are different criteria for different situations.

That means it's time to think about your identity as an investor.

What Kind of Player Are You?

For investors with an intermediate time frame, looking to catch 10% price moves, it probably makes sense to stick with the simple outright purchase of puts or calls. To minimize the impact of time decay, use contracts with at least 90 days remaining and exit the position 30 days prior to expiration.

However, this approach excludes a lot of strategies that reduce the flexibility that makes option trading so attractive.

A lot of option traders prefer to trade near-term options and gain leverage from lower-priced out of the money options. If trading were baseball, these people would be "home-run hitters" as they're usually swinging for the fences.

The thinking goes that even if you strike out often, losing 100% on trades, you can come out ahead by hitting the occasional big shot.

Others like to sell premium to take advantage of the acceleration of time decay. This approach should result in "singles," or smaller but more reliable profitable trades.

I'd probably opt for the latter, but remember that there are different strokes for different folks.

There is more than one route to the Hall of Fame. Reggie Jackson made it on home runs. And Wade Boggs made it on base hits.

Spread Game Management

For a lot of options traders, including myself, the bread-and-butter strategy is the basic vertical spread. This consists of buying (or selling) options with one strike price and selling (or buying) an equal number of options with a higher strike price and the same expiration date.

The attraction of this position is that since you're both buying and selling options (either puts or calls), you're minimizing the impact of the Greeks while retaining a defined risk profile.

Vertical spreads can be used in bullish or bearish formats and over short-or-long-term time frames. They are certainly not slam dunks or home runs, but they're a nice way to stay in the game and avoid wild swings.

Adapting to 2014

But as discussed in this recent article, 2014 might see a break down in correlation. So one of the things that I'm doing now is taking a longer time perspective and buying calls and puts in specific names in greater size than normal.

To leave you with some specifics, I'm now the proud owner of longer-dated, out-of-the money calls in JetBlue (NASDAQ:JBLU), Target (NYSE:TGT), and iShares MSCI Mexico (NYSEARCA:EWW), and puts in Panera Bread (NASDAQ:PNRA) and Zillow (NASDAQ:Z).

But I'll keep dipping and diving in the short term because that is also part of the game. Check out OptionSmith if you want to join the team.

Twitter: @steve13smith
No positions in stocks mentioned.

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