11 Nov

Read This Before You Trade Another Options Contract

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For years I traded stocks.

Options weren’t even on my radar. And whenever I did try to trade them— I would get absolutely hammered.

Here I was, a successful and profitable equities trader — unable to translate it to options.

Even worse, I had one of the best mentors teaching me the ropes, Jeff Bishop.

Jeff was returning five figures per trade and making it look easy. And I wanted in.

My goal was simple — swing for the fences and go for five-figure and even six-figure winning trades.

So I’d try to hit home runs by buying options…

Sometimes it worked out perfectly…

But the success was inconsistent — and the gains would get wiped out on just a handful of trades.

I didn’t blame it on the options market, and cry “The market is rigged!”

I knew I was doing something wrong… and the root of the problem was the way I approached options trading.

After all, the ability to efficiently use leverage makes them ideal vehicles for traders with small (and large) accounts to attack the market.

Sure, when you buy calls or puts… you can lock in some massive gains…

That’s exactly what got me hooked on buying options in the first place…

What you might not know is that the odds are stacked against you when you buy options.

You always hear about options buyers making tons of money on one trade… but you never hear about their string of losses.

Once I figured out I was losing on a bulk of my options trades… I knew I needed a quick fix.

So I looked at how the traders on the other side were faring in the market.

That’s when I found out I could sell options…let’s just say I was stunned in disbelief (which doesn’t ever happen) at how easy and profitable options can be.

Let me take a moment to give you a short guide on the foundations for selling option spreads, along with a host of other good stuff to get you on your way to printing money.

The Small Account Conundrum

I can’t tell you how many times traders ask me how to trade small accounts. They either heard it’s impossible to make money with one, or requires too much work.

Nothing could be further from the truth.

Today’s trading world offers low to no commissions in many areas. You don’t need a lot of money to trade. What you need is a plan.

Small account trading has a few limitations that you need to be aware of.

Note: I’ll be discussing this from the U.S. trader standpoint. Regardless, you should check with your appropriate regulators.

Margin Restrictions

Traders typically need to have a minimum of $2,000 in their account to be able to trade on margin. You will need margin to short stocks and trade options spreads.

Pattern Day Trading

In order to regularly trade in and out of stocks and options, traders need to maintain a minimum of $25,000. Otherwise, you are restricted to three opening trades every five days.

Many traders see pattern day trading as a major obstacle. However, when I sell options, I typically want to hold them for several days. This reduces the risk of running into pattern day trading problems.

Risk Management

Nothing will define your success more than risk management. Risk management requires discipline and homework. It’s not something you should take lightly.

Let’s start by discussing some of the most common mistakes traders make that destroy their accounts.

Over leverage 

It’s so easy to get caught up in the moment. You get some quick wins and feel the hot hand coming. Instead of keeping your trade capped at 5% of your total bankroll, you pump it up to 25%.

Next thing you know, you’re staring down the barrel of a loss 5 times more than you should be. It’s happened to the best of us (yours truly being no exception).

Stick with your trading plan. If you’ve limited yourself to 5% per trade, then never deviate.

Disrespecting your stops

It’s all too easy to get into a trade and let the stock blow pasture stop. You rationalize and justify why it’s fine.

Risk management relies on clear and defined targets, stops, and capital allocation. Without these, you’re just gambling.

Chasing stocks

Chasing entries hurts just as much disrespecting your stops. Again, you rationalize why you can afford a worse entry price.

Yet, doing this completely alters your risk to reward profile.

Imagine you had a target of $75, an entry of $45, and a stop of $25. You expect to win 50% of the time. Chasing your entry up to $50 changes the expected value of the trade to $0. Go even further, and you’ll lose money over time.

This is where selling options premium comes into play — it’s the single solution to prevent you from getting a bad price. More on that later.

Understanding risk and reward

Most people inherently understand they should be paid more for taking additional risk. You expect that you’ll get paid more to invest in a risky small-cap than IBM.

Risk and reward work off of two important concepts: expected value and the probability of success

You don’t need to be a math whiz kid to understand probabilities. All you need is some basic knowledge.

If you take 20 trades and win 10 of them, you have a 50% win rate. Win 5 of those trades, and you have a 25% win rate.

Your win rate calculates simply as:

Win rate = Number of wins ÷ Total Trades

Traders with higher win rates don’t need to make as much per trade relative to their risk.

Conversely, if you only win 10% of your trades, you’d better be hitting home runs on that 10%.

That brings me to the second concept – expected value.

The expected value tells you how much you should make on average for the trade.

That doesn’t mean you’ll make that exact amount each trade. Rather, if you repeat the same trade over and over, the average of those trades will zero in on the expected value.

The formula for expected value is:

Expected value = (Amount won per trade x Win rate) – (Amount risked per trade x Loss rate)

An expected value below $0 means you lose money on average (AKA gambling). A $0 expected value means you will breakeven. Anything above $0 means you make money.

Real Money Case Study

Let me give you a real-life example.

I took a trade in LULU, selling a put spread at the $192.50/$190.00 strike prices.

My goal here was for LULU to close above the $192.50 strike price at expiration. I received a credit for selling the call spread of $0.81 per spread.

The total risk here sat at: $192.50-$190.00 – $0.81 = $1.69

My maximum reward stood at $0.81 per spread.

Let’s assume that I expected to win 70% of the time using a similar setup. That would make my expected value:

Expected value = ($0.81 x 70%) – ($1.69 x 30%) = $0.06

So, if I repeated this trade over and over, I would expect to make $0.06 per contract on average.

That comes out to $6 per contract since each contract controls 100 shares of stock.

In fact, as long as I win more than 67.6% of the time, I’ll come out on top in the end just like this.

Becoming a Spread Head

It wasn’t that long ago that I really started trading option spreads. I fell in love with them immediately.

Quite honestly, it made me feel like I was the Bellagio — ready to take all the gamblers’ money.

But let’s talk for a moment about why selling options gives you an advantage.

Think of options like an insurance policy.

Someone buys the policy to protect them from upside or downside risk in a stock. They buy a policy that another party sells them.

If you were the selling party, would you sell policies at no profit? Of course not! You want to get paid for your time and risk.

So, you price the insurance accordingly.

It’s the same when it comes to options trading.

Someone wanting to buy options has to pay a premium to the seller. That’s why most of the time, option sellers will come out on top.

In fact, if you sold options at one standard deviation on the S&P 500 over the last 10 years, you’d win over 80% of the time!

That’s why I love selling option spreads. It lets me control the risk and puts me in charge.

Option Spread Basics

Option spreads come in two varieties: put and call spreads.

To construct an option spread:

  • Sell an option contract at a strike price
  • Buy the same number of option contracts on the same symbol and expiration at a strike price further away from the current price

Here’s an example of a short (bear) call spread trade.

  • The Trade Desk (TTD) trades around $200.
  • I sell 10 call contracts with a $200 strike price expiring in two weeks and receive $6.00.
  • At the same time, I buy 10 call contracts with a $205 strike price expiring in two weeks and pay $4.00
  • In total I received $6.00 – $4.00 = $2.00

$2.00 is the maximum amount I can make on the trade. My breakeven price is the lower call strike plus the premium – in this case, $202. Anything above $202 at expiration, and I lose money.

The maximum loss comes at the difference between the strike prices less the credit you receive. In this case it’s $205 – $200 – $2 = $3.

The payoff diagram for a call spread at expiration shows the maximum profit at $200 and a maximum loss at $205.

Put spreads work the same, except you choose a strike lower than the first contract. The payout diagram looks like a mirror image of the call spread.

We want the stock to close at or below the lower call strike for a call spread.

On the other hand, for a put spread, we want the stock to close at or above the upper strike price. That’s where we achieve maximum profit.

Why not buy directional options instead of selling spreads?

At first glance, you’d think it would just be easier to buy a call option or a put option. True, it can be. But, it’s much, much easier to sell option spreads.

As I mentioned before, option sellers immediately have an advantage over buyers.

Time is On Your Side

Options buyers lose value every moment they hold an option. They’re immediately fighting time.

However, the real key comes down to extrinsic value.

The price of an option is broken into intrinsic and extrinsic value. Intrinsic value is the amount of the option price that would be left if it expired today.

An option has to be in-the-money to have intrinsic value (a stock trading above a call option strike, or below a put option strike).

Everything else is extrinsic value.

Any call option with a strike price above the current stock price is out-of-the-money. That means the entire cost of that option is 100% extrinsic value.

Extrinsic value wastes away every day that you own an option. Unless your trade moves quickly and significantly in your favor, you stand to lose.

However, selling an option spread works the exact opposite. Everything that works against an option buyer works for the seller.

Here’s a graph to show you how time works against an option buyer and for the seller.

The trick is you don’t have to be head over heels bullish or bearish with selling spreads. All you’re saying is you think that a stock will stay above or below a key level.

That’s a heck of a lot easier to manage.

This exact scenario played out with BABA. The stock got hammered on trade war news that plagued many Chinese companies. Still, there was hope for a trade deal on the horizon.

More importantly, BABA continued to trade in a channel.

I could have bought shares off the lower trendline. However, that opened me up to risk the stock could crash and burn on any poor news. I also knew that it may not take a rocketship higher to the upper band.

So, I sold a put spread. I received a premium for selling the $165 strike and buying the $162.50 strike.

That capped my losses at $2.50 minus the premium. At the time, BABA was trading at $163. That meant I got paid both extrinsic and intrinsic value.

If BABA traded back above $165, I would earn the extrinsic value plus the intrinsic value of $2!

And the trade worked out marvelously.

This example highlights everything I love about selling spreads; defined risk, controlled probabilities, and efficient use of capital.

Picking the right spread

Selling option spreads come in three varieties:

  • In-the-money
  • Out-of-the-money
  • At-the-money.

In-the-money spreads will pay you a higher premium. You’re getting paid partly from intrinsic value and partly from extrinsic value. Depending on how far in-the-money you go, you can get a risk/reward of well over 50%.

However, the win-rates drop the further in-the-money you go.

Selling in-the-money spreads requires the stock to make its way back beyond the put or call strike you sold. That takes a lot more effort when it’s starting in the hole.

At-the-money spreads contain no intrinsic value. They pay out the maximum possible amount of extrinsic value you can receive.

These work really well at reversal points such as key support and resistance levels. Depending on the implied volatility and time to expiration, I don’t try to get much better than 35%-40% reward for my risk.

Out-of-the-money spreads don’t pay a lot, but they win quite often. Some traders love to sell far out-of-the-money option spreads to get highly reliable win rates.

They let time decay and implied volatility contraction work in their favor.

Regardless of the trade you choose, I wouldn’t go out further than 45 days. Most trades I take expire within a week or two.

As you saw in the time-decay chart, at-the-money options lose their value at an exponential rate as they approach expiration. I like to play in this area and use the rapidly decaying value of the options to make money.

Tame Implied Volatility

Of all the components that define an options price, Implied Volatility (IV) is misunderstood the most. And yet it’s so easy to utilize.

Academics tell you IV defines the market’s expectations for the move in the underlying over the next 365 days. If the IV says 15, that means the market expects a 15% move.

But that’s not exactly how it works. IV actually comes from the supply and demand generated by options orders.

That creates moments of opportunity for us to put IV in our favor.

As option sellers, we want to sell when implied volatility is high.

High volatility = Higher Option Prices

Implied volatility has a little quark that makes it useful for option sellers – it’s mean-reverting. Over time, implied volatility will tend to move back towards the average.

So, if we sell when implied volatility is well above average, then we’ll benefit from any contraction in IV.

Most traders use two main methods to understand the current IV.

IV Rank – Implied volatility rank takes the highest and lowest implied volatility values in the past year. Then it tells you where the current IV sits as a percentage of that distance.

Here’s an example. The high and low of implied volatility for a stock was 60 and 15.  Current implied volatility is 25. 25 is 22.2% of the way between 15 and 60.

IV Percentile – Implied volatility percentile works a bit differently. It takes all the implied volatility values for the last year as individual measures. It then tells you in what percentile the current volatility ranks amongst those entries.

Master yourself to master trading

Emotional control comes in a close second to risk management in determining trader success and failure.

I’ll be the first to admit I know the feel of the dopamine drip…the immediate high you get from clicking the mouse.

Honestly, half of these platforms could be designed to create the same look and feel of a casino.

Why else would we need all these flashing lights and pretty charts?

One thing to recognize – we’re all different. Some people have greater self-control than others.

However, everyone can benefit from some simple tools to keep your animal brain under control.

Create a trading plan – A trading plan outlines how you plan to trade the markets. This includes the strategy you trade, the risk profile, capital constraints, along with scheduled events. Developing different scenario outcomes for stocks and the market is a great way to take back control of your trading.

Write out your trade beforehand every trade I enter I know three things:

  • Entry
  • Stop loss
  • Target

Without these, I’m a bag in the wind.

Put these down on a sheet of paper, if even for a moment. That small delay and focus puts you back in control and break the cycle for a moment.

Talk it through with someone – One of the best things I get with members of Weekly Windfalls is a group to bounce ideas off of. Nothing works better than working together. Just the simple act of telling someone your trade idea can help you realize what you wanted to know.

Wins never feel nearly as good as losses feel bad  – Humans are a deeply flawed bunch. We crave attention, constantly need validation, and focus on the wrong things.

It’s easy to dismiss our wins as common. But, every loss haunts us like a traumatic event.

Realize that we focus on our losses far more than our wins. That’s why risk management becomes so important. Controlling your losses becomes the first step to controlling your emotions.

Journal your trades – I probably spent 5-6 years journaling all of my trades. It’s tedious and bores you to death. But nothing puts things in perspective like seeing your trades in front of you in black and white. Nathan Bear even puts pictures of his setups to help him see the context of the trade.

Pick the right stocks

Not all stocks work well for options trading, especially spread trading. Many traders like myself, Nathan Bear, and Jeff Bishop all keep small lists that we go back to time and again.

Here are the best ways I’ve found to trim down your stock list to the best of the best.

Volume Options don’t trade nearly as frequently as stocks. However, the volume of shares traded works as a good barometer for the interest in stocks. Stocks that have weekly options will tend to be great candidates. You can look at the bid/ask spread to get a sense of the option’s demand. If the spread is large enough you can drive a mac truck through, you probably want to steer clear.

Identifiable Trend – Trading with the trend is a heck of a lot easier than going against it. While I work with fish hook patterns and other reversals, they play much better in larger trends. However, choppy stocks work great too. The important aspect is you can easily identify what’s going on. If you stare at a chart and can’t figure which way is up, move on.

Clear Support & Resistance – I do love trading reversal patterns. Nothing makes that easier than crystal clear support and resistance levels. Fibonacci retracements, consolidation areas, swing points…it doesn’t matter. When you have clear spots to work with, you greatly increase your odds of success.

If selling options still sounds unfamiliar to you… that’s okay, I went through the same learning curve you’re about to go through.

However, I went at it alone… and now I’m going to show you the ropes — teaching you the same strategy that’s instantly improved my odds of success.

How lucrative is this strategy?

In just about 3 weeks, I had a streak and locked in $113,752.34 in real-money profits…

… I’m not promising a 100% win rate on all of your trades.

What I will promise you: I’ll do everything in my power to help you start winning in the options market.

All you have to do is take the leap like so many others have, and join Weekly Windfalls now.

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