Wednesday, June 17, 2009

Mail Bag


Received a solid question in response to yesterdays Stuck in a Rut post.

Hi Tyler,

What was the main driver that led you to decide on the Bear Call Spread? What other play could you have done with today's market conditions?

There are a few reasons I chose OTM bear call spreads. First off, due to the breakdown that occurred on the RUT on Monday, my bias on the overall market turned to mildly bearish. Obviously with options there are a myriad of positions I can put on that profit from a downward move in price. Besides bear calls I may have considered buying puts, bear put spreads, or put ratio backspreads. Let's consider the advantages of entering a bear call spread vs. other alternatives:

1. Bear Calls are positive theta trades

The 3 primary variables that influence an options price are: stock movement, time, and implied volatility. Of these 3, time is obviously easiest to predict, followed by volatility, then stock movement. I'm an advocate of putting theta to work for me whenever possible, so the first reason I prefer bear call spreads vs. other bearish trades is they are positive theta.

2. OTM bear calls have a higher probability of profit

In yesterday's example I used a 570-580 July bear call spread. Based on the delta of the 570 call (which was .12), I have a probability of profit around 88%. In terms of price, RUT would have to rally above 570 by July expiry for me to lose on the trade. Thus, whether RUT goes down, sideways, or up, I have a very high probability of profit.

3. Personal Preference & Risk Tolerance

Some people may look at the bear call spread and balk at the "measly" $1.00 credit. They may prefer a higher potential reward trade. Others may be more aggressively bearish on the market and desire to enter straight puts or put spreads that afford more profit if we drop significantly. In my experience its much less painful (and I would say easier) to manage an OTM bear call spread vs. straight puts or ratio backspreads. In the end there isn't one right strategy or approach when bearish (or bullish for that matter) on the market. I've traded OTM credit spreads the most and have personally had the most success with them, thus they tend to be my bread and butter or go-to strategy. That's not to say that there aren't scenarios where other strategies are better choices though.

Tyler-

8 comments:

Charley240 said...

Thanks for this piece Tyler. I am relatively new to trading and am struggling with all the various option plays one can make. I have traded single options and they are quite nerve racking to watch when they go against you. I don't like the idea for a stop loss because you accrue a bunch of small losses and don't learn anything. I much prefer to understand managing the trade with options to maximize the profit or minimize the loss. Of course panic sets in when a trade goes against you and then doubt about what to do and the initial plan you had going in seems like a bad idea and.... well you get the idea.
Do you have standard calculations setup on .xls for the various trades you could share or do you rely on the edutrader graphs?

Tyler Craig said...

Charley 240,

Let me offer up a few suggestions:
1. Don't become a jack of all trades and master of none. Although there are a ton of option strategies, focus on mastering one or two basic ones before jumping into all the advanced ones. You don't need to know every strategy to be a profitable trader.
2. Long calls/puts are probably the most aggressive way to use options, so keep in mind there are more conservative strategies that won't be as gut wrenching.
3. I would certainly recommend using stop losses in some fashion or another. Unless you can afford to risk the entire amt. of money you place in a long call or put trade, you should be using stops.
4. I don't have any excel spreadsheets- Most of my trading rules are in my head. Feel free to look in the archives for any past option strategies I've highlighted. I usually run through the rules in the blog posts.

Mob said...

Ty7ler, thanks for advising on software two posts back....

I would appreciate your thoughts on teh following dilemma I have for ages:

- fixed allocation per option position (eg USD3,000)
- in anticipation of a correction, xyz is at 132 today, expect a correction of 20% down

What would be the best strategy for max return, assuming that prediction of 20% down is correct:
- ITM put at 132 with delta close to 1
- OTM put around 106
- bear spread 130/120
- bear spread 120/110
Unfortunately I presently do not have access to software that allows me to work this out myself.... Appreciate your help!

Tyler Craig said...

Mob,
The strategy that will result in the highest percentage return is purchasing the OTM put. That is of course assuming you buy adequate time in the OTM put. Obviously if you bought a 2 month OTM put and it took the stock 3 months to drop 20%, you wouldn’t be around to participate because the put option will have already expired.
The ITM put would have the 2nd highest percentage return.
110-120 bear spread would have 3rd highest percentage return
120-130 bear spread would have the lowest percentage return
Remember there is usually a trade-off between potential % return and prob of profit. So from a probability of profit viewpoint here’s how they would rank:
120-130 bear call would probably have the highest prob of profit (depending on how much credit you received).
ITM put probably ranks next in highest prob of profit
110-120 bear spread is 3rd
The OTM put would have the lowest probability of profit.
So there isn’t one right answer in terms of which is the “best strategy”. As stated, the highest percentage return, lowest prob of profit is the OTM put. The lowest percentage return, highest prob of profit is the 130-120 bear call spread. Based on personal preference & risk tolerance you’d have to choose which is the best fit for you.

Mob said...

Tyler, thanks a lot for your detailed answer, I really appreciate that you took the time. There are unfortunately very few sites that help me to understand the nitty gritty of option trading, and thus I am doubly thankful to you.
1. I usually work with LEAP options nowadays, as I often seemed to be able to predict trends but usually am in too early...
2. If I amy, I would like to add the some follow-on questions:
- do you usually use options for shorter term (max 2 months) or longer?
- what are your two preferred option strategies?
- how to you usually decide on the high probability vs max gain issue, e.g. do you tend to go for the higher probability strategy?c

Tyler Craig said...

Mob,

-do you usually use shorter term options or longer?

One thing to keep in mind is that EVERY strategy is different. Thus, certain strategies will by nature involve longer term options, while others involve shorter term options. So my answer is "yes" and "yes". I use both short and long term depending on what strategy I'm using.

-What are your 2 preferred strategies?

It completely depends on the market conditions. My favorite strategies are the ones best poised to profit for whatever market conditions I'm anticipating. That being said, I tend to trade a lot of credit spreads (bull puts, bear calls) or iron condors.

how to you usually decide on the high probability vs max gain issue, e.g. do you tend to go for the higher probability strategy?

It's complete personal preference. I prefer higher probability strategies. B/c I like making smaller returns, but having a higher winning percentage as opposed to making higher returns, but having alower winning percentage.

Tyler-

Mob said...

Thanks once more for having taken the time to answer my questions!

Tyler Craig said...

Your welcome Mob