My dad introduced me to trading when I was 16. After some hesitancy in the beginning, I jumped in feet first. Got my options trading certificate from tastytrade.com. Traded options for quite a few months. Lost money (lost a lot on a Brazilian ETF that still causes me pain to think about) Got scared. Quit trading.

Typical.

It’s been a year or so since my last option trade.

If you never learn from failure, all you did was fail. So beginning today, I am going to trade.

And I’m going to teach you along the way.

This blog had lost direction (thanks for bringing that to my awareness, Dad)

I was doing too many things, trying to do things that I had no business writing about. This blog is for TRADING (and some opinion pieces along the way). It’s not meant to be whitepapers about blockchain (although, I will continue research in that area if anyone is interested)

So let’s refocus.

Let’s place a trade. Let’s make some money through MATH!

I am going to place a credit spread in my paper trading account. I will follow this trade throughout the 45 day cycle, as well as placing new, more complex trades.

I use Dough, a platform of Tasty Trade (that isn’t tradeable anymore, but still has great information) and execute my trades through Think or Swim, an platform of TD Ameritrade.

So how do we pick a stock?

Liquidity

Liquidity is the the most important variable. It’s basic (finally, something not complicated): the more liquid the stock, the better. Liquidity just means how many people are involved in trading the underlying. The more people involved means that the tighter the bid/ask spread will be, and the easier it will be for you to sell the trade (AND MAKE SOME $$) when the time comes.

Image via Dough.com

Dough has a great filter for both IV (see below) and liquidity. We want 4+ star liquidity!

Implied Volatility

The first step when picking a stock is to make sure that it has a high Implied Volatility.

(Read about why here: Implied Volatility: It’s All Relative, Even More on IV: The Important Variable, or IV Rank and Strategy Selection)

To summarize those articles briefly:

We can measure volatility as the amount of “fear” in the marketplace. It determines how large the swings in the price of the underlying are going to be.

The higher the IV (implied volatility) is, the higher the implied move is, and the farther the probabilities are from the stock price.

For a basic example:

Image via Dough.com

TSLA (the ticker for Tesla, Elon Musk’s company) has an implied volatility of 57. So taking TSLA’s share price of $345.54 (as of 3/12/2018) that means we have an implied move of +/- $196.9, so between $148.64 and  $542.44.

As we can see, the higher the IV, the higher the implied move.

 

That means, as option sellers, we can go pretty far out on the legs of our trades (reducing risk) and still collect a pretty decent amount of premium (I’ll explain this more later).

The reason that we seek out high implied volatility is because it’s a mean reversion opportunity. To quote myself, “When the volatility contracts, or decreases, that’s when we make our money. Based on the law of large numbers, stationary variables like implied volatility have a baseline, or a mean, that they return to after upticks or downticks.”

When volatility contracts, that means that prices are contracting. As we look to sell in these high IV environments, that’s good news for us! We can now buy back at a lower price, which results in increased profits.

Image via The Trading Rush

What goes up must come back down. And vice versa. And that makes us money.

Without getting too complicated, there are different ways to measure IV – IV Rank or IV percentile (30 days, 60 days, 6 months, and 1 year).

IV percentile treats each trading day equally. As Dr. Data from Tasty Trade explains, it “tells the percentage of days over the past year that were below the current IV” whereas IV Rank tells where IV is relative to JUST the high and low IV.

Image via TastyTrade

IV Rank = (Current IV – 52 Week Low IV) / (52 Week High IV – 52 Week Low IV)

• Current IV = 15.8
• IV Low = 11.8
• IV High = 40.7
• (15.8 – 11.8) / (40.7 – 11.8) = 14% – 15.8’s ranking for the year

Image via TastyTrade

IV Percentile = # of days below Current IV / # of trading days in a year

• = 162 / 252 = 64%
• This means that over the past year, 64% of days were below the current IV level of 15.8.

We are going to stick with the 30 days IV percentile. Either IV Rank or IV Percentile is fine to use, but I personally like IV percentile as it takes into account the entire history, rather than just maximum and minimums.

To note, higher IV is only good when we are option sellers. Higher IV means that options are pricier (hence, the premium amount that we collect is higher) which is bad for option buyers.

Binary Events

We want to make sure that an earnings call won’t get in the way of our trade. Earnings releases can sometimes cause even more unexpected movement in the market, which isn’t good for our trade.

Seeking Alpha, NASDAQ and other companies have earnings calendars that you can check to make sure there isn’t conflict.

The Trade

When we look at all that (IV, liquidity, earnings), we are left with 2 stocks (which is what I have access to through Dough; there are more).

Image via Dough.com

XLU is an ETF that tracks utilities. IBM is a tech company, to say the least. This picture shows the IV Rank of both stocks.

I am going to choose IBM because their IV Percentile is high, and so is their IV rank.  XLU’s 30 day percentile is only 15%, which means that right now, they have pretty low volatility, which isn’t great for premium collection.

To initiate the credit spread, I am going to take a look at both a short call vertical and a short put vertical. 1/3 the width of the strike is going to be the goal for the amount of premium we collect.

So if the width is $3, I want to make sure to collect at least $1 in credit.

For example:

I am selling a call vertical (bearish play) in IBM (sell an OTM call and buy a further OTM call) with a stock price of $160.53

Image via Learn Stock Options Trading

This is what the trade looks like on Dough’s platform. I sold 165/175 to collect $219 in credit (a bit off from the $300 goal: 10 width * 1/3) and with a total defined risk of $781. This gives us a 70% probability of profit (POP)!

Statistically, stocks are only a 50% POP. Can only make money if they increase in price – lose money if they decrease.

Already options are giving us a better deal!

The stock just needs to stay within the [width of the spread – credit received] (10 – 2.19 = 7.81). So we need IBM to stay BELOW $160 + 7.81 = 167.81, or else we will lose money.

I did it for 10 contracts, because my BPR in the paper trading account is $100k.

I will follow this trade, and implement new ones, as much as I can. The more I do them, the more sense they will make.

Trade small, trade often. Make some money.

3/12/2018: IBM @ $160.26

•  165/175 short call vertical

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.