One of the best things about trading options is the math behind it.
Place your strikes based on the deltas. Adjust for your desired probability of profit and risk/reward appetite. Trade in a 45 day cycle. Roll. Place a new trade.
Rinse and repeat.
Fun fact: I talk about options often.
A close friend of mine is also in the field of finance, so we got into a discussion one day about diversification. “Options can’t be the only thing you do.” He stated.
And of course, I agree. You need exposure to long equity (to sell options against) and maybe some fixed income in the forms of bonds depending on your age.
And options are complex. They aren’t something that the average investor engages in (which is the reason I have this blog; I want to change that). Options carry risk, but so do stocks. But options also can add value to a portfolio.
In fact, even Warren Buffet recognizes that.
Yes. The man himself, Warren Buffet writes puts.
“Warren Buffett – the man who has literally bet it all on Keynesian theory (who in late 2017 speculated that the Dow could be on its way to 1 million) – is unwinding a huge put option position in equity indices that he wrote during the worst of the financial crisis in 2008, about a decade ago. According to Bloomberg, the puts that he wrote have netted Berkshire Hathaway $2.4 billion in profit over the course of the last decade.” – Zero Hedge
If Mr. Buffet is doing it, it has to be right, right?
But of course, we all can’t be Warren Buffet (unfortunately).
But we too can trade options, just like him.
When he traded those equity puts, he was making a bet on a bull market. BUT you don’t even have to have an assumption when you trade. You don’t have to think that an underlying is going to do ANYTHING.
You just have to use delta to your advantage.
If you don’t expect a stock to move around much, you carry a neutral bias (just like the Swiss!).
For example, let’s say that you think that stock XYZ is going to remain between $40 and $42 for at least the next 45 days, and you want to make some money off that assumption.
How do we profit off that neutral bias? (yes!! you don’t have to rely on the market to go up in trading!! it can go down!! or remain the same!! and you can still make $!!)
You can trade a strangle (or for those less risk averse and with less capital – like me – you can trade an iron condor).
A strangle involves selling a OTM put and simultaneously selling a OTM call at different strike prices, but within the same expiration, as shown above.
When placing a trade like this, we tend to look for a stock that has a high implied volatility, so we can place those strikes out as wide as possible. We want the stock price to remain between the two strikes of the trade, and thus, the wider the strikes, the more room that we have to be right.
Think of it like a big net. When your net is little, you are going to catch less fish. But the bigger the net, the more fish that you can catch. The strategy is similar here. We use implied volatility to widen our net, and thus, catch more fish (aka more $).
It’s a little unfortunate because the VIX (ETF that tracks volatility) has been crushed the past few days. Its all the way down to 12.18, two points below the month-average of 14.23, and one point below the YTD of 13.55.
I love when the VIX is high. It makes things interesting. It also makes option trading more profitable.
I like to trade within ETFs, because you get the price of one underlying with the exposure to many. Think of it as diversification, but within one stock. (ETFs are essentially baskets of stocks). The last couple of trades that I’ve placed have been in the SPY, so I’ll place this trade in a different ETF.
GLD is trading at a 74 30-day IV percentile, which is pretty good considering the rest of the market. Also there are no earnings or binary events that could shake the trade up, because it is gold. (side note: there is the opportunity to back-test pre and post earnings movements and trade based on those historical ranges. Still learning about how to implement that).
GLD has also had a pretty tight trading range for the past year, between 115 and 129. I am choosing it specifically for the volatility purposes. It’s kind of weird to be trading gold because it tends to move inverse to the market. So if the market keeps grinding up, gold should be going down (theoretically).
But I don’t think GLD should move too much outside of my neutral range within the next 45 days.
And that neutral assumption is all that matters.
I can collect $180 on the 116 put/120 call strangle in gold. I’m trading at the 47 DTE. The underlying GLD itself is liquid enough, so I should be able to get filled at both of the strikes.
I have a 60% POP, with a slight positive delta skew of 3.47. That means that this trade is skewed a little bit to the upside, based on the placement of strikes. If I had skewed more to the downside, I would be carrying some negative deltas.
That’s not too big of a concern for me, but I will definitely keep that in mind when managing the trade. I have more exposure to a potential drop in the stock price, and an expectation that leans towards an up-move (I would make more money from $117.61 to $119, for example).
As long as the stock price remains in-between $114.20 and $121.80 based on my breakeven calculations (call strike + credit and put strike – credit), I will remain in the clear.
- Put Side Breakeven: 116 – 1.80 = $114.
- Call Side Breakeven: 120 + 1.80 = $121.80
One of the things about strangles is that the risk is essentially unlimited. If the stock price goes through either leg, then I can start to lose some serious money.
The premium I collect (in this case, $1.80) is the max profit I have on the trade, which occurs when I can buy the trade back for less (which I will probably do about halfway into the 47 day cycle) through a reduction in extrinsic value (which is composed of theta + implied volatility)
So let’s breakdown those components of extrinsic value.
Theta: One of the ways that the options will lose value (and enable me to buy it back for less) is through theta/time decay. Basically, the closer the option gets to expiration, the less it is worth.
Think about when a college student gets paid at the beginning of the month. At first, the bank account is nice and full, but as the student starts to approach the end of the cycle, there is less and less money in the account, up until payday, when the balance is zero. Time passes, the account decays.
The same thing happens with theta and options. I can collect money on this decay. The theta on my strangle is 3.16 meaning that everyday, the trade loses $3.16 in value JUST FROM TIME DECAY (approx) enabling me to buy it back for less.
Implied Volatility: The value of the option decreases as volatility decreases, which is why we look for high vol trades. It’s a lot easier to collect more from something if it starts out from more.
Let’s go back to the fish example. Let’s say you’re a really BIG fan of swordfish, and you go to the market looking for swordfish specifically. All other fish make you want to cry. You’re a lot more likely to find that swordfish if there are 100 sellers at the market, rather than just 10. You can collect more swordfish, because you started off with a higher opportunity to do so.
More vendors, more swordfish.
More volatility, more opportunity to make money.
So right now, gold is trading at an IV Percentile of 74. If volatility halves, then the value of the option should also drop. We have a higher opportunity to collect our swordfish.
Hypothetically, if gold dropped down to a 37 IV percentile, my individual options would also drop in vol, and would trade for approximately half of the current combined price of $1.80, which would result in a value of $0.90 – enabling me to buy back the trade at 50% of max profit.
But if I’m uncomfortable with the amount of risk I put on through a naked strangle, I could simply combine a short put vertical and a short call vertical.
Welcome to the IRON CONDOR.
Basically, this would involve buying a further OTM put and buying a further OTM call against my short strangle.
Using the same underlying (GLD), I would trade the 113.5 / 116 put vertical and the 120 / 122.5 call vertical spread.
I’m trading the long options at the 16 deltas and the short spread at the 30 deltas.
This gives me a 48% probability of profit, with a $1.00 max profit and a $1.50 max loss.
This is pretty reasonable, given that my long and short strikes are only 2.5 points wide (we aim to collect 1/3 the width of the strikes, which I am more than doing).
I’m collecting that same $1.80 credit from my short strangle that I did previously, but now I am buying protection to the upside and protection to the downside. I still carry a positive skew to the trade (which is an interesting analysis that I will dive deep into at some point in a different blog), but my overall assumption is neutral.
The protection bought costs me $0.80, which brings that max profit to $1.00 ($1.80 – $0.080). My max loss is equal to the:
- Max Loss = Strike Price of Long Call – Strike Price of Short Call – Max Profit
- In my case, this would be equal to 122.5 – 120 – 100 = 150 or $1.50
(Side note: I tend to use $1.00 and $100 interchangeably. That is because options are traded in terms of 100 contracts. So the $1.00 I talk about is really $100.)
My breakevens are 115 and 121 (such nice, round numbers; not common in trades normally!) calculated by taking the strike price of my short call (120) and adding my premium received to it ($1) to get $121. I would then do the same for my short put but subtract premium received (116 – 1 = 115)
- Call Breakeven: Short Call + Premium Received
- Put Breakeven: Short Put + Premium Received
The profit opportunities are similar in the iron condor as they are in the strangle. Just need the stock price to remain in-between the two strikes.
I can make $100 taking off a lot of risk through the iron condor, or make the $180, through the strangle, but both have the same goal.
I take most of my trades off at about 50% max profit, which usually ends up being about in the 20 day range.
When you wait until expiration day, gamma risk is through the roof, and there is a lower rate of success for profit. Its not always enticing to simply take the trade off (especially when the stock keeps on doing what you want it to do afterwards) but it’s another risk reduction measure. That beautiful risk-reward tradeoff.
Buying longs against my short legs in the iron condor enables me to have a defined risk trade, but it does limit my profitability (by about $80). But in either trade, I can still collect some theta decay and take in some volatility crush (aka make some money).
So I would place an iron condor if my risk appetite (and capital structure) was a bit small. If I want to take on a larger profit, I would put on a strangle. Simple.
All about personal preferences.
We don’t always have to think that an underlying is going to go up or down. We can make money even if it stays the same. And that is the BEAUTY of options.
Have fun employing the strategy of the Swiss (neutrality). It’s seemed to have worked out pretty well for them. After all, Switzerland’s flag is a big plus.
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.