Some traders wrongly assume that if they can’t trade unlimited risk option strategies, such as straddles and strangles, that they should just avoid trading altogether. Today however, I want to present four great alternative trades to some of the more common unlimited risk options strategies and help you learn how to convert these trades into their synthetic counterparts. The goal of all conversions is to turn a trade from unlimited risk to defined risk so that the broker will allow it in your account or based on your options approval level. I think that you’ll find after you listen to today show it’s much easier to trade unlimited risk strategies using a synthetic, risk-defined alternative than you might have otherwise thought.
Key Points from Today’s Show:
- There are only four types of strategies that end up creating what’s called an “unlimited risk” type of option strategy.
- The term “unlimited risk” is often misleading and can frighten traders when it really shouldn’t.
- These types of trades are naked positions; short puts, short calls, short straddles, and short strangles.
- While you could have a big loss in these for sure, it is not always the case and rarely happens.
- When you control position size and don’t get too aggressive with the contracts you are selling, it is always a good way to control risk as well.
Why Convert Trades?
1.If you are a beginner or new to options trading.
- You might want to convert trades if you are a beginner and you don’t want to do a naked position.
- You can turn them into alternative, synthetic positions and do something different
2. If you are trading in an IRA or a retirement account.
- In many IRA’s and retirement accounts you are not able to trade undefined risk positions
- You have to be doing some sort of spread, buying and selling options if you are going to be taking in a net credit.
1. SHORT PUT OPTIONS CONVERTING INTO PUT CREDIT SPREADS
- A short put option strategy is selling a naked put option, usually below where the market is trading.
- The easy way to convert this is just to buy a put option at a lower strike.
- Essentially, the short put can be converted into a put credit spread.
Example: If the stock is trading at $100, you might sell the 95 strike put options. You could then buy the 94 strike put options, which are just a little bit lower and therefore create what’s called a put credit spread or a bull put spread. This converts the short put into a risk-defined credit spread.
- When converting the trade over to a risk-defined counterpart or alternative trade, you are giving up premium to gain potential risk-capping of your position.
Example: If you sold the short 95 put option for $100 and you bought the 94 put option for $80. Now the difference between that spread is just $20 that you still captured. You are still an option seller, net short options, but in order for you to get the benefit of having a defined risk position, you had to give up some of your premium — you had to take $80 out of your $100 initial credit on the 95 short put and you had to use $88 to buy the 94 put option at a lower strike price, creating a spread effect in trading.
2. SHORT CALL OPTION CONVERTING INTO A CALL CREDIT SPREAD
- If you want to trade a short call option, do the same thing as with the short put option, just on the opposite side.
- For both the shot put and the short call, the wider that you make your spread, the more margin you have to put up for the trade but the more capital and net premium you will collect.
- The further you get out of the money, it becomes less and less expensive.
- The wider the spread, the more it will mimic the short options contracts/synthetic options contract, the higher premium you will take in.
- Ultimately, it depends on the market situation as to how wide you should go (see trade optimizer software).
Example: If you have a stock trading at $100, you might sell the 105 call option and if you wanted to create an alternative or risk-defined trade, buy an option contract at a strike price higher than the one you sold. If you sold the 105 call, buy the 107 call or buy the 106 call option. When you buy the contract, you give up some of the premium that you took in on the short 105 call in exchange for capping your risk.
3. SHORT STRANGLE CONVERTING INTO IRON CONDOR
- The first two strategies are the building blocks for the last two strategies — short strangles and short straddles.
- With the short strangle, you are selling options at both sides of the market — selling a call option and a put option.
- To convert it into an iron condor, buy options even further out than where you are selling options.
Example: If the stock is trading at $100, sell the 95 put option and sell the 105 call option. To convert it into an iron condor, buy the 94 put option and buy the 106 call option. In both cases, buy options contracts just $1 further out than our short strikes or our “inside legs”. This converts the undefined risk position into its defined risk counterpart or defined risk synthetic position.
4. SHORT STRADDLE CONVERTING INTO IRON BUTTERFLY
- With a short straddle, you are selling options with the exact same contract on both sides.
- Converting this trade uses the same concept as with the iron condor, but with an iron butterfly, you want to go a little bit further out.
- Your break-even points are a little bit further out from where your short strikes are.
Example: If the stock is trading at $100, you are selling the 100 strike put, the 100 strike call and take in a massive credit to do this. Now you want to buy options even further out again: buy the 108 call option and buy the 92 put option to make the iron butterfly really wide and capture a big potential profit range.
- In all of these cases, it is the same basic mentality around all of them: the buy options at strike prices further out than you inside or short legs.
- When you do that, you create a risk-defined scenario.
- The wider you make the spreads and the further you buy options out, the cheaper they become.
- This allows you to take in more net credit for your position, which potentially means more capital and slightly higher win rates, but you sacrifice putting up a bit of margin in advance.
Free Options Trading Courses:
- Options Basics [20 Videos]: Whether you’re a completely new trader or an experienced trader, you’ll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
- Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an “edge” in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
- Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We’ll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
- Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You’ll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
- Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we’ll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
- Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can’t seem to get answered, then this section will help you.
- Portfolio Management [16 Videos]: When I say “portfolio management” some people automatically assume you need a Masters from MIT to understand the concept and strategies – that is NOT the case. And in this module, you’ll see why managing your risk trading options is actually quite simple.
- Trade Adjustments/Hedges [15 Videos]: In this popular module, we’ll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we’ll help you create an alert system to save time and make it more automatic.
- Professional Trading [14 Videos]: Honestly, this module isn’t just for professional traders; it’s for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.
Option Trader Q&A w/ Steve
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Steve, who asks:
I was only introduced to options in January, and I’ve found your site and podcast extremely helpful in learning about them. I still have a lot to learn, but my question today is about trading from Canada. We are not allowed to do spreads or uncovered calls and puts in our registered accounts, only long calls and covered positions. What are your thoughts on buying in the money calls and puts? I’m thinking deep enough, say a $5 premium to get a good Delta – about 60% plus. Obviously for a call I have to choose the right direction and a suitable strike price.
For example, the June 141 call on IWN. It’s 45 days to expiration and a small move in my favor makes ma profit without having to actually buy IWN. I am also thinking I would probably have to sell it about a week or so before expiration, but as a limited risk trade, I’d like to know your thoughts?
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.
PDF Guides & Checklists:
- The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
- Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
- Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
- Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
- When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we’ll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
- 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.
Real-Money, LIVE Trading:
- EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
- VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
- DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we’ll discuss why I’m adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
- COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
- TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
- MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
- IBB Call Debit Spread (Opening Trade): We’ll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
- TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly – even still the drop in implied volatility helped generate a $330 profit for us.
- XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
- COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
- EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
- IBM Iron Condor (Earnings Trade): Shortly after the market opened you’ll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
- SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.
Thank You for Listening!
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