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You’re ready to place an option trade and you’re confident the stock is a good candidate. Now what? With dozens of contract months and hundreds of option strike prices to choose from – which ones do you select? In today’s podcast, we’ll help bring some more light to the “dynamic approach” we now use at Option Alpha for each and every trade we place. The framework and concepts around dynamic contract month and option strike price selection can help dramatically improve your long-term performance and reduce portfolio volatility.

Key Points from Today’s Show:

  • There is no one consistent framework that works across all trading scenarios; everything has to be dynamic. 
  • When you have more information, tweak and adjust your trades based on factors like option month, time until expiration, strike prices, etc. 
  • Every trading environment will be slightly different from the next, especially if optimization is the goal. 
  • Optimizing your trades will give you a lot more bang for your buck than simply using on single strategy throughout.
  • The key to understanding which strategy to use is to back-test your trades. 

Case Study

Back-tested 10 years of data on an EWZ short straddle. EWZ is the Brazil benchmark ETF; very liquid with some volatility in it. This is a great trading vehicle to gain exposure to overseas markets and to Brazil. 

Basic setup across all four variations:

  • Started with a portfolio of $250,000.
  • Trade frequency was always weekly – entered a new trade every single week, when possible. 
  • Standardized the overall allocation, using 10% of the portfolio. 
  • Took profits at 25%, which is a standard benchmark for short straddles. 
  • Had no stop loss in place and no IV rank filter. 
  • Took a hyper-focus on both days to expiration and the short strikes or Deltas that were selected.

Setup 1: 

  • 30 days to expiration time period, short strikes at a 50 Delta – selling the at the money strikes. 

Results: Trade lost $15,000, dramatically underperforming the market.

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Setup 2: 

  • 30 days to expiration time period, short strikes at a 40 Delta, slightly out of the money – selling a tight strangle (straddle synthetic).

Results: Trade made $30,000, creating a $45,000 difference in your P&L.

Setup 3: 

  • 60 days to expiration time period, short strikes at a 40 Delta.

Results: Trade lost $80,000, creating a dramatically different payoff diagram. 

Setup 4: 

  • 60 days to expiration time period, short strikes at a 50 Delta – the true short straddle. 

Results: Trade lost $41,000.

Conclusion: 

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  • When you change one factor, it does not mean that you can automatically assume that if the other factors remain the same that it will produce the same result.
  • The 60 days to expiration contracts behave differently than 40, 30, and 20 days to expiration contracts. 
  • Contracts behave differently and pricing is different in high IV versus low IV environments.
  • Your portfolio and sequence of returns are dramatically different when you allocate 50% to a trade and have 5 losing trades in a row than if you allocated 10% and have 5 losing trades in a row. 
  • There are a lot of moving parts to consider in each trade, that requires smart decisions and rational thought.

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:

Question 1: I’ve always heard people say that once you go inverted that’s the end of the game and you just close out the trade as close to expiration as you can. However, is there any possibility of rolling out the inverted trade for additional premium? For example, if you’ve inverted your trade so that you have $24 puts and $22 calls (inverted by $2), you know you have to pay at least $2 to close out the trade at some point. As you get near expiration if you have a belief that the stock will continue trading in a range of $22 to $24, could you roll out your $24 short puts and your $22 short calls for another 15 to 30 days and pick up yet an additional bit of premium?

Question 2: When do you roll a single strike that is going against you? For example, a stock is trading around $27 and you sell a $25 put. Then over a period of a day or two, the stock drops down to around $23, so you are in the money by a couple of dollars and 15 days away from expiration. When do you consider rolling that? While the stock is under pressure and volatility is high, or waiting until volatility subsides?

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!

I’m humbled that you took the time out of your day to listen to our show, and I never take that for granted. If you have any tips, suggestions or comments about this episode or topics you’d like to hear me cover, just add your thoughts below in the comment section.

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