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As a new options trader, it is easy to get confused.
When approaching a trade, the stock trader has a simple binary decision: get
long by buying stock or get short by selling stock.
The
options trader faces a host of potential trade constructions including
verticals, calendars, ratio spreads, and perhaps most confusing of all a wide
array of complex spreads in which butterflies, condors, and iron condors can
be created at will.
Even more
confusingly, these complex spreads are easily mutated from one to another by
simply adding or subtracting portions of their trade structure. Taken
together with learning the concepts peculiar to the world of options, most
notably the potentially confusing topic of implied volatility and its
nuances, the aspiring trader can be easily discouraged.
In
today’s missive I want to look at an extremely simple longer-term
trading plan which can produce substantial returns and is easily managed on a
day-to-day basis. For this plan I would like to use the example of one of my all time favorite trading stocks, XOM. This underlying
has tremendous option liquidity, as indicated by having traded on average
$8.6 million worth of options daily over the last few weeks.
In
addition, Exxon’s options trade with bid / ask spreads of only a few
pennies, and there is huge open interest in a wide variety of strikes. Taken
together these characteristics indicate that while price behavior may not
always allow a profitable trade, a liquidity trap is not a risk factor.
In
addition to these options characteristics, the stock pays a bit over 2%
annually by virtue of its dividend. Finally, there is little chance that its
fundamental business as the world’s largest producer of energy is going
the way of the buggy whip manufacturers anytime in the near future.
These
facts provide reassurance to the investor that during times of this ongoing
trade in which he is long stock, he is exposed to
neither the risk of a collapsing business model nor is capital encumbered
without receiving regular income via the dividend yield.
The
trading plan can be adjusted to accommodate accounts with a wide range of
capital but in its simplest form consists of simply selling naked puts at the
first out-of-the-money strike which have 25 to 35 days remaining to
expiration.
The
potential outcomes are two: price remains above the strike price and we can
close the position for a small debit or price is below the strike and we take
assignment of the stock. If the price remains above the strike, my strategy
entails closing the naked puts when the trader has extracted 80% of the
initial credit received when the puts were sold. Once the position is closed
we simply do it again and again, month after month.
The other
potential outcome is that price drops below our strike price and we are
required to buy stock at the strike price as the result of assignment. At
this point, the most basic aspect of the trading plan dictates that we begin
selling covered calls against our long stock, thus establishing a covered
call position.
Since the
stock would have decreased in price, implied volatility would have presumably
increased resulting in richer premiums for the calls we would be selling.
As long as
we are in the position of owning stock, we are entitled to the dividends. The
basic plan allows the stock to be called away if the calls go in-the-money.
At this point, we return to the initial strategy of selling out-of-the-money
puts with 25 to 35 days of life remaining.
Let us
look at the current status in order to consider a potential trade. Below is
displayed a current options montage:
The first
out-of-the-money put in the October series, currently 31 days from
expiration, is the $90 strike. We could enter this trade for 82¢ with a
potential 5% return on capital based on margin calculated for a Reg T account. This trade has a 76% chance of
profitability and a 70% chance of reaching maximum profitability.
The
nuances that could be applied to this trade are numerous and would be
reflective of the trader’s price hypothesis for XOM. For example, consider
the daily chart of XOM displayed below.
The
current price may seem somewhat extended being well above the current 50 day
and 200 day moving averages. The technical driven trader may wish to sell the
more conservative $87.5 strike, hypothesizing support at the recent area of
consolidation.
Is this
the elusive “free money” trade? It is not, but over a long series
of trades, the overwhelming probability is a significant positive return.
Negative features to this trade include requirement of substantial capital to
secure the ability to buy the stock should assignment occur. This could be
addressed by using put credit spreads instead of naked short puts if capital
is an issue.
This is
but one example of using a carefully crafted option based trade to deliver a
high probability of success. I invite you to subscribe to a trial membership
of my service at OptionsTradingSignals.com to learn more about probability
based option trading.
JW
Jones
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