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My last missive dealt with a simple trading plan for
XOM using the straightforward easily managed and easily understood strategy
of selling naked puts and either allowing assignment of the stock and
entering a covered call campaign or closing the position after extracting
most of the premium initially received. Continuing on the theme of basic
strategies, I would like to look at a different high probability strategy
applicable to AAPL.
The reason
for focusing on basic option trades is quite simple: they consist of few
moving parts, are easy to enter and manage, and the statistics underlying
their probabilities of success are straightforward.
While the
available option strategies are protean and can be tailored to fit a wide
variety of market conditions, it is easy to get confused with these
multi-legged constructions.
I
encourage the novice option trader to understand fully these basic approaches
and recognize that many of these are the core of more advanced strategies.
I want to
emphasize again that traders should focus their trading on the most liquid of
the options series available. Life as an option trader is sufficiently
difficult that there is no need to introduce the additional complications of
dealing with liquidity traps.
Let us
take a look at the current situation in AAPL. This stock has incredibly
liquid options, trading well over $1 million in daily option volume over the
last several weeks. Another manifestation of liquidity, the size of the bid /
ask spread, is only a few cents. Finally, there is robust open interest in a
wide variety of the option strikes. This is a liquid trading vehicle, and it
in fact has THE most liquid options of any individual common stock.
The
strategy on which I would like to focus has as its essential element the
simultaneous selling of both an out-of-the-money call and put resulting in
establishing a high probability short strangle.
The trade
has potentially unlimited risk on the upside and risk of AAPL trading to $0
on the downside. However, at a practical level risk is controlled by two
essential characteristics; the trade is taken in small size relative to the
total portfolio, and the specific options sold have in excess of 90%
probability of expiring worthless.
Let us
consider the specifics. The first thing to consider in premium selling
strategies is the current state of the implied volatility of the underlying
asset in question. AAPL is one of a small number of stocks that has its own
ticker symbol for the implied volatility, symbol VXAPL. The current status is
displayed below:
As can be
seen above, the current implied volatility is mid-range, meaning options are
neither particularly rich nor poor in valuation.
Now, let
us consider a specific trade. Below is displayed the current option chain for
AAPL. We will be selling options with a delta of around 5. The delta is
roughly equivalent to the probability of expiring in-the-money. Therefore,
the option has an estimated 95% probability of expiring out-of-the-money.
Since we
are selling both the call and the put, the probability of both being out of
the money is 0.95*0.95 = 0.90. The position therefore has a 90% probability
of expiring out-of-the-money while keeping the entirety of the premium
received when it was entered.
The trade
is capital intensive, requiring approximately $6,700 of margin encumbrance
per 1 lot in a Reg T account. Substantially less
capital is required in a Portfolio Margin account, approximately one-third of
that amount. On the basis of this maximum potential initial margin, the trade
has an annual yield of 57%.
While the
nuances of trade management are beyond the scope of today’s missive,
suffice it to say that prudent management is not to allow the position to
incur a loss greater than the initial credit received. The trade can be
actively managed by closing the “good” side and rolling the
strikes up or down to receive additional credits as price action permits.
Last week
we discussed the elusive “free money” trade. This Is not it
either, but is simply a high probability trade constructed in a liquid
trading proxy. It is important that this trade be entered with only a small
portion of total portfolio value.
Remember
that probabilities only are realized over a growing series of specific
encounters. It is imperative to retain sufficient capital in reserve to allow
enough subsequent entries that probabilities are allowed to be realized.
Happy
Trading!
JW
Jones
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