TradeWins Inside Trading Newsletter

April 9, 2019

How to Trade Options: Free Strategy Guide

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PULSE Options Weekly Newsletter by Chris Verhaegh

TradeWins Author Team

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Stock Options: Selecting the Right Strategy

To select the strategy, the first thing you do is choose your expiration series. Let’s choose February, then you look three to five months out. It takes about two to three months in time for the move to fully develop, and you want to give it time to let those profits run.

You also want to think about contingency planning – what happens if things go wrong. There’s a well-known curve on how time decays in options. And at-the-money options decay parabolic-ally, which basically means that the rate of time decay speeds up as you get closer to expiration. Our expiration selection gives us an opportunity to avoid catastrophic loss in the last month. If the move takes 3 months, I want to buy a 4-month option. If the move takes 2 months, I want to buy a 3-month option so that I can avoid that catastrophic time decay as the option gets closer and closer to expiration.

We want to keep the strategy very simple. We want to use Straddles and Strangles. If the asset price is in the middle of two strike prices, choose the strangle, otherwise choose the straddle. What that means is, if you have a stock that’s at 57.50, you have the 55 strike and you have the 60 strike. Well, 57.50 is right smack in the middle of it, so I need to choose the strangle. And the strangle would be the 55 put and the 60 call. If the stock is right around 54 to 56, in that range, then I’m going to choose the straddle. I’m going to buy the 55 call and the 55 put.

The next thing is entry price. You can use a calculator – either the Chicago Board Options Exchange, or any options calculator out there, and you can put the data into the calculator to come up with the fair value of the options. The CBOE option calculator is a great resource for options information.

Then, the next thing you want to do is, you want to choose your exit strategy. And here’s where it gets down to, just being prudent in your planning and choosing strategies that are appropriate for individuals. In this particular instance, when you buy a straddle or you buy a strangle, it’s impossible to have a catastrophic problem prior to expiration. Now some of you might be aware of this: at expiration, you need to get out of your positions, because there is an automatic assignment provision in stock options. If your options are in-the-money, you’ve got to sell them before they expire. Otherwise, there are potential problems. But, generally speaking, if you buy a straddle or a strangle, it’s really hard to have a serious problem. That tells you about your contingency planning.

The next step is to know is “How do I take my profits”? You want to use volatility and probability to determine your stock price targets and act accordingly. Below is a graph of Amazon. In this particular instance, Amazon made a pretty good move for us. We put the position on in early February, right when it went flat. Then the stock started to move down. I thought, “Okay, well, I’m going to make money on my put.” Instead, it turned around and it started moving higher, and then gapped up. That was when we started to take some profits, and just rode it all the way up until we got into July. At that point the options just ran out. So, then you have a choice. You can either just let the options expire and take your profits – or you can sell your options at that point.

You could also consider strategy, that in this particular instance I used. It’s called Rolling Up and Out. Here’s what that means: originally we bought the July 22.50 calls and the July 22.50 puts. The stock got up to about 45. Well, I went from the July 22.50 call out to the November 50 call. That’s rolling up from a lower strike to a higher strike (rolling up) and then out to a further expiration month (rolling out).

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