Progression Through Option Strategies

Mark,

You mention in your response to Aldo that you would recommend “credit spreads” as a top suggestion for new traders (assuming they are comfortable). Do you have a kind of progression through strategies you would suggest?

I’ve traded covered calls, naked puts and bought calls/puts based on a course (similar situation to Aldo) and I’m looking to expand my trading strategies into spreads.

Thanks,
Patrick

Hello Patrick,

Good question.

I do have a recommended progression. However, it is not because the trader moves from one strategy to something that is “better.” I recommend beginning with covered call writing (CCW) because it involves stock trading and many option newbies have stock-trading experience. That makes it easier to begin using options.

I also recommend writing covered calls because it is a hedged, reduced risk strategy – when compared with stock ownership. One more important point: CCW positions earn profits more often than straight stock ownership, although profits are limited. I want traders to make money with options, and CCW produces far better results than simply buying/selling options (the method taught in the course you took). In fact, I hate the idea of brand-new option traders trying to make money by buying options. There is far more involved than predicting when a stock price will change. One must have a good idea of whether the options are reasonably priced (that requires an, understanding of implied volatility) and which options to buy (avoid OTM options). And the brand new trader knows nothing about any of that.

Option traders should learn about options and not about reading charts.

Next I encourage the sale of naked puts because it is equivalent to CCW. By switching strategies, the trader must learn about equivalent positions. That knowledge is very important to an option trader.

I then encourage traders to understand a collar position (a covered call plus the purchase of a put option) because it demonstrates how options can be used to limit losses. I’d love to get the new trader interested in learning to limit risk from day one, but it is important not to overwhelm a trader with too much new information at one time. Thus, I begin with a risk-reducing (and not a risk-limiting) strategy.

I consider those three strategies to represent the “Three Basic Conservative Option Strategies.”

Next I encourage the use of credit/debit spreads as a method of taking on far less risk.

The call debit spread can be looked at as something similar to a covered call, but instead of owning stock, one buys a call option. This is where the trader learns the difference between buying calls and buying stocks — each combined with the sale of a call option (essentially the ‘covered’ call).

The credit spread is a high-probability, limited profit strategy and is ideal for most traders. Sure there are other strategies that accomplish specific needs, but for the trader who has a small bullish or bearish bias, these plays are far superior to buying options.

Continuing with the discussion of equivalent positions, the trader should next learn why credit and debit spreads are equivalent strategies. To be more specific: Selling a call spread is equivalent to buying a put spread when the strike prices and expiration are identical. That must be mentioned repeatedly, otherwise some people may believe than selling any call spread is equivalent to buying any put spread. Thus, I’m careful to mention that essential requirement as often as necessary to be certain that it is well understood.

Basically that’s it. Once a trader has those strategies in his/her arsenal, more advanced strategies come from combining one or more credit/debit spreads into something that appears to be more complex. The other more advanced concept is understanding implied volatility and the importance it plays in selecting option strategies:

    –Condors, butterflys — vanilla or broken wing varieties; vanilla or iron varieties are just the purchase or sale of one vertical spread and the purchase/sale of another.

    –Then there are strategies that involve volatility more than just price changes. For example, Calendars and diagonals — single and double fall under the volatility umbrella.

NOTE: A vertical spread involves two calls or two puts on the same underlying with the same expiration date. Both credit and debit spreads are vertical spreads.

Bottom line: I do not suggest learning the next strategy is done because it is a “better” strategy. What I urge traders to do is understand something basic and then move on to something that requires a bit more knowledge. We learn strategies to learn more about how options work – and not specifically as a way to make money. Whenever a trader discovers a strategy that suits his/needs and is comfortable to trade, I suggest pausing and getting some good experience using that strategy before moving on.

Patrick, there is one more concept that is crucial (in my opinion): We all want to adopt strategies that have a good probability of meeting our requirements. In other words, strategies that we understand how to use and which make money. However, it is the trader’s ability to maintain discipline and manage risk that is far more important in determining a trader’s success/failure rate. Choosing “a good” strategy for ourselves plays a role, but it is dwarfed by the need to skillfully manage risk.

One Response to Progression Through Option Strategies

  1. Patrick 09/04/2014 at 9:02 PM #

    Mark,

    Thanks for the detailed response! It seems to follow along with your book which I have and am a big fan of. You’ve mentioned multiple times you’re not a fan of the “buy/sell” courses out there for beginners, but are there any courses you do like for beginners?

    I’ve seen mention elsewhere in your blog about a potential course you may be providing in the future. But until then, do you have any recommendations?

    Additionally, you briefly hit on the topic of risk management in your book as well in your response above. Do you have any suggested books which go into detail on risk management specifically?

    It seems to be the one facet of options trading everyone says is “key”, but most of the techniques I see for risk management involve just “rolling” positions.

    I appreciate the response and thanks again!
    Patrick

    Most courses charge thousands of dollars and there are no circumstances under which I think that a beginner should spend big money. It is easy enough to read about and learn option basics for free, or little cost. Advanced courses for advanced traders do make sense to me — if the instructor and student are compatible. Note than many new traders do spend the money believing that yo get what you pay for. Please understand that the options business has plenty of highly-skilled and well-qualified teachers. But the scammers are also ever present. Whenever money is the topic, it is common for people to get fleeced.

    Most brokers offer training. The CBOE and OCC also offer free courses. Those lessons, along with a good book should be more than enough for the vast majority of new traders to learn enough to begin trading. At that point, each student should have some idea as to whether he.she can carry on alone or whether extra instruction is needed.

    My course-giving days are behind me. I will be posting individual video lessons on YouTube from time to time, and those may prove to be helpful.

    Rolling is not a bad strategy, but it is used far too often. I know of no book that is specific to risk-reducing adjustments. However, I do briefly describe several decent ideas in the new Iron Condors book.

    Risk management is not difficult to grasp. If and only if a position is worth salvaging (i.e., it has not become hopeless), any trade that reduces negative gamma and adds some needed delta (positive or negative) and does not make a worst case scenario any worth than it already is — works as an adjustment.