Tag Archives | Russell 2000

How I Choose my Trades

Mark,

First and foremost I want to wish you a very Merry Christmas. I also wish to thank you for your gift to us of the Options for Rookies website. It's helped me learn a lot, along with your O.F.R book. Especially the "lose the pride, take the loss early" lessons.

I would like to ask you to consider a segment that would talk about your thought process in choosing your trades. If possible, I'm curious how you choose your spread widths, lot size, and strikes and what products you trade in overall.

I've noticed before your protocol of striving for a $3.00 premium for IC's. Is that a one-lot price or the total value for numerous contracts? I currently do only paper trading in Paper Money on Think or Swim (6 months now in verticals and IC's)and I see a lot of loss-risk vs. reward on the p/l graph when I try to reach those levels.

I thank you for any help in this area and again wish you and yours the best.

Bob

***

Thanks or the good wishes. I'm having a very happy Chanukkah right now, and hope to enjoy Christmas as well.  Your request is a good one, but my technique is pretty simple and thus, don't on't know how useful it will be to others.

The $3.00 is a one-lot price. I find it much easier to follow discussions when trades are broken down into the lowest common denominator, and so that's the way I write.

 

Market Bias

When making trades, the first thing to consider is whether you want to take a neutral, bullish or bearish bias.  This part is simple for me.  I never know what to expect, so I always choose a market neutral stance. 

 

Strategy

There are always several strategies that suit a trader's market expectations and it's a good idea to experiment with several and maintain anything that works for you as part of your trading arsenal.  I've come to favor iron condors, and use them most of the time.  This is something for each trader to decide for himself – especially when in the paper trading stage.

I'll shift to double diagonals if and when I expect market volatility to be higher over the shorter-term, or when I believe IV is 'low enough' that I do not want to trade short vega positions.  It's important to have a suitable strategy when seeking profits from an option position.  You cannot just go out and'do something' and hope it works.


Underlying

If you have some market expectations – regardless of direction – it's important to choose an underlying that you believe will participate in that directional move.  Other considerations are ease of entering trades, width of bid/ask spreads, satisfaction with fills, ability to adjust when necessary.  Once again, lacking predictive powers, I use a broad-based index, and always trade Russell 2000 options (RUT).  That may not be a good idea for you, but it's how I do it.

 

Specific Iron Condors

I know this is the heart of your question

1) Spread width.  I hope that you understand that this is far less of a big deal than it appears to be.  I choose 10-point iron condors because I find them comfortable to trade.  It's as simple as that.

If you want to trade 20-point spreads, there is one thing that must be understood.  A 2o-point spread is exactly the same as trading two consecutive 10-point spreads.  Here is what I mean:

Selling the 480/500 call spread is exactly the same as selling:

The 480/490 call spread and then selling the 490/500 call spread.  There is nothing 'special' about the 20-point spread.  I consider it to be a compromise and would choose that any time I was not sure which position I preferred to have in my portfolio: The 480/490 or the 490/500.  By choosing the 480/500, I get to sell an equal quantity of each spread.

One major point is obvious, but must be made:  NEVER sell the 480/490 and then immediately sell the 490/500.  That foolishly spends twice as much in commissions and increases slippage (the cash lost when trading due to the fact that we must deal with bid/ask spreads).  Just open the 480/500 spread in a single trade.

However, if you have a position in the 480/490 call spread, there is no reason why you cannot trade the 490/500 call spread at a later time.  Perhaps it would be adding a new trade to your portfolio. Or it may be part of an adjustment.

2) Lot size

If I am ready to be fully invested right now, then I decide how much margin money to have tied up in this trade, and enter an order for the maximum size.

When doing that, I always reserve some margin room for future adjustments, if needed.  If you never use anywhere near your maximum available margin, this is not a consideration.

At other times, I'll enter a portion of my preferred trade size, to get started, and then try to do more an a better price.  So, for example, if I decide to allocate $20,000 of margin to a new February RUT iron condor, I would enter an order to trade 20-lots of my preferred iron condor.  I'd keep the cash generated (let's call it roughly $6,000) available for future adjustments.

Alternatively, I would enter an order to trade two different iron condors, 10-lots each.

Most of the time, I enter an order to trade 4-lots.  Then trying to get $0.05 more for a 6-lot.  Then I try to add the final 10-lot for yet another 5 cents better.  If I cannot get my better prices, I have two choices.  I can go back to my original trade price, find another iron condor, or just play smaller size that month.

I do not take too long to get as invested as I want to be.  Perhaps Monday thru Wednesday after expiration (I'll open March RUT positions once the December option cycle is over)

 

3) Premium (price) and strikes

Each trader has a primary method.  Either the strikes are more important or the premium is moe important.  For me it's the premium.

One good way to choose strikes is by standard deviations.  The trader sells spreads in which the short option is 1.0, 1.5, or any other number of standard deviations out of the money.  This does not work for me, but it truly is a viable method for selecting strike prices.  It has the advantage of keeping the probability of seeing the options expire worthless at the same level (at least on the day the trade is made) each time you open new positions.

I prefer to take in a certain cash premium for my 10-point, 13-week iron condors.  Note:  I am not insistent.  If I find that the strikes chosen don't feel right – because of a market bias (I may not want to be bullish or bearish, but that does not mean I must ignore those thoughts.  If I feel my chosen strikes are just not far enough out of the money, then I'll take less premium and move out one additional strike price).

My preferred price is $3.00.  I always seek higher prices when implied volatility is high and the price of credit spreads is higher.  I could move further OTM, but prefer to collect $3.30/$3.40.  This is fairly flexible.  When concerned with risk, I'll go farther OTM and collect nly $3.00.  My point in offering this much detail is to explain that this is very flexible for me.

When IV is low, and it is lower than it has been in a long time right now, I'll just take $2.60 or $2.70. I'd rather feel safer going into the trade.

I don't always open three-month iron condors.  If I believe IV is just too low to sell extra vega (3-months options have more vega than 2-month optioons), I'll sell those 8- or 9-week options instead.  I prefer to collect just over $2.20 for these trades.  Hwever, as you may anticipate, it's a flexible number.

If you trade a different underlying, they these prices would be meaningless to you because the implied volatility of the options would be very different.

4)  Products.  i do believe diversification is important when selling premium.  Thus, if trading individual stocks, I'd want to have about five positions open simultaneously.  Trading indexes, I feel that supplies sufficient diversification and there is no advantage (for me) in trading more than one product.  This is the main reason:  If trouble looms, if the markets get violent, I want to have the fewest possible posiitions to adjust.  One product ismuch easier to handle than two.  I may lose a bit to diversification safety, but I make up for than in having half as many troubled positions to handle when important decisions must be made.  True my trade plan helps with those decisions, but I prefer to depend on being able to 'see' what's available at the time when others may be in a panic.

5) Expiration months

I'm happiest with 13week iron condors.  But when IV is especially low, or I don't like the premium available from 3-month trades, I'dd choose 2-month positions instead.

I do not trade front-month options,except to exit any front-month positions that I still own.  I do this to avoid positions with so much negative gamma.  yes, I give up the rapid time decay, ut it's safer and I'm happier with less overall risk.  You may feel differently.  that's ok.  Most traders prefer to trade front-month options and love trading the Weeklys. (RUT has no Weeklys as of this writing).

Bob, I hope that gives you enough insight to allow you to find methods that are suitable for you.

848

 

 


 

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Ratio Spreads: Part IV. Broken Wing Butterfly

The first three posts in this series on ratio spreads (Part I, Part II, Part III) were published recently.

The broken wing butterfly spread (BWB) is a frequently used strategy for more experienced players.  Today I'll introduce that option strategy to readers of Options for Rookies.

In general, any butterfly spread is used when the trader wants to forecast a specific price range for any underlying.  It's also created as an adjustment for existing positions (as a risk management play to limit losses or lock in profits).

In the scenario under discussion (ratio spreads) the BWB is constructed to limit losses, always a good idea when trading options.  Buying options that are relatively far OTM is not done to 'take a shot' at a gigantic market move.  Instead the trade is made to convert a position that is already short naked calls or puts (a ratio spread) into a position that is no longer short any options.  In fact, You can always buy an extra contract or two to provide an unlikely, but nice profit when the market makes an unexpected large move.  If this concept is not obvious, that's not a problem.  Use your broker's graphic software to examine the risk picture. Do not forget to look ahead and examine risk one day prior to expiration.

The BWB differs from a traditional butterfly spread as follows:

Butterfly spread: A trading strategy consisting of the sale of two options, along with the purchase of one option with a higher strike price, and one option with a lower strike price. Necessary conditions:  All options are of the same type (calls or puts); the options owned are equidistant from the options sold, all options expire on the same date

Broken wing butterfly (BWB): Same as above, except that the options bought must NOT be equidistant from the options sold.

Although these positions frequently stand on their own, they can be traded by conservative investors who would like to trade ratio spreads, but who refuse to own positions with any naked short options.  The BWB comes to their rescue.

 

The ratio spread

Let's say you are bearish on the market and want to make a trade that suits your expectations.  Your guess is that the market will fall, but not too far.  With RUT (Russell 2000 Index) trading near 673, you decide to Buy 3 RUT Jan 650 puts (@ $8.20) and Sell 6 RUT Jan 630 puts (@ $5.70).  This is a 1 x 2 put ratio spread, and you collected a credit of $3.20 for each spread. [Most rookie traders think of this as collecting $960.  However, that makes the conversation awkward.  It's far easier to refer to this spread – as well as any other – in terms of its lowest common denominator. That's 1 x 2 in this example]

As discussed in talking about break-even points for ratio spreads, when the market moves too far, you may lose a significant sum.  I know that you (the person making this trade) really believe the market can move through 650 – that's why you bought the 650 puts.  You also believe it will not decline beyond 630 – and that's why you sold the 630 puts.

However, if your are correct about direction, but very wrong about magnitude, there is no reason to lose a lot of money.  This trade is naked short 3 puts, and that leaves you exposed to a gigantic loss if and when there is a big market collapse.  Why take that risk when it's unnecessary? 

If you take the more conservative approach, you can buy some Jan puts and accomplish two things

  • Limit losses
  • Allow you to maintain a cash credit for the whole trade
    • Allows you to earn a profit, even when wrong – and the market does not decline

You can buy RUT Jan 590 puts @ $3.  Or you may choose to save a bit more cash and take a bit more downside risk by buying a put with a lower strike price.

Such a trade turns your ratio spread into a broken wing butterfly spread.  You would own 'a 3-lot' of the BWB:

Long  3  RUT Jan 580 puts
Short 6  RUT Jan 630 puts
Long  3  RUT Jan 650 puts

Maximum loss occurs when RUT is below 580 at expiration, and that loss is $3,000 [per BWB] minus the credit collected when opening the position.

Why $3,000? [$9,000 total].  With RUT settling below 580:

The 650/630 put spread – and you own that one – will be worth its maximum, or $2,000.

The 580/630 put spread, which you are short – will be worth $5,000

 

There are two main ways to earn a good profit from this spread:

a) Expiration arrives and RUT is well under 650 but above 630.  This is the risky way to play because the Jan 630s would have a good deal of negative gamma (and lots of positive time decay) as expiration day draws near.  I don't recommend holding to the end, because this is the highest risk and highest reward play – and many traders are tempted to hold and hope.  I much prefer the next method (less reward and substantially less risk).

b) Hold the position long enough that theta works its magic and erodes the price of the options.  You hope to see the market undergo a slow decline, increasing the value of the Jan 650 puts that you own, but not far enough to offset the time decay in the Jan 630 puts.

Under those conditions, you exit the trade, collecting more cash.  The profit potential is very dependent on how much time has passed, the current price of RUT, and the implied volatility of the options.  In other words, to estimate a profit, you must use an options calculator. 

One good method for establishing a rough idea of when to exit the BWB is to make a trade plan just before or after making the initial trade.  That plan sets your (flexible) profit goals, as well as the maximum loss you araae willing to accept.  Those targets make the exit decision easier – especially for the less experienced trader who may be encountering specific situations for the first time.

When the broken wing butterfly works well, deciding when to exit requires discipline.  It's always going to be tempting to wait 'just one more day' to collect that time decay.  However, the risk of a big move exists as long as you hold the trade. 

One major warning: don't ignore risk. If RUT approaches 630 far too early for your comfort, then risk of loss mounts (in fact your trade is probably already under water).  Sure, losses are limited, but that is no reason to own a risky position.  The thought process is similar to trading any limited-loss strategy, such as the iron condor.  Prudent investors take losses – by exiting, or adjusting, the trade – to prevent the occurrence of large losses.

 

The BWB is a stand-alone trade that gives the trader protection against unlimited losses while providing a very good profit when that trader is correct in his/her market forecast.  This forecast involves more than direction.  In other words, it's not the best choice when very bullish or very bearish.

This post provides the general idea of what a broken wing butterfly is and how it can be used to minimize risk whenthe trader owns a ratio spread.

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