Introduction into Options Trading Lesson 4

Hi Steemians,

in the previous three lessons, I taught you everything you need to know about options.
If you have missed the these three lessons of this course, you can read them here:
https://steemit.com/money/@stehaller/introduction-into-option-trading-lesson-1
https://steemit.com/money/@stehaller/introduction-into-option-trading-lesson-2
https://steemit.com/money/@stehaller/introduction-into-options-trading-lesson-3

Today and in the following lessons, I will show you the most important strategies in options trading and how to implement them.
But first before we start, some important advices:

• you need a very good broker with low commissions and a fast and stable trading platform.
  There is no better broker than https://www.tastyworks.com
  They have the lowest commissions and by far the best trading platform.
• always look for stocks with a liquid option market.
  You need to look for narrow bid/ask spreads and high options volume.
  Underlyings like SPY, IWM, QQQ, TLT, XLE, GLD, AAPL, FB, NVDA, NFLX have very liquid option markets. At tastyworks there is a liquidity rating for every underlying (1 star - 4 stars; 4 stars = very liquid, 1 star = stay away)
• The best time frame for an options trade is 45 days until expiration (anywhere between 30 and 60 days is ok)
• Always place limit orders at the mid price. Never do market orders.
• in order to make the probabilities work out, you need a very high number of trades.
  When you flip a coin you should win 50% of the time, but it is totally possible that you flip a coin 10 times in a row and lose every single time. But when you flip the same coin 10,000 times, your win rate should come pretty close to 50%.
• It is also very important, that you trade small, so that several losers in a row, don’t wipe you out.
• If you have a small account, never risk more than 5% of your buying power per trade. If you have a big account, your buying power reduction per trade should be more like 1% of your account value.
• Selling premium will not produce big winners, but thousands of small winners per year will add up over time.
• be patient and start out small.
• manage your winners (and in certain cases your losers). This will give you a much higher probability of profit and over time will make you way more money. I will show you how to manage your winners/losers for every strategy.
• Close your trades or roll them to the next expiration month, when there are 21 days left until expiration. This way, gamma won’t hurt you.
• trade mechanical and don’t start guessing. Stick to the rules I give to you, especially the management and defense rules.

Ok, I hope I did not forget anything, now let’s dive into the strategies.

But first let’s have a look at a long stock position:

Being long 100 shares of stock always give you 100 long deltas. For every $1 move up/down you are going to win/lose $100.
Being long stock is always a 50/50 shot. So you have no edge and you have to lay out a lot of money (50% of the stock price times 100 in a margin account and 100% in an IRA). If you really need to be long stock, there is a better way, which gives you a slightly higher probability of profit than 50% and costs you way less in buying power:

1. The Synthetic Long:
With options you can create the same position as being long stock.
In order to understand this please take a look at the following formula:
long stock = short atm put + long atm call

As you can see, the P&L graph is the same as in the picture of the long stock position above.
It only costs you $5,800 in buying power (compared to over $13,700 for long stock) and since you can do it for 24 cents in credit, your probability of profit is above 50%.
But, as I said before, I don’t like to be just short or long stock.

There are better strategies:

2. The Covered Call:

If you are already long shares of stock or you have invested in an index ETF, like SPY in your IRA, selling calls against your position is the best way to bring your probability of profit over 50% and by selling calls, you can create a monthly income stream and this way lower the basis price on your stock.
This strategy is great for your core position, meaning a stock or index you wanna own for the long term.The best call to sell, which gives you a high probability of profit, but also a chance to make some money is the 30 delta call with 45 days until expiration.

Let’s have a look at the P&L graph:

Please note: I did these screenshots on Thursday February 15 2018, therefore the price of SPY is different from the pictures above.

By buying 100 shares of SPY (or already owning them) and selling the 30 delta call against it, you collect $1.76 (times 100 = $176). Your probability of profit goes up to 54% and your break even point goes down to $269.01.
This way the price of SPY even can go down $1.76 before you start to lose money.
The buying power reduction for this trade is 50% of the stock price times 100 minus the credit for the short call in a margin account and 100% of the stock price minus the credit for the call in an IRA.
Having a higher probability of profit and a lower break even comes with a cost.
Your max profit goes down from unlimited for long stock to $799 (short strike - stock price + call credit, 277 - 270.77 + 1.76 = $799).

How to manage this trade:
When you have reached 50% of max profit ($400) you either close the position (if you don’t want to own it anymore) or roll your call to the next expiration cycle and collect more credit.
You roll your call to the next month, by buying to close your short call and selling to open the new 30 delta call (or the same strike as the old one) in the next month, but do it only, if you can collect a net credit. Never roll if you have to pay a debit.
When you reach 21 days until expiration, always roll or close your position, to avoid gamma risk.

What if...

• If the price of SPY blows through your short strike and you can’t roll your call for a credit, you either close your position (sell your stock and buy back the call) or you wait until your stock gets called away. By selling a call, you basically signed a contract to deliver 100 shares of SPY at the strike price. This is a high class problem. Congratulations, you made money ($799 profit). If you want to still be long SPY, you can either reestablish or sell a put instead (more on short puts in a moment).

• If the price of SPY moves down and your short call becomes basically worthless (price below 30 cents), you either roll down to the new 30 delta strike (if you have still more than 21 days to go until expiration) or roll out to the next month and to the new 30 delta call.
  This is a defensive maneuver, you probably will be down on the position, but your losses will be lower than with outright long stock.

Exercise Risk:
If your short call is deep itm and has very little extrinsic value left, there is always the risk, that your stocks get called away before expiration.
You can find out the extrinsic value of an itm call by looking at the price of the corresponding put.
Let’s look at an example:

This SPY 237 weekly call, which expires in 7 days is deep itm. Its extrinsic value is 6 or 7 cents (price of the put). The chance of being exercised is very high. So you either roll (which is almost impossible to do, since the call is so deep itm), or you close your covered call, or you just wait until you get exercised. If the price of the put is higher, it makes no sense for the owner of the call to exercise, since he would throw away all the extrinsic value. He can just sell his long call and if he wants to own the stock, he can buy it.

Dividend Risk:
If a company or an ETF pays a dividend, there is the risk, that you have to pay the dividend, if you are short a call, which is itm and the owner of the call exercises his call.
If you have a covered call, this is not a problem, since you own the stock, so the dividend for your long stock, goes to the owner of the long call, if he exercises his position.
This risk only exists on the day before the stock goes ex dividend.
There is a simple method to find out if you have the risk of being exercised.
You have to look at the corresponding put for your short itm call.
If the price of the corresponding put is higher than the dividend, there is no risk of being exercised. If the price of the corresponding put is lower, you either need to roll your short call to the next month or close your position. If you don’t care that your stock gets exercised, than you can’t just do nothing.

You probably ask, why somebody might exercise your itm call.
The one who is going to exercise your short call the night before a stock goes ex dividend is usually a professional trader or more likely a computer algorithm.
If this trader or algo sees that an itm call has less extrinsic value than the amount of the dividend a company pays per stock, he buys this call and the corresponding put and immediately exercises the call. The next day, the price of the stock trades without the dividend, meaning it goes down. He collects the dividend, but loses on his long stock, but since he also is long a put, his position is perfectly hedged, so he collects the dividend (minus what he paid for the put) basically for free.

But as long as you are not short naked calls, the dividend risk is nothing you need to worry too much about (if you are short a naked call and get exercised a day before a stock goes ex dividend, the dividend comes out of your pocket)
Good brokers will warn you, if you have a position, which is likely to get exercised, before a stock gets ex dividend.

The Greeks:
A covered call is a long delta, long theta, short gamma, short vega position.
So you get hurt, if the price of the underlying stock goes down and/or if the implied volatility rises.

3. The Short Put
The short put is a great strategy to start a long position. Especially when IVR is high (above 50%).
You sell a 30 delta put with 45 days until expiration (anything between 30 and 60 days is ok) and if the stock price goes up, you roll your put to the next month and collect more credit. Some day the price of the stock will fall well below your strike price and you will get assigned 100 shares of stock for every contract you were short.
But since you already wanted to get long the stock, this is great. You already collected a nice premium and therefore you bought the stock at a much lower price. After you get put the stock, you start selling calls against it, until your stock gets called away some day. If you still want to be long the stock, you start all over again by selling puts. Rinse and repeat.

But let’s look at the best method to sell puts in detail.

First the P&L graph of a short SPY 30 delta put:

Looks pretty much like a covered call, right?

By selling this SPY 264 put, you are willing to buy 100 shares of SPY at 264, if the owner of the put exercises his put. For taking over this obligation, you get paid $2.62 (times 100 per contract = $262). The margin requirement for this trade is about $4,700 ($26,137 in an IRA)
Again like with the covered call, the 30 delta put gives you the best risk/reward.
Your break even is 264 - 2.62 = 261.38 and your probability of profit is 73% (compared to 50% for long stock) and your probability of making 50% of max profit is 88%.
Your max risk on this trade is $26,137 if the price of SPY goes to zero.

By selling a naked put, your are selling insurance.
The best time to sell insurance is, when there is a lot of fear in the market (when IVR is high), so after a huge sell off.
Fear is usually overpriced and overstated (that's why insurance companies make money) , therefore in reality over time you are going to have a much higher win rate, than the probabilities suggest.

How to manage this trade:
You manage this trade at 50% of max profit ($262/2 = $131), so if your put trades only at $1.31, you buy it back.
If you wanna keep a long position in this company or ETF, you immediately sell a new put at the new 30 delta in the next expirations cycle.
If you reach the point where there are only 21 days until expiration left, you either close your position or roll out to the next month (new 30 delta or same strike), but only if you can do it for a credit. This way, you avoid most of the gamma risk.
If you don’t want to own the underlying stock, you also close the trade, if your losses have reached 2 times of the credit received.
In this example you would buy to close this short put, if it trades for $7.86.
If you want to own the underlying stock, you just keep rolling, as long you can get a net credit. If you can’t get a net credit, since your put is too deep itm, you just wait until the put gets assigned and then you own the stock and immediately start selling the 30 delta call against it. The goal of this strategy is, to collect so much premium over time, that in the end (after a few years) you own the stock for free.

Assignment Risk:
If your short put is deep itm, you have to look at the corresponding call.
If the corresponding call has basically no value left (around 5 cents or less), the risk of getting assigned is very high. In this case, try to roll out to the next month (buy to close your short front month put and sell a new one at the same strike in the next expiration cycle, but only if you can do it for a net credit). If you can’t roll for a credit, than you either wait until you get assigned (if you still like the stock) or close the position (buy to close).
If you want to own the stock, you can also start selling a 30 delta call against your position, right now. This way you can get a bigger credit, as if you wait until assignment and then start selling calls.

Defense:
If the price of the underlying stock goes against you (down) and your put goes itm, your long deltas grow.
What was a 30 delta put in the beginning, quickly becomes a 50, 70 or even 100 delta put. To reduce your long deltas, you can sell a call against your position (this won’t cost you more buying power). This way, you collect more credit and you have a higher chance to break even on this trade.
Of course, there is always the chance, that the underlying stock jumps back up and blows through your short call. If this happens, you need to roll up the put in order to collect more premium and try to break even on the way.
When the price of the stock goes back up, implied volatility should come down, which makes your short options cheaper. So the chances of breaking even or even closing your position for a profit grow.

The Greeks:
A short put is a long delta, long theta, short gamma, short vega position.
So you want the price of the underlying stock to go up and/or the implied volatility to go down, in order to make money.

Again we covered a lot today.
You now know the most basic options strategies.
The Covered Call and the Short Put.
In the next lesson, I’m going to talk about the opposite of theses strategies, The Covered Put and The Short Call.

If you liked this lesson, please upvote and resteem.

If you have any questions, feel free to ask.

Have a wonderful day,
Stephan Haller