I consider high probability, out of the money options spreads, to be the holy grail of trading.
By defining the risk and placing a trade that has been calculated based on prior moves and expected forward moves to have a 70, 80 or 90 percent probability of profit is absolutely amazing.
The day I came across this type of high win rate trading, my life changed. But, it’s very true that sometimes you’re wrong. I had been long gold via GLD since the summer, which has gone down more than 11 percent, a much larger move than any market maker had built into the options prices.
There are a myriad of ways to help offset some of the risk to an active trader’s portfolio, and today I wanted to cover my top three go-to strategies when dealing with drawdowns.
The first method can be done if the portfolio is long stock. By selling an out-of-the-money call, the profit potential has been capped, which definitely could turn some investors off. However, the costs per share, has been reduced.
By buying 100 shares of XYZ for $20 per share and selling a call against those shares for $2, you actually have reduced the price per share down to $18 per share, reducing the risk in the trade and turning a buy-and-hope strategy into a high probability options trade.
I generally look at the 30 delta call at least 45-60 days until expiration. This will give a high amount of credit and still have a 70 percent probability that the call is not breached, allowing the trader to roll the call out after time passes to collect even more credit, further reducing the cost basis on the trade.
Secondly, if you sold an out-of-the-money spread, which is my go-to trade, and the stock moves against you and is now in the money, you could sell an opposing spread.
So if the portfolio has a short put spread, this would mean to sell a call spread against it. By doing this, it creates an iron condor trade, but it also allows the trader to take in an additional credit on the trade. If you sold a $2 wide put spread for 50 cents, then the risk on the original trade was $150.
By selling the opposing call spread for an additional 30 cents, you’ve taken in $30 in credit and reduced the risk in the trade down to $120. It won’t salvage a trade gone wrong, but it will mitigate some of the risk.
I look to implement this adjustment if both the short and long legs of the trade are in the money for at least three consecutive trading days. I’ve adjusted too soon and then had to fight my adjustment before, so I tend to work slowly with this method.
The final — and my preferred — method is to roll the spread out in time. I generally will do this if it’s not turned profitable by the time 30 days or so until expiration has arrived.
By rolling out in time, this allows you to typically take in additional credit and gives one to two more months of time for your trade to turn profitable. I will occasionally roll for a debit if it is less than 5 to 10 cents, but not more. The goal here is to take in more credit, reduce risk and increase time to be correct.
I keep all of my trades in a trade journal which you can access for free at 10minutestocktrader.com/free-portfolio. With this year’s 77 percent win rate, you can see how powerful options trading is with all the trades that have been winners and losers, and the ones where I’ve implemented some of the adjustments mentioned above.
While options trading does allow a trader to build a massive probability of profit, there’s always a chance that something goes wrong. Having a plan in place before entering the trade is key. Keeping the risk per trade small and having a written exit target and adjustment trigger will help you trade more effectively than just buying and hoping for the best.
Christopher M. Uhl, CMA, MOSM