Trading with Spreads - Looking for Advice

Quote from aijourneyman:

Hi-

This is my first post here, and I hope its not too much off topic. I have been studying trading for two years, have made and lost money trading equities, though nothing drastic on either side. I have been studying options for about 9 months now, and to be sure, I have only made real trading decisions in the OnDemand feature of TOS.

Yesterday I sat in on a free options trading presentation/mini-seminar, buy someone who has a lot of experience (being a market maker at the CBOE with over 20+ years in options). Some take-aways from the seminar, which I am interested in pursuing more, were:

1. Retail investors typically only by long calls or long puts or do simple covered calls, and for the most part lose most of their money in time decay.

2. The only real way to trade options and remain in the game is to play spreads, offsetting as much time as possible with selling and buying various spreads.

3. Most option traders dont care much about direction like retail investors.

The main focus for me is the spreads piece. He did a lot of examples of showing how to basically ride some upside movement but by paying much less premium by playing with selling the opposite side. It was fancy, fast and hard to follow - I later fond out this was a pre-cursor to being canvassed to pay for his course, which I am sure is very good.

How do I learn more about this way of playing options? Are there any good books that focus on this? I have actually read quite a few options trading books, but the way this presenter used options yesterday, I have never seen that or at least gleaned it from the books I have read.

Heres a hypothetical scenario - see attached images of google. I have never played google, so I have no idea what happens in the next few weeks - the images are taken from within OnDemand of TOS.

At this point price could go either way. I know one trade, which would be expensive, is a straddle. But I am wondering what other trades could be considered here to take advantage of the situation without losing everything blindly. And maybe there isnt a trade, I dont know.

I realize there are many things that could be said here, and I apologize if this is a silly or simplistic question for the traders here.

Thanks,

AIJ
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Hello aijourneyman, there is certainly money to be made using complex option strategies. There are plenty of resources on the Internet and books that will cover the most common ones for different scenarios. You should start there (like the investopedia links that were already provided).

I don't know about those seminars though. I have never taken one, but I have seen plenty of promotional/educational materials and the impression I get is that they are focused more on the Technical Analysis side than on the options themselves.

My personal opinion on how to tackle the learning curve is this one:

There are several levels of abstraction when we think about options:

1. High level of abstraction: where they are just explained conceptually (Puts, Calls, expiration, strikes and so forth).

2. Medium level of abstraction: when the concepts of time decay, implied volatility, and the greeks are introduced. You learn what they do but you don't really know the origin or the impact of one over another.

3. Low level of abstraction: you finally understand the valuation of options and have a commanding handling of the different models, like Black Scholes, Binomial, Bjerksund-Stensland, etc.

You could trade options at any of those levels, but to actually make money in a consistent manner you would need at least to be comfortable thinking about options at a medium abstraction level. And, If you have the academic background, I would recommend going all the way down to the arcana of the actual mathematics behind them, it helps a lot and it opens your eyes and imagination in terms of strategies.

Don't get me wrong, options have been around for a long time and I think that every possible strategy has already been devised, used and abused. Although you never know, there are some traders out there that figure out ways to use the old combos in very ingenious ways.

While you expand your theoretical knowledge you could do some paper trading with simple strategies, and that way you get a feeling for them and get more confident.

Good luck!
 
Quote from Put_Master:

The more you know about the GREEKS, the better a trader you will become. But not all Greeks are equally important or as relevant as others may be.
A lot really depends on the type strategy(s) you are comfortable with and prefer to specialize in. But the more you know about how they work the better. There are a lot of ("if's, and's and but's"), when it comes to option trading, and not all of them are as obvious as you might think.

I'm the least expert of all here, so keep that in mind when evaluating my comments. But my suggestion is to start with an area you are comfortable with and strong in.
For example, if you are a good stock picker when it comes to price value and quality, consider a strategy that plays to that strength.
If you are good at selecting stocks that are range traders, consider spread type strategies. Or perhaps you are good at trading volatility and making adjustments.

Don't do things just because you see others doing them, or because you think it's a "cool" strategy, or because you want to impress others with your sophistication.
You really have NO IDEA how quickly you can lose all your money trading options. What may seem relatively safe and predictable on paper, can wipe you out faster than you can imagine in the real world of option trading.

If there is one thing you need to learn above all else, it is RISK MANAGEMENT.
And how to manage that risk, will be different for different strategies.
Different (if's and's and but's), for different strategies.
And avoid using excessive margin leverage, until you are ready for that responsibility. That is what kills a lot of investors. Very easy to be on excessive margin with options, and not even be aware you are even using margin at all..... until your account is wiped out because of it.

Personally, I would suggest selling OTM cash secured puts instead of buying calls, at the moment, as you want theta working for you. Not against you.
But just as important, is waiting for the right time to initiate a trade, what ever your trade strategy preference is.
Getting in too early or getting in too late can be a big mistake.
Wait for opportunities.

As for paper trading, it really doesn't work. Most people make money paper trading. Unfortunately, you will make different decisions, or you will "time" those decissions differently, when under the STRESS of real time/real money/real margin risk management.

Post the trade you are thinking about doing, or after you have done it, so it can be discussed, debated, argued, challenged, and perhaps even insulted. There is no better way to learn...... and it's free.
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Hey, Put M... we have not seen eye to eye on a lot regarding spreads... But this was a good piece you up here.

And you were wrong in one area ... Even though we disagree at times, I would say you are more knowledgeable in this area then me.
 
Quote from webicknell:

Hey, Put M... we have not seen eye to eye on a lot regarding spreads... But this was a good piece you put up here.

And you were wrong in one area ... Even though we disagree at times, I would say you are more knowledgeable in this area then me.
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Re: courses \ education \ training

Are you aware that TOS has a daily FREE education session called "Swim Lessons" that you can access thru the platform (support chat button, then "chat rooms"). It runs 3 hours per day, 11:30 - 2:30 every week day. They could be more focused and concise sometimes on specific subject areas, but it's free and if you tune in regularly you will definitely soak up some options knowledge
 
I've recently been eyeing an idea on spreads, not to hijack this thread but the discussion may lead further along with the OP's premise.

The idea is to be long a spread with the lower strike in the money and the higher strike out of the money (bullish spreads are what I'd mainly be sticking with, though bearish aren't ruled out and may be substituted). Common sense says use large/stable bellweather type companies.

For example, an October 38/42 call spread on JPM costs $251 at the time of writing.

The $38 strike costs $305 and is in the money with the stock currently at $40.89.

The $42 strike costs $51 and is out of the money.

My rationale is that time decay is is my side, plus $51 in downside protection if the stock dips (not a great deal of course).

Profitability being from neutral, mildly bearish, or bullish outcomes.

Limited risk which could be further hedged by an out of the money long put/spread and while limiting profit, the position is self hedging and the ROI percentage looks very good on a month to month basis.

Thoughts?
 
Well, as long as you asked, I'll throw in my 2 cents.
Just a few months ago, between mid May and mid June, when the stock was formings a base of support in the $32 area, you were not bullish or interested in a trade.
When it then formed another base of support in the $34 area, you were still not bullish or interested in a trade.
Now that the stock has risen almost 30% from that $32 area,.... now you are bullish and interested in a trade???
6 month chart below:
http://finance.yahoo.com/q/bc?s=JPM&t=6m&l=on&z=l&q=b&c=

While the credit and annualized % return for the trade looks good, the "probability" of actually keeping that profit, doesn't look quite as good.
WHY?
You are investing high, as the stock has already had a nice run,.... your otm safety cushion is only about 2.5%,.... since it's a spread I'm assuming you don't want to consider buying the stock, and probably can't buy the stock if it trades below your bullish strike, which means you plan to close the trade for a loss, if the stock drops more than 2%,.... you are using a 4 point strike gap, which means you won't get as much benefit neutralizing a drop in stock price and/or a spike in VIX, if/when closing your spread, as a more narrow strike gap spread would offer,.... JPM earnings are reported one week before the trade expires. That could be a stressful day and subsequent volatile week, and so on...
Like I said, the credit looks good. But I'm not as impressed with the "probability" of actually keeping the profit.

There are plenty of positive issues about the trade as well. But you already know them. And simply having a cheer leader tell you what you want to hear, doesn't really add anything of value to your analysis of a potential trade.

One last issue. You mentioned the spread trade as having a "limited risk".
In spread lingo, that is "code" for,.... "I would be on excessive margin leverage if I considered buying the stock if put to me. So I will be forced to close the trade for no more than a pre-set maximum loss, if the stock drops a penny or more under my bullish strike."
And if all your investment cash is used to trade spreads, and they all experience a sig drop, then that "limited risk", is only limited to the size of your entire account. That being, you can only lose up to 100% of your account. Not any more.
Why?
Because 98% of spreads are using a significant amount of margin leverage.
And the higher the strikes are that you use, and/or the more narrow your spread gap, the higher the margin leverage you are using.
And the more margin you are on, the more you are at risk of that.... "limited loss"
Just my 2 cents.
 
From Optionistics:

http://www.optionistics.com/f/probability_calculator

Prob JPM below 38 = 65% ; P/L = -$251
Prob JPM Greater then 42 = 8% ; P/L = $149
Prob between 38 and 42 = 1 - (.65+ .8) = 27% ; P/L = -51 (average)

Probability wise a bad bet... unless you have information that the future for JPM is bullish. I don't get that from the chart:

http://stockcharts.com/h-sc/ui?s=jpm

This is of course just one instance of your hypothesis. However the probability of success in a bull call spread with the long call ITM and the short call OTM will always be on the edge because you are straddling the current price. You would get better stats if the price were lower in relation to price history but would always be betting the stock stays the same or goes up.

i.e. this is a bullish trade... as all bull call trades are.

My rationale is that time decay is on my side

Oct 38 call: Theta = -.0112 Delta = .8798
Oct 42 call: Theta = -.0198 Delta = .3511

The majority of variation in option pricing is in delta which again helps you if price goes with your trade and hurts you if price goes against you. At this point in time Theta is on your side but Theta is small relative to delta. As you get closer to expiration Theta will be more on your side... but not all that much relative to Delta.

http://www.amazon.com/Option-Volatility-Pricing-Strategies-Techniques/dp/155738486X/ref=pd_sim_b_3
 
I am a retail trader. on the contrary,

1. I just buy calls/puts
2.Never care about spread, butterfly, delta,greek, IV... never want to kknow
3. I care about the direction, just as jessie livermore said, big money is in the trend, not in the market makers' fluctuations, those just noises.
retail traders have a disadtange, they often have a small account, they are under-captilized, not deep pocket like MM. so each bullet counts. as a retail trader, must find our strength, then use our strength. do not use weakness to trade, you will lose.

only when you have a clear trading idea, and you have a clear direction expectation, also have higgly odd in your favor, almost 99% sure (rember each bullet counts) then you should trade in the direction. do not gamble like MM, they are deep pockets, that is their strength, lost couple deals to me, mean nothing, but to a retail trader, disaster.


my most recent big directional gain is in KBH/BZH, about three weeks, all my position turned out to 3times more gain. I have lots of short-term big gainers too. My expe last turned to five fold gains. EXPE gapped up, then retraced to my 50EMA, I bought 55 calls at 0.7~1.0, sold at the friday closing. the trend is so classic.

I view my option trading successful. I know I have lots of losers, but compared to my big winners, just nothing,i.e. can be ignored.


in option trading, the simpler the strategy, the more chance you will gain.





Quote from aijourneyman:

Hi-



1. Retail investors typically only by long calls or long puts or do simple covered calls, and for the most part lose most of their money in time decay.

2. The only real way to trade options and remain in the game is to play spreads, offsetting as much time as possible with selling and buying various spreads.

3. Most option traders dont care much about direction like retail investors.


AIJ
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plus most people have misconception about time decay.

they think because of time decay they lose if they use long timeframe.

they do not realize this is only true if the market after a long period of time, it does not move.

as you know, market just has two directions, either up/down. someone may say there is a flat market.

flat market actually does not exist, and you should never trade flat market. this kind of market is just preparing to breakout either up or down, the more time it is flat, the more powerful the explosition or fall.

in another word, time decay means nothing compared to those big move.

trade a flat market, just like coin flipping, you are gambling since you have no direction bias. you think it is coin flipping, that is gambling!

and in this case, time decay has meaning. i.e., you will lose for sure. so why put yourself into losing position.

so you must have a direction bias to trade option!
 
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