Is This Options Strategy Realistic?

Let me preface this with the fact that I am not an Options guy which is why I am asking you Options guys this question. But be forewarned, this strategy, if implemented, will be considered extremely non aggressive and tame to the typical Options trader.

If I had to put a label on myself I’d say I am, for the most part, a swing trader. I’ll usually hold a position from one day to one month. I have been reviewing my trades and trading logs from the past two years and I have noticed that my swing trades all end up as one of the following:

1- I was right, the stock goes up and I sell for a profit.
2- I was wrong, the stock goes down and I stop out for a loss.
3- I was right, but I place protective stops too tight and get shaken out, stock continues upward leaving money on the table.
4- I was right, but learning from #3 I keep stops loose and a profit turns to a loss.
5- The trade is going nowhere yet, I sell because I see a new setup and need the funds to enter it, original trade breaks out without me, and I’m not chasing it.

You can see that most of the time I find a good setup but fail to get the most potential either for lack of capital (I currently have a small margin account of 15k) or by stopping out or dumping positions before the trade had time to work.

OK, here is my idea. Suppose I use my usual swing trade strategy, but where I normally would go long 200-500 shares of a stock I buy 2-5 calls, at the money, instead? This way if I’m right I can either sell the calls for a profit or exercise the calls since I would have been long that many shares anyway. With the Options I would know the exact dollar amount of my maximum loss as soon as I enter the trade. I wouldn’t need to worry about gap downs or slippage as I would with the stop loss on the stock position. This strategy would also give me time to let the trade work (30-60 days) without worrying about being shaken out just before a breakout, which has happened to me way too many times. One other advantage is that I can enter more setups that come along while letting the others take their course.

Seems like a no-brainer to me but as I said, I am not an Options guy. So I respectfully ask you Options traders……is there a flaw that I just don’t see or is this Options strategy realistic?

Thanks,
Don

 

the most important thing about options buying is money management. So if you have a $15k account, treat it as your investing limit was $15k, not the margin equivilent (4x, or $60k).

In other words, unless you are fine with your account quickly disappearing, you probably shouldn't buy 5 contracts (500 shares equiv) of a $50 stock, even though you can afford even 5 times more. That controls $25k worth of money. And 5 different positions of 5 contracts controls $125k - way out of the league of only $15k.

Perhaps your positions should be limited to 1 or 2 contracts max, a total of 4 or 5 positions for the account this size.

That way, your bad moves won't kill you. We all make bad moves. And you will have bad moves - its just a matter of time.

 

Hi Don,

Two points you might not have considered:

1) An at-the-money call is expensive. Every day, you will lose money on it. As an example, a July 420 GOOG call is going for $14.50. If GOOG goes nowhere today, that call will be worth $13.92 tomorrow.

2) An at-the-money call does not give you a 1:1 return on movement of the stock. If GOOG rallies to 430 today, the call mentioned above will be worth $20.40. In short, you'll make $5.90 instead of $10.00.

In my experience, long-only option strategies make the swing trader's odds even worse. Whereas you may be making 40%-50% profitable trades today, a long-only option strategy could drop you to 20% profitable.

Two possible alternatives to look at:

1) Very In-the-money calls. A July 350 GOOG call will cost you ~$72.80 to control 100 shares of stock. That's not bad compared to the $420.00 you'd have to put out to buy the stock. If GOOG rallies, you'll make practially a 1:1 match of the stock price. If GOOG falls, you'll lose slightly less than 1:1 (perhaps .97:1). There's practically no theta (time decay) working against you, so if GOOG goes nowhere, it doesn't matter much. You don't have much of a stop-loss benefit (unless you're running VERY loose stops ).

2) Very out of-the-money calls. A July 480 GOOG call will cost you $.60. Instead of buying 1 ATM call for $14.50, you could buy 20 480 calls for the same price. If GOOG rallies $20, you'll nearly triple your money. Of course, theta REALLY works against you here. Those .60 calls will be worth .55 tomorrow, and if GOOG doesn't rally massively, and fast, they'll expire worthless.

3) Bull spreads. Buy a July 400 C, Sell a July 420 C. It'll cost you $13.00 out of pocket. If GOOG goes up or nowhere, you'll pocket $20 in 11 days. You can't possibly lose more than $13, but you can't possibly make more than $20. If you think there's going to be a bigger up move, you could be more aggressive. Buy a 420C, sell a 440C. It'l cost you $8 out of pocket, but you could make $20 if GOOG goes up $20.

I hope that helps.

 

The bull spreads are a great tip -- think of it as a covered call for your long call (or a 'covered' put for a put). It will offset theta and vega decline, reduce maximum amount lost on the spread, etc.

And if you are still long, but see a bad day or two for no good reason, you can buy back the otm call for a cheaper price if you really don't want the limit on your gains.

 

Great Info guys, thanks.
I suppose I am thinking more like a stock trader than an options trader. In other words, I am not considering the value of the options day by day, instead I am considering holding the options (instead of the stock) as a swing trade. Allowing the swing time to work without worry of shakeout.

Here is an example, I went long ERS on 3/22/06 at $22.90 and had a profit within a few days. I placed my stop tight and was shaken out on 3/27/06 at $25.65 only to watch ERS go to $64.20 by May 4th. Yes, I could have jumped back in but I felt I would have been chasing it. However, if I had bought the April or May calls and excersiced them, I would have done much better. ERS is just a typical example of how most of my trades work out. Many of the trades I choose to enter end up making the move I anticipated but I'm not always right on the timing.

As far as the amount of calls/puts I would purchase, that would be based on how many shares I would have purchased/shorted. If I'd normally go long just 200 shares I wouldn't buy 5 contracts, I'd buy just two.

Anyway, I'll re-read your posts and see what I can come up with. Thanks again!

Don

 

My language was confusing, I apologize.

If GOOG goes up or nowhere, you'll profit $7 in 11 days, but you could conceivably lose $13. (You'll pocket $20, but you spent $13 to get the position)

 

It's almost never worthwhile to exercise a call (exceptions include OEX, dividends, and a few other rare cases). There will still be time value left in the option until the last few days before expiration. In other words, you could sell the option for more than the profit of exercising would bring you.

It sounds like want to dynamically adjust your exposure based upon your "faith" in the position moving with you. There are tons of ways to do this with options. For example, you could sell a call against a stock you're long term bullish on, but short term bearish. If the stock goes down (or goes nowhere), you'll profit on the call (but lose on the stock). Alternatively, you could buy a put (which synthetically turns your long stock into the profit profile of a call).

You're looking at the surface of a very deep pool which could deliver lots of the things you're looking for. For me, at least, it was well worth the effort to dive in.

 

In any directional option trade you have to decide how much the price can move in what time frame besides how much money you can loss in that trade. Then you need to decide the option strategy, etc.

I will never buy any spread can cost 65% of the strike difference. Since I usually use spreads for a big move, I will spend most 20% of the strike diffence to get OTM spreads.

The trade "Bull spreads. Buy a July 400 C, Sell a July 420 C. It'll cost you $13.00 out of pocket." is not a good trade to enter, you have more chance to loss money.

When the stock moves your way, the opeions that you sold will move better. The spreads do not open up close to the $20 until the last moment. 99% of time you should close the position way before that.

 

OP, how do you set your stops?

Have you read Van Tharp on money management/position sizing/etc? He seems to favor using volatility.

 

If I could ask one more dumb question.
Why would one prefer to sell a call as opposed to buying a put?