Options Trading Answer Vault Published by Option Alpha. All Rights Reserved.
About This Guide Over the last 8 years I ve been asked so many different types of questions about options trading. Recently I decided to spend a couple days going through all the questions, sorting them out and answering as many of them as humanly possible. The result is this Answer Vault guide with more than 114 detailed questions and specific answers on everything there is to ask about options trading. But that s not all. We also created an interactive page inside our membership area which will be the hub moving forward for any future questions (and answers) we get from our growing community of traders. You can access the web vault by >> CLICKING HERE << Each week I m adding new questions and answer but if you ever need help or having additional comments feel free to contact me directly! ~ Kirk Du Plessis (Founder, Head Trader) Published by Option Alpha. All Rights Reserved.
Is my short option contract at risk of assignment? Generally your short option is not at risk of assignment until the last week of expiration. Technically speaking an option can be exercised and assigned at any point up until expiration (american style that is) but almost 90% of assignments happen the last week of expiration so don't freak out. If you get to the last week of expiration and you have a short call or put option ITM then you'll need to go ahead and reverse the trade and buy back the option to close the position or you do risk being assigned the stock. What does it mean if an index is cash settle? Indexes like SPX and RUT are cash settled meaning that at expiration you do not actually get shares of the indexes either short or long but rather the options are settled to the cash value of the position at that time. This is in contrast to most equity options which are settled to actual physical stock of the underlying symbol. 3 of 69
What is the best strategy for an earnings trade? Because earnings events are a one time binary announcement they are usually followed by a volatility crush where implied volatility drops dramatically after the earnings announcement. Therefore the best option strategy to take advantage of this IV drop is to trade either short strangles and straddles or iron condors. These option strategies are specifically designed to take advantage and profit from an implied volatility drop. How do I select the strike prices on an earnings trade? There are a couple different ways to select strike prices on earnings trades. The first way (and my personal strategy) is to short both the call and put options that are one standard deviation away from the current price of the stock. These would be at the 15% probability of ITM level. The other way is to find out what the expected move of the stock is after earnings (say $5 in either direction up or down) and make sure that your short options on either side are just outside this range, maybe $6 away on either end. Again, this will get you about a 70% chance of success during the earnings event. 4 of 69
Should I roll my earnings trade from the weeklies to the monthlies? Yes, only if the trade moves against you after the earnings announcement. If the stock opens inside your expected range on your strategy then you want to close out the trade and take whatever profit is there. What time frame should I make an earnings trade? Again because earnings trades are 1 day events, short timeline and duration is the best choice. As a result the closest weekly option we can find will be your best contract to trade. If the underlying stock does not have any weekly options available then you are okay to go out to the next contract month. Weekly options however give you the best opportunity for a quick decay in the options value following the announcement. 5 of 69
What happens if my earnings trade goes against me? If you're trading these strategies correctly more than 70% of the time you will have winners but there will always be trades that go agains you right? Your first line of defense if an earnings trade goes against you is to roll up the side that the market moved away from. For example, if the stock gaps higher then you would roll up the put side of your trade to a level closer to the new market price after the event. Doing this will allow you to take in a bigger credit which will widen out your break-even prices. If the stock continues to move against you during your short expiration cycle and you want to continue to hold the position then your next adjustment would be to roll the entire strategy out to the next monthly contract. This will add even more premium to widen out your breakeven points, but more importantly it will give you more time for the stock to settle into your range. How do I determine my breakeven price on an earnings trade? For most earnings trades that are short premium strategies like strangles or iron condors you will determine 6 of 69
your break-even prices the same way you would otherwise. Take the premium or credit received from selling all the options and add or subtract that from your short strikes. For example, if you took in a.50 credit on a strangle at $40 put strike and $60 call strike you would have break-evens of $39.50 and $60.50 now, respectively. What extra choices do you use on your orders: i.e. OCO, TrailingStop, TrailStopLimit, etc? For nearly all of the trading that I do, I will use limit orders only. This is because I want to be 100% sure of the price that I am getting into or out of the trade at. However if I am traveling or unavailable during that day, I will use other types of contingent orders that we cover in our video library. How do I figure out the expected move of an earnings trade? To figure out how far a stock might move up or down after earnings (70% of the time) you'll want to take the price of 7 of 69
the ATM straddle of the closest weekly options contracts and multiple that number by 70%. Then take your answer and divided it by the stock price. For example, if a stock is trading at $50 and the ATM straddle is trading for $2.25 then we would take $2.25 X 70% = $1.575 / $50 = 3.15% expected move up or down. Do you have a preset way to scan for new trades? There are literally millions of ways to scan for different trades however what most traders fail to understand, hence why most traders fail to make money, is that scanning for trades is far less important than finding a list of highly liquid options and stocks to trade. You can do all the scanning you want but at the end of the day, if you're trying to pick direction you are going to be no better than a coin flip or 50/50. Therefore it's important that you focus on different strategies in a small group of highly liquid options. Of course there are different techniques to look for new trades and I like to particularly look for trades that are at recent highs or recent lows and may revert back to the mean. 8 of 69
What is the difference between front and back month options? Front month options are the closest monthly contract that you are able to trade. Back month options are any other options that are not front month options. For example, if today is January 1st then the front month contract would be the January expiration and February or March would be the back month expiration. Note that you will also see weekly contracts between all of the monthly expirations but when we generally refer to the front and back month options we are talking mostly about the monthly contracts. When you referred to trade duration do you also meantime timeline? Yes duration is the financial term for holding time and whenever I refer to a trade needing more or less duration I also referring to that trade needing more or less time to profit. 9 of 69
Why is it important to understand Delta? An options Delta is the ratio comparing the change in the price of the underlying option to the corresponding change in price of the stock. This is sometimes referred to as the"hedge ratio". For example, with respect to call options, a Delta of 0.7 means that for every $1 move higher that the stock goes the call option should increase by $0.70. On the other hand put option deltas will always be negative because when the underlying stock goes up the value of the option will go down. So if you have a put option with a Delta of -0.7, it will decrease by $.70 cents for every $1 that the stock increases in price. What is an inverted strangle? An inverted strangle is when you have a call option strike price that is below the put option strike price. In this case the least that the strangle will trade for in the open market is the difference between the strike prices. An example would be a short $50 call and a short $55 put. How do I trade a delta neutral portfolio? 10 of 69
Trading a Delta neutral portfolio is nearly impossible because at all times deltas are moving up or down. Delta is a fluid data point with respect to an option s change in price as a result of a stock s movement. Most traders attempt to trade a Delta neutral portfolio would have to add or remove positions very frequently throughout the day in order to maintain your neutral Deltas. This doesn't mean that you can't have a neutral portfolio to the market's direction. However this does mean that the concept of Delta neutral trading only would apply if you have significant capital to put at risk and can make hundreds of trades per day. What is an option contract multiplier? Contract multipliers just give us an easy definition of the underlying contract size. For most options that we will be trading, the contract multiplier is 100 meaning that every 1 option controls 100 shares of the underlying stock or ETF. This is where you find the power of leverage with options. How do you determine if an option contract has enough liquidity? 11 of 69
To determine if a specific option contract and strike price has enough liquidity look at both at the daily volume that the option contract is trading and the open interest. A good rule of thumb is that you should see daily volume towards the end of the trading day around 500+ contracts and open interest of a couple thousand contracts for ATM strikes. Some options will have much more open interest and volume which obviously leads to better bid/ask spreads and quicker execution on entry and exit trades. How can you synthetically go long/short a stock with options? Creating synthetic long or short stock positions is a great use of capital and the power of leverage in options. To go synthetically long a stock you would buy the ATM call option and sell the corresponding ATM put option at the same strike price. To go synthetically short a stock you would buy the ATM put option and sell the corresponding ATM call option at the same strike price. These will give you a replicated stock position for a fraction of the capital usage. 12 of 69
What should you look for when placing calendar spreads? Calendar spreads by their nature are generally low probability trades that you should use in low implied volatility markets because they have the potential to profit from an increase in implied volatility. When placing a calendar spread trade I generally like to look for two things. First, I like to have a wide profit window on the spread which you can see when you use the analyze tab and profit loss graph. Second, I like to make sure that there is enough premium in the front month contract to decay in value so make sure that when you are selling the front month options they are not worth less than $.10. If this is the case then you are basically going long a call or put option and selling the front month option serves you no real purpose. What is considered a tight market with respect to bid ask spread? The tightest bid ask spreads are generally 1 penny wide markets. However anything 2 to 4 pennies wide is 13 of 69
considered a fairly liquid and tight market for trading purposes. We publish our personal watch-list that is updated every month of the most liquid stocks and options that we are monitoring and you can find that through the dashboard. How does a covered call reduce cost basis? Covered calls reduce your cost basis in owning the stock by taking in premium from selling a call option which is directly offset by the underlying price of the shares you bought. The benefit to doing this strategy is that you reduce your cost basis which increases your probability of success on the trade because the stock can go down in most cases and you would still make money. However the drawback to this strategy is that you do give up major upside potential if the stock rallies dramatically. At what point do you look to take profits on a calendar spread? Because calendar spreads are low probability strategies you will want to take profits earlier and I generally like to start exiting the trade at 25% of max potential gain. So if I 14 of 69
can make $100 on the trade I would look to take at least $25 out of the trade and start exiting. What dictates the width of a calendar spread? The width of a calendar spread is mostly determined by the pricing differential between the front month and back month options; the smaller the disparity and pricing the wider the calendar spread will be. This is because you will be taking more advantage of the time differential in the option prices as opposed to one option being dramatically more expensive than the other and effectively going long or short stock. What are the pros and con of starting out with one leg of a spread then depending on if the movement is against you, then add the second leg? Starting with one leg of a credit spread or debit spread is a risky proposition because you have unlimited risk to begin with or if you go long the first option you are buying options which generally never works out anyway in the 15 of 69
long run. Therefore it's best on credit spreads and debits spreads to enter both legs at the same time with one order. You can choose to leg out of a spread but I do not suggest legging into it. Given low volatility rank, when do you use a debit spread vs.a calendar spread? I like to use debit spreads when I want to be more directional on the stock. With calendar spreads you need significant time in the front month options so if there is less than 20 days in the front expiration contract I will generally use a debit spread over a calendar spread purely based on the amount of time left. What is the difference between a bear put debit spread and the bull call debit spread? A bear put debit spread is when you buy one put option in the money and sell one put option out of the money for a net debit to go short the stock. A bull call debit spread is 16 of 69
where you buy one call option in the money and sell one call option out of the money to go long the stock. Given high volatility rank, when do you use a credit spread vs. an iron condor? Since iron condors are created out of two separate credit spreads you can use them interchangeably whenever you want. I preferred to use iron condors when I want to be neutral on the direction of the underlying stock versus using a credit spread when you want to go bullish or bearish on the stock by trading on the one side of the iron condor. Sell a wider spread or more contracts? I will always default to using a wider spread versus more contracts because you are able to get in and out of them quicker with less commission. However you do always need to make sure that there is enough liquidity in doing a wider spread and if the options at that wider spread strike prices are not liquid enough then I will narrow my contract with an increase in the number of contracts I'm trading. 17 of 69
How many trades should I be putting on each week month year? In order for high probability trading to be profitable long term you need to make a lot of trades so that the probabilities work themselves out over time. It's similar to how a casino runs in that you need lots of people gambling little bets over long periods of time and you will eventually become very successful as the odds work in your favor. Though you may find success earlier you should look to target making at least 500 trades or more per year if possible. After this point you have a much higher chance of having a profitable P&L moving forward as the odds are more likely to work themselves out over a long period of time. How do you figure out the probability of a strike price being in the money at expiration? There are 2 basic ways to figure this out. First, you could use delta as an approximate assumption (though it s not as reliable as the second choice below). If a strike price 18 of 69
has a delta of 0.30 then that means there is approx. a 30% chance that the strike will be ITM at expiration or a 70% chance it won t. The second way to figure this out is to use an ITM probability calculator on your broker platform. We cover this in specific video tutorials here in the membership area but you would basically just look at each strike price and the columns next to the strike prices would show the ITM probability as an exact number (like 28.75% or something vs a 0.30 delta). How do you calculate return on capital or return on portfolio? First you need to figure out how much capital the option position you are trading will require in either cash or margin. For this example lets say that the margin requirement for selling a credit spread is $500. If you take in a $75 credit then your return on capital is $75 / $500 = 15%. However this is not your return for your entire portfolio. If this $500 position represented 5% of your portfolio then your 15% return on capital is actually an overall return on portfolio of 0.75%. Here I took the 15% divided by 5% allocation size = 0.75% return overall. 19 of 69
Does implied volatility always overstate the expected move? Long-term yes. The more often you make trades the more that IV will overstate the expected move. There will be outliers in all stocks where the underlying moves 2X or 3X the expected move (the black swan type of events) but those will not hurt you overall if you stay consistent. Should I be a net buyer or a net seller of options? Net seller. No study or body of research has found that just option buying is profitable long term. In fact, even when you buy options before huge market moves higher or lower the embedded volatility edge that you pay for as an option buyer erodes your ability to consistently make money. Does this mean you can t make money buying options - nope, you can, just not as your only strategy. Net sellers of options consistently outperform option buyers in nearly every market situation. When IV is high the edge to net sellers is even greater. 20 of 69
How do I select strike prices on a debit spread? Debit spreads are low probability trades where we are taking a directional bet on the underlying stock. Therefore our strike selection with the debit spreads needs to be more conducive to getting a favorable break even price and a fair risk reward. I first start with one in the money option and one out of the money option and see if I get a break even price that is very close or favorable compared to the underlying stock s current trading price. I also want to make sure that my trade is giving me as close to 50-50 odds and risk reward as possible. How do I select strike prices on a short straddle? Because short straddles are very high implied volatility strategies, strike selection is very easy as you will sell both the ATM put and ATM call option. If the closest ATM options are not near the current underline price then choose to play the strategy a little bit directional and select a strike price either just above or just below the market. 21 of 69
How many days until expiration should I generally be placing my trades? During low IV markets we should be targeting approx. 60-90 days until expiration. The longer time frame gives us more premium as a result of theta and also more time to be right with our directional assumption. When IV is high we want to come a little closer in on trading timeline and trade options 30-45 days out. These options will be more liquid and priced for a drop in value. Unless we are making an earnings trade I generally will not trade anything shorter than 20 days. How do I select strike prices on a short iron condor? Strike price selection on an iron condor is virtually identical to that of a short strangle. You want to place the short strikes of your iron condor at the targeted probability levels that you are looking for and from there you can buy further out options for protection and a reduction in capital requirement to hold the trade. 22 of 69
How do I select strike prices on a calendar spread? Calendar spreads are by their very nature much harder to select strike prices because you'll be looking at different contract months and the spread between those. As a good rule of thumb we like to place most of our calendar trades one or two strikes out of the money. This ideally should maximize the pricing differential between the two contracts months and give you the best possible risk reward ratio. So for example if a stock is trading at $50 we would look to place the calendar around $47-49 strikes if we are bearish and $51-53 strikes if we are bullish. How do I select strike prices on a short strangle? One of our favorite strategies is the short strangle and strike price selection starts with knowing what probability level you want to be at? For example if you want to make a 70% probability of success trade that means that each side of your short strangle will need to be placed at the 15% probability of expiring ITM level (because 15% on each side is 30% chance of losing in both directions together). This would also equally roughly to a 0.15 Delta on each side. 23 of 69
Do you make adjustments to short premium strategies when delta rises above.30? Using a.30 delta is a good road marker to use for starting to make adjustments. Because most of our trades are placed at the 1 standard deviation level (or about a.15 delta) we use.30 as our "trigger" to adjust. With a short premium strategy, if the market tests one side and the delta of your short option increases to a.30 delta then that "triggers" you to roll up the untested side closer to the market to take in more premium. But you can use whatever delta you want as a guideline for adjustments, just stay consistent in your methodology. Should I buy long single options like puts and calls? Never. They have never been statistically proven with any significant market study to be a successful trade. Sure you might get lucky here and there but long term you will lose money. Don t let anybody tell you otherwise. 24 of 69
Why is theta important to know as an options trader? Theta with regard to options trading gives us an idea of how much money each contract is losing on a daily basis because of time decay. Because all options become less valuable as time erodes, theta is always a negative number when shown on a broker platform. Theta will also increase in velocity as the time until expiration draws closer. It's important to remember that theta is like a slow drip from a bucket of water that is constantly draining the funds or value of an option contract. For example, an option with a theta of.06 means that each day regardless of the underlying market move that option contracts will lose $6 of value due to the passage of time. How do I select strike prices on a credit spread? With credit spreads you are taking a slightly more directional approach to your trading strategy assuming that the market won't go too high or too low beyond your strikes. In order to find out what strike prices you need to select you first need to figure out what probability of success you want. Most credit spread trades that we make here at Option Alpha are 70% chance of success trades 25 of 69
and therefore we place the short strike at the 30% probability of being ITM or roughly the.30 delta level. If you are more conservative with your trading and account you would want to go with short strikes that are further OTM (maybe at the.15 delta level). How much money should I have in reserve in my account? At no point should you allocate more than 50% of your account balance towards options trading. As your account grows in size this reserve fund should continue to stay large as you take on more positions with more risk. Trust me, if you cannot learn to generate money with a small portion of your account allocating more money to more trades is not the solution and will guarantee that you blow up your account at some point in the future. What constitutes a high implied volatility trade? High implied volatility trades are set ups when the IV percentile of the underlying stock is at least at the 50th percentile or higher. 26 of 69
What is a broken wing butterfly? A broken wing butterfly is when you skip a strike on one end of the spread. A regular butterfly would have for example the 10/11/12 calls. A broken wing butterfly would have 10/11/13 where you skip over the 12 strike and buy a further out strike. This should typically be done for an overall credit so that you don't have risk to one side of the trade and they work better in high implied volatility markets. What is a skewed iron condor? These condors have unbalanced strike spreads which creates skew one way or another. For example you could have the put spread side 5 points wide and the call spread side 10 points wide. This would create skew to the bearish side because that side has the smaller strike spread. The call side would also carry more risk should the stock rally because the strike spread is wider. 27 of 69
What is the best option strategy to trade that has the highest return on capital? The highest return on capital strategies are risk defined strategies like credit spreads and iron condors however these are not the most profitable strategies when you look at overall profit and loss statements. They do have a high return on capital because they do not require high margin amounts but with the added protection from buying the outside legs of the spreads you will generally have a reduced profit in total dollar terms. How reliable is technical analysis for determining a stock s future direction? Technical analysis absolutely has its place and function in the market but it s reliability in determining future direction and the magnitude of stock moves is not good. That said, I still will use technical analysis to get some sort of understanding as to where a stock may NOT go as opposed to where it might go in the future and this is just as important information when it comes to selling options. 28 of 69
What are some of the most liquid stocks that have tradable options? Each month we continue to scrub and screen for liquid stocks that have tradable options. We post this watch list inside of our membership area for those who purchase it with free lifetime updates. You can access this watch list from the main dashboard. Which options do I buy and sell for a calendar spread? If you are buying a calendar spread you would first sell the front month option and then buy the back month option. For example, a Jan/Feb calendar spread would mean that you are selling the January options and buying the further out February options. 29 of 69
What is delta and why is it important for my option positions? Delta is one of the four major greeks that we use to measure possible risk/return. Specifically delta compares the ratio of the change in price of the underlying stock to the change in price of the option contract. This is sometimes referred to as a hedge ratio. For example, if the delta of a call option is 0.70 that means that for every $1 move higher in the stock, the option should increase in value by a factor of 0.70 and visa versa for a $1 move down in the stock. As options traders, delta is also an important relative measure of probability of success (see our video tutorial on this inside the library). We can also use delta to hedge other positions in the portfolio. If we have a short position with a -0.80 delta we can look to add another position that has a 0.80 positive delta to neutralize the risk of the first position. 30 of 69
How much money should I allocate for each trade that I make as a percentage of my account value? You will want to allocate as little money per trade as possible. The smaller your trade size the less risk you have overall in your portfolio. I generally suggest that your trade size should be on a sliding scale between 1-5%. When trading high probability spreads you can allocate slightly more to that trade as opposed to low probability strategies like calendars or debit spreads. Should I diversify my option trades among different stocks? Absolutely. Having more uncorrelated trades and stocks in your portfolio is a great strategy to diversify and prevent anyone sector or industry from taking down your portfolio. For example you would not want to have all social media stocks in your portfolio. Instead you want to have social media, technology, utilities etc. 31 of 69
What market setups do you make the most money trading options? It should come as no surprise that most of the money we make as options traders comes when implied volatility is high and heading lower. This gives us the most theoretical edge in the market because option pricing is so much further from what true levels should be. Knowing this you should always strive to be more aggressive during periods of high implied volatility and less aggressive and conservative during periods of low implied volatility. When should you not make a trade? There are a lot of scenarios in which you should not make a trade but if I could summarize the top two scenarios it would have to be when implied volatility is low and when you do not have an assumption on the future direction of the stock. If you are unable to get some sort of directional assumption (bullish/bearish) AND if the underlying IV is low then your best trade is actually NO trade at all and to sit in cash. 32 of 69
Does implied volatility expand or contract as we get closer to earnings? In most cases implied volatility will expand as we get closer to earnings because of the one time binary event and unknown company announcement that follows. The more unsure the market is of the possible announcement being good or bad for earnings the higher the implied volatility will go. Some stocks will peak in IV the day before earnings while others might peak a week before so we cannot trade this increasing IV with long options (just in case you were wondering). If I want to trade volatility which symbols are best for a pure volatility play? The two best ways to trade volatility directionally either up or down is to trade either the VIX or VXX. Both are very liquid and will give you a more pure directional play on volatility. 33 of 69
What should I look for when considering to roll a trade to the next contract month? When considering rolling a strategy from one month to another it's important to consider the following. First, does your underlying assumption for the stock remain the same? If you were originally bullish are you still bullish on that stock for the next month out. If you are then this checks the box. If you are not, why would you want to hold that position for another month if you think the stock could now go the other direction? Second, you want to make sure that you are not paying a lot of money to roll a contract. In most of the scenarios that we deal with rolling a short premium strategy from one month to another, we would like to take in a credit for the roll because we are adding time to the trade. If you cannot take in a small credit or pay a very small debit then it's not worth rolling the contract and you are better off to close the position and reset the probabilities at new strike prices for the next month. Last, you want to make sure that whatever you ultimately choose extends the trading timeline while keeping your risk to reward the same or similar to the original trade. If you are taking on substantially more risk just for the sake of extending the trading timeline then it's not worth doing. 34 of 69
Why do you use implied volatility rank versus implied volatility of the actual options? Implied volatility rank or percentile is a way to compare all stock IV's apples to apples. Using a percentile basis gives us a framework as to where implied volatility is in its historical range for that particular stock. For example, if XYZ stock has implied volatility of 18% and ABC stock has implied volatility also at 18%, most people would assume that both of these stocks have the same implied volatility rank or percentile. However upon further investigation we might find that XYZ stock has IV rank in the 90th percentile meaning that an 18% implied volatility is 90% higher than where it has been historically in the past so this is relatively high implied volatility. Likewise we might also find that ABC stock with implied volatility at 18% is in the 10th percentile meaning that almost 10% of the time historically implied volatility is lower and almost 90% of the time implied volatility is higher than it is right now. Therefore we could say that ABC stock has relatively low implied volatility. See why IV percentiles are so important!? 35 of 69
Should I be trading naked options with undefined risk? First, I suggest anyone with an account size under $20,000 strongly consider not making any naked or undefined risk trades. These trades just take up too much in margin as a percentage of your account balance and you can do just as well trading with risk defined strategies in your smaller account. That said you should not completely avoid making undefined naked trades in your account because these trades have a higher probability of success and a higher profit potential in total dollar terms over the course of many trades. The downside to making these trades is that they do require more capital allocated per position which is why they are better suited for larger accounts. On risk defined trades should I ever use a stop loss order? Never. The best way to manage these trades is to make them small from the beginning since these types of trades are defined in risk you are much better off to let the probabilities work themselves out over many many trades. We actually recorded a podcast (episode number 14) that discusses the exact reasons why you would not want to 36 of 69
use a stop loss orders and why these types of orders actually create more losses because of a strike price's probability of touch. How do I know how much risk my portfolio has relative to the general market? The best tool to use as a way to measure overall portfolio risk relative to the general market is to beta weight your portfolio to the SPX. Beta weighting your positions to the SPX will show you how bullish or bearish your positions are relative to the overall market and give you a good understanding of where you need to either increase or reduce risk to get back to neutral. What type of order entry should I use; Day or GTC? Day orders are only good for that particular trading day so I prefer to use these types of orders when I am getting into or adjusting a position because I want to know what the prices are for that particular day. At the end of that day I'm okay letting these orders expire if they are not filled because then on the next trading day I can reset the pricing based on the new open. GTC orders are great 37 of 69
when you are trying to exit a trade and allow you an automatic price point for removing the trade or closing the position. I will generally use these types of orders right after I enter a position to automatically put in the order to close the trade at a predetermined price in the future. What is margin and why is it required on some trades and not others? Margin is simply the ability to use other securities in your account as collateral for separate trades. In its most traditional sense you can buy stock on margin by putting up other stocks as collateral for that new positions should it go bad. When it comes to options we generally see margin as a way to put up a smaller amount of capital to hold a short premium strategy (like a credit spread or iron condor). The margin amount is usually always lower than what the cash value of holding that position would be which allows us to use our capital more effectively. Some trades don t require margin because you are a buyer of options and have to put up cash to buy the options to begin with, so there is no collateral needed outside your initial investment. IRA and retirement accounts mostly do not allow margining so those would require cash funding or backing of all trades. 38 of 69
At what point should I close out a credit spread trade for a profit? Based on various substantial market studies it has been found that if you close out your credit spread trade once it reaches 50% of max potential profit you have the ultimate win rate long-term. So if you sell a one dollar wide credit spread for $.50 you would try to close out the trade when the value of that spread decreases down to $.25 which is half of the max potential gain. What's the best way to adjust a credit spread trade that goes against you? Your first and best adjustment to a credit spread trade is to add the opposing side of the trade once the market starts to move against you. For example, if you have a call spread above the market and the stock starts to rally higher, you would add a put spread below the market. The key to making this type of adjustment is to keep the number of contracts the same as well as the width of the strikes. This ensures that you are not taking on additional risk and that the credit received from selling the opposing 39 of 69
order helps reduce overall risk and widen out your break even points. What's the best way to adjust an iron condor trade that goes against you? While there are many ways to adjust an iron condor trade we prefer that our first adjustment is to roll up the untested side of the trade when the tested short option reaches a 0.30 Delta. Because we enter our iron condor trades at a one standard deviation level to begin with, a 0.30 Delta would be a doubling in our probability of losing and that is the appropriate level we deem necessary for making our first adjustment. After this adjustment we will generally let the trade go all the way to expiration win or lose and let the probabilities work themselves out. Why can t we just buy options? You are completely free to buy options and I would be glad to sell them to you all day long because overtime option sellers are far more profitable than option buyers as a result of the fact that implied volatility always overstating the expected and option pricing is always too rich longterm. 40 of 69
What's the best way to adjust a debit spread that goes against you? Likewise with butterfly spreads, debit spreads are 50-50 bets to begin with so we do not suggest that you do much (if any) adjustments to these types of trades. You're much better off to let these trades work themselves out and keep your position sizes very small given that they are not high probability trades. What is a one standard deviation (1 SD) move? A one standard deviation move encompasses 68% of the expected move of the sock range in the future. This is a statistical measurement of the probability and variance going forward into the future at a specific time. When it comes to stock and options trading a one standard deviation move on a stock that is currently trading at $50 might be $5. This means that 68% of the time going forward into the future the stock will trade in a range five dollars above and five dollars below its current price at $50. This also means that 32% of the time it will trade outside of that expected range. Using this information we 41 of 69
can then build option strategies to profit based on these probabilities and statistics. How can I make sure that my portfolio is neutral to future market movements? There is no way to guarantee that your portfolio will always be 100% neutral to future market movements. You can trade an initial position Delta or market neutral but as soon as the position starts to move the deltas are fluid and will start to change as the position evolves. That said, you can use portfolio beta as a good tool as to how bullish or bearish your underlying positions are relative to the overall market. What does the "100" mean next to an option contract? The 100 next to an option contract is that contract s multiplier factor. The 100 designates that each 1 option contract controls 100 shares of underlying stock. 42 of 69
If you want to trade a stock long which option is best to select both strike price and expiration date? The best way to trade stock long is to use a directional call debit spread. In this case you would buy one call option in the money and sell one call option out of the money taking a 50-50 bet directionally on the future movement of the stock. When trading a vertical spread why do you buy one option and sell another? Overtime one option will make money as the other one loses so why make the trade? Yes with a vertical spread you are buying one option and selling one option at a different strike price. Over time the reason that you make this trade is because you will profit from the decay in both options but the spread differential between them leaves room for money to be made. For 43 of 69
example if you sell one option for $100 and buy another option for $80, and they both expire worthless at expiration you would make $20 or the differential between the two contracts that you bought and sold. How can I be more consistent with my trading? Great question. Consistency starts with having a system in place to make and exit trades. Have a set of guidelines or trading rules that you follow and do not deviate from those. The more robotic and mechanical you can be with entry and exits of trades the more consistency you'll see longterm. Consistency is not something that happens overnight, but is rather build up over many weeks and months of smart trading. What's the best way to adjust a short straddle trade that goes against you? Because of the undefined risk feature in a short straddle you need to be more aggressive in your adjustments and management of these types of positions. Our first adjustment would likely be to roll down one side that the market is moving away from and collect more premium. 44 of 69
But we are also looking to take trades off at 25% of max profit which is much earlier than most of our other short premium strategies. You don't want to get caught going too inverted on these short straddle trades because you are already taken a very big credit to begin with that widens out your break even points. 1 or 2 adjustments at most and then from there let the trade go until it shows a profit. What's the best way to adjust a butterfly spread that goes against you? Because butterfly spreads are narrow risk to reward trades we do not suggest that you adjust these trades but rather let them go all the way until expiration and let the probabilities work themselves out over many different occurrences. Risk management on these types of trades is best done at order entry by making small reasonably sized trades. 45 of 69
The biggest problem I have with trading is getting the direction right; how can I get the direction right? Sorry if I'm the first one to tell you but we are never able to consistently pick a stocks future direction. It just won't ever happen so stop trying so hard to be a directional trader and start learning how to make high probability trades that profit from multiple underlying movements in any direction. In fact we just recently did a podcast where we proved that not even the most successful and influential investment banks on Wall Street are able to consistently pick the right direction of any underlying stock and are no better than 50-50. Rather then learning how to get directional, I encourage you to learn how beta weighting can help you remain as neutral as possible with your overall positions. When should I start to adjust a credit spread that goes against me? I suggest starting to make adjustments on a credit spread when you're probability of losing doubles. For example, if you make a one standard deviation credit spread entry 46 of 69
with a 15% probability of losing money then you would start to make adjustments if that short option now has a 30% probability of losing money. This is just one way to go about making adjustments but you can see that it's all about having some set of rules or guidelines to follow and sticking with those. Can I be successful trading options with a small account? Yes. In fact, account size has very little to do with your ability to trade successfully and make consistently profitable trades. Having a small account is not something that will prevent you from finding success so please stop using it as an excuse! Even as your account size grows a key factor in your ability to find success is being able to make lots of small trades. Therefore you can see that making a small profitable trade has nothing to do with how much money you start since you need to trade small from the beginning. 47 of 69
I have a very large account and want to be conservative with my money, how much should I allocate per trade? You should allocate as little as possible to each individual trades. Remember that this business is all about making lots of trades so that the probabilities work themselves out over many occurrences. The higher the number of smaller trades you can make the more closely your targeted probability of success will be at the end of the year to the actual expected move. I currently allocate 1-5% of my account per trade. What's the difference between buying an option and selling an option? When you buy an option you have the right but not the obligation to buy or sell stock in the future. When you sell an option you take in a premium which then gives up your right to choose when to buy or sell stock in the future. But being an option seller doesn't mean you can't still reverse the trade and close out the option position - you just can't decide when to buy/sell the underlying stock. 48 of 69
When is the best time to sell a covered call on a stock to get the most premium possible? The best time to sell a covered call is when option premiums are very high. In these situations you are compensated much more for the short call that you sell and you'll receive a higher credit which will reduce your cost basis on the stock more so than when implied volatility is low. I need to generate more money trading options but have a small account, should I increase my allocation per trade? Possibly. Depending on how small your account size is you might need to scale up your allocation per trade so that you can get into single and one lot trades. However I have found after coaching hundreds of students that in mostly all of the cases I've seen, you do not have to 49 of 69
increase your position size but rather increase the number and frequency of the trades you make. I'm completely new to stock trading and options trading where do I start? Start where you are. There are so many different concepts and topics to learn when it comes to stock and options trading that you can't possibly learn all of them overnight or even over the course of a couple months. Therefore I suggest that you lay out a framework of topics you want to cover in a systematic fashion. You could for example learn everything there is to know about credit spreads one week and the next week focus on learning everything you can about the Greeks. Sure there will be some overlap and you might not know all the concepts as you start to go through the different weeks and topics but over time you'll start to understand by focusing in on one area at a time. What is the minimum account starting balance you suggest? While you can start trading with less money I do suggest that you at least start with $5,000 to make it worth your time and energy and to cover commissions with the 50 of 69
number of trades that you'll need to be making. If you have less than this amount please do not get discouraged, start paper trading as soon as possible as you save up enough money to start live trading. If you show us a trade that utilizes naked call or put selling what should we do if we don t have level 4 trading permissions? If your broker prevents you from trading naked or undefined risk trades then you can simply add another long option further OTM as protection and a way to reduce capital requirements. This will reduce your overall credit that you received but you are able to replicate the same trade that we are trying to enter. How can a call option go down in price when the stock goes up that day? This is a common question for new traders because for all intensive purposes you should be making money when the 51 of 69
stock goes up right? But in this case a call option can go down in value because of two different things that may have happened. First implied volatility might have dropped in which case the option price drops along with volatility even if the stock goes up. Second time decay could have slowly eroded away the value of the option again even if the stock goes up. With my job I do not have access to trade options during market hours how can I make trades without being in front of my computer during market hours? One of the best ways to learn how to make trades without being in front of your computer during market hours is to learn how to trade with contingent orders. These contingent orders allow you to set predetermined requirements before trades are entered or exited during the day. It takes a little bit more time to set up in the morning and in the evening but it's worth the effort if you truly want to be successful trading options but don't have the ability to monitor positions all day. 52 of 69