Welcome to the OptionsMeister Roadmap
READY TO START TRADING OPTIONS?
The focus of this training is to develop the skills required to be a consistent, successful probability based trader. Research has proven that being a probability based premium seller will give the trader the necessary edge that will result in becoming a consistent and most of all profitable trader.
If your preferred method of investing is stocks, options or both then probability based trading is the only way to differentiate yourself from the crowd and to generate consistent, above average returns. The strategies you will learn are structured specifically for you and your comfort level.
Every trader is unique. Each has his own trading experience (or lack of), account size, risk tolerance, trading goals (income, growth, speculation, protecting assets, computer proficiency and many other individual characteristics). Be honest with yourself. Most of us weren’t born with an innate knowledge of trading. But the good news is, trading is a learned skill. It is critical to your success to fully understand each step. Learn at your own pace. Spend as much time as you need to develop your skills. You will be handsomely rewarded for your efforts.
Learning to be a conservative, defined risk trader using all of the tools and technology now available to you is not as daunting or confusing as you might expect. After you have completed the initial process of your personal assessment, opening the correct type of account, installing the trading platform and familiarizing yourself with the basic concepts you will be placing your first trade within hours.
Having a knowledgeable mentor side by side with you every step of the way will dramatically accelerate your learning curve. You will not be learning in a large group session that by design must meet the most elementary goals of the students In the class.
You do have choices. You can educate yourself through a litany of online courses, webinars and seminars. It is possible you can arrive at the destination but at what cost? What will take you several years to learn at a much higher total cost you will learn in a few short months with the intense one on one help of your mentor.
Let’s Get Started!
What is Your Why?
The very first step that you need to take as you embark on a trading/investing career is to “determine your why”. That may sound corny but it is important that you fully internalize why you have taken the step to become a “self-directed” investor and put your financial future fully in your control.
I am not sure who gets credit for the common phrase, “patience is a virtue”, but it is advice well taken. As you begin your trading journey I would urge you to be patient. The financial markets will always be there. Spend the amount of time you need to familiarize yourself with the trading landscape
If you are new to trading/investing I want caution you not to be overwhelmed with the trading terms and other industry related nomenclature you will encounter. I am on record as stating that I am of the opinion that many of the “crazy names” that the industry has attached to
I am passionate about helping others manage their own financial investments. I assure you that if you will invest the time in yourself you will outperform 99% of the “self- proclaimed” financial experts. And you can do this without complicated strategies, that I promise you.
Congratulations on taking this most important step. Remember that this process is a marathon and not a sprint.
Matching Your Why to Your Options Trading
I assume you have now spent some time to really have a concrete idea on what your “why” is? You now need to develop your “how”.
Developing your “how” (or plan) must be aligned with your personality and your goals as a trader. First you need to assess your goals and you must be extremely honest with your assessment. In your trading you are the only person to whom you must answer.
To help you along with the process, let my outline four distinct scenarios:
- You are conservative and look to hedge or protect your existing portfolio.
- You have accumulated a nice portfolio and you would like to generate a consistent cash flow from your investments without assuming unlimited risk
- You are conservative in your investing but you want to participate in the financial markets with less exposure than just buying stocks and taking your chances.
- You are a speculator and have some risk capital that you would like to put to work in structured investment strategies to achieve above market returns
Perhaps one of these four scenarios precisely fits your goals or your goal is a blend of a couple of them. Whatever the “how”, options offer a tremendous amount of flexibility. With some knowledge you can learn to use these derivative products to accomplish your goals.
It is important that you treat your options trading like a business. Remember if you “fail to plan” you can “plan on failing”. However, I do want to encourage you to understand how to use options that is congruent with your goals.
Furthermore, I want to assure you that trading options as an investment or in a speculative nature is a “learned skill”. You can take heart in the fact that becoming a successful options trader does not require any extraordinary physical qualities or athletic ability. What it does take to become a successful options trader/investor is of course, the desire, followed by choosing a methodology that provides an “edge”, then implementing the discipline to execute and manage the methodology.
BEFORE YOU TRADE
As you embark on your options trading journey you will encounter many terms that are no doubt unfamiliar to you. Your learning curve may seem very steep at first but do not allow yourself to become discouraged. You will have plenty of time to broaden your knowledge as your experience grows.
The most basic option terms are:
calls and puts
long and short
exercise and assignment
implied and historical volatility
out of the money
at the money
in the money
Spend some time becoming familiar with these terms and you will have a good handle on the basic information you need to get comfortable with trading.
Don’t allow yourself to be overwhelmed by all the trading terminology. As your trading experience grows you will be surprised at how quickly you become familiar with the nuances of trading.
I encourage you to take trading one step at a time. As you progress through this “roadmap to trading” you will certainly have enough information to become familiar with and execute basic option trades. As you become proficient with the basic strategies you will naturally begin to add more advanced strategies to your trading plan.
Usually the first objection that I hear from prospective investors when I speak to them about the merit of trading options is, “aren’t options too risky”? My response is always the same, “are they too risky to buy, or too risky to sell”? Think about it!
Simply stated, options are merely derivatives of the underlying financial security (stocks and ETF’s) that they represent. I believe that some of the negative response to options investing comes from the professional money management industry as part of their mission of self-preservation.
After you have reviewed the “Roadmap” you will have an understanding of options and how they can be used to lower the cost basis of your investments and improve your probability of profit. Of course options have risk, but any investment you procure has risk. If you are totally risk adverse I suggest you put all of your investment dollars in the bank where you will earn a whopping ¼ of one percent!
Options can be utilized in a variety of ways. Options can be bought or sold as speculative instruments or to hedge your existing portfolio against losses. After having completed this course you will have a thorough grasp of the concept, so do not allow yourself to be dissuaded by naysayers.
Options are financial contracts that transfer rights to the owner of the option to either to buy or sell an underlying security at a predetermined, set price (“strike price”) within a specific time.
- A “call” is the option or right, but not the obligation, to buy an asset at a certain price within a specific period of time.
- A “put” is the option or right, but not the obligation, to sell an asset at a certain price within a specific period of time.
Characteristics of options:
- Equity option contracts represent 100 shares of the underlying stock.
- Options can be bought (long) or sold(short) as an opening order.
- Option positions can be closed by buying to close a short option or selling to close a long option.
- Options can also be exercised (by the holder) or can expire on the expiration date. Out of the money (OTM) options expire worthless and in the money (ITM) options have assignment risk.
KNOW WHAT YOUR OPTIONS ARE!
The owner of the option (the holder) is the party that has bought an option. The holder controls the exercise or assignment of the option contract.
The seller (the writer) of the option has the obligation to take delivery of the underlying security instrument at the strike price of the option on or before the option expiration date.
The strike price of the option is the price at which the asset will be bought or sold.
The expiration date is the contract date agreed upon between the holder and the writer to buy or sell at the strike price.
There are two styles of options, American style and European style.
- An American style option may be exercised at any time prior to the expiration date.
- A European style option may be exercised only at the expiration date of the option.
ESTABLISH YOUR TRADING PARAMETERS
To be a consistent, successful and profitable trader it is important that you establish trading parameters and that you adhere to them. It is important that you establish a few key trading parameters:
1.Establish a maximum percentage of your total account that you will have invested (or at risk) at any given time. Contrary to what most professional money managers do when you turn your investment portfolio over to them (they invest 100%) it is imperative that you never risk more than 50% of your risk capital at any one time. I would suggest that your maximum risk exposure be materially less than 50% of your account. Always keep some “dry powder”.
2.Establish what percentage of your account you will risk on each trade that you execute. A good starting point is about 1% or your account per trade.
3. Establish the annual return that you want to generate on your account. Don’t wing it! Are your goals realistic? Your return goals need to be congruent with your risk tolerance and the maximum amount of your account that you plan to risk at any time.
The technology that is available to the retail trader today is light years ahead of what was available just a few short years ago. It is important that you have the proper equipment to take advantage of today’s technology.
I would suggest that you invest in a computer that can handle the data, charting package and and allows your trading platform to operate efficiently. It is very important that when you execute a trade you are not being limited by the resources of your hardware.
I use a quad core I7 computer with 16 gb of ram. Your operating system can either be Windows or IOS (Apple) as most brokers and trading platforms are compatible with both operating systems.
With the computing power available in laptops today, you can choose to use a laptop or a desktop PC. I use both and they work equally well. Just make sure your specs are adequate.
While you can get by using a single monitor, I prefer to use at least two monitors. I like to have my trading platform open on one monitor my supporting software on the other monitor. It just makes the process much more efficient for me, but it is personal preference.
I know many traders that do just fine with a laptop and the monitor on the unit. I have often traded with my laptop when I am not at my home office. With the advances in WIFI internet connectivity I find it amazing that I can trade even while I am in the air or riding in a car. But don’t trade and drive!!
As a last resort I do make trades on my smartphone. Most brokers now have an app for their trading platform which greatly facilitates the functionality. For me the screen size is a challenge, but I have used the device to manage trades when a computer was not available (ie on the golf course).
Wireless internet accessibility is almost everywhere today. When I am not in my home office I do rely on wireless connectivity. However, whenever possible I much prefer an Ethernet connection to the internet. It goes without saying that you must have a broadband internet service.
Always be mindful of the security of your internet connection. Professional hackers are everywhere and it only takes an instant to snag your important personal information.
Options are exchanged in an electronic marketplace. If you are going to trade options you must have a brokerage account. A brokerage account can be a traditional account with a full-service broker in a physical location or an online, direct access account.
In recent years with the conversion of most trading pits to electronic trading the direct online brokerage model has become increasingly popular. Not only has the platform technology improved to the point of almost instant order execution the technology has “leveled the playing field” between the retail trader and the professional and institutional trader. And you should only expect this to continue to improve.
When you initially open your brokerage account you will be required to answer a series of questions to determine your experience in trading. It is a good idea to seek the help of an experienced trader or coach in order that you request and are granted the correct trading permissions that will be required to execute more advanced trading strategies as your trading horizon broadens.
My broker of choice is TD Ameritrade. I have used several different brokers to trade options and equities. You can find less expensive alternatives but that comes with a price. My experience with TD Ameritrade is that their customer support is unmatched.
Here is a link for your convenience: www.___________________
Important considerations before opening a brokerage account:
1. Compare commissions on the brokerages you are considering. There is a wide range of commission structures. Find the commission structure that is most efficient for the trade size that you will be trading.
2. Be on the lookout for scam trading sites and trading platforms. Be sure to vet the firm before you make your first deposit. Do some online research and watch for negative reviews.
3. A margin account will be required if you plan on selling options on underlying securities without already owning the security (selling short “uncovered” options). Ask the broker that you choose to provide you with all the information regarding margin accounts.
4. Determine what type of account(s) you require for your trading. You can have multiple accounts with the same brokerage firm. Many traders have a regular trading account (individual or joint), an IRA account and/or a Roth IRA. Each account has a specific set of regulations and you must have them set up correctly prior to either transferring to or funding the account.
The trading platform is the piece of technology that you use to find, research, structure and execute option trades. The rapid development of modern technology has put the “retail” trader on a level playing field with the professional trader.
In most cases your broker will provide you with an options trading platform. Of course all trading platforms are not created equal but each platform provided by your broker will at least provide you with the basic requirements to execute trades.
In most cases the platforms provided by your broker are proprietary. This simply means that to use their platform to execute trades you must have a funded account with that broker. Some option trading platforms will allow you to use the sim (paper money) account to simulate trades without having funded an account.
There are several sophisticated trading platforms that are “stand alone” platforms that option traders use to analyze, model and structure trades. These platforms are not tied directly to a broker. Using these platforms requires the trader to execute the trade with their broker.
I have been using the ThinkorSwim trading platform exclusively for over eight years. ThinkorSwim was designed by option traders for option traders. I have found that the ThinkorSwim platform is the most powerful trading platform available to the retail trader. ThinkorSwim was purchased by TD Ameritrade several years ago. TD Ameritrade continues to enhance the functionality of the platform with constant upgrades.
If you are a more visual person, a very good choice is the Dough.com platform. Dough is not owned by TD Ameritrade but it can be linked to your TD Ameritrade account. Dough is free and is a great resource. I have both platforms but I have been using ThinkorSwim for so many years I prefer to trade on that platform. But if you are just starting out, you should take a look at Dough.
I would suggest that you give serious consideration when choosing your platform. There is a learning curve associated with the use of each platform and while the basic metrics are the same the nuances specific to each platform often make it more challenging that one may think. The time you spend in the selection process will serve you well in the long run. Don’t hesitate to reach out to your mentor or trading community for suggestions. Traders love helping other traders and “they” all have “been there”.
SETTING UP YOUR PLATFORM
After you have decided on your platform(s) of choice you will need to set up the platform for functionality and efficiency. As I previously mentioned I use ThinkorSwim exclusively for my trading whether I am on my desktop, laptop, tablet or smartphone.
ThinkorSwim offers a great feature that allows traders to share charts, watch lists and complete workspaces. I frequently use this feature to share my charts, and other custom setups with my coaching clients. This feature can be a great time saver.
One of the benefits to membership will be access to the charts, watch lists and workspaces on ThinkorSwim I use for my trading. This will be a great time-saver for you.
Most platforms offer a large number of default settings to facilitate your trading. For example on ThinkorSwim the default size for trading option contracts is ten. As a new trader I would strongly recommend you trade a one lot. Rather than having to change the quantity on every order you can set your order default size to reflect the size you want to trade.
There are many other default settings on trading platforms. Take the time initially to set the defaults to your liking and your trading life will be a lot easier and with fewer mistakes.
SIM (PAPER) TRADING
At this point in the course you should have your computer, broker and trading platform in place and “ready to go”. Most of the trading platforms that are worth considering offer a sim account or “paper money”. I would strongly suggest that before you put your “real” money to work you spend some time practicing in the “sim” mode. It is very important that you familiarize yourself with the basic execution and management functions of your trading platform.
There are a few things you need to consider about paper(sim) trading:
- Paper trading is not the same as real trading because you don’t experience the psychological pressure that is involved when real money is on the line.
- Use paper trading to familiarize yourself with the platform and begin to trade “live cash” as soon as you know how to execute simple defined risk trades.
- While paper trading can provide great practice as you get comfortable with the technology and execution of various strategies, you will not experience trade “fills” or “no fills” as you will in trading your live cash account. Most platforms operating in the “paper money” mode fill trades almost instantly. Therefore you must realize that paper trading is great practice but not a predictor of real results.
When you begin to trade it is natural to feel anxious about executing trades and properly managing them. Those feelings are very natural. You should expect to have those feelings of discomfort, all traders do in the beginning. The more trades you execute and manage the more your comfort level will grow.
As you begin to execute more advanced trades you will experience a return of anxiety you initially felt when you started to trade but don’t let that deter you. Just as you did with your initial basic trades you will become increasingly comfortable as your experience accumulates.
Even as your proficiency with the platform grows you will make what I call “fat finger” mistakes. Don’t beat yourself up about making mistakes. All traders, regardless of their experience, still make “fat finger” mistakes. Accept mistakes as a cost of doing business and move on.
BASICS OF OPTIONS TRADING
TRADING METHODOLOGIES - AN OVERVIEW
There seems to be about as many trading methodologies are there are traders. Most of the popular trading methodologies are centered on technical analysis or fundamental analysis.
- Technical analysis relies on past statistics including price and volume to predict the future price of the security.
- Fundamental analysis is the study of the financial metrics, industry conditions and the management of a particular company to predict the future performance of the company with the expectation this will manifest in the future price of the security
As your interest in trading increases you will naturally be drawn to the “latest and greatest” method. My experience is that there are many methodologies that work great……until they don’t.
The trading space is ripe with many “self-proclaimed” experts claiming to have a “proven”, indicator, candlestick, “Black Box” or system that “guarantees” success and above average market returns. Never lose sight of the fact that the street is littered with those “one-hit” wonders and they do sound so compelling and convincing.
After many years of trying many different methods I was introduced to the Probability Based Trading methodology. My first reaction was, “here I go again”. But quickly I discovered that trading using known probabilities (or odds) was different.
I have traded the Probability Based method for five years. And for the first time I have been able to produce predictable, consistent and most of all profitable results.
I don’t use any indicators, systems or “black boxes”. I simply use the probabilities that are right in front of me on the trading platform. I found that statistically most options (about 76%) expire worthless. So if such a high percentage of options expire worthless than why do I want to buy them?
It is incumbent on you to find a methodology that does not rely 100% on being directionally correct, but that is what most traders believe. There are empirical studies that prove picking direction is a 50/50 proposition. You will be exposed to many methodologies that will refute that, but it is important to understand how the method you are evaluating performs in bull markets, bear markets and flat markets.
If you want to trade for the long term and generate consistent, predictable and profitable results I would strongly suggest that you focus on a methodology that relies on probabilities that provide you with an “edge”. Every trader wants 100% winners. But you must understand that losing trades are just part of the process.
A probability based trading method using established criteria will provide you the consistency you should be seeking. Of course you won’t realize those “home run” trades that many like to brag about. What you will realize is a lifetime of consistent “singles” that will allow you to achieve above market returns while being
TRADING METHODOLOGY - INTRODUCTION TO PROBABILITY BASED TRADING
Probability Based Trading (PBT) assumes that all price changes in the highly efficient stocks and ETF’s are totally random. Everything there is to know about a particular underlying is priced in. There are no secrets!
In the previous section I discussed technical analysis and fundamental analysis. It is important for you to understand that technical analysis or fundamental analyses have elements of subjectivity and because of that subjectivity the results are not truly quantifiable.
PBT uses applied mathematics with known variables to solve for the expected move of the stock or ETF. At first glance I trust that you think that is not possible, and the markets are manipulated. I can assure you that by focusing on the most liquid stocks and ETF’s it is in fact possible to calculate the expected range of the security for a specific period of time.
PBT also relies on the “Law of Large Numbers”. This theorem states that the larger the sample size becomes, the closer the results will be to the expected results. Here is an example”
If you flip a coin the known probability is a 50% chance of the coin turning up heads and a 50% chance that the coin will turn up tails. That fact is not refutable. Of course it is certainly probable that you could have 5 heads or 5 tails in a row. However, if you flip the coin a “statistically significant” number of times (i.e. 1,000 occurrences) the results will be close to 500 heads and 500 tails.
Simply stated the PBT method uses expected probabilities like in this example to generate predictable, profitable results over a long period of time. Most of the trades that I execute statistically have a 70% probability of profit using known probabilities. By adding specific PBT criteria (“secret sauce”) I raise my expected winning percentage from 70% to over 75%. And I have proven that concept for over 5 years now!
As a member of Options Meister you will have access to the PBT Criteria, my PBT “Truisms” and the PBT “Keys to Success” . And you will be able to easily implement the PBT method without being a math savant. The criteria you need are right on the option chain.
THE CONCEPT OF SELLING PREMIUM VS BUYING PREMIUM
Premium as it relates to options trading refers to the current price of the option at the specific strike price that you are considering to trade. As an options trader you will be confronted with only two choices, you can buy an option (buy premium) or you can sell an option (sell premium).
Buying an option is a pretty simple concept to understand. You are simply buying a call or a put at a specific price with the expectation the underlying security will move in your predicted direction.
Selling an option, on an underlying security that you do not known, is often more challenging for the newer trader to comprehend. A common question from a new trader is “how can you sell something that you don’t own”? The simple answer is to think of it as just doing a normal transaction but in reverse.
We usually buy an asset with the expectation that the value will increase and we will sell the asset for a profit. Selling an option short is simply reversing the process. You sell an asset that you believe to be overvalued with the expectation of buying it back at a later date for a lower price.
When you sell an option short your account is immediately credited with the amount that you sold the option. The broker will reserve from your account what he believes to be his maximum exposure should the trade go against you. The amount reserved is commonly called “margin” or “buying power reduction”.
Most asset classes you cannot sell something you do not own. Selling options short is common place in options trading.
Consider this, wouldn’t it be nice if we could sell a new car instead of buying it, then after the value is reduced by depreciation we are able to buy it back at a lower price and generate a profit? This is precisely what happens when we sell an option short. The market maker is the party that stands in the middle and facilitates the transaction. Remember, for every buyer of an option there is a seller and vice versa.
Understanding the Risk in Options Trading
Options can be purchased as speculative investments or as a vehicle to hedge against losses.
- Speculative purchases allow traders to make a large amount of money, but only if they can correctly predict the magnitude, timing, and direction of the underlying security price movement. This also opens up these traders to large losses and high trade commissions. This makes trading options somewhat risky, especially for novice traders.
- Options can also be used to hedge to protect an investment portfolio. For example if you own a portfolio of long equities you could purchase a put to sell some or all of the shares of a stock that you are concerned may suffer a material price drop within a defined period
Due to the inherent risk in buying and selling options, brokerage firms will provide those opening an options trading account with a booklet entitled “Characteristics and Risks of Standardized Options,” written in compliance with the SEC. That publication provides information about options terminology, exercising and settling options, tax considerations for options traders and the risks associated with the buying and selling of options.
FINDING, EXECUTING & MANAGING YOUR FIRST TRADES
FOUR BASIC STRATEGIES - VERTICAL SPREADS THE PROBABILITY BASED WAY
Simple options strategies are usually the way to begin investing with options. By mastering simple strategies, you’ll prepare yourself for advanced options trading. In general, more complicated options strategies are appropriate only for experienced investors.
It is highly recommended that the “newbie” trader execute only defined risk trading strategies. By using defined risk strategies you can learn how to find, execute and manage options trades. Defined risk trades are exactly what they sound like. At trade execution you know exactly what your maximum risk is and your potential profit.
Every option trade is comprised of a put, a call or some combination of both. If you acquire a good foundation of basic trades it will be much easier for you to expand your trading horizon to more advanced strategies.
Obviously, the most basic options trades consist of buying or selling a put or a call. If you are bullish you can buy a call or sell a put. Conversely if you are bearish you can buy a put or sell a call. As a “newbie” Probability Based Trader I would highly recommend that initially you restrict your trades to “defined risk” vertical spread trades.
The four basic vertical spread trades are:
1. Vertical call debit spread (bullish)
2. Vertical put debit spread (bearish)
3. Vertical call credit spread (bearish)
4. Vertical put credit spread (bullish)
Master these four simple strategies and you will be well on your way. In this “roadmap” you will be introduced to these four basic option strategies that you need to fully understand the execution and management of these strategies.
If you are interested in a more detailed course on trading these strategies I would encourage you to enroll in my online course, “Trading Vertical Spreads the Probability Based Way”.
Here is a convenient link to that course: http://bit.ly/2bIdm2o
Vertical Spread Trades
A vertical spread is made up of a short option and a long option at different strike prices in the same expiration cycle. This is a defined-risk strategy to use when we have a bearish (stock will go down) or bullish (stock will go up) assumption. By trading in the same cycle we maintain a linear relationship between both options.
There are two distinct variations of vertical spreads. One is a vertical credit spread and the other is a vertical debit spread. Both strategies are very simple but are distinct in their respective probability of profit.
Additionally there are two types of vertical credit spreads, call credit spreads and put credit spreads. There are also two types of vertical debit spreads, call debit spreads andput debit spreads. Both are defined risk strategies. In the credit spread we are receiving premium at trade execution and in the debit spread we are paying premium when we execute the trade.
Listed below are the four basic strategies. The strategies consist of two call strategies and two put strategies. There are two strategies that are credit strategies and two strategies that are debit strategies.
- Call credit spread (bearish bias)
- Call debit spread (bullish bias)
- Put credit spread (bullish bias)
- Put debit spread (bearish bias)
My goal is to encourage you to take control of your own finances. And I want to assure that to become a successful, self-directed investor is really not that complicated.
Call Credit Spread
The call credit spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go down moderately in the near term. With the call credit spread strategy premium is received as a credit upon trade execution.
Call credit spreads can be implemented by buying call options of a certain strike price and selling the same number of call options of lower strike price on the same underlying security expiring in the same month.
The maximum gain attainable using the call credit spread options strategy is the credit received upon entering the trade. To reach the maximum profit, the stock price needs to close below the strike price of the lower striking call sold at expiration date where both options would expire worthless.
Call Debit Spread
The call debit spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go up moderately in the near term.
A call debit spread can be implemented by buying call options of a certain strike price while simultaneously selling a higher strike call option of the same underlying security and the same expiration month.
Maximum gain is reached for the call debit spread options strategy when the stock price moves above the higher strike price of the two calls. The maximum gain is equal to the difference between the strike price of the two call options minus the initial debit paid to enter the position.
Put Credit Spread
The put spread credit option trading strategy is employed when the options trader thinks that the price of the underlying asset will go up moderately in the near term.
A put credit spread can be implemented by selling a put option at or near the the current price of the underlying asset and buying a put option one or more strikes below the option sod on the same underlying asset with the same expiration date.
The maximum gain (profit) for the put credit spread is the amount of premium received at trade execution. The maximum gain (profit) is attained for the put credit spread when the price of the underlying asset remains above the strike price of the put that is sold (the short put).
Put Debit Spread
The put debit spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go down moderately in the near term.
A put debit spread can be implemented by buying a put option of a certain strike price while simultaneously selling a lower strike put option of the same underlying security and the same expiration month.
To reach maximum profit, the stock price needs to close below the strike price of the lower put on the expiration date. The maximum profit for the put debit spread option strategy is equal to the difference in the strike price of the two options minus the debit paid when the position was entered.
There are several order types that are common place in the trading space. Whenever possible the newer trader should use specific or “limit” orders for their order entry and exits. There are more detailed definitions and explanations of the various order type that you can study on the internet. Below are brief overviews of the most common order types that you will encounter.
A limit order is the order type in which you specify the price at which you want to execute the transaction. If you are purchasing a stock, ETF or option you are instructing your broker to purchase the security for your account at a price not to exceed your limit price. Conversely, if you are selling a stock, ETF or option you are instructing your broker to sell the security at a price no less than your limit price.
There are pros and cons to using limit orders. The pro is that you are in full control of the price at which you buy or sell your options. The con is you may experience a long wait for the order to be filled, or you may not be filled at all because the price has moved way beyond your limit price.
A market order is the order type where you are instructing your broker to either buy or sell the stock, ETF or option at the current market price. As a buyer you will pay the “ask” price and as a seller you will sell at the “bid” price. In both cases your order will be filled very promptly, but the disadvantage is that you not be filled at the optimum prices.
Be especially careful not to use market orders on security instruments that do not have significant volume and/or the spread between the bid and the ask prices are very wide. In most cases you would be best served avoiding market orders.
Stop Loss Order
A stop loss order is typically used by the trader to minimize loss on the exit price of a stock, ETF or option by setting a maximum loss that the investor/trader is willing to accept on a particular investment position. Stop loss orders are only executed when the market price of the stock or ETF reaches a specific price.
Be advised that a stop loss order is not a limit order. If, for example, you are long a stock at $100.00 per share and you want to limit your loss to $8.00 per share you would place a stop loss order at $92.00. Understand that you are not guaranteed to close your position at $92.00 should the stock have a sharp spike down. At the point your $92.00 stop loss order is breached, the order now becomes a live market order. The actual fill may be much, much lower than the stop loss price point. You could suffer much larger losses than your initial limit.
Severe short term declines happen rarely, but they do happen. Make sure that you have a complete understanding of stop loss orders prior to using them in your trading.
Stop Market Order
A stop market order, or simply stop order, is an order type that can be used for trade exits. A stop market only executes when the underlying stock price trades at or through a designated price.
- Buy stops, designed to limit losses on short positions, are placed above current market price.
- Sell stops are used to protect long positions and are placed below current market price.
While the stop market order guarantees execution, the actual transacted price maybe slightly lower or higher than desired, especially when the underlying price movement is very volatile. For that reason the trader/investor may realize significantly poorer price executions in the event of a “flash crash” or similar market event.
Stop Limit Order
A stop limit order is a limit order that only gets activated only when the underlying stock price trades at or through a specified price. While a stop limit order provides complete control over the transaction price, it may not get executed if the underlying price moves too quickly and the limit price is never reached. Therefore, a stop limit order is ineffective if there is a material gap in the price of the underlying security and the security did not trade at the specific price of the stop limit order.
By now you should have a basic understanding of the terms, the Probability Based Trading methodology, and the four basic option strategies that you need to focus on as you begin your trading journey. I would dare say at this point you might even be “itching” to place a trade. You are no doubt asking yourself, “how do I find trades”?
Most traders want to go through some process of research or using scanning software to find the “perfect” trade. As a technical or fundamental trader you will spend an inordinate amount of time in the pursuit of trades that meet your criteria. I suspect you will find, as I did, that picking direction is at best a 50/50 proposition.
If you choose to use the probability based trading method your task is really quite simple:
1. Use a “pre-vetted” database of stocks and ETF’s that meet the PBT criteria
2. Sort your database (high to low) by Implied Volatility Rank
3. Select potential trades that have 20 to 45 days to expiration
4. Confirm that there is enough open interest and volume for the options you are looking to trade
If the stock or EFT has an Implied Volatility Rank above 50 and your bias is bearish you will be executing a call credit spread. If you bias is bullish you will enter a put credit spread.
If the Implied Volatility Rank is 25 the proper strategy is a debit spread. If your bias is bearish you will place a put debit spread. Likewise, if you bias is bullish you will execute a call debit spread.
It really is “not that complicated”. You now have at your disposal four basic trading strategies, two are credit strategies and two are debit strategies. You understand under which market conditions to execute credit spreads and under which market conditions to execute debit spreads. There is no need to make it any more difficult.
Don’t be discouraged if initially this process seems a little daunting a first, it really is quite simple. You will get it! If you desire a more in depth course on the process and accelerate your learning process, I have published an online course titled,
“AN INTRODUCTION TO PROBABILITY BASED TRADING”
Here is a convenient link to that course: http://bit.ly/25PT8pS
It is extremely important to execute spread trades that are congruent with the risk that the trader is accepting at entry. Here are the guidelines:
Credit spreads – collect 1/3 in premium of the width of the strikes
$1.00 wide credit spread – collect a minimum of $.34
$2.00 wide credit spread – collect a minimum of $.67
$3.00 wide credit spread – collect a minimum of $1.00
Debit spreads – pay ½ the width of the strikes (or less)
$1.00 wide debit spread – pay $.50 maximum
$2.00 wide debit spread – pay $.75 maximum
$3.00 wide debit spread – pay $1.50 maximum
The physical act of placing either a basic debit spread or credit spread is a simple “one click” process on most trading platforms. On ThinkorSwim simply hover over the bid or ask price of the strike you are buying, then “right click”, choose buy or sell and vertical.
MANAGING WINNING TRADES
Ok you have a couple of trades on and you must be asking, “now what do I do”? The most basic premise to Probability Based Trading is to manage winning trades. Most traders have been schooled to manage losers and let your winners run. And that is precisely the reason that a high percentage of traders lose money and quit trading never to return.
There is compelling research that proves to be a consistent, successful trader you should manage winning trades at 25% to 50% of maximum potential profit. On trades that are not going in your favor, the first step is to see if the trade can be rolled to the next expiration cycle for a credit. The “roll” process can be completed with one click on most trading platforms.
On trades that have met your profit objective, simply close the trade and look for more trades that meet your criteria.
PROVING THE CONCEPT
To gain the confidence to become the consistent, successful trader that you desire to become I am convinced that you must “prove” the concept of your trading methodology to yourself. The Probability Based Trading method relies entirely on known and proven probabilities. Just like in the coin flip example, you can’t be frustrated if you have a string of losses because you know that if you continue to “flip” the coin the winning percentage will meet your expectations as your sample size gets larger and larger.
Armed with the knowledge that the probabilities are on your side, here are a few bullet points that you will need to embrace:
- Just “take the trade”
- Trust the math, it does not lie.
- Never react to the P&L on the trading platform when making your decisions
- Keep accurate records (at least in the early stages of your trading)
After you have become proficient in Probability Based Trading you can monitor your results with your P&L (or Net. Liquidity) and a simple graph of your account but in the beginning you will reach proficiency much faster keeping track of your trades. I believe you will find, as I did, that the accountability of tracking your trades will make a huge difference
READY TO TRADE
At this point you should have a basic understanding of the four vertical spread trades that I have covered. Spend as much time as you need becoming familiar with the technology and trade execution using the “sim” or “paper money” account before you use live cash.
I do encourage you to move to “live cash” as soon as you are comfortable with the process. My experience is regardless of how hard you try, you just won’t experience the emotions trading with paper money that you will when you begin to trade your own live account.
Another issue with “sim” accounts is that the fills on trades, both entries and exits, are virtually automatic. You will not experience that when you trade “live cash”. When you are trading your “live cash” account you will find that you did not get filled on trades so easily in some cases. So I just want to caution you that the results you have on your “sim” account are going to be 100% replicated when you go live.
I certainly do not want to dissuade you from using the “sim” account to practice your trading. It is much better to make platform mistakes when real money is not at risk. Use the “sim” account for the purpose it is intended. And don’t allow it to be an excuse for not moving on with real trading.
Trading the Probability Based way is all about trading small size and executing a large number of trades. Only by placing enough trades that meet the PBT criteria can you expect to put the odds in your favor for success.
So get started now! I hope I have encouraged you to take control of your finances. Your future financial security depends on it. Contrary to what you have been led to believe, it really is not that complicated to become a consistent, successful trader. Furthermore, you don’t need to spend countless hours to learn a lot of meaningless technical jargon.
Learn to rely on the probabilities that are right in front of you. Learn to trust the concept and the process. Remember, “The Math Does Not Lie”.
Good Luck and Good Trading!!
ADVANCE YOUR TRADING PROFICIENCY
If you are new to trading don’t allow yourself to get to “hung up” on the “Greeks”. The option trading space uses Greek names to identify different option metrics. The “Greeks” most commonly referred to are:
- Delta – the amount an option price moves relative to the price movement of the underlying security. An option with a delta of .5 will move (up or down) half of that of the underlying security. If the stock moves $1.00, the option price will move $0.50. Similarly if an option has a delta of .3, every $1.00 move in the underlying security will move .30.
- Theta – is also commonly called “time decay” of the option price. It measures how much the price deteriorates as the option gets closer to expiration. For traders that primarily sell premium the “Theta” decay is a primary consideration. Theta is not linear. The rate of Theta increases as the expiration date is approached.
- Gamma – the rate that delta will change based on a $1 change in the stock price.
- Vega – the amount the option price will change based on the volatility of the underlying asset.
The “Greeks” are dynamic and move with every change in price and/or volatility. Many advanced traders manage their investment portfolios relative to the “Greeks”. The most common reference point for the advanced trader is keeping track of the total number of “Deltas”, positive or negative” that are represented in the account.
If you are new to trading, you have plenty of time to become more knowledgeable of the “Greeks” and their impact on the price of the options you own or have sold. The simplest way to have a basic understanding of “Delta” is if you are short “Deltas” you are net short the market and if you are long “Deltas” your portfolio has a long bias.
To trade options successfully, investors must have a thorough understanding of the potential profit and risk for any trade they are considering. Many traders are very visual and may find the use of risk graphs as a great tool in understanding various trading strategies and the key risk and reward levels in their trades. Risk graphs or risk profiles provide the trader with clear picture of the trade.
Most good options trading platforms provide the trader with the ability to generate a risk graph Risk graphs are basically profit/loss diagrams. Risk graphs provide the trader with a clear picture of potential profit and levels that present the greatest risk.
If you are a “visual” person you may find that using risk graphs help you to visualize the critical inflection points in your trade. Below is an example of a simple risk graph for a call credit spread. It is easy to see the important levels. At a glance you can see that the maximum profit on the trade (to the left) is $40.00 and the maximum risk (to the right) is $70.00.
It is not incumbent on you to use risk graphs to be a successful trader. Initially you may find them helpful to confirm your understanding of your maximum risk, maximum profit and breakeven level(s). As your trading experience grows you will develop an inherent sense of the key levels in your trades. That being said, risk graphs do provide a clear and convenient way to “picture” your trade.
MAINTAINING YOUR FOCUS
In order to become successful trader it is extremely important that you maintain your focus. One of the most recurring issues that I see with traders who have not yet become consistent and profitable is their constant search for the next bright, shiny object.
Since we began our formal education at ages 5 or 6 it has constantly been drilled into us to seek more and more knowledge. This works great in the real world but not necessarily so in a traders world. Our natural quest for knowledge leads us to believe that if we are currently not successful as a trader it must be for lack of knowledge or skill.
If you subscribe to the probability-based trading methodology nothing could be further from the truth. There is no question that you need technology and methodology knowledge and it takes some time and practice to acquire the skill set.
Of course there was always the need to continue to refine and improve what you do but the answer does not lie in the next great indicator, black box system, or what the next self-proclaimed guru is promoting. Everything you need is right in front of you on the options chain.
In conclusion, don’t be tempted by the “next great thing”. Focus on understanding the methodology, finding, executing and managing trades that meet your criteria. Prove the concept to yourself by executing a significant number of trades and TRUST the probabilities. The math works!!