Traders Edge Blog

Coaches Corner:
Welcome!

Welcome to the Coaches Corner. It’s a great place to tap into a wealth of knowledge in each monthly newsletter. Our experienced coaches have decades of options trading experience and will share their thoughts, strategies and trading ideas in this section each month..

You’re sure to benefit from the thoughts and insights you’ll find in each issue of Coaches Corner, provided by some of the sharpest and most experienced option traders around. We plan to discuss issues ranging from specific strategies and trades to general market analysis and tips and tricks to help improve your trading—information you’re sure to find priceless.

Allow me to introduce myself. My name is Mike Curtis and I have been an active option trader for eight years now. I have personally coached and worked with hundreds of traders just like you, focused on helping them find a successful system that they can implement over and again.

Throughout years of trading successes, having personally paid some “market tuition,” and working with all types of traders to help them find their pathway to successful trading, I’ve found there’s ONE common mistake most traders make. I know sharing this bit of information can help any trader, whether you are a beginner just getting started or a seasoned veteran with years of experience.

Most traders entering into the world of option trading usually start out as option buyers— especially call options—as this closely simulates buying shares of stock, which most traders can relate to. Buying a call option gives you the right, without any obligation, to buy shares of stock at a specified price, called the strike price. For example, if you buy a 50 strike price call, you have the right to buy shares at 50. If the stock goes higher, the value of your call option will increase since you maintain the right to buy the stock at 50.

Sometimes your gains can be exponential when you buy a call option and catch a large move up in the stock. A 50 strike price call expiring a few months out in time might only cost a couple hundred dollars. If the underlying stock moves five to 10 percent, you could see your option contract almost double in price in some cases! (This is a generic example and there are several variables to consider, but it illustrates the profit potential)

Buying calls (or puts) can be slightly addictive mainly because of the high rates of return that can be achieved. You can see a couple-thousand dollar investment double or triple if the stock makes a decent move in your direction.

I have seen MANY traders narrow their focus and try to implement a trading plan consisting of 100percent call option buying. This is a path to a very short trading career in most cases. The problem with buying options is that options have an expiration date and depreciate. You determine before buying which expiration period you want to trade, but as that expiration date approaches the option will start to lose value. Imagine buying a new car for $50,000; after a few years that car will have depreciated by maybe 50percent or more. Ten years later that $50,000 car is only worth a few thousand dollars. Options depreciate at a similarly rapid rate, but on a shorter time frame. A portion of their value is ‘time value” and that time value will decay rapidly, especially on options expiring in just a month or two.

In my experience of working with hundreds of traders, purchasing a call option is one of the hardest ways to make money in option trading. The time decay working against you proves difficult to overcome. You could buy a call option, have the stock climb slightly higher, and still lose money. The stock could trend sideways or not move much at all, but the time decay can still cost you dearly. If the stock were to drop, you take an even bigger loss as the option loses value.

Options are fairly cheap compared to the stock price, so they are appealing in that sense as well, but that cheap cost can also lead to being reckless at times. It is not uncommon for me to see people take a 100percent loss on an option purchased that expires with no value. Luckily, people don’t usually invest as much into an option contract as they would into a stock position. That said, even with a cheaper option contract, the losses can really start to add up.

So how can we stack the odds more in our favor? How can we avoid falling into some of these tough situations that can occur when buying options? Let me clarify, we still buy options… once in awhile. It is a small piece of our overall trading plan and we always control our positions sizes. However, the bulk of our trading focuses on taking the other side of the option contract. We can really put the probabilities in our favor by being option sellers, so let’s talk about how this can really help improve your trading.

By selling options and taking the other side of the option contract, you flip the time decay on your side. Now as time decays you profit from it instead of the decay hurting your position. Why is this so important? Well, we ALWAYS know time will pass. It is really the only true constant in the market. Also, whether the stock moves in the direction you are hoping or if it just stays flat, you can still profit.

Here’s an example:

If a stock is trading at 101 and we sell a 100 strike put for $2.00, the stock could go up and the put would expire worthless. We’d keep the full $2.00 per share as profit, or $200 per contract. The stock could stay at 101 or drop a bit to 100 and we could still keep the full $2.00. In fact, we don’t start losing money (at expiration) until the stock drops below 98 per share, in which case we would need to buy back the sold put and close the position. That in itself gives us a statistical edge. The stock could move up, stay flat or move slightly down and we can still make money.

(Note – selling a put is a bullish/neutral trade while buying a put is a bearish trade. It is easy to get confused when thinking about selling options until you gain experience)

Next, we layer on a high probability setup (compelling news, strong reaction to earnings, a pre- announcement, etc.) where we know a stock is likely to behave in a certain way and now we’ve really stacked the probabilities in our favor!

Selling the option is only part of what we usually do. It’s crucial to add protection to your

positions when selling your options. If selling a put, you add protection by simply buying a put contract as well. This turns the trade into an option spread. If you sell an option without buying a position to cover (a naked position), your broker will most likely hold a large margin requirement for the position. Let’s look at another example:

Following the previous example, if the stock is trading at 101 and we sell a 100 strike price put for $2.00, we would then go out and BUY a protective put at the 95 strike price or lower. Now your broker will recognize your obligation to buy stock at 100, but you’ve covered the position by buying the right to sell at 95, capping your risk at $5 per share, or $500 per contract. Adding the protection covers you from substantial loss if the stock really falls apart, but if the stock still goes up, sideways or down slightly we can still generate a phenomenal profit with limited risk.

If you have never sold options before or traded option spreads in the past, I would recommend trying it in a virtual/paper account first. It is always helpful to get some practice to ensure you avoid silly mistakes before putting your hard-earned capital at risk.

The next time you see a stock that you feel is likely to move higher, consider utilizing this high probability strategy to take advantage of the move instead of simply buying the call. If you start incorporating more option selling and spreads into your trading plan, I think you’ll find yourself winning on more trades, being more consistent and experiencing fewer big drawdowns in your account equity curve.

Happy Trading!

Mike

 

Mike Curtis has been an active trader in the derivatives markets for 8 years. He has mastered the world of equity and index options along with spread trades, futures and foreign currency. He loves teaching and has personally coached over 500 individual investors needing help learning to apply a consistent trading method. Through his mentoring, he has helped hundreds of people change their financial situation through trading in the financial markets. He is a husband and father of 4 young children currently lives in Salt Lake City, Utah.

Karson Keith’s Options Insight:
Dynamics Behind the Butterfly

Most option traders are familiar with what a butterfly position is, but few traders know how to take advantage of the dynamics behind the position. In fact, most traders are not even aware that you can take the other side of the butterfly. The typical position is a long butterfly, when you buy the outside legs and sell the middle. The long butterfly benefits from time decay and can be a great trade as long as it is done in the correct time frame and with the right stocks. The short butterfly is a less common trade. You simply sell the outside legs and buy the middle. This position benefits from a stock making a move in either direction.

Let’s take a $5 spacing butterfly on something like AMZN or NFLX.

One of the most important factors of trading butterflies is how far away you are from expiration. The short butterfly with $5 spacing makes almost no money in the longer time frames unless the stock makes an extreme move. On the other side the long butterfly with $5 spacing has almost no time decay in the longer time frames. In other words, doing a butterfly in longer time frames is almost pointless with $5 spacing.

Timing is everything…

With $5 spacing you need to know where (or when) the sweet spot is to enter either a long or short butterfly. In the case of AMZN and NFLX, the sweet spot for the long butterfly tends to be about when the new weekly option comes out on Thursday. This puts us eight days away from expiration. The idea is to hold the long butterfly over the weekend and melt away some time decay. Even if the stock makes a $5 move you can usually take the trade off the table at about break even, or in many cases with a small profit. If the stock doesn’t move much over the weekend, then we can simply hold the position for another day to melt away more time decay.

I will usually take part of my position off of the table regardless when it gets to Wednesday. This is usually the tipping point for how sensitive the butterfly is to movement in the stock, which is why I will take some of my profits off the table. On Thursdays and Fridays butterflies are at their most sensitive to movement in the stock, so I’ll be much quicker to take long butterfly profits off the table those days because I don’t want the market to make a swing and wipe out all of my profits for the week.

On the other side of the butterfly (the short butterfly), I favor reserving this position for the last two days before expiration, with at least $5 spacing. AAPL has been an easy winner for this position almost every single week for the last few months. The drawback is you have to deal with rapid time decay with a stock like AAPL, so I am quick to take the trade off the table if things are not moving as expected.

A more in-depth discussion is that of volatility. Timing volatility spikes and dips can improve results, but it can be tricky. A great entry for a long butterfly is when volatility has spiked, as the position will benefit from a drop in volatility. On the other side of the coin, a great entry for a short butterfly is when volatility has dipped lower. This position will benefit greatly from a move in the stock coupled with a spike in volatility.

You can also tweak the sensitivity of the butterfly based on how far apart your spacing is between the strikes. The further the spacing the more time decay and the more sensitive the position will be to movement.

Obviously, butterflies can be very complex and have many moving parts involved, but I hope this article helps you gain a better grasp on how they work.

Karson Keith

 

Karson Keith’s interest in trading started at a very young age. By age 13, he began trading and managing his father’s money. Today, his passion for trading has attracted a following of like-minded income traders seeking his help in taking their trading to the next level.

Karson specializes in cutting-edge options strategies, volatile markets and small trading accounts. He not only has single-handedly grown several small accounts into large portfolio margin accounts within just a few months, but he has also helped countless people achieve the same results.