Welcome to the coaches corner. I’m Beau Keenan, a long time coach for the Pirate. One thing that appealed to me when teaming up with Preston was his emphasis on trading with favorable probabilities. I want to convey some of the important principles of probability in this article.
Mike and Jon did a good job previously of alluding to some things that we as traders can do to “stack the odds in our favor.” Mike discussed the advantages of selling versus buying options and Jon outlined the importance of having a game plan. What’s key to the concepts Mike and Jon shared is that they increase probability and are things we can control as traders.
It’s natural to feel somewhat overwhelmed and powerless when trading the markets, especially given the enormous market influences constantly at play, such as the billions of dollars being thrown about by institutions, the superior timing of super computers, volatile macroeconomic factors, etc. That said, there are things we can control to increase our chances for success.
There are six things that we as “Master Income Traders” need to build into our trading systems:
- Employ option selling strategies.
- Take advantage of option pricing discrepancies between short-term and longer-term options.
- Utilize compelling fundamental information.
- Buy and sell based on market cycles.
- Always use insurance.
- Seek appropriate risk/reward opportunities.
Every asset can go one of three ways in value—up, down or sideways. We know as a general rule that markets go up about 40 percent of the time, they create a neutral trading range 35 percent of time and decline roughly 25 percent of the time.
One big reason Preston’s trades favor the upside compared to the downside is because the markets are neutral to bullish 75 percent of the time. When utilizing buying strategies with options, we are limited to making money in only one of those three market direction scenarios—if the market goes up when using calls or down when buying puts; neutral movement actually causes losses.
Meanwhile, a selling strategy actually doubles your odds for success because you gain time decay during periods of neutral movement, offering profits in two of the three aforementioned directional movement scenarios. Of course, the person buying an option has the potential to gain more than the option seller, but you have to ask yourself how many trades you’ve witnessed where the stock shot to the moon—not very many is the likely answer.
Option Pricing Discrepancies
Options are typically priced unevenly across their different expirations—although a one-month option might cost $3, that doesn’t mean the two-month option will cost $6 or the three-month $9, and so on. As a general rule, one-month options cost about three times as much as the average monthly cost of a one-year option.
We prefer selling shorter-expiration options because they have the most bang for the buck; weekly options actually enhance this concept. Four weeks of option premiums typically equate to one and one-half to two times the premium value of a one-month option. On the other hand, if we plan to be in a trade longer than a week we should buy a protection leg with a long expiration to take advantage of the option pricing discrepancy. Doing so is much like buying in bulk during the monthly visit to Costco—you pay a little more up front, but the per-item price is much less. Preston favors calendar and diagonal spreads for these very reasons.
Once we decide to use selling strategies employing diagonal spreads, we must consider the reason for getting into a trade. We need an edge to increase the probability the stock will go the direction we want it to go. Although there are many factors that can provide an edge, the fact is the majority of market volume is controlled by institutions, so we believe it’s best to focus on what the institutions are doing.
Although there are more than 400 technical indicators available, we know institutions are looking for things that will affect a company’s bottom line. As such, we need to look for key fundamental events, such as stock splits, upgrades, product developments, earning’s preannouncements, etc. In the long run, these kinds of fundamental events are better indicators of where a stock is heading versus a MACD crossover.
Preston often talks about trading with the markets because it increases probabilities working in our favor. History demonstrates that three of four stocks will go the way of the market,” providing us with an edge if we take advantage of this knowledge. As Jon detailed last month, we use Investor’s Business Daily to help determine the market cycle. Although IBD will not predict tops and bottoms, it does keep us from fighting the trend and helps us to capture the meat of major market moves.
Utilizing insurance with option strategies is a necessary evil. Hoping for the best and trying to fix trades gone awry is a sure equation for disaster. To protect yourself, you have to be ready to adjust your protection leg, decrease your position size or simply avoid the trade altogether. While most limit their approach to the use of protective puts, we utilize strategies such as adjusting position sizing, hedging with different assets (Preston likes to do so with FAZ and other inverse ETFs) and using pre-established exit points. We don’t skimp when it
comes to insuring our positions because we understand that the costs of not doing so can be exorbitantly higher. Ultimately, we recognize that mitigating risk is just as important as increasing gains when it comes to trading.
We always look for scenarios providing a risk/reward ratio of 1:2 or greater for most positions. You don’t have to be the world’s best stock picker to make consistent gains in such trades. Calculating your risk is very easy when utilizing selling strategies—you know that the premium
received is the most you can make per share. Inversely, when buying options it can be harder to calculate because your upside is not capped.
A good example of a favorable risk/reward ratio is the Money Press trades we do. You’ll see Preston with $10 of risk per share for the month, but a gain potential of $5 per week per share ($20 per month per share), which meets our risk/reward rule and justifies a trade. Granted, there’s
no guarantee such a position won’t lose money, but it provides us with good odds for making more money over time when things do go well.
Bottom line, great traders rarely incur losses due to issues they can control. While losses are inevitable, we can limit them by always seeking trades offering higher probability. Moreover, incorporating our six principles enables us to leverage probabilities in our favor to
maximize gains and mitigate losses.
Beau Keenan has been an active trader for six years. He graduated from BYU’s Marriott School of Business with a degree in corporate finance, but found his passion in trading. During that time he’s traveled the country coaching individuals on the markets and how to trade equities, options, futures and foreign currencies. He enjoys teaching and since joining the Traders Edge Network has personally worked with hundreds of individuals. Beau is a husband and father of two young children. He enjoys the freedom he has to do lots of other activities, from traveling to building businesses.