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Apple (AAPL) is one of the most actively traded
stocks currently. For the trader who trades only stock, there are two major
difficulties in executing trades in this stock:
1. It is
breathtakingly expensive.
2. It
exhibits periods of neck snapping volatility exposing the trader to
substantial losses if he gauges the direction wrong and does not act quickly.
For the
investor who is willing to learn an option based approach, both these
problems can be easily dealt with by using structured option trades to control
risk crisply and make efficient use of capital.
Because
this underlying is such an actively traded stock, the options are extremely
liquid and trade with very tight bid / ask spreads. These are the two
essential characteristics for selecting an appropriate vehicle in which to
trade options.
I thought
it would be interesting to look at a high probability trade that does not
depend on accurately predicting the price direction of AAPL. Let us first
consider the price chart below:
The
horizontal orange lines represent the price boundaries of the option trade we
will consider. The lines have been placed to coincide with areas of recent
support and resistance. The lines are obviously placed somewhat subjectively
and can be modified to reflect the nuances of the reader’s technical
analysis biases.
The point
of the thought process I want to lay out here is not to debate the exact
placement of these lines, but to demonstrate how a high probability trade can
be constructed using whatever technical methods you wish to use to determine
areas of support and resistance.
The next
point we need to discuss is the concept of a “vertical credit
spread”. This is, as implied by the name, an options spread in which a
credit is received into the trader’s account. The spread is constructed
in either calls or puts, and represents a bearish or bullish trade
respectively.
An example
of a bullish trade, a vertical put credit spread, would be to sell the AAPL
490 strike put in June and buy the 485 strike. The result of entering this
trade would currently be a credit of $60 for each contract and the full value
of this contract would be realized if AAPL closed at 490 or above at June
expiration. No additional profit is possible for this trade. The position has
a maximum potential loss of $440 because we own the long put.
A similar
bearish trade can be established using a vertical call spread. In this
example, the June 595 call could be sold and the June 600 call bought for a
net credit of $45 per contract. This is the absolute maximum profit that can
be made from the position.
The full
value of the position would be realized if AAPL closed at 595 or below at
June expiration. The position has a maximum defined risk of $455 because we
own the long call.
The astute
reader will now undoubtedly ask the question: Why would anyone take a trade
where he could make $45 and lose $455? The answer lies in the probability of
realizing the profit. At current prices, each of these credit spreads has an
88% probability of achieving its maximum profitability.
The
position I would like to call to the reader’s attention is to do both
trades simultaneously. The combination of a bearish call spread and a bullish
put spread is termed an “iron condor”. The characteristic P&L
curve is presented below:
 
The
illustrated trade has a return of 31% on margin requirements and a
probability of being profitable of 72%. Because it is a credit spread, the
trade has no direct cost, but does have margin encumbrance requirements to
secure the ability to enter the trade.
An
important point is that only one side of the trade requires margin since it
is clearly not possible to lose on both sides of the position. It is critical
to confirm that your broker only requires margin on one side; a few
“option unfriendly” brokers require margin on both sides.
If you
find your broker is one of these dinosaurs- run, don’t walk away since
that illogical requirement halves the potential return on the position.
This is
but one example of using options to construct a high probability trade that
is profitable over a wide range of price and uses capital efficiently. In
addition, risk is crisply defined and accounts cannot be “blown
up” by Black Swan events.
The use of
options opens a host of potential profit opportunities beyond the simple
“going long” or “going short” available to the stock
trader. In missives to come we will explore more of these unique
opportunities.
JW Jones
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