Welcome back to the world of
options. My reality exists in three dimensions and far more combinations of
potential positions than does the one-dimensional world of the stock trader.
The view from my turret is
ruled by the three primal forces of options -- time to expiration, price
of the underlying, and implied volatility. Consider for a moment the fact
that each of these factors can independently impact a given option.
Multiply this by several
available expiration dates and strike prices; add in the fact that individual
option positions can include a variety of short and long positions at
different strikes and expirations, and the potential combinations that make
up an option position in a single underlying can approach a very large
number.
For those traders first
beginning to navigate this unfamiliar world, I think it is important to
understand trade selection is manageable. There are certain families of
trades that are unified by similar characteristics.
It is important to become
familiar with the various trade constructions available to the knowledgeable
options trader. Grouping the potential trades into related groups
dramatically reduces the number of trade setups you must consider before
entering a new trade.
If you are familiar with the
various trade constructions, it makes discussion of a specific family member
whom we may consider for employment in a trade far easier to understand.
Description of the family
characteristics will take a little time, but it forms the framework on which
we can hang the individual trades we will discuss in future postings.
I want readers to begin to
become familiar with these patterns because it is these families of
multi-legged option trades that we will return to on a regular basis to
consistently perform for us.
Let me begin discussion of the
various families by pointing out the redheaded stepchild of the trade
constructions available. This family member, the single-legged position of
being long either a put or call, is not completely without utility.
The reason for its seldom use
is that for the knowledgeable options trader, this position rarely represents
the best risk / reward structure given the variety of available trade
constructions.
One basic and important family
is that of the vertical spread. We will return several times to this family
not only because of its utility in its basic form, but also because these
spreads form the basic building blocks for more advanced spreads such as
butterflies and iron condors.
The basic vertical spread is
constructed by both buying and selling an option of the same type, either
puts or calls, within the same expiration series. This is a directional
spread with one breakeven point that reaches maximum profitability at
expiration or when the spread has moved deep in-the-money.
It has a defined maximum
profit and defined maximum loss when established. The spread is used to trade
directionally in a capital efficient manner and largely neutralizes impacts
of changes in implied volatility.
There are four individual
vertical spread family members -- the call debit spread, the call credit
spread, the put debit spread, and the put credit spread. Each has its
distinct and defining construction pattern. These are not the only names by
which these spreads are known. Trying to keep independent option traders
confined to a single set of terminologies is like trying to herd cats -- it
is not going to happen.
For this reason, the
additional confusing and duplicative names for these spreads include bull
call spread, bear call spread, bear put spread, and bull put spread. To make
matters even more confusing, traders often refer to "buying a call
spread" or "selling a put spread." This multiplicity of names
for the same trade structure is mightily confusing to those getting used to
my world.
I am a visual learner and find
that a picture is worth well more than the often cited thousand words. When I
review in my mind the various option families available to use in trade
construction, I think of the characteristic family portrait of each as
displayed in the profit and loss, or P&L, curve.
Attached below is the first in
our series of family portraits, but remember within this framework is
abundant room for individual variation.
This particular example is a
call debit spread, a bullish position in Apple (AAPL).
We will see trades displayed
in this format with many variations as we meet the different families. The
solid red line represents the profit or loss at expiration. The dotted line
represents the P&L curve today and the dashed line the curve halfway to
options expiration from today.
In future articles I will
discuss other trade constructions that are regularly employed by experienced
option traders. Until then, be sure to manage your risk accordingly.
In 2012 subscribers of my
options trading newsletter have won 12 out of 13 trades. That's a 92% win
rate, pocketing serious gains with the trades focusing only on low risk
credit spread options strategies.
If you are looking for a
simple one trade per week trading style then be sure to join www.OptionsTradingSignals.com
today with our 14 Day Trial
