DAY TRADING OPTIONS:
PROFITING WITH LONG OPTIONS
It’s a known statistic in the options markets that the writers end up banking money 9 out of 10 times simply because the erosion of time is in their favor. This can lead the buyers (holders) to leave the table with less than they came in with, and the fallacy that “it’s a scam”. “Long options” (buyer/holder side) are therefore thought to be the “losing camp”, while “short options” (seller/writer side) are seen as the “winning camp”.
I believe I have formulated a “long options” strategy which suggests otherwise, however, and which leads to far greater returns than possible with the writing of options. The reason I’ve stayed in the “losing camp” with the “longs” all this time is because of several factors ranging from my risk tolerance (I cannot stand the thought of being exercised or the stock moving heavily in the opposite direction merely on an unexpected press release), and the fact that my broker only allows the opening of long options positions… A reason I’ve hated my broker previously. After formulating this strategy though, I’ve come to the conclusion that I now prefer STAYING in the “losing camp” because it’s only a “losing camp” if you don’t employ the right technique.
The Method:
The main jist of this strategy is that it’s basically a form of day trading of exchange traded options rather than stocks.
1. Buy long calls or puts only… No straddles, strangles, spreads, or naked writes. Covered call writing is okay, but that’s a (income) strategy of it’s own and doesn’t generate the triple-digit types of returns this strategy does.
2. Enter the position (opening contract) fairly close to expiration (with about 2 weeks remaining till expiration).
3. Analyze the stock and it’s near term prospects thoroughly prior to opening your position, and determine the likely direction and price range of where it will PROBABLY trade the NEXT TRADING DAY. The key word here is “probably” as you have to think in probabilities in order to plan for the likely and even unlikely scenarios the stock may undergo in such a short timeframe. Therefore, you’ll have to set price targets you believe have VERY HIGH odds of being hit in this very short time frame. The easy part here comes from realizing that in such small and non-volatile time spans only a very limited number of highly probable scenarios, and an even lesser number of unlikely scenarios is possible (as compared with an earnings release, for example) so you won’t have to lose sleep over it too much. On another positive note I will admit I’ve managed to get two winners in a row so far while losing some money on the third. Though a 67% success rate is nothing to sneeze at in such a risky transaction, I do believe that over time, with intense focus, one can achieve an even higher success rate than this (though 100% is obviously unrealistic). So a really focused individual might get 10 winners in a row and lose some on the his 11th trade.
4. The daily options volume on the underlying stock should be liquid enough so as to allow you to bail quickly when your profit target is hit. Opening an options position on a large cap stock (> $5 billion market cap) is probably the right course of action here because options volume and “open interest” on such stocks is usually large.
5. The open position must last no longer than 1-3 days, after which the position must be closed as the premiums will begin to erode quickly as expiration nears. At this point if your trade is slightly unprofitable (or breakeven in the best) then you should consider closing out the contract.
6. The underlying stock’s near term expected (implied) volatility must be low to medium (in the low end of it’s recent trading history) so that 1-3 days of being in the position would not shrink the premiums you paid because the IV eroded unexpected. Again, having an options position on a large cap stock is useful here because such companies are inherently less volatile than smaller (growth) companies.
7. The stock’s price itself must be at a short term bottom or peak, and within a trading range.
8. Buy only at-the-money or in-the-money options (avoid out-of-the-money, deep-out-of-the-money, and deep-in-the-money options).
9. Do not open a position during an earnings cycle, or other major event like an analyst day, product launch, analyst downgrade/upgrade, or pre-scheduled conference call. It is fine, however, to enter a position well in advance, or after such an event as long as you are sure you will have closed out the position shortly prior to the commencement of such an event. Such events cause the market’s expectation of near term volatility on the underlying stock to increase significantly. Thus, for opening a position you would be overpaying for the premiums. This would, however, be a desirable time to close out previously open positions.
10. Carefully select stocks that require a VERY SMALL move in your expected direction – like 1.5% - for a large move to occur in your options – like 100% profit. Such a stock could vary in price range from the double digits to triple digits (single digit stocks will probably not work well for this strategy, and penny stocks don’t have options traded on them). Selecting such stocks will also prevent you from incurring consecutive losing trades as you might be lucky to bail at break-even or even a profit less than you expected… If you aim for 100% you might do 10% if things go only partly the way your analysis suggested as such large cap stocks usually have low enough implied volatility that premiums erode less drastically than with a stock like Google – which at the date of this writing has a whopping $115 billion market cap, mind you. So it’s clear to see that sometimes mega large cap stocks make for a poor candidate for this strategy.
11. Reinvest ALL proceeds into the next trade (after commissions and monthly expenses) so the effect of compounding begins to leverage your portfolio.
12. Do NOT become greedy, depressed, or impatient and think of abandoning this strategy when you see other options moving up 5000% in less than a day hoping for a similar return. While it may be possible to achieve 5000% on a single options play the odds of you finding one (like MAYBE Google – when it crashes, for example, lol) and then actually profiting from it are very small, involve great risk, and too much patience in searching for and subsequently analyzing the underlying company. This strategy, on the other hand, will make you rich over time. And anyway, the feeling of having 5 big winners in a row is much more gratifying than the feeling that comes with having 1 super big winner, as having 1 super big winner will lead you to doubt your future abilities and lead you to assume “it was luck that did it”.
13. Set goals and follow them through. For example, if you know you can only reasonably manage to do 1 winning trade in a month (i.e., 1 trade every options expiration) then don’t overdo it because first of all that in itself is a marvelous feat. And secondly, you are not here to “prove yourself” to the markets, to your broker, your friends, or even to satisfy your own ego. You’re here to make money. So stay realistic with your goals, but more importantly make sure you HAVE goals and the aptitude to FOLLOW THROUGH on them!
14. This brings us to a closely related point: Don’t become overconfident in your ability to make successful trades that you begin doing stupid things! 5 winning trades in a row… NOT GOOD ENOUGH! Keep raising the bar, and DON’T become complacent! If you become satisfied then you get stuck in the comfort zone from which you will never venture out. And if you become overconfident - thinking the markets are a slam dunk - then your emotions will have taken control of your rational mind, and rationality is a mindset needed for long term success in the markets. While trading on emotions is NOT what makes this, or any other strategy successful!
15. Acknowledge IN ADVANCE that there will be times where this strategy will NOT BE APPLICABLE because the right stock at the right price and the option to go with it will simply not be there. DON’T FRET! And DON’T deviate from this strategy! Otherwise you’ll have your first losing trade wiping out most if not all your gains after a VERY HARD series of winning trades (because you’re reinvesting everything over and over), and that sucks! So if after 5 HARD trades you have $50,000 and on the 6th trade you lose 90% of it because you wanted to “try something new”… Let’s not go there. DON’T “try something new”. Instead stick with what you KNOW WORKS… And this strategy WORKS!
It’s a known statistic in the options markets that the writers end up banking money 9 out of 10 times simply because the erosion of time is in their favor. This can lead the buyers (holders) to leave the table with less than they came in with, and the fallacy that “it’s a scam”. “Long options” (buyer/holder side) are therefore thought to be the “losing camp”, while “short options” (seller/writer side) are seen as the “winning camp”.
I believe I have formulated a “long options” strategy which suggests otherwise, however, and which leads to far greater returns than possible with the writing of options. The reason I’ve stayed in the “losing camp” with the “longs” all this time is because of several factors ranging from my risk tolerance (I cannot stand the thought of being exercised or the stock moving heavily in the opposite direction merely on an unexpected press release), and the fact that my broker only allows the opening of long options positions… A reason I’ve hated my broker previously. After formulating this strategy though, I’ve come to the conclusion that I now prefer STAYING in the “losing camp” because it’s only a “losing camp” if you don’t employ the right technique.
The Method:
The main jist of this strategy is that it’s basically a form of day trading of exchange traded options rather than stocks.
1. Buy long calls or puts only… No straddles, strangles, spreads, or naked writes. Covered call writing is okay, but that’s a (income) strategy of it’s own and doesn’t generate the triple-digit types of returns this strategy does.
2. Enter the position (opening contract) fairly close to expiration (with about 2 weeks remaining till expiration).
3. Analyze the stock and it’s near term prospects thoroughly prior to opening your position, and determine the likely direction and price range of where it will PROBABLY trade the NEXT TRADING DAY. The key word here is “probably” as you have to think in probabilities in order to plan for the likely and even unlikely scenarios the stock may undergo in such a short timeframe. Therefore, you’ll have to set price targets you believe have VERY HIGH odds of being hit in this very short time frame. The easy part here comes from realizing that in such small and non-volatile time spans only a very limited number of highly probable scenarios, and an even lesser number of unlikely scenarios is possible (as compared with an earnings release, for example) so you won’t have to lose sleep over it too much. On another positive note I will admit I’ve managed to get two winners in a row so far while losing some money on the third. Though a 67% success rate is nothing to sneeze at in such a risky transaction, I do believe that over time, with intense focus, one can achieve an even higher success rate than this (though 100% is obviously unrealistic). So a really focused individual might get 10 winners in a row and lose some on the his 11th trade.
4. The daily options volume on the underlying stock should be liquid enough so as to allow you to bail quickly when your profit target is hit. Opening an options position on a large cap stock (> $5 billion market cap) is probably the right course of action here because options volume and “open interest” on such stocks is usually large.
5. The open position must last no longer than 1-3 days, after which the position must be closed as the premiums will begin to erode quickly as expiration nears. At this point if your trade is slightly unprofitable (or breakeven in the best) then you should consider closing out the contract.
6. The underlying stock’s near term expected (implied) volatility must be low to medium (in the low end of it’s recent trading history) so that 1-3 days of being in the position would not shrink the premiums you paid because the IV eroded unexpected. Again, having an options position on a large cap stock is useful here because such companies are inherently less volatile than smaller (growth) companies.
7. The stock’s price itself must be at a short term bottom or peak, and within a trading range.
8. Buy only at-the-money or in-the-money options (avoid out-of-the-money, deep-out-of-the-money, and deep-in-the-money options).
9. Do not open a position during an earnings cycle, or other major event like an analyst day, product launch, analyst downgrade/upgrade, or pre-scheduled conference call. It is fine, however, to enter a position well in advance, or after such an event as long as you are sure you will have closed out the position shortly prior to the commencement of such an event. Such events cause the market’s expectation of near term volatility on the underlying stock to increase significantly. Thus, for opening a position you would be overpaying for the premiums. This would, however, be a desirable time to close out previously open positions.
10. Carefully select stocks that require a VERY SMALL move in your expected direction – like 1.5% - for a large move to occur in your options – like 100% profit. Such a stock could vary in price range from the double digits to triple digits (single digit stocks will probably not work well for this strategy, and penny stocks don’t have options traded on them). Selecting such stocks will also prevent you from incurring consecutive losing trades as you might be lucky to bail at break-even or even a profit less than you expected… If you aim for 100% you might do 10% if things go only partly the way your analysis suggested as such large cap stocks usually have low enough implied volatility that premiums erode less drastically than with a stock like Google – which at the date of this writing has a whopping $115 billion market cap, mind you. So it’s clear to see that sometimes mega large cap stocks make for a poor candidate for this strategy.
11. Reinvest ALL proceeds into the next trade (after commissions and monthly expenses) so the effect of compounding begins to leverage your portfolio.
12. Do NOT become greedy, depressed, or impatient and think of abandoning this strategy when you see other options moving up 5000% in less than a day hoping for a similar return. While it may be possible to achieve 5000% on a single options play the odds of you finding one (like MAYBE Google – when it crashes, for example, lol) and then actually profiting from it are very small, involve great risk, and too much patience in searching for and subsequently analyzing the underlying company. This strategy, on the other hand, will make you rich over time. And anyway, the feeling of having 5 big winners in a row is much more gratifying than the feeling that comes with having 1 super big winner, as having 1 super big winner will lead you to doubt your future abilities and lead you to assume “it was luck that did it”.
13. Set goals and follow them through. For example, if you know you can only reasonably manage to do 1 winning trade in a month (i.e., 1 trade every options expiration) then don’t overdo it because first of all that in itself is a marvelous feat. And secondly, you are not here to “prove yourself” to the markets, to your broker, your friends, or even to satisfy your own ego. You’re here to make money. So stay realistic with your goals, but more importantly make sure you HAVE goals and the aptitude to FOLLOW THROUGH on them!
14. This brings us to a closely related point: Don’t become overconfident in your ability to make successful trades that you begin doing stupid things! 5 winning trades in a row… NOT GOOD ENOUGH! Keep raising the bar, and DON’T become complacent! If you become satisfied then you get stuck in the comfort zone from which you will never venture out. And if you become overconfident - thinking the markets are a slam dunk - then your emotions will have taken control of your rational mind, and rationality is a mindset needed for long term success in the markets. While trading on emotions is NOT what makes this, or any other strategy successful!
15. Acknowledge IN ADVANCE that there will be times where this strategy will NOT BE APPLICABLE because the right stock at the right price and the option to go with it will simply not be there. DON’T FRET! And DON’T deviate from this strategy! Otherwise you’ll have your first losing trade wiping out most if not all your gains after a VERY HARD series of winning trades (because you’re reinvesting everything over and over), and that sucks! So if after 5 HARD trades you have $50,000 and on the 6th trade you lose 90% of it because you wanted to “try something new”… Let’s not go there. DON’T “try something new”. Instead stick with what you KNOW WORKS… And this strategy WORKS!
posted by Raphael Blogger @ 7:50 PM
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