Last week we discussed how to simply 'hide' from the high risk area of the market, playing the options trading strategies game of pickle where we try and snap up as many coins as we can in front of the steamroller without getting run over. It's a game of high probability and low risk and often for just little a profit, but done on a consistent basis could be quite rewarding.
Today we'll talk more in depth about the specifics of the greeks, what we are looking to happen, how to avoid missteps and a trade example.
A quick review: As we look for ways to extract return from the markets, options offer some tremendous leverage opportunities, and as sellers of premium that leverage is magnified into a substantial advantage. Mostly, 80% of options will expire worthless, and being the seller's side provides this advantage to 'likely' win every 4 of 5 times. However, we can be even more precise with probabilities, where the delta and gamma give us better information and odds at certain moments in time.
We use time as our friend, pulling in time premium when the odds are stacked in our favor of the option value going to zero at expiration. That would be considered a 100% total win.
Definitions: Delta is the change in the option price with a $1 move in the stock, while gamma is the rate of change in the delta (a derivative). This tells how fast or slow the delta is likely to move, and clearly a slower (or lower) gamma is a huge advantage to the premium seller.
If we are short options (delta), we would like to see that rate of change slow down, or have the gamma start heading toward zero. Ideal when volatility is low and not moving upward, or even falling. If we are short put spreads for instance, that falling gamma means the option prices are falling, and if we were initially paid a credit, we want to see the options expire worthless to keep the entire credit. If we are long options (delta) we want to see that gamma expand, giving our options a great chance to overcome time decay. An ideal environment for this is when volatility is rising.
When volatility is low the market expects very little overall movement. There are always good and bad times to sell premium, but in this case we have to accept smaller rewards for less movement. As long as the steamroller is far enough away as we pick up coins, that's okay for us. A great example here is one by my partner and Real MoneyPro colleague Suz Smith, who runs the Spread Trader product at www.explosiveoptions.net. She has pulled off many of these trades this year with mastery and precision.
A recent trade idea of hers was to sell the RUT (NYSE:IWM) bull put spreads with strikes at an area that was deemed 'safe'. Spreads deliver less return but define our risk to the size of the spread only, just in case something really bad occurs - we won't likely be wiped out (that is if we apply our right-size rules). No guarantee, but the probabilities are high enough that the odds are strongly in our favor for the amount of time remaining.
On May 31, the markets swooned down hard and bounced back, but before that bounce Suz was looking at the 1320/1300 bull put spread (sell 1320, buy 1300) for the June monthly expiration which would expire in just over two weeks.
At some point during the day, the RUT got down to about 1355 or so, penetrating the lower bollinger band, often a good place to open this type of trade (low risk entry point). Collecting 2.30 for this spread and then just waiting it out for 12 trading days was pretty nice, too.
At expiration, the RUT was at 1400, the day Suz put the trade on was the low for this cycle, the price never came close to the short strike of 1320. As a result, we kept the entire credit of 2.30 as the contracts expired worthless on June 16. Selling ten spreads would have resulted in making a cool $2,300 for the twelve day period, a very nice annualized return on risk. Fortunately, this trade went smoothly and we didn't break a sweat, but it's not always like that.
The very low delta (about 12% at the time) and low gamma were enough to convince us this trade had an excellent chance of working. Simply put, an 88% chance of success was built in at the time the trade was established. Suz picked strikes that would be far enough away from trouble but with the understanding the heat could be turned up at anytime. Repeated over and over again this strategy can be an enormous boost to your portfolio.