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The options strategies can be applied using stocks or futuresBasic Trading Strategies Trading is a diverse activity that encompasses a wide variety of analysis techniques and innovative approaches. The optimal approach for you requires an assessment of both your time availability and your risk tolerance. Once these factors are determined, youre ready to specialize in those techniques that fit your parameters. There are three fundamental approaches on which all trading strategies are based: strategic trades, long-term trades, and delta neutral trades. Each has its own set of conditions and rules that foster a unique trading style. Strategic trades are typically short-term trading opportunities geared especially for day traders and short-term traders who have the opportunity to monitor the markets very closely each day. Strategic trades are specific to certain markets and may be driven by economic data or events. Many strategic traders use the Standard & Poors 500 as the key index on which they focus their attention when trading market-related instruments. The Dow Jones Industrial Average (the Dow) is also watched closely to tip off certain bond and currency trades. As a trader, you need to develop your own personal trading style based on the patterns you encounter in the markets. Consistently applying the use of a strategic trading approach fosters success. Long-term trading methodologies differ greatly from strategic trades. Long-term traders do not look at trades from a second-to-second perspective. Instead, they approach trades from the perspective of a couple of days to a few months, or even into the next year. These trades are based more on market trends and seasonal factors. They take a while to blossom and bear fruit, which gives the long-term trader more time to develop the art of patience. Delta neutral trades make up the third kind of trades, and probably the most complex. These strategies create hedged trades in which the overall position delta equals zero. As the market rises and falls, the overall position delta moves away from zero. Adjustments can then be made by purchasing or selling instruments in such a way as to bring the overall position delta back to zero. Each adjustment has profit-making potential. Most delta neutral trades can be structured in such a way that your total cost and risk are minimized. Delta neutral trading strategies and longer-term trading opportunities are better suited for traders who are not able to sit in front of their computers all day watching the markets move. Successful delta neutral traders create a trading system with a time frame they feel comfortable working in. You can create trades that are three months out, two months out, one month out, or even only one day out. If you are the type of person who does not want to think about your trading every single day, simply take a longer-term approach. Delta neutral strategies can be applied to any market. It can be advantageous to learn to trade both stocks and futures. Even if you think you want to trade just futures, you can make just as much money trading stocks if you use delta neutral strategies. In either case, the options strategies outlined in this book can be applied using stocks or futures. As you read about them, think about the ones that make the most sense to you and then specialize in those strategies. RISK PROFILES Before launching into our discussion of specific strategies, lets discuss one of the most important tools for viewing the profit and loss potential of any options strategy: the risk profile. Understanding and managing risk is the critical task of all traders. Very experienced traders and the mathematically adept may be able to intuitively understand what risk is being assumed by a given trade, but the rest of us work best with a visual picture of the risk we are taking. For that reason, the drawing and understanding of risk curves is an essential part of daily trading activities. A risk profile is a graphic representation of the profit/loss of a position in relation to price changes in the underlying asset. The horizontal numbers at the bottom of the graphfrom left to rightshow the underlying stock prices. The vertical numbers from top to bottom show a trades potential profit and loss. The sloping graph line indicates the theoretical profit and loss of the position at expiration as it corresponds to the price of the underlying shares. The zero line on the chart shows the trades breakeven. By looking at any given market price, you can determine its corresponding profit or loss. Risk profiles enable traders to get a feel for the trades probability for making a profit. In order to get a better handle on what a risk curve is, lets use a hypothetical example. The first thing to understand is that the risk graph depicts the value an option or an options position in relation to changes in the underlying assets price. As an example, lets consider call options on Wal-Mart Stores (WMT). Here, WMT is the underlying asset. Assume shares of Wal-Mart are trading for $60 each and one January 70 call can be purchased for $2.50 (or $250 per contract). Therefore, the underlying asset is Wal-Mart Stores and the option is the WMT January 70 call. Table 4.1 shows the risk and reward of holding the WMT January 70 call. The prices are hypothetical prices that might exist at expiration on the third Friday in January. Notice that if the stock doesnt rise above $70 a share, the position loses $250 because the option expires worthless at or below $70 a share and yields no profit. If the stock climbs to $75, the options are worth $5 and the profit totals $250: [(75 - 70) - 2.50] 100. At $80 a share, the profit equals $7.50 ($10 - $2.50). Notice that the position breaks even at $72.50 because $2.50 was the initial cost of the call when purchased. Rather than creating a table for the risk/reward profile of the WMT January 70 call, we can create a risk graph. It plots the profit from the option (on the vertical axis) along with the price of the stock (along the horizontal axis). Figure 4.1 shows the risk graph of the Long WMT January 70 call in its standard form. The potential profit from the call is plotted along the vertical axis. The classic view risk graph shown in Figure 4.2 was created using Optionetics.com Platinum software. The lowest of the four lines on the graph considers the potential profit and loss of the WMT January 70 call at expiration and contains the same information as the table. Just as we saw on the table, the profits begin to accrue when WMT hits $72.50 a share. The breakeven point (at expiration) occurs where the straight black diagonal line intersects with the zero profit line. The other lines reflect the risk/reward with a specific number of days (as shown in the upper lefthand corner) remaining before expiration. The position of the profit/loss lines at various time intervals is based on the models assumption that implied volatility remains constant. While this assumption doesnt reflect reality, it must still be made in order to produce the chart. In addition to using Optionetics.com Platinum, you can also use other options pricing software or compute the graph manually. To actually draw the risk curve, your tools can be anything from a pencil and piece of graph paper to a computerized spreadsheet program such as Lotus 123 or Microsoft Excel. The steps will be the same. Drawing a risk curve for any trade, regardless of its complexity, consists of five basic steps: 1. Determine the stock prices for which you will have to calculate values of your trade at expiration. 2. Calculate the profit (or loss) at each of those points, and determine the breakeven level. 3. Sketch the two axes of your risk curvethe vertical axis will delin eate the profit (or loss) of the trade, while the horizontal axis will depict the price of the underlying for which you have determined a profit or loss. 4. Actually plot the points that you calculated in step 2 onto the graph set up in step 3. 5. Draw lines connecting each point plotted in step 4. This simple five-step process will permit you to calculate a risk curve (even without a computer), detailing the actual profit or loss that can be expected at any stock price upon expiration. Granted, you cannot estimate potential profit or loss prior to expiration, but a basic rule of thumb is that the profits will not be as high, nor the losses as great, at any time prior to expiration. If you dont have a sophisticated risk-graphing program available, this process will give you the basic outline of what your trade will look like. As you gain experience and your trading becomes more refined, you will find yourself needing the power of the packaged programs. However, for the beginning trader, a simple risk curve at expiration like this one will help explain where profits can be made or lost. If you graph out the risk curve on every trade you are contemplating, the visual recognition of the risk will soon improve your trading in countless ways. Skill Builder Now its your turn. Follow the five steps to see if you can manually create a risk graph (using the framework in Figure 4.3) for 1 Long WMT 70 Call @ 2.50. The complete risk graph can be found in Figure 4.1 if you want to check your work. LONG STOCK While the term going long might have you envisioning a football player going deep for a pass, in the financial markets going long is one of the most common investing techniques. It consists of buying stock, futures, or options in anticipation of a rise in the market price (or, in the case of a long put, a drop in the price). An increase in the price of the stock obviously adds value to a stock holding. To close this long position, a trader would sell the stock at the current price. A profit is derived from the difference between the initial investment and the closing price. A long stock position is completely at the mercy of market direction to make a profit. Long Stock Mechanics In this example, the trader is long 100 shares of XYZ (currently trading at $50). Remember, shares of stock do not have premium or time decay. Long stock has a one-to-one risk/reward ratio. This means that for every point higher the shares move, you will make $100. Conversely, for every point the shares fall below the purchase price, you will lose $100. Figure 4.4 shows the risk profile of this long stock example. As you can see, when the share price rises, you make money; when it falls, you lose money. Notice how the profit/loss line for the stock position shows a 1-to-1 movement in price versus risk and reward. This means that the stock trade has an unlimited profit potential and limited risk as the price of the stock can fall only as far as zero. Exiting the Position When you purchase a stock, the only way to exit the position (without exercising options) is to simply sell the shares at the current market price. If the price of the stock rises, the trader makes a profit; if the price falls, then a loss is incurred. Thus, if XYZ rises to 60, 100 shares will yield a profit of $1,000: (60 - 50) 100 = $1,000. If XYZ declines to 40, 100 shares create a loss of $1,000: (50 - 40) 100 = $1,000. |
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