Trading Options for Income

09/13/2012 3:00 pm EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Dan Passarelli, a speaker at the Forex & Options Expo this weekend in Las Vegas, has a knack for explaining option trading in plain English.

In this interview, he talks about several ways option traders can use spread trading and other methods to generate income with even a small option account. In fact, Dan insists that all his students begin with just $5,000 until they learn the nuances of trading options.

Here we discuss several ways to get started in option trading for income, and a few tips and tricks for choosing the right strike price and expiration period for any option trade.

Tim Bourquin: Hello everybody and welcome back. Thanks for joining me again today.

Today, my guest is Dan Passarelli. He’s a speaker at the Forex & Options Expo, and also a frequent speaker at the Traders Expo, another one of which is coming up in November in Las Vegas as well. So Dan, first of all, thanks very much for joining me on Skype today.

Dan Passarelli: Glad to be here, Tim. Thanks for having me.

Tim Bourquin: All right. Let’s talk first of all about what you’re going to be talking about in your session at the Forex & Options Expo, what’s the gist?

Dan Passarelli: Options, options, options. I am going to be having a paid presentation, it’s four hours live, in-person seminar and it’s all on income trading. I’m really, really excited about that. I’ve never done that before and attendance is really, really great. I think there’s still a couple of seats open, but it’s going to be an awesome class.

Tim Bourquin: All right, great. Well let’s talk about that and what income trading is. How do you define that? I know options, yeah, I think of covered calls and that sort of way to make income, but what else is available to me?

Dan Passarelli: Yeah. Covered calls are kind of the most basic example. For the basic people out there let’s just start there. If you own a stock and the stock isn’t really moving, I mean if you own a stock, you need it to go up. If it’s not going up, you can sell a call to generate income on that stock to make it pay you basically kind of like a dividend, not a real dividend but it’s a way to get money out of a stagnant stock.

Now there are other ways of doing that also and arguably sometimes more efficient ways. For example credit spreads, call and put credit spreads, iron condors, time spreads, butterflies, and there’s a whole host of these neutral oriented strategies that we call the income trading family.

 
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Tim Bourquin: Yeah. I see of so many traders these days starting to talk more about spread trading in options and whereas it used to maybe at least beginner traders anyway would start with just selling a call or buying a put.

It seems today that and rightly so that the better way to do it is with these spreads because it does limit your risk but it adds a bit of complexity to this. How long does it take for somebody who’s relatively new at this to start putting on iron condors and start putting on calendar spreads?

Dan Passarelli: Yeah. I mean you bring up a good point. It’s not for total beginners. So many times I hear people who just heard about options last week and they say, oh, my buddy told me the best way to do this is with iron condor so I started trading them and I don’t know what happened, I had ten grand and now I have 500 bucks left in my account.

So there is a little bit of education that is necessary to do it. I mean some of these spreads have four different options as all part of one big spread. So I would recommend people put in the time, they start with the basic things.

They take a class of course because it’s really hard for you to stuff out on your own and be effective with it. Take a class from somebody who has experience and work your way up. About three months from now, you too can be trading some of these more complex neutral oriented strategies.

Next: An example of an income option type of trade

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Tim Bourquin: Give us kind of a general idea, is there a trade that you’ve done recently or talked about or taught in the general market that gives us a good example of an income option type of trade?

Dan Passarelli: Sure. As a matter of fact, I just the other day was being interviewed and I talked about a potential credit call spread trade in the spiders, the S&P 500.

Basically, the gist of the spread is if the S&P 500 falls, the trade makes money. If the S&P 500 stays where it is and doesn’t move much at all, the trade makes money. If the S&P 500 rises a little bit, a couple percent, the trade still makes money. It’s only if the S&P 500 really rises a great deal where the trade becomes a loser.

So this is actually a pretty high probability trade. I mean statistically speaking, intellectuals tend to think about stock prices as bell curves or more specifically a log normal distribution and the log normal curve that means your chances of this trade being a winner are really great. It’s only if a bigger than expected move in one particular direction, the upside occurs.

So these can be really powerful strategies because what traders can do is they can put the odds in their favor for a change. They can trade trades that have probability that makes them more of a potential winner than a potential loser and that is really, really powerful for an individual person to be able to do.

Tim Bourquin: All right. So let’s talk about how you put that on. Was that some technical analysis that you did on the spiders that told you that this was the right option trade, that it wouldn’t rise a tremendous amount and that’s why you put this trade on?

Dan Passarelli: Yes. There are really three different analyses that a trader has to do and I’m going to talk about all of them in my four-hour seminar at the expo. The first one is technical analysis. Traders need to find stocks that are either in a channel or have hit a support or resistance level and shown that it’s not likely that they’re going to go through that level, maybe they bounce off it and they’re retracing a little bit.

Basically, you’ve heard people say the trend is your friend, well this is one of these examples where the trend is not your friend. When the market is trending, hey, it’s really easy to make money, just buy some calls if it’s trending up, just buy some puts if it’s trending down. But a lot of the time, maybe even most of the time the market is not trending and in those cases that’s where you can make money if you know how to trade income trades.

Tim Bourquin: Yeah. Now this is I think what attracted me. I’m not a huge option trader, but I do put on an occasional trade and I’m starting myself to learn about the iron condors and things like that.

But what it allows me to do is be what I like to say, I only have to be sort of right to make money with options. I don’t have to be perfectly right, which any stock trader who just buy stocks out right is constantly long knows, you pretty much have to be right right away and 100% correct in the right direction and with options I can only be sort of right and still make money. Is that a fair assessment?

Dan Passarelli: It sure is and that’s really the strength of these trades. I mean it’s really putting the power into the hands of the individual trader.

Tim Bourquin: Now I don’t want to say—no amount of trading is easy or no part of trading is easy but how do you decide? Give us kind of just a general discussion about on this spider trade for example how you decided what month to use in terms of the expiration and maybe strike prices, how you determine those on each side?

Next: An example of the expiration and maybe strike prices

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Dan Passarelli: Sure. Let’s start with the expiration month. Being good at income trading means kind of understanding some of the little nuances of options that kind of go beyond the obvious and one of those is the rate of time decay.

So the idea is that options lose value as they get closer to expiration it’s just kind of one of those laws of option trading. All options lose their value. However, options with a shorter amount of time until expiration lose their value at a faster rate than longer term options.

So if you’re selling options and you take a short option position like the spread is, you want the options to lose their value as quickly as possible. So it behooves a trader to sell the shortest amount of time until expiration as possible while still having the option position have enough value to lose if you will.

So the trade that I looked at was the SPY quarterly expiring options. They expire on the final trading day of September. Now as far as the strike prices goes, that’s both art and science. I like to start with the support and resistance levels.

So I looked at the resistance level and we were pretty close to the resistance level. We were just below it. So I like to give myself a little bit more wiggle room or I should say a little bit more room to be wrong so I decided that if I were to put this trade on, I would sell the 145 calls and buy the 147 calls in that September quarterly option.

So there, the stock or the ETF rather could rise a couple of bucks against me. I mean I want it to either stay the same or go down but even if it rises a couple of dollars, the trade is still a winner.

Tim Bourquin: Yeah. I think that’s the biggest challenge for me as a relatively new option trader is that strike price, or finding that value. I can sell something that doesn’t expire until the last day December or whatever that quarterly expiration is, it’s a lot more money but I’ve also got a lot more time for the trade to work against me.

So it’s that constant battle of how much money is too much and fighting that greed factor that I want to grab and yet still being smart about getting it not too much time to work against me.

Dan Passarelli: Yup.

Tim Bourquin: All right. I like the idea of using the support and resistance of the underlying. Do you do the same thing for individual stocks?

Dan Passarelli: Yeah, I sure do. ETF stocks, even indexes, I use that same technique to set the short strike price. The short strike price is the option that you want the stock to not go beyond.

We’re typically selling out-of-the-money options so if the stock goes the wrong way and goes towards that out-of-the-money option, it could be okay, we just don’t want it to go through that short strike price. So support and resistance that sets up for perfectly natural levels to coincide that short strike width. That’s one of the things I talk about.

Next: How volatile will the VIX be?|pagebreak|

Tim Bourquin: Now volatility through the summer here in 2012 has been relatively low. It started to creep up now, which a lot of people said is expected when you’re coming closer to a presidential election. What do you see for the VIX coming forward here in terms of how volatile the VIX will be and then what that number will be?

Dan Passarelli: I think that the VIX is going to remain a little higher, higher than it was during the summer for a number of reasons.

I mean one is the presidential election, one is back in May people were talking about sell in May and go away and that’s not just stocks, it’s options too. The market had great opportunities for option selling income trades over the summer and that’s why the VIX is so low because people are selling options pushing that VIX lower.

But now it ain’t May anymore baby. After Labor Day, all the traders come back, the New York traders come back from the Hamptons, Chicago traders come back from their summer homes in Michigan and they’re ready to trade them up again. So I think volatility is going to be here to stay.

Tim Bourquin: So does that necessarily mean then it’s going to be a better time to sell options and to make money that way?

Dan Passarelli: Yeah. Well traders have to pick their spots. There’s always kind of the double-edged sword and this is where sort of the art of income trading comes in.

On the one hand, it’s a great time to sell options because implied volatility, the VIX is higher. That means options are more expensive. You’d rather sell more expensive anything. However, on the other hand, they are expensive for a reason. They’re expensive because the underlying stocks are going to be more volatile as well.

So you’ve got to be careful. You’ve got to implement some pretty sound techniques with your technical analysis, your fundamental analysis, and even your volatility analysis, but I think there’s going to be plenty of really great income trading opportunities going forward.

Tim Bourquin: One of the things I know that a lot of traders like about options is that you can get into a position relatively cheaply with a smaller account. Is it possible for me to make income with options with say a $5000 account or a small account with reasonable expectations about that income will be?

Dan Passarelli: Absolutely. I teach basic, intermediate, and advanced people. I’ve taught market makers before but with the people who are just getting into options who come to me and they want to learn, I tell them okay, there are three steps here.

  • One, learn, take my class, let’s get some knowledge down pat.

  • Step two, paper trade. Use fake money because what you know intellectually might not translate exactly into what actually happens in the market.

  • Step three, put $5000 into an account and absolutely no more than that.

When you start trading with real money, it’s different than trading with pretend money. You think differently, viscerally the whole process is a little bit different, you get some fear, you get some greed, you trade differently. So I want my traders to start trading small, very, very cautiously, one lots, two lots until they build up some confidence and then you can move on from there.

I’ve had traders with literally $10M accounts, I said look $5000 that’s all you should be trading with, start small then build up your confidence.

Next: Are we talking about just doing one contract?|pagebreak|

Tim Bourquin: At those levels, are we talking about just doing one contract? Even if you’re doing a spread, it’s one contract on each side?

Dan Passarelli: Generally speaking, I mean it does somewhat depend on the option position. For example, if I were to put on a credits spread on Apple, that might be, the strikes might be $10 apart and I might stand to make 400 bucks or lose 600 bucks or something like that. But if I put on a similar credit spread in the Ford Motor Company, one lot means maybe I’ll make 40 bucks or lose 60 bucks.

So it can be a little different. I mean with those higher valued, greater risk-reward spreads because the underlying stock price is bigger, definitely one lot. When you’re trading these cheaper stocks where the options are cheaper too, maybe two lots or something like that but keep it small, keep it tight.

The idea is when you’re first trading real money, it’s still a learning process and in the learning process, you’d rather risk a little bit of money than a lot.

Tim Bourquin: How about the sectors or individual stocks? Are there better ones to start with that because they’re more volatile they’re better for options spread trading or income trading?

Dan Passarelli: Yeah. A lot of traders like to start out with the ETFs because the risk of loss can arguably be less because the volatility of the underlying shares tend to be lower.

Now there is of course a tradeoff there, your reward is lower. When your risk is lower, your reward is lower so you tend to not get as big premiums but you probably end up having more winners than losers especially relative to a more volatile stock, something like Apple or something like that.

Tim Bourquin: How about weekly options? Are you using those much? You mentioned the quarterly options, do you use the weeklies as well?

Dan Passarelli: Yeah. With income trading, I try and look for weekly trades all the time. When you can set up a good income trade with weeklies, the trade can be great. The problem is that the weekly options they only have a week or so until expiration or less so sometimes it’s harder to find the options that have enough value to make it worth selling. But the times you can find a good weeklies trade, I’m all over it.

Tim Bourquin: All right. How about the types of spreads trades that traders should kind of look at first? Is there an order in which here’s kind of the easiest one to learn and then we’ll go up from there? Do you have any recommendations that way?

Dan Passarelli: Sure. Investors, now not traders but investors who already own stocks they can start with covered calls. They’re arguably the most basic but they’re more for people who own the shares, they don’t want to sell the shares no matter what happens. It’s an investment overlay strategy.

As far as more active traders, they’re probably better off doing something like call and put credits spreads to start with. Those are probably the most basic income trades and then once they get those under their belt, it’s an easy extension to move on to iron condors because really they’re just a combination of a call credit spread and a put credit spread. Once they get those under their belt, they can move on to butterflies and then calendar spreads, and then they can even get a lot fancier after that.

Tim Bourquin: All right. We should also say too that we’ve got some great articles on MoneyShow.com, some of which have been written by you about credit spreads and put spreads and call spreads and all of that sort of thing so that’s going to be an excellent resource. Anything else you can tell us about your seminar that’s coming up, Dan, that people should know about?

Dan Passarelli: Yeah. I am not holding back. I am giving from soup to nuts every single thing that you need to know in order to trade credit spreads, excuse me, income trades in general I should say.

It’s going to be a great class. You’re basically being put into my mind for four hours. I’m showing you my process, how it works, what to look for, all the little details, all the little nuances and I’m really excited about it.

Tim Bourquin: Well you can find out more information about Dan’s session at the Web site, MoneyShow.com. You’ll find that information there about the Forex & Options Expo as well as the Traders Expo coming up in November. So Dan, thanks for your time.

Dan Passarelli: Thanks, Tim, I appreciate it.

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