Which Option Strategy Pays Off Most?
02/13/2012 11:40 am EST
Strategies that allow traders to be net long options can be highly profitable and limit the effects of time decay, explains Juan Sarmiento, reviewing a strategy he has used successfully in his 20-year career.
You might have heard that most options expire worthless, and/or that options are a wasting asset, therefore, why would you want to own them? I would like to make a case for being net long options, particularly if you are a retail trader rather than a “professional.”
The basic reason is that retail traders (including myself) are by far specialists of forecasting price movement, and the power of options for us is in their leverage. Most retail traders got into the stock market as stock buyers, so we have experience in forecasting prices long before we enter our first options trade. We learn about technical and fundamental analysis, and some of us go further and learn advanced technical analysis strategies, like Fibonacci, Elliott Wave, candlesticks, and Ichimoku Kynko Hyo methods.
Our hedge is in being contrarians, identifying potential turning points, and taking advantage of that first rally after a downtrend or on the first decline after a rally, both of which can be quite powerful.
We are experts in trading stocks with momentum, so why not leverage our trading with long options? Yes, it is true that options are wasting assets, but that wasting is mostly significant in options that are less than a month to expiration.
So we can, in fact, simultaneously sell front-month options and buy options with two or more months to expiration and be net long options in order to mitigate the Theta decay risk (effect of time on options value).
See related: Understanding Theta and Time Decay
Of course, we have to have a good directional bias, and yes, we have to be right in our forecast, but if we are wrong, we can control the maximum loss per trade that we are willing to tolerate.
Many traders suggest selling premium as the safest way to trade and promote iron condors as instruments to generate high-probability trades. The ugly side to these trades is that there is a high risk that could cost you dearly if the market you are trading moves strongly, and this does occur from time to time.
Typically, an iron condor has a high risk/reward ratio, usually 2:1 with a 60% probability of profit. With butterflies and vertical spreads, you have a defined risk and reward scheme as well.
However, it is sometimes disheartening to be right in the direction and have to settle for the limited reward that a vertical spread or unbalanced butterfly can return when a simple, cheap, out-of-the-money (OTM) call would have done much better. Nothing can pay off as nicely as a net-long options trade, if you are right.
I have built a 20-year career around trading and teaching such strategies, including put and call ratio calendar spreads, and more recently what I call the “S trade” (see video below). My goal is to anticipate the direction of the market and/or the implied volatility of the markets and to take advantage of both for maximum profits with a relatively low risk.
Here is one example of how I trade with options:
By Juan Sarmiento