5 Simple Steps to Trading Breakouts with Options

06/11/2012 12:00 pm EST

Focus: OPTIONS

Steven Place

Founder, InvestingWithOptions.com

Option trading is one of the few places where investors have the possibility for incredible rewards in return for low absolute risk. But, there's a catch. If there's one thing to know about the options market, it's that there is always a tradeoff between risk, reward, and odds.

Want to get that high-reward, low-risk trade? Then your odds will go down significantly. That's because you will be a net option buyer, subject to what's known as "time decay."

So, if you want to be an option buyer, you must align yourself with the best odds of a market moving in your direction very quickly--and that comes through trading breakouts.

The five steps below show you some key tactics and techniques that you can use to add or improve your breakout trading playbook.

1. Use Volatility to Define Your Set-ups
Breakout trading is based on a form of technical analysis that looks for a market to continue in its trend after a period of consolidation. Traditional technical patterns are well known for this subset of trading: channels, flags, pennants, triangles, and so on. But I've found that the "tightness" of the pattern can help to increase your odds. This means subdued volatility during the consolidation, which can lead to explosive gains.

The quickest way to look for lower volatility consolidation is to use Bollinger Band charts. When a low volatility period occurs, the Bollinger Bands "pinch" in, which often indicates that the market is ready to move out of equilibrium. That is when the breakout is primed.

2. The Delta Defines Your Odds
Many new traders look at the high percentage wins that some may get in the options market--but in reality the absolute gain is not that great. On top of that, the rewards seen often hide the risks in the options market, namely theta.

A simple trick to figure out the implied odds in the market is to view the deltas. An at-the-money option will have a delta around 0.50, which means that there is about a 50% chance that it will be in-the-money at expiration. That means if you are buying a 0.25 delta option, the odds priced in the market are about 25%. So if you assume random entries, random price action, and holding to expiration--you will be successful only 1 out of 4 times.

Allowing the delta of an option to dictate your entry gives you the ability to be consistent regardless of the market you are trading. A good rule of thumb is to buy options with more than 1 month to expiration, and with a delta between 0.35 and 0.45. This way your gamma exposure is maxed out.

3. Know Your Stops to Figure Out Your Size
The primary risk in single option buying is the directional exposure, known as your delta. You must figure out your per contract risk before you decide on your size. So, if you buy a call and set a stop 3 points lower (you are setting stops, right?), then you can model your per contract risk on that stop.

If your call option on this trade has a delta of 0.40, that means your per contract risk will be around -120. If you want to risk no more than $800 per trade, then you must trade no more than six contracts.

But unlike stocks, options have other risks known as the Greeks. Theta is another risk, which is the change in the value over time. When buying options you are short theta--that means you need to see a fast move soon otherwise your losses will increase.

That's why it's important to have a time stop to your position. A rule to start off with is 10 trading days - 2 weeks. If you haven't seen a move then you need to reassess the position and potentially close it.

4. Be a Spreader
The option market gives you the ability to adjust your risk and enhance your returns through trade evolutions. One tactic to consider is "spreading," where after a favorable move, you sell an option that rolls your single option buy into a vertical spread. If this is done well enough, many times you can get into a risk-free trade, effectively playing only off the initial gains.

Let's take an example trade of one I played recently. Visa (V) was exhibiting relative strength after a solid earnings report, and had been consolidating in a very tight range for nearly a month. On a breakout, the May 120 call was purchased for a debit of 2.80. After nearly being stopped out about 3 times, the stock finally saw some strength and made new highs. On that impulse higher, the May 125 call was sold for a credit of 2.53.

This put me in a vertical spread with a net debit of 0.27. This means I reduced my risk from $280 per contract to $27 per contract. There were other benefits to this trade, namely reduced directional exposure and a removal of the majority of the theta risk. This trade was exited prior to earnings for a net gain of around 2.50 per contract.

5. Get Prepared to Look Stupid
Keep in mind, trading breakouts will expose you to different psychological issues compared to income trading or mean-reversion trading. Specifically, there will be times when you look stupid. Get used to it.

Breakout trading is lower odds. If you have a 30% success rate but have a 4:1 reward/risk profile, you will be consistently profitable. There will be times where the stock fails to breakout and you get stopped out, only to see the stock reverse again and rip higher.

Other times you will enter into an option position to see it lose value over time, and when you hit your time stop the stock will move without you. Just understand that it's part of the game, and that when these trades work... they really work.

Steve Place
Head Trader, InvestingWithOptions.com

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