When you think of stocks, you probably think of buy, sell, or hold when it comes to your investing choices.
When you take a position in a stock, it must move in your desired direction for you to be profitable.
Depending on your opinion toward a particular company, you are really limited as a stock trader to more of a full “on or off” sort of sentiment. Of course, you can choose to only allocate a certain percentage of your account to the trade (to manage your risk) or you can even diversify your portfolio to mitigate volatility and/or create a partial hedge in your account.
Here’s a diversification example:
The fact of the matter is that if you were to have bought ETFs in five different S&P 500 sectors in late April (April 28, to be specific), you would most likely have net losses in every one of your positions. Below you will see the price changes from April 28 through June 29, 2010 in these popular sector ETFs:
If you had allocated 20% of your account evenly into these 5 sectors, you would have a net loss of 13.2% over that time period. Individual stocks may have done better or worse, but ETFs may also in and of themselves offer another level of risk reduction through diversity.
By diversifying, this particular strategy helped to moderate the major losing trades, but also worsened the better-performing investments in the same manner. This method of diversification through ETFs is one of several techniques that stock traders have at their disposal. The challenge with trading stocks and ETFs outright is that each share of stock has a delta of 1, so for every share you own, you will make a dollar for every dollar the stock rises (and lose a dollar for every one that it falls). While this is wonderful when you are long stock and it’s going higher, it’s not so much fun when you are long stock and it is dropping like a rock (or even down 13% as in the situation above).
It works the same when you decide to take a short position in a stock, only then you have unlimited risk to the upside and some additional margin requirements and costs. These can cut into your potential profitability, not to mention your stress levels.
If you have traded the markets at all or even read or watch financial news, you know that stocks don’t go straight up or down. They tend to zig-zag all over the place and generally form a bullish, bearish, or sideways trend when observed over certain periods of time.
We options traders tend to take a more realistic, detailed, and sometimes much less absolute view of the marketplace. I say realistic because many of us take on our risk based on volatility with minimal directional bias and detailed in that we look at typical patterns, news events, charts, and current and past options pricing to help choose an appropriate strategy (that doesn’t have to be just buy, sell, or hold).
And taking a less absolute view means we don’t have to be “all in” all of the time when it comes to an options strategy’s sensitivity to stock movement.
Some of the more popular options strategies are vertical spreads, such as the bull put spread, which involve the purchase and sale of puts in the same month. What these strategies allow us to do is act on the thesis that a stock, index, or ETF will stay above or below a certain price by a specific date. That price can be some distance away from the current price, allowing the instrument to actually move against you, but still potentially profit.
For example, let’s assume you wanted to buy IBM, which is currently trading around $125, but were a bit nervous about the current market conditions as well as the upcoming non-farm payrolls numbers and earnings season. Based on your analysis of the charts and fundamentals, you thought that it was not only feasible but probable that IBM could just stay above $120 by August. (IBM has not closed below $120 since November of 2009).
You could sell the August 120/110 bull put spread (selling the 120 strike, buying the 110 strike) for a net credit of $2.00. As long as IBM is above 120 at August expiration, you get to keep the $2.00 premium. At this point, you’re probably thinking, $2.00 is a pretty crappy return on an investment in IBM, which is currently trading for $125.06. But this is actually one of the ways that options shine. In this particular example, your maximum risk is $8.00, ($800 per spread), no matter what happens to the stock. If IBM were to open at $50.00 per share tomorrow, you would only be liable for $8.00. A $2.00 profit on $8.00 of risk equals a percentage return of 25% in less than two months (through August expiration).
Even if you put this trade on back in April and the stock managed to stay above $120 by August, you would still realize the 25% return. What is crazy is that IBM was trading at about $130 on April 28, which means that it could theoretically fall $10.00 and you could still potentially make money on this quasi-bullish spread.
That’s not to say that your P&L might not go into the negative in the process of being in the trade, but you know at the end of the day that your max risk can only be $8.00 and you also know where you need IBM to end up ($120).
Remember the delta I discussed earlier? The delta of this hypothetical spread is currently 19, which basically means that this spread will be susceptible to roughly 19% of IBM’s movements. IBM has a beta of 0.75, meaning it should move 0.75% (roughly 93 cents) for every 1% move in the market. The spread would move 17 cents in response, which is a beta of 0.14. The spread’s delta can and will change as time decays, but most likely wouldn’t get much more than about 30 in this case because the short call and long call deltas offset one another.
Granted, you are limited to a 25% return in this trade, but that would be the equivalent of the stock rising to roughly $157.00. IBM has never seen that level, even without adjusting for splits!
We option geeks like to take things a step further and use statistics when placing our trades. Looking at historical volatility as well as implied can help us form a more realistic expectation of a stock’s movement moving forward so we can set up our trade to have even more of an ‘edge’.
In our IBM example, we could take the implied volatility of the at-the-money options (which are roughly equal to what the options market believes forward movements will be) and look at the statistical probability of our trade working out. OptionsHouse offers a handy tool for that called the probability calculator (available for use in all trading accounts, virtual and funded). Click image to enlarge.
This trade example has a statistical success probability of slightly more than 65%, where success equals IBM finishing above the breakeven price of $118. If you didn’t like those odds, you can adjust strikes, expiration month, or strategy. Also remember that these are just statistics and as volatilities change, so can your odds of success and your risk assumptions. The odds of finishing at the maximum loss of $8, by the way, are 14.4%.
The point is that we can not only reduce risk and volatility using options but also increase the probability of success in our trades. In this example, we may even be partially wrong on the direction of IBM, but still potentially profit in the trade, which is a mathematical impossibility when it comes to buying or selling stock short.
This is only the proverbial tip of the options iceberg but highlights one of the dozens of options strategies at your disposal if you take the time to learn and practice them. If used properly, options can offer true diversity and statistical edge in certain circumstances. But without the knowledge and understanding of how options behave and how strategies are supposed to work, you can easily lose a ton of money.
A good friend of mine once said, “If you don’t know what you’re doing, you’re going to hurt yourself.” Get the knowledge, use our tools, and practice, practice, practice.
Photo Credit: _nickd
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Tags: Delta, IBM, options trading, Stock Trading, The Greeks
