Down the Rabbit Hole With Options: Searching for Profits
Imagine this: You’re either long or looking to get long equities and in order to lower your cost basis, collect some income and limit your downside risk to a certain extent, you plan to sell calls against your stock position.
But instead of pulling up the nearest options chain and picking a random strike price, it would be far more beneficial for investors to consider a wider range of choices.
First, when considering selling call options, what most investors are really considering is income. They are looking for a neutral to slightly bullish options strategy that will net them a return in the form of a collected credit.
Another neutral to slightly bullish credit-collecting strategy? Selling cash-secured puts. It’s similar to selling calls and opens up more options for investors to find the best trade, rather than eliminating half of their choices from the get-go, (in the form of looking at both sides of the options chain).
This may sound counterintuitive, but in order to narrow down your options, traders first have to expand their options to be the most inclusive.
Narrowing down by opening up? It makes no sense, it seems.
But in order for a trader to narrow down the best options, they first have to be willing to consider every option. Luckily, OptionParty makes it so that investors don’t have to do this by hand or by each individual stock.
So instead of just covered calls or cash-secured puts, let’s consider both. And instead of just options that expire this month, let’s look at those that expire next month too. I don’t want our trade ideas to revolve around volatility- or commodity-based ETFs, so I will black-list a few of the more well-known ones such as GDX, GLD, VIX and VXX.
If you wanted to only include those securities, or any security for that matter, it’s referred to as white-listing, and both options can be used on the OptionParty platform.
As opposed to saying we only want to sell covered calls on a few stocks, we now know what offers us the best risk/reward on a number of different stocks over a number of weeks. In our specific trade inquiry, the top trade that came back is a cash-secured put option in SolarCity (SCTY).
It involves selling the $16 put option expiring December 16th for a $0.71 credit
SolarCity may not be the first name that comes to mind when looking for bullish to neutral trades. But that is precisely the point! Without this screening technique, many investors may not have found SolarCity as a viable option. Yet it offers a great risk/reward for our capital.
The position offers an 84.2% probability that we will hit our target return of 4.6% and an 88% chance of turning a profit of some kind. The 0.1% total loss probability is incredibly low as well.
What Else to Consider?
The point here is clear – and somewhat ironic: Open up your options in order to narrow down the best trade.
To narrow, one must open.
The example above is a good representation of that, but it can be applied more broadly as well. Instead of looking for just a call option for a long position, investors can search for bull call spreads and bull put spreads, in addition to neutral-to-bullish plays like the covered call and cash-secured put strategies we just looked at.
Investors can also consider options that expire in 10 or 12 weeks (or longer), not just 4-8 weeks. Here, look at this:
We are bullish on the market, but only want to consider a long call or a bull call spread to take advantage. Additionally, we’re looking for a play that expires within the month and only includes the top ten holdings of the PowerShares QQQ ETF (QQQ). At the moment, this includes Apple, Microsoft, Amazon, Facebook, Alphabet, Intel, Cisco, Comcast, Amgen and Kraft Heinz.
We will white-list these stocks and see what we come up with. Here are the top 5 results:
There are certainly a couple attractive options in there. But a wider scan among the same stocks might reveal some better trades. Instead of just bull call spreads and long calls, this scan also includes covered calls, cash-secured puts and bear put spreads. We also extended the scan to 12 weeks instead of 4. Here’s the top 5 results:
Both time frames offer returns of about 5% to 6%, and both can be done with a total loss probability of ~1% to 3%. So on that front, it doesn’t seem to matter if we use a scaled down and shorter time frame approach vs. a longer time frame and more broad scope of strategies.
But, one will likely notice the tremendous difference in target return probability and the probability of profit.
To read more about the three key probabilities, you can do so right here.
In the second table, one can quite clearly see the odds of success are tilted much further in their direction than in the first table. Again, these are the same stocks with the same directional bias. But in the second situation, both probabilities are above 90%, offering much better odds of success than the sub-80% probabilities for the first results.
Far too often we become too close-minded. Not just on strategies but on stocks as well. Naturally we want to go to our “lucky” plays and the ones we know best. There’s nothing wrong with favoring stocks we know better than others, just like there’s nothing wrong with avoiding the ones we don’t want to touch, (such as what we did with volatility-based securities earlier).
However, even when white-listing our favorite stocks, it is simply too cumbersome to work out the odds for each security against a number of different strike prices, expiration months and strategies.
Using the OptionParty platform vastly aids investors and traders in not only saving time, but also finding the best trades available.