Your Personal Trading Strategy

By: Dave Caplan

The following is an excerpt from Dave Caplan's The Option Secret

The two concepts of “strategies” and “uses” blend or cross over where options are concerned because options are so versatile.  They come in all sizes, shapes and colors.  Some are built for speed; others for dependability and smooth sailing.  Still others are very crafty, putting the odds in your favor.  Which suits you?

There are basically two types of options traders, namely, speculators and hedgers.  The speculators are risk takers, while the hedgers wish to transfer risk to someone else.  The objective of the speculators is to generate profits.  Hedgers want to preserve the status quo.  We’ll probe the role of the speculators first, since this is what most traders are.  Then we’ll tackle the hedging because it can have a dramatic impact on the speculators.  Some investors who speculate in one market, such as stocks, can manage or hedge that risk in another one, such as the options market.

All speculators are not created equal, but all have the same goal (profits) even though their strategies vary widely.  Also, the complexion of the market can strongly influence or change your approach.  You must be more flexible than the markets you trade to win.

As you develop your strategies, keep two things in mind – the Power of Leverage and the Law of Probability.  Leveraging allows you to control a large amount of a commodity, or a large number of shares of a stock, with a small amount of capital.  For example, let’s say corn is trading at $2.10 per bushel and the $2.10 strike price call is trading for $0.055 (5 ½ cents).  The contract has six weeks to expiration.  You would have control of $10,500 worth of corn with an option that costs $275, plus commission and fees for a total of $325.  Your leveraging ratio would be 32 to 1 ($10,500/$325).  A similar situation in the stock market would be the purchase of an AT&T $40 per share call at 1 7/8 ($1.875), or $187.50 (100 shares x $1.875), plus $40 transaction costs.  If the stock is at 41 ¼ or $41.25 per share at the time, the total value of 100 shares would be $4,125.  Divide this by the total invested giving you a ratio of approximately 18:1 ($4,125/227.50).

Now, what does leveraging do for you?  It gives you the opportunity to make a high return percentage wise on your investment.  Take the corn example.  When corn gains a dime, the total value of the contract increases $500.  Your $2.10 option is at-the-money.  Therefore, its intrinsic value would increase by an equal amount or a 65% return.  Additionally, there could be some increase in the time value, depending on how much left to expiration.

You would have a similar situation with the stock option.  It’s for 100 shares, therefore, every $1.00 gain per share increases the value of the in-the-money option by at least $100 of intrinsic value.  A gain of $4 per share doubles your investment.

Also, remember we are talking about relatively short periods of time.  These options had only six weeks to expiration.  There are few investment opportunities that offer the potential of doubling your money in a matter of weeks or months.  To make the gains meaningful from a dollar standpoint, serious options investors trade multiple lots of contracts.  This would be 10, 20, 50 or 100 options (lots) at a time.

Before you call your broker to make one of these “piece of cake” trades, you need to think it through.  The sellers of these options, in the trading pits and all over the world, are not dumb.  When you buy a put or a call, someone has to sell it to you (underwrites it).  That person expects your option to expire worthless so he or she can keep the premium.  To put it more bluntly, the option seller wants you to lose 100% of your investment.  Writing (selling or granting) options entails more risk than buying options.  The seller can be assigned the opposite side of the buyer’s option position any time the buyer decides to exercise it.  It would probably only be done when it was in-the-money, which means the seller would be losing money as soon as the buyer acted.  The loss could be substantial.  Think what would happen to a seller in the futures market who has been assigned a position that is making daily limit moves against him.  For example, let’s say for hogs on the CBOT, it would be $600 per day per contract.  After a day or two of limit moves, the daily limit – or maximum a contract can trade in a single trading session – might be extended to $700 or $800.  Some markets, like the foreign currencies, have no daily limits.  It is because of this possibility that the downside risk of selling options is considered unlimited.  The upside or profit is limited to the amount of the premium, less transaction costs.  Why would anyone enter an investment where the profit potential is limited and the risk of loss is unlimited?

Since selling options can be a profit strategy, it insinuates that buying options must be risky.  It isn’t a “piece of cake”.  The risk may be limited to your initial investment, but all of this can be lost.  This line of thought brings us to the Law of Probability.  The strategy you select will have a greater probability of succeeding if it is diversified.  This means trading options on a variety of commodity markets or stocks.  To be a successful trader, you must be in the right market, at the right time, and on the right side (put or call) of the trade.  You are investing in what you expect to happen in the future – five days, five weeks, or five months from the moment you call your broker and place your order.  You have no way of knowing if you will be right or wrong until afterwards.

At the same time, you must protect your risk capital as carefully as possible.  This requires sound money management techniques, which is the second part of the Law of Probability.  A sure way of ending a trading career abruptly is putting all of your risk capital on one or two trades.  A “double or nothing” approach to the markets will invariably, in our opinion, lead you to end up with nothing.

Just as you increase the probability of being in the right market at the right time, on the right side by trading several different markets, you’ll increase your probability of success by putting no more than 10% of your risk capital on any one trade.  This gives you at least 10 opportunities to select one or more trades to pay for the ones that lose or just break even.

You must further consider what is known as the “distribution of winning - losing trades”.  For example, your distribution might look like this:

Your objective is to let winners run and cut losers short.  If you do an analysis of the trading performance of the most successful CTA’s (professional commodity trading advisors), you rarely find a winning percentage higher than 60 percent.

Keep in mind, the prime objective is to make money, not to generate a high percentage of profitable trades.  You can be a net winner with a low percentage of winning trades.  By low, we mean 40 percent, 30 percent or even 20 percent.

To do this, you must be very disciplined.  You develop, for example, strict rules for exiting losing trades.  For example, when a trade begins to make money, you place a trailing stop behind it (below a long position or above a short).  Eventually this stop position is taken out, offsetting your position.  In other words, the market decides for you when to close a position.

As you develop your personal trading strategy, you need to keep all of this in mind.  Trading several markets takes more time than just trading one.  As does updating a system that is tracking a number of alternative commodities or stocks.  On one hand, you need to be diversified.  Equally important is to avoid becoming over extended financially, psychologically, or personally.