One of the benefits of working with hundreds of options students on a daily basis is the great interaction that comes along with it. In fact, I had a newer student recently write in and ask a few really great questions. These are questions many traders wonder about as they look to gain an edge in their options trading. Let’s take a look at how the answers to these questions can help us increase our profitability in the options markets.
“How do YOU determine when to buy a call or put versus using a spread, collar, butterfly, or iron condor? What is the criteria you are using to make the decision?”
The number one reason I love trade options is the flexibility that they offer. We aren’t limited to buying and selling calls and puts. We can actually use different options strategies that will allow us to adjust how aggressive we want to be. To take it a step further, we can use different strategies to adjust whether we want to be bullish, bearish, or market neutral. You can’t say this about any other market. If you are trading futures, forex, or stocks you are limited to buying or selling individual contracts, lots, or shares. This is fine if you want to put on a directional trade, but we all know that the market doesn’t always trend. In fact, more often than not we are stuck in a sideways range. Trading options allows us to profit from these sideways moves instead of getting whipped back and forth with false breakouts.
While the flexibility that options offer is great, it can be intimidating when starting out to know which strategy is best to use at any given time. Over the last 13 years, I have taken thousands of trades and have tracked each one in my trade journal. As a result, I have come up with a method that fits my trading style and makes sure the odds are in my favor long term. Let’s walk through what my normal process looks like when setting up a trade.
Steps for Identifying Options Trades:
Have a small universe of stocks/ETF’s that you look at on a regular basis.
I write and talk about this all the time in our training materials. I don’t want to look at hundreds of names on a daily or weekly basis because in those cases you can be left trading names that you aren’t familiar with. I would rather focus on a small list of names that I get to know over time. This way I can easily determine whether I am bullish, bearish, or neutral without spending a ton of time each day staring at the charts. My watch list can change once a month. Currently my list is 24 names which you will see below. These 24 names come from my universe of 50 stocks and ETF’s that I track on a monthly basis. In other words, when I created my watch list of 24 names for the month, those names came from my universe of 50 products that I have tracked and researched for an extended stretch of time.
We will share more insight into my favorite Stocks/ETF’s below including a great list that you can start trading today.
Look at the charts for each product on your watch list to get a feel for any key levels, directional outlook, or overbought/oversold extremes.
This step is very important in helping you determine which options strategy should be used. For example, we just closed out of a short call spread on EWZ that we opened back on 4/13. We chose this trade because we looked at the EWZ chart and saw that we were at a bullish extreme. We then took a look at the level of implied volatility on the EWZ options and saw that it was also high. When we see this type of scenario, we know that the options prices will also be high. Instead of buying a put option to take advantage of a move lower, we decided to sell a call spread which is still a bearish position but it also gave us more ways of making money.
We decided to sell the May 29/30 call spread for $.41 or $41 per spread. This gave us a maximum profit potential of $41 per spread while our risk was $49 per spread. While this doesn’t look like the greatest reward to risk scenario, it was actually a great trade because of all the different ways we could have made money. We made money if EWZ moved lower, sideways, or slightly higher as long as it stayed below our break even point of $29.41. We made money from time decay adding up and also from the implied volatility contracting. This meant we had 5 different ways of making money on the trade. Instead of having to pick market direction perfectly in order to make money, we were left with a trade that gave us a tremendous amount of flexibility.
We were fortunate enough that after opening the short call spread, a few weeks later EWZ made a move slightly lower. The levels of implied volatility also contracted and the time decay added up over the few weeks that we held the trade. As a result, we ended up closing the trade by buying the call spread back for $.11. This gave us a profit of $.30 or $30 per spread. That’s a nice return given we only tied up $49 of capital for each spread that we put on.
The only way I had a feel for using the EWZ short call spread was because I have traded EWZ for years. This gave me a comfort level with the ETF that I wouldn’t have had if I just pulled it up off a stock scan. Looking at the charts will help us determine how aggressive we want to be. If we are strongly bullish or bearish then we can reflect that in both position size and the options strategy that we will use. If we are neutral then we can also adjust position size and go to options strategies that work well in sideways moves.
Look at the levels of volatility to determine if it’s high or low.
We track the Implied Volatility (IV) levels for each stock/ETF on our watch list. This helps us know if those levels are high or low at the given time. If the IV is high, then we know we have an opportunity to sell premium (short vertical spreads, iron condors). If it’s low, then we will lean towards using strategies like long calls/puts and long vertical spreads. My first choice is always to sell premium because those strategies give us so many ways of being profitable. However, we have also seen over the years that when we wait for high IV when selling premium our odds of success really improve.
Determine which options strategy best fits our outlook.
We started by looking at the charts of each of the products on our watch list. This helped us decide if we wanted to be bullish, bearish, or neutral.This also helped determine how aggressive we want to be (position size, option strategy). Once we have an opinion on what we think the stock or ETF is going to do, then we go to our playbook to follow the guidelines that we outline for each strategy. Let’s take a look at a few of our favorite strategies.
What criteria do we use to select the best options to trade?
Long call or put:
When buying a long call or put we need to make sure we have a strong opinion on which way the stock or ETF is headed in the near term. We have to keep in mind that whenever we buy an option the clock is ticking the second we decide to initiate the trade. The time decay will start to add up and potentially eat into the profit potential that we have. This means not only do we need to be right on market direction, but the move needs to happen in our favor quick enough.
To combat some of the negative features of buying an option, we like to be very picky with the criteria that we use when selecting the call or put option. First, we don’t pick the option based on what we can afford like so many retail traders make the mistake of doing. In many cases, this will leave you with an out of the money option which has a very low probability of success. Instead, we like to trade the in the money options. Our criteria has us going out 20-40 days until expiration and buying the call or put option that is 1-2 strikes in the money. This criteria is the same whether we are trading GOOGL, DIA, or C. By using the same criteria on all stocks and ETF’s, we are able to take much of the discretionary decisions out of the equation.
Long Vertical Spread:
When using a long vertical spread, we still need to have a strong opinion on which way the stock or ETF is heading in the near term. While the time decay is still going to be there like with a long call or put, the long vertical spread is able to limit the effect of the time decay slightly. We like to use the long vertical spread when we desire to be in a more conservative position. We are able to do this because a long spread is constructed by both buying an option and selling an option with a different strike at the same time. Vertical spreads offer a unique ability to control risk and reward by allowing us to determine our maximum gain, maximum loss, break-even price, maximum return on capital, and the odds of having a winning trade, all at the time we open a position.
When setting up a long vertical spread we still like to trade the options that have between 20-40 days left until expiration. We structure the trade by always buying the option that is 1 strike in the money and then selling the strike that is closest to our target for that stock or ETF in the near term. The nice part about using this simple criteria is that it is the same when using call or put options. The criteria is also the same regardless of the symbol of the stock we are trading.
So why wouldn’t we trade a spread on every trade?While it’s great that vertical spreads limit the risk, they also limit the profit potential at the same time. Our profit is limited to difference between the strike prices minus what we paid for the trade. For example, if we are putting on the long 25/30 call spread that would have us buying the 25 call and then selling the 30 call. This leaves us with a $5 wide call spread. If we paid $2.00 for the spread our maximum profit potential would be $3.00. This is calculated by taking the $5 difference between the strikes and subtracting the $2.00 price that we paid for the spread.
Many newer traders get intimidated by trading spreads because they think they will be left with huge risk. However, in reality the long vertical spread is actually safer than buying an outright call or put. The reason for this is that we can never lose more than what we paid for the vertical spread. It is a defined risk trade. This is due to the fact that we are buying the option that is one strike in the money and at the same time offsetting some of that cost by selling the option that is farther out of the money. As a result we are able to lower the overall cost of the trade.
The long vertical spread is one of my favorite trade types and should be a part of your overall options toolbox.
Short Vertical Spread:
Trading long calls and puts or a long vertical spread give us great ways to put on an aggressive trade when we have a strong opinion on market direction in the near term. What if we are a little less certain of market direction?Selling vertical spreads to open a position can give us a great way of scratching out a profit even in a period of choppy price action. We do this by selling an option that is closer to the current price of the stock and then going out and buying an option with a strike price that is farther out of the money. By doing this we are still able to be in a risk defined position but it does give us multiple ways of being profitable. Let’s take a look at the criteria that we use when setting these trades up.
When selling vertical spreads to open a trade we still like to use options with between 20-40 days left until expiration. Why do we prefer to go out farther in time? In most cases the monthly options will have more volume and open interest when compared to the weekly options. This will make them easier to trade.
Going out to the monthly options will also give us more time to be right just in case the market moves against us initially. This gives us time to recover while the weekly options don’t give us that flexibility.
When selling spreads, we like to collect as close to 40% of the width of the spread as possible. For example, if SPY is currently trading at $204.76 and we wanted to put on a bearish trade to take advantage of a pullback we could sell a call spread. We would look at the available strike prices to see that they are $1 wide. This means we could go out and sell a $1 wide spread that would allow us to collect around $.40 or $40 per spread (40% of the width of the spread). This $40 is our maximum profit potential. The most we can lose on this trade is $.60 or $60 per spread.
When looking at the SPY options, we see that the 208/209 call spread is trading for $.40 or $40 per spread. This would have us selling the 208 call and then buying the 209 call to make it a risk defined position. Since we are collecting $.40 when putting the trade on, we would add that to our short strike to give us a break even point of $208.40.
Why would we risk $60 to make $40? That doesn’t sound like a very good risk to reward ratio. The reason we would like a trade like this is it would allow us to make money 5 different ways:
We make money if SPY moves higher as long as price closes below $208.40.
We make money if SPY moves lower.
We make money if SPY moves sideways as long as price closes below $208.40.
We make money as the time decay adds up each day that we hold the trade.
We make money if the implied volatility contracts.
When I see a trade that allows me to make money in 5 different directions I get excited. These are the opportunities that I look for each and every day.
We like to close out of our short vertical spreads when we can keep 50-75% of the maximum profit potential. In our case of the short SPY call spread we collected $.40. When I can buy the trade back for between $.10-$.20 I will close the trade out and book my profit.
It’s important to note that the criteria outlined above is the same for both short call spreads and put spreads. By staying consistent with a rule set it allows us to be more consistent and eliminate much of the discretionary decisions that so many retail trades get stuck on.
Selling vertical spreads to open positions is a very powerful approach that many retail traders miss out on. While short spreads are not the holy grail of trading, they give us the flexibility that we need to make money in any type of market condition that comes our way.
Is there a perfect recipe for finding the right trade?
Selecting the right trade and determining the right size of the trade is not always a perfect science. There are times when I want to be conservative, so I trade more spreads and use smaller position size and end up leaving profit on the table. The whole goal here is to have a method in place that you can follow everyday. We aren’t going to be perfect on every trade but by following a method we will be sure to have trades on that leave us with risk that we are comfortable with. The key is to follow a set of criteria that put the odds in your favor and then diversify your account by adding numerous trades that fit your criteria. When doing so, you won’t be backing yourself into a corner by putting on 2-3 trades and hoping for the best. By having a bigger sample set of trades then the odds will better play out in the long run.
Which stocks and ETF’s should I be trading?
Now that we have talked through how we identify trade opportunities, let’s circle back and talk about how we establish the best watch list of products that we should be looking at on a regular basis. With thousands of possible stocks and ETF’s available to trade, I’m often asked how I decide which ones to trade. It’s really a simple process based on a few criteria. The hot list that I trade from each and everyday is based on the criteria that I outline below.
Liquid Options– I want to trade the products with the most actively traded options. This way I can get in and out quickly at good prices.
Volatility– I’m looking for products that show a history of good movement back and forth. Ideally, I’m looking for quick moves so I can get in and out as soon as possible. A stock or ETF that only makes a few decent moves each year is not going to make the cut into my hot list.
Diversification– It would be really easy for me to load up my entire list with tech names and call it a day. The tech sector tends to lead the market and has an endless number of quality names to trade. However, I would rather establish a broad list of names covering a number of different sectors (tech, energy, financial, index are the big ones for me).
With the above criteria in mind, I have created the following watch list of products that give you a diversified universe of products to trade.
Options Fast Track Hot List:
SPY– The S&P 500 ETF remains one of the most liquid products in the world. The massive volume in the stock and the options make this an easy one to trade. The Implied Volatility has also increased in the past few months which really opens up our options playbook giving us endless trade opportunities to consider. Others to consider:IWM, DIA
QQQ– While not as liquid as SPY, the Nasdaq ETF has plenty of volume for us to work with. It’s an easy way to diversify as many of the big tech names are reflected in this product. I like this one for pure directional plays as well as for short premium plays (selling spreads).
TLT– With everyone’s focus on the Fed these days, I want to have exposure in names that will be active with anything the Fed throws our way. The bond market is an area that can make big moves with anything a Fed speaker says. As a result, having access to a bond ETF like TLT is a great option. TLT is liquid enough for us to do anything that we want with either basic or advanced options strategies. Implied Volatility has also increased in the past few months giving us more flexibility.
AAPL– Apple is still one of the most popular stocks to trade for day traders and swing traders alike. It is a very liquid product, with both the shares of stock and the options very active on a daily basis. I like trading it because it doesn’t like to stay quiet for long. It is also an easy name to see defined ranges in. While I love the products that Apple produces I like it as a trading product even more.
NFLX – Netflix has been a really fun stock to trade for years now. It continues to make really great swings back and forth. When it’s not moving, the Implied Volatility is high enough to sell premium making it one of my favorite products to look at these days. The stock split from last year has also made it more accessible for retail traders to look at. The options are reasonably priced and have decent liquidity, making it a top candidate going forward.
C and GS– The financial sector is another area that can be very sensitive to Fed speak. Regardless of experience or account size, you will want to have some exposure with this sector. I like Citigroup and Goldman Sachs for my personal account. They are names that tend to lead the sector both higher and lower and have reasonably priced options as well. The options have decent liquidity, which means we can trade many different strategies with both of these and get filled at good prices. As long as interest rates remain the center of attention, make sure you have a handful of financial names on your list. Others to consider: XLF, BAC, JPM, FAS.
XLE and USO– The price of oil has been all over the place for most of this year and I don’t see that changing anytime soon. Both XLE and USO are energy ETF’s that we have had nice success with in the Options Fast Track program. I like the liquidity in the options and I like how each one does something different for us. XLE is the slower one of the two and it typically does a better job of getting through the volatile moves back and forth better. USO is directly correlated with the price of the Crude Oil futures market, which means it’s a more aggressive way to play directional moves. Both products are liquid enough to do just about any options strategy that you can think of.
EWZ, EEM, and FXI– All three of these are global ETF’s which we have had nice success with. EWZ is the ETF tracking the Brazil markets. EEM is the ETF that tracks the emerging markets. FXI is the ETF that tracks the Chinese markets. Much of the volatility that we have seen in the U.S. this year can also be tracked to the movement in the global markets. I like having products that allow us to participate in that movement without being overly exposed to one individual stock. You have to be careful with these names as they do tend to see overnight gaps for us in the U.S. A good number of the moves happen during the overnight hours so you have to be disciplined to not chase trades that have moved without you. The liquidity in these names also tends to be streaky. Over the last few months it hasn’t been an issue, but if markets start to settle down in the coming months you will want to watch volumes closely. If they start to go down we will want to potentially reconsider some of these names.
AMZN– Amazon has been a streaky product for us the last few years. When it’s on there aren’t many products out there that will outperform AMZN. However, when this stock settles into a range it can get ugly quickly. The liquidity in the AMZN options also needs to be watched closely. I haven’t had an issue getting filled on my trades at good prices the last few months but if volume does dry up in the coming months we are willing to put this one back on the sidelines. It is a $600 stock so the options aren’t cheap, but I have had really nice success trading vertical spreads on AMZN which is a good way to lower the cost.
GOOGL– I know Google is another expensive stock, but I have found that it likes to make really nice tradable moves back and forth on a regular basis. This is another product that I like to use vertical spreads on to lower the cost of the trades. However, it is also another one that you have to be picky where you get in and out of trades at. The bid/ask spread can widen out quickly on the GOOGL options, so make sure you do your best to get filled at or near the mid price.
AAL, BA, DAL– The airlines have been a new area to my watch list this year. I like any of these 3 names but I personally trade AAL and BA. I don’t always trade these names directionally though. For newer options traders, what I’m talking about here is that I like to sell premium on these 3 whenever possible. Selling spreads is a great way to get exposure to some of these names without placing a big directional bet. With energy prices all over the place, along with the health of the consumer in doubt, I think the airlines could be a good play for the coming months.
GLD– Gold and silver tend to be names that get more active as more doubt starts to creep back into the market. When fear jumps, there are many traders that start looking at the metals for safety. I like GLD over SLV in my own trading as GLD tends to be more liquid and easier to trade. If we continue to see volatility at elevated levels, look for Gold and Silver to remain active.
FXE– With global currencies in focus these days I also want to have some exposure there. FXE is an ETF that tracks the Euro. It’s not the most liquid product that I have ever traded, but as long as we see the global currency wars front and center I want to be able to profit from some of these moves. The implied volatility on the options of FXE has also been at levels where we have had good success selling premium by using strategies like Iron Condors. I hope to continue that trend over the coming months.
These are some of my favorite names that I continue to find great success with in the current market conditions . I’m not saying these are the only names to look at or that you should trade every one of these. However, taking what the market is giving us right now, these are the areas I feel give us the best opportunities to make money. If you want some other areas to look at the argument could be made to have exposure to more retail/consumer related names or even the social media names. Just remember, a bigger watch list doesn’t mean bigger profits. Create a list of names that is diversified, but is also small enough where you can get in and out each day without spending hours looking at the charts. All of the names listed above are active enough to where we can have multiple types of trades on for each name if we wanted to.
As is the case with any trading approach the key is having a system that you can stay disciplined to.Swaying in the wind with everything you hear in the media these days or from other traders can lead to inconsistent results. Every trader is a little different, so make sure you are using a method that fits your style and risk tolerance. This might take time to develop your methodology but in the end it will make all the difference in the world. It’s so important that if you don’t have a system in place now then take a big step back and don’t put any more money to work until that system is in place. You will see the benefits right away not only in your P/L but in your confidence as a trader. In the end trading is all about discipline. If you can become that disciplined trader with a detailed system in place then you will be well on your way to success.