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Strategy Selection & Structuring your trade

The most important consideration for picking a strategy is your understanding of the trade.  You can get the same results from different trades as long as you structure them correctly so pick the one you understand the most.  That understanding must include the adjustments for the trade.  Adjustments can require more capital or less capital.  Adjustments can require the correct timing and that timing is more critical for some adjustments than others.  Know your trade, the adjustments and the timing of those adjustments before you enter any trade.

Let’s take a look at some bullish trades as an example:

The Bull Put is a very versatile trade.  You can place it Deep In The Money, A Little In The Money, At The Money, Out Of The Money or Way Out Of The Money.  Each placement has different properties.

Deep In The Money (DITM): Bull puts are thought of as theta positive trades.  A Deep In The Money bull put is a theta negative trade.  It loses money with the passage of time.  Bull puts are also thought of as delta positive trades.  A Deep In The Money trade can start as a delta neutral trade depending on the placement and the width of the spread.  Doesn’t sound like a great trade, so why trade it?  The Deep In The Money bull put has very little risk and a huge return.  So you compromise theta and delta for risk/reward.  You also sacrifice probability with the Deep In The Money bull put.  All the properties just mentioned are true of the way-out-of-the-money Bull Call.  Use the same strikes as the bull put and you’ll find the properties of the trades are very similar.

In-the-money (ITM): Bull puts placed slightly In The Money are also theta negative but typically have a positive delta.  For this trade you trade risk/reward for delta/probability.  Your risk is higher and your reward is lower than the Deep In The Money bull put but you have a higher probability of obtaining the full profit of the trade.  The same is true for the Out Of The Money Bull Call.  Starting to see a pattern yet?

At-the-money (ATM): Bull puts placed with the short At The Money are what people typically think of when considering a bull put.  They are theta and delta positive and have a higher probability than the In The Money or Deep In The Money bull put.  They have a higher risk and lower reward in exchange for that higher probability.  Those properties hold true for the In The Money bull call.

Now are you seeing the pattern?  Take a look at the Out Of The Money bull put and the Way Out Of The Money bull put on your own to see if you are right.  When you have done that, take a look at the bear call and the bear put.  You will find the same properties for them as the bull put, bull call.

Each spread trade is a compromise of some type.  You can structure them to take advantage of any expectation.  For credit trades, the wider the spread, the difference between the strikes of your long and your short, the more theta and the more delta you will have but the lower your return on risk.  The wider the spread the lower your reward and the higher your risk.  That is the compromise risk/reward for delta/theta.

The further you go out in time with an Out Of The Money credit trade the lower the risk and the higher the reward per trade.  The compromise there is that you have to be right for a longer period of time.

The safest way to trade involves stock ownership.  Not everyone can afford to own the stock they want to trade.  Options can make it very inexpensive to trade a stock with a high price but at a compromise.  The main compromise is time decay.  Options decay but stocks typically do not.  There are ETF’s and other equities with fees that will cause some decay.  Stock can also have the advantage of dividends.  You have forever to short calls against a fundamentally sound equity.  All fundamentally sound equities will return to a rational value.  The market determines what is rational.  So you have forever wait for the equity to recover and/or to make money from short calls if you own the equity.  That is not the case when you replace stock ownership with an option.

Many trades can be adjusted or enhanced with calendars and diagonals.  The properties of calendars and diagonals change as you go further out in time with the long and also as you go further away from the money.  Calendars are thought of as theta positive trades.  Way Out Of The Money calendars can be theta negative.  Calendars and diagonals can be used to protect stock positions or as standalone trades.  Calendars may not be appropriate for equities that gap but a well-structured diagonal can be used effectively on stocks that gap.

Using due diligence to characterize your equity you can pick the trade that best fits your equity and your style.  Using technical analysis and the properties of the various trades, you can structure the trade that best fits your expectation, style and portfolio.   The possibilities are nearly endless.

Ken Bailey
OptionsANIMAL Instructor

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