How I Trade Options

I was asked to talk about how I trade options. I'm not a habitual options trader, but I have traded my share over the years. Unlike my stock trading system, my options system is high-risk. I don't think of options as a way to make a steady income; instead I consider it a way to go to Vegas while staying at home. There are low-risk ways to trade options, such as a strategy based on buying deep in-the-money calls instead of stock. But that's not for me.

First off, I want to caution you that this post will assume you know all the basics about options, meaning you grasp such concept as expiry, strike price, underlying, calls vs. puts, and in-the-money vs. out-of-the-money. If not, try this course.

I trade options when I anticipate a significant reversal in trend. Rather than bottom-fishing with equities, I'd rather limit my risk with options. I can hold the options even if I pick the wrong spot and price falls below my "mental" sell-stop because I'm OK with letting my options expire worthless. Keep in mind that my entire purchase is equal to that 0.2% risk figure. With stock, that same risk figure represents just the difference between entry and exit price. Imagine buying an 0.2% risk's worth of stock. In most cases I'd be lucky to afford a round lot!

My options strategy is to buy guts options, preferably in the week prior to expiry. Guts options are options that are several strikes out of the money. For example, on Friday when EEM was trading at 23, I bought calls for October expiry with a strike price of 30, 7 points out of the money. Those calls cost me 0.19/contract, and they peaked today at 1.50. (I managed to sell 2 at that price, but I've been selling ever since Monday, some for as low as 0.35). So the profit potential is very high, but to achieve it demands great discipline, nimbleness, and accuracy. Not only do you have to be right about the direction, you have to be right about the entry and exit timing. That's a lot to ask, and I still need so much work on the discipline part since I tend to sell so tragically early. Until yesterday I was probably a net loser on options because of some horrible trades early on in my trading career. There's no surer way for a beginner to be wiped out of the market than by experimenting big with options. I have heard many stories of people who made 6x their equity trading options in their first month, only to be broke six months later. Maybe that's the new rule of thumb: you'll be out of the market in as many months as the degree of your first month's option trading return! In that case I'm glad I lost money the first time I tried it! Seriously though, use great caution, and limit your risk to very small numbers!!

Back to my EEM purchase. How did I choose the $30 strike? Thursday night I looked at the intraday chart of EEM and eyeballed where I thought it could go if it were to bounce. I cross-checked with the daily chart and chose $29 as a likely target.



Then I went to my Ameritrade Izone account and looked up open interest in contracts around $29. The screenshot below is the current snapshot of the EEM option chain, but it's reflective of what I saw Thursday. Namely, that open interest was several times greater at $30 than at any price below it. In general, as a small trader, you want to go where the volume is. In high volume issues, prices are less likely to be distorted by big players, and the bid-ask spreads narrow, both of which are to everyone's advantage.



So that's how I came to choose the EEM 30s on Thursday. I confirmed yesterday that the optimal strike price is around the price you think the stock will get to on the day you want to sell it. In this screenshot are yesterday's lunch-time prices for the DIA option chain with strikes from 80-100. The price for the underlying is the top row (red column bid price, green column ask, the next column last traded), and the shot is taken from my Interactive Brokers trading platform.

Note that the daily return peaks with the strikes that are close to the current price of 90. Also, note that some contracts actually fell in value, because even though DIA had risen 8% at that point, it didn't look like it would have enough juice to make it all the way to, say, 98 by expiry this Friday. In quant-speak, neither volatility nor price was high enough. Later that day, after DIA showed even greater strength by hitting 94, that all changed, and we see the peak daily return coalesce around the new DIA price:

So, in a nutshell, my strategy is to guess the maximum price that I think the stock can achieve on reversal, pick the closest strike to that price that has high open interest, buy that contract around when I think the reversal will happen, and sell that contract when I think the reversal has run its course. It is a strategy fraught with risk, which I account for by not buying too much and making sure only to act when I am highly confident of a reversal, based on Elliott Wave or Gann analysis (i.e., whenever Andy Askey says the market will reverse!)