Just as with trading calls or stocks, you will be more effective as a trader with put options by following specific rules you have outlined for yourself about the types of information you will look for. The types of technical signals you should look for in put trades vary according to where a stock is in its trend and trading range. These signals are outlined more specifically late in this chapter in the Put Strategies and Setups section. The use of trading rules doesn’t apply only to the technical signals you have decided you will wait for. In options trading, it also applies to the information about the contract itself: the strike price you want to buy at, how much time you want your contract to carry, the risk you are taking contrasted against the opportunity you have, and what you will do in the event of either a profitable result or a loss.
Choosing a Strike Price
Choosing the strike price you will use in your put trade is a critical question you must answer. Just as with call options, buying in-the-money puts is more conservative the deeper in-the-in-the-money you go, while buying out-of-the-money contracts is more aggressive the further out-of-the money you are. Whether you decide to go in-the-money or out-of-the in-the-money, a good general guideline to apply to put trading is to not go further out of the money than the nearest
95 out-of-the-money strike price to the underlying stock’s current
price. Going deep in-the-money simply makes a trade more conservative, but remember that by doing so you will have to place a significantly greater amount of your money into the trade. Making an options trade more conservative by going deep in-the-money doesn’t increase the odds that you will place a winning trade; it only improves the likelihood that if the stock moves against you and you need to get out, you will be able to do it without incurring a large loss. Being able to minimize loss is critical to the success of your options trading system, and this can be effective. Just remember that you will be using larger amounts of your capital to do so. The more money you put into a trade, the smaller your profit will be if you are right, because your leverage is lower than with a strike price that is closer to the current stock price.
Many traders prefer to defer the decision of whether to buy in-the-money or out-of-in-the-money contracts until they are ready to place a trade. This means that before they place the trade, they must complete another step in their analysis. In the last chapter, we discussed using delta as a way to identify which contracts are likely to provide the best value for the given opportunity you are looking at. This analysis can be applied with equal effectiveness to put options once you have considered how much time you want to buy. Let’s apply this analysis to an example.
To find a viable put, let’s give ourselves as much advantage as is possible. Let’s look for stock that is losing price on increased volume. Seeker has an excellent search engine under its basic scan “Top Losers on Increased Volume.”
Figure 4.2
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The results are in alphabetic order. We will select VLO because it has a negative five-star rating and its price is above $20. At the risk of sounding predatory, it has room to fall.
Figure 4.3 is a side-by-side chart comparison of VLO using a 60-minute chart and a daily chart.
In both time frames, the stock is headed toward the basement.
Notice in the daily chart, VLO has just broken through a triple-bottom resistance at about $45. Further, the 14, 5, 3 stochastic shows no sign of reversal.
Figure 4.3
VLO is currently trading at $44.56. We need to check news and find why VLO is in this downward trend.
Figure 4.4
97 Earnings is the culprit. Usually when a stock falls as a result of bad
earnings there is an initial opportunity created to take advantage of the “market shock and awe.” Perhaps a five-point play. It is, in any case, a short-term play. An initial trade with June Options may be prudent. VLO is an energy stock. Going into summer is usually not a wise time to bet against energy for a long period of time. Checking for put options we obtain the option chart seen in Figure 4.5.
Figure 4.5
The June 45.00p are going for $2.82 at the ask. There is a substantial volume on these puts and the delta is -48.46.
The June 42.50p (one strike price out-of-the money) are going for
$1.62 at the ask. There is respectable volume and the delta is -33.60.
If we compare the two respective positions to determine maximum leverage we get the following results:
June 42.50p .3360/1.62 = .20 June 45.00p .4846/2.82 = .17
Said differently, for every dollar we invest in the June 42.50p we will receive $.20. For every dollar we invest in the June 45.00p we will receive $.17. That assumes, of course, that the stock goes the direction we have anticipated.
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From this perspective, it appears the June 42.50p options are the better play. They are not, however, the safer play. The laws of probability always favor the plays that are just in-the-money as opposed to those which are just out-of-the money.
Which option to buy is left to the discretion of the individual investor. If there were a “best” solution, there would be no other options sold at a different strike price.
Determining Your Time Objective
When using call options, a common principle many options traders follow carefully is to buy more time than they think they need. This approach minimizes the effect of time decay and allows a trader the choice of staying in a trade longer if a stock shows strength in its trend so as to maximize its profit.
It may sound logical to take the same approach with put options trading, but be careful. Put options with longer expiration dates tend to be more expensive than the call options with the same expiration. This means that even though you can minimize time decay in your put trade by buying more time, you will usually do so at a much higher cost; the cost may be such that if the stock moves in the direction you forecast, you won’t get enough profit in the trade to justify the amount you risked. This is simply because of the fact that stocks tend to drop more quickly than they rise in price. Corrections and downward trend reversals are harder to maintain in most stocks than are rallies and upward trends. You can generally assume that if the stock is going to drop, it will do so in a short period of time; if you don’t get the drop you anticipated within a week to two weeks, it is unlikely the stock will give it to you, and you would be best served to close out the trade and look for something else. For this reason, a good guideline for choosing your expiration dates on put options trades is to buy no more than a month of time more than you expect it will take the stock to make the drop you forecast.
Identifying how quickly a stock will likely drop to a support level or to your target price is not an exact science and will vary depending on the type of put trade you are placing.
It is important to note that there is an inherent danger of projecting an option price based on the delta and theta. Because there are actually six elements in an option formula, using just two of them to
99 determine the advantage of a one option position or that of another
by just using two of the six elements is overly simplistic. The elements in the formula are:
n s = the price of the underlying stock n x = the strike price
n r = the continuously compounded risk free interest rate n t = the time in years until the expiration of the option n = the implied volatility for the underlying stock
n Ф = the standard normal cumulative distribution function
Taking the time to gather all the data required by the Black-Sholes formula to make an accurate projection is an exhaustive process.
An Excel spread sheet calculating all the elements in the Black-Sholes formula and making two additional assumptions necessary for a valid projection is illustrated in Figure 4.6. The two additional assumptions are the predicted future price of the stock and the date on which that price will occur. In this example, the future date is arbitrarily set at June 10 and the price of the stock is projected to drop an additional $5 on that date. Now, taking into consideration all the dynamic formula elements, you can see from the spread sheet that the 1st strike price in-the-money has a greater rate of return. That option would be the June 45 puts.
Figure 4.6
In doing projected calculations without the benefit of a sophisticated spread sheet, do not fall into the trap of using a static delta value
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for movements greater than $1. As the price of the stock changes so does the delta value. Assuming it will stay the same over a $5 movement of the stock is not a safe assumption.
When trying to figure out which expiration month you should use, remember that if all other information is equal, buying adequate time to let the stock move while minimizing the effect of time decay is generally the best strategy. Again, remember that buying as much time as possible may not be the most effective approach—
January may or may not be more profitable or effective at managing loss than November, for example—so you have to find a reasonable balance. Experiment in your first several put options trades with different expiration months to develop a feel for how much time works best in the application of your trading system.
Planning Your Exit
You are probably used to identifying a specific target price on any stock trade you make. This target price is a level at which you need to re-evaluate the stock’s move and its current strength, and determine whether it is time to get out of the trade or stay in it and let the trend continue to work for you. Planning your exit helps you to rationally and objectively manage the decision you have to make once the stock has reached your target price; you have already thought about what you will do when the stock gets there, so you don’t have to deal with indecision or “what if” questions. This is an important element of a successful stock trading system, and it is no less important to successful options trading.
101 Figure 4.7
In Figure 4.7, we see that VLO stock has just broken through a double bottom at approximately $45. Prior to that it broke through a triple bottom at about $47.50. In the last seven trading days, it has fallen six points. We are going to assume, given the trend, the news and the time frame of the previous seven days, that the stock will fall another $5 on or before June 10. There is nothing magic about June 10. But if it has not moved to that point by that date, it’s time to take your money off the table and look for another opportunity. If the stock falls $5 three days from now, take a serious look at exiting the trade. Once again, the only thing predictable about the market is its lack thereof. The stop loss should be set at about 30% less than the purchase price of the option. There are no hard and fast rules about stop losses. All traders wishing to maintain a friendship with one another agree to disagree on where to establish a stop loss. Set it at your own comfort zone. If you’re getting stopped out of your trades too quickly, then make it more generous. If you’re losing too much before you get out of the trade, make it tighter.
Remember that when you are trading a put option, trying to maximize a trend is usually more dangerous than advantageous.
Unless you see clear indications of continued weakness in the stock—high-selling volume along with an increasing number of short positions, for example—the best general guideline to use is to sell your put and close the trade once you reach your target price. If the stock does continue its downtrend, you will likely get another trading signal before too much longer.
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The next section will demonstrate specific applications of planning your exit following the principles discussed here.