Choosing the Best Option Strategy
Choosing which option strategy to use is one of the most difficult decisions for an option trader. Some seminar gurus push covered calls as the best strategy because it reduces risk but still allows for a profit. Others suggest straddles, because you can make money whether the market is going up or down. If you have traded options for a while, you no doubt have heard many others tout a particular option strategy as the holy grail of trading, the one that will always work and make consistent profits year after year.
But the unfortunate truth is that no single trading strategy works in all types of markets. In order to really understand options trading, you need to understand that each option strategy comes with its own set of risks and rewards. Someone who says a particular strategy is superior to another is simply saying they have a preference for a particular risk-reward profile.
But that does not mean it is the best strategy for current market conditions or for your personal risk preference. Be careful of anyone that tells you otherwise. They either do not fully understand options, or are trying to sell you something. Those that claim one strategy is the best for all markets usually focus on only one aspect of the strategy – either the risk or reward side – and completely neglect the other side.
The best option strategy to use is the one that directly matches your set of risk and reward tolerances for a given outlook on the underlying. To make the best trading decisions you need to know what market conditions each strategy works best in, and understand the risk versus reward profile of each one. This allows you to reduce each position into its component parts to make sure you are willing to accept the associated risks and tailor the position to match the current market conditions and your outlook.
Using Risk/Reward Graphs
To fully understand the relationship between risk and reward in any options trade you need to look at profit and loss diagrams. If you compare the profit and loss diagrams of any two strategies, there will always be a part of the diagram where one of the strategies performs better. The decision you have to make is how likely each scenario is, and which strategy gives you the best risk/reward profile for your market outlook.
Let’s compare two different option strategies, a simple call purchase versus a bull call spread, using US Steel (Symbol: X) for this example. First we will open the Matrix, which brings up a window which displays all the information on US Steel, including the full option chain, current prices, and the current implied volatility of all its options.
At the top of the Matrix is the information for stock itself. Below that are all the current options available. Each column shows the expiration month (which days to expiration in brackets), while each row shows a specific strike price. The call options are in the top half of the Matrix, the puts in the bottom half. The colored Legend boxes show what each number in the Matrix represents.
Notice that the number +5 is displayed in the Trade field of the July 55 call options. The program automatically puts in an At Price ($6.00 in this case) that I should be able to buy these calls at. Now that a prospective trade has been entered, all you need to do is click the Analyze button near the top to bring up the risk graph of this trade.
The Graphic Analysis shows the profit/loss for the position on the vertical axis, with the various prices of the underlying asset (the price of US Steel stock in this case) on the horizontal axis. Each of the colored lines represents a different point in time. The currently selected solid line shows the position on expiration day, the dotted line on top shows the trade today, while the dashed line in the middle show the trade in 66 days, halfway between today and expiration. The profit and loss tables at the bottom, including all the Greeks, display the information from the currently selected line.
In the bottom left corner is a summary of the trade that shows the expiration date (July 22, 2006), that no change (0%) in volatility is being projected, and that the total capital required for this trade would be $3,000 (this example does not include commissions). Below that is displayed the expected return (E.R) of the trade is $892, +/- $5,730. The breakeven point of the trade (where you neither make nor lose any money by expiration day) is at $61.00. Finally, it shows a Probability of Profit (P.P.) for this trade of 39%.
Comparing Risk/Reward between Different Trades
Let’s see how this long call position compares to a bull call spread, keeping the amount of capital needed as close to the same amount as possible. For $60 less ($2,940 total, again not including commissions) you could buy 14 of the July 55 Calls, and sell 14 of the July 60 calls. The risk graph for the vertical debit spread (often called a bull call spread) is displayed below.
Looking at the summary to the left, you can see the expected return is slightly lower (only $323), but with a much smaller variance of $3,510. The breakeven point is lower, at $257.10, and the probability of profit is higher (48%). But what makes one trade of these trades better than the other?
The answer to that lies in your tolerance for risk, as well as your future expectations for the stock. The long call position is much more sensitive to changes in the stock price. If you think the stock will move up in price in a short period of time, you are probably better off with the long call position. The spread takes a longer time to develop, and you only reach the full profit potential as you get near expiration day.
That is the reward side. But what about your risk? As I mentioned before, the long call position is more sensitive to changes in the stock price, and that works both ways. If the stock were to drop in price in a short period of time, you will lose more money with the long call position than with the bull call spread. Let’s take a look at the two trades superimposed on each other, so we can graphically compare at what stock price each trade would outperform the other.
On expiration day, you would make more money with the bull call spread position if the stock ended up between $55 and $69. But if the stock were to really move up a lot, at a stock price above $69 you would make more with the long call position. On the downside at expiration the biggest difference is the lower breakeven point of the bull call spread. If the stock price ends below $55 there is no difference between the two trades. Both positions will expire worthless and you will lose all your money.
Pick any two strategies and look at their profit and loss diagrams. You will always see that one strategy is better over a given range of stock prices or a certain period of time. Try switching one position from long to short. Try changing strike prices. You will soon see that it does not matter; one strategy cannot dominate another for all possible stock prices. Strategies come in all shapes and sizes. Different strategies alter the risk-reward relationship, and it is up to the trader to decide which is best. Don’t be afraid to alter a strategy to meet your risk preferences – that is what option trading is all about.
Accepting an option strategy recommended by someone else as being the best one means you are also accepting his risk/reward profile. If that is not in sync with your own preferences, you will not be able to relax and enjoy your trading. Take on more risk than you are comfortable with and you may not be able to sleep well at night. Low risk trading may bore you and you will soon find yourself deviating from your trading plan. Either way you are sure to find out the expensive way that no strategy is superior to another, and that the best trading plan is one that matches your personal risk profile.