This is a continuation in the series dedicated to explaining my personal flowchart for identifying an options trade set up. You should read parts one through seven in order to acquire the continuity for the presentation that follows.
The world of options trading today offers so many variations on its theme that being schooled and experienced in them all can only help any options trader. The more you become comfortable with these variations, the more able you are in your attempt to use the best one for any underlying stock at that particular time.
Once you have determined the time factor (see part seven in this series), the trade strategy you chose is the next critical decision as that choice is definitely a vital part of the art of the trade.
What follows is each strategy I use, as well as pertinent comments about each one. I do not use all the variations, but instead have a core of strategies that follows:
1) Back Spread: A spread which has more long options (or stock in lieu of) than it has short options. Use a back spread if the volatilities are near or at bottom for that cycle (use the coiling pattern for evidence of such). You can back spread with puts or calls, but not a combination of them. An expected move by the underlying stock of at least 10% within the timeframe of the life of the contracts is a must. Decay and lack of stock price movement is a big negative. I prefer to use the back spread to speculate on takeovers.
2) Vertical Spread: A spread that has the same expiry, different strike prices and contract size equal in number. I prefer not to sell vertical spreads, but instead buy them because the shorted side of a bought (long) vertical spread allows you to morph it. You cover the shorted side, creating a naked long call or put should the opportunity and risk/reward set up to do so. You must be more inclined to be a premium buyer to accept this tact. Premium sellers tend not to morph their positions, but instead favor decay. The personal choice for every options trader is whether or not to be inclined to short premium or buy it.
3) Calendar or Time Spread: A spread that allows for some premium decay as well as the expectation that the anticipated time for the underlying stock will cycle to the spread's advantage. I prefer to time spread when I have concluded that the market and underlying stock will be in a swing mode for the period of time that the shorted side of the spread is in play. This strategy allows for decay as well as morphing the position into a naked long call or put, or a newly formed vertical spread once the shorted side is covered. Never morph any spread until the shorted side is first closed out as the negative gamma that would incur can be lethal.
4) Calendar Diagonal Spread: A spread that is biased in one direction and allows for decay as well as potential favorable price moves. Most calendar diagonals will either be morphed by choice because they become profitable or they will be morphed by force because things changed negatively for the spread. Thus, calendar diagonals must be constantly watched over. The stock and overall stock market bias will catalyze as per how this spread is adjusted. I prefer this type of spread when the overall market is cycling in the favor of the shorted side, but has excellent potential to reverse that move at some point during the life of the spread. The shorted side's strike price is the option that is closer to the stock price. The risk is much higher than the calendar spread. I prefer to morph this spread when staying short that side of the spread is not a good risk/reward situation. This can be used for a bullish or bearish situation.
5) Naked Long Calls or Puts: This position should only be taken with highly discretionary capital. I use the term shooter for this position. Use the shooter strategy when you are very confident that your homework has a very high risk/reward probability that is in your favor. Never gamble with a shooter! I define gambling as being when the odds are 49%-51% against the trade. Speculating is 51%-49% or greater in favor of the trade's potential. Do not gamble.
6) Front Spread: Last and least (!) is the spread where you are short more contracts than long them. This is the most lethal of all strategies as it allows for the outlier event to enter the probability mix. The enticement is the decay offered to the trader that employs it. Use the front spread only if the potential for the outlier is zero.
These are my core strategies and this is in no way an all-conclusive list. However, if you can master these strategies, knowing which one to use, when to use each one and how to morph (adjust) them, you will then be quite proficient in the art of trading options. I know to keep things simple so I can eliminate many potential problems and be able to maneuver while others are calculating what to do next. Thus, butterfly spreads and condors are not for me. Besides, I know that if these esoteric strategies set up, they will not set up for long as the professionals will execute them in the seconds it takes to see them set up. In addition, once these strategies are opened, they are not easy to profitably unwind. Finally, if they are executed, they tend to lock the trader's mind into that one particular hope for their success which closes the mental door to any possibility of change and morphing the position when that potential arises.
As for various types of ratio spreads, they are the proverbial grenade with the pin pulled. They will blow up when you least expect them too and are enticing because they reduce if not eliminate decay. They might even have the effect of producing decay in your favor. But, trust me: they are very lethal!
This concludes the series. Thank you!
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