A small trading account shouldn’t stop you from trading like traders with large accounts. Here are three options trading strategies to let you trade lower-priced stocks with similar risk/return as more expensive stocks.
In a world filled with expensive stocks, traders with smaller accounts (say, less than $5,000) may feel like they’re priced out of the market. Trading opportunities for high-flying stocks, some of which may trade over $1,000 or require bigger margins for short strategies, may be out of reach for the smaller trader.
That doesn’t mean you can’t try to get a similar bang for your buck as a bigger player. Size is relative: $200 or $20—it doesn’t matter. If the implied volatility (IV) in the $200 stock is the same as in the $20 stock, that $20 stock might offer you the same risk/return percentage, but with smaller margin requirements. With options, there are ways you can play alongside the pros. Consider three strategies that can put you on par with big traders.
Strategy: Think about selling puts on cheap stocks.
What is it? If selling puts is your thing, you may find that smaller accounts can get priced out of this strategy because of higher margin requirements. And the higher the stock price, the bigger the requirement is likely to be. A short put on a $1,000 stock, or even a $250 stock, can easily mean margin requirements in the thousands of dollars or more. Then, if things turn nasty and you’re short a put on a stock that’s falling, you could be required to ante up additional capital. Even selling put vertical spreads, which can have less risk, could easily tie up your account with margin requirements, depending on the price of the stock and your strike selection.
Just because you can’t afford to sell puts on pricier stocks doesn’t always mean you can’t get in on the action. Think about looking for another stock in the same sector with similar IV to the high-priced giant but with a lower price—maybe $25 instead of $250. Because the IV is similar, the cheap stock may offer a similar risk/return to the expensive stock, but the margin requirement isn’t going to be nearly as steep.
You can fire up the thinkorswim® platform from TD Ameritrade and use the tools to find inexpensive stocks with volatility (vol) profiles that are to your liking (see figure 1).
Who says you can’t party with the big fish? Even with a small account, there are ways you can get added to the VIP list.
Strategy: Consider scalping directional bets.
What is it? Scalping is trader-speak for pursuing small, incremental profits on trades with short holding times. Futures contracts are often used by the savvier traders for scalps. But many of them may use liquid options, too. Penny-increment options, for example, tend to be fairly liquid.
You may want to avoid options with wide bid/ask spreads. A wider bid/ask spread means you could pay more when you buy and collect less when you sell, and that’ll hurt your overall bottom line. Also, watch out for poor liquidity—it makes it harder to get in and out at prices you want. What does poor liquidity look like? Illiquid options tend to have low open interest and wide bid/ask spreads.
You might also consider at-the-money or slightly in-the-money options. These may move faster than out-of-the-money (OTM) options and can be a useful choice, as the whole point of scalping is to get in and out efficiently. Keep in mind that OTM options require more movement in the underlying, so it can take a much bigger change in the underlying price before those OTM options begin to move. Slower-moving options can mean fewer scalping spots.
Strategy: Iron condors or butterflies in lieu of short straddles.
What is it? Let’s face it. Short straddles are high-risk trades. And if you’re a smaller trader, you likely can’t afford the margin on them anyway. A possible alternative is to use defined-risk iron condors or iron butterflies. It’s basically the same concept—you short either a straddle or strangle to collect a premium as the options decay or drop from an IV implosion. But you add a measure of protection and therefore lower your margin requirement by buying a further OTM strangle.
Yes, buying that OTM strangle reduces the total credit you receive. But without it, a short straddle (or strangle) might not be viable. Even if you can cover the margin, you might not be able to trade more than one or two. With an iron condor, depending on the price of the stock and the IV of the options, you can adjust your long/short strikes until you can afford to do something bigger.
How does this work? Say a stock is trading at $98, and a short 98 straddle for $4 (minus trading costs) requires a margin of approximately $2,000. On the other hand, the 91-96-101-106 iron condor for a credit of $1.50 (minus trading costs) requires roughly $350 of margin. For a little more than half the cost of the straddle margin, you could sell three iron condors. Plus, there’s no maintenance margin requirement should the trade move against you (see figure 2).
Compare the risk graph of one short 98 straddle for $4 versus three short 91-96-101-106 iron condors for a net credit of $1.50 (commission costs not included).
The two trades also have similar break-even points if they’re held until expiration. The straddle breaks even at $94 ($98 – $4) if the stock drops and $102 ($98 + $4) when the stock rises. The break-even points for the iron condor are $0.50 better on both sides—$94.50 ($96 – $1.50) and $102.50 ($101 + $1.50), respectively.
Take note that the short straddle has more risk than the initial margin is going to cover. The iron condor’s risk is fixed and is less than the straddle, even for the three iron condors in this example. Yet, the iron condor can generate more theoretical potential profit at $4.50 if the stock settles between $96 and $101, compared to the short straddle that needs the stock to settle exactly at $98 to achieve a max profit of $4. Keep in mind that the trade could go against you and you may risk losing on the trade.
Who needs those high-flyers? With options, strategies that are out of reach for smaller traders probably have close cousins you’d be happy to dance the night away with.