The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation. Probability analysis results available in the tools discussed in this article are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring.
In our daily Swim Lessons program, co-host Kevin Hincks and I look at all sorts of options trading strategies, and we consider scenarios under which a strategy might be a good trade candidate. Now, you might think that there’s only one criterion that matters—“winning”— and though that’s our ultimate goal, we like to focus on strategy parameters that are more likely to get us there in the long run. In general, we look for three key elements:
- Defined risk
- High probability
- Positive time decay
Active options traders understand it’s impractical to expect to make money on every trade. We focus instead on seeking favorable probabilities (theoretically, anyway), objectively managing the risks, and, when possible, making sure the meter is not running against a trade.
1. Is My Risk Defined?
The first key element is that the trade is “defined-risk.” This means that, regardless of what can happen, your risk of loss is limited to a maximum amount, and this maximum amount is something that you can live with. The most basic example of defined-risk is a single-leg long call or put option—you pay a premium for the right, but not the obligation, to buy or sell the underlying, and if it’s out-of-the-money (OTM) at expiration, you lose the premium plus transaction costs that you paid for the option.
But, as we’ll see, buying single-leg options, or even buying vertical spreads, won’t meet all three criteria.
2. Is It a High-Probability Trade?
And one high-probability trade we often feature is a short call vertical spread—the sale of a near-the-money call and a purchase of a further out-of-the-money call with the same expiration date. In a recent Swim Lessons article, we used a tennis analogy to compare the buying versus the selling of a vertical spread. Buying the spread was seen as a “wide-angle shot,” which might have a low probability, but might be used when you see an opportunity. In contrast, selling a vertical spread was compared to the exchanging of ground strokes to the center of the court, and letting the opportunities come to you gradually as you “grind it out.”
And the difference between the two strategies is what leads us to the third element—time.
3. Is Time Working in Your Favor or Against You?
The third criterion we consider when assessing an options strategy is whether it has positive time decay, or “theta” in options terminology. In other words, does the passage of time, all else equal, result in a higher theoretical value of the strategy?
There’s uncertainty in every corner of the market, but the one constant is time. Time—and thus time until the expiration of an option—ticks away at the constant rate of 60 seconds per minute, 60 minutes per hour, and so forth. So why not put time on your side? In general, the closer an option is to at-the-money, the higher its theta. Also, shorter-term options tend to decay more quickly than options with more time left until expiration. Understanding these dynamics – the rewards and the associated risks - can potentially help you create strategies that seek to profit from option decay.
Strategies With All Three Elements
So what strategies put all three of these elements together? While a number of strategies could make the list, it can depend on market conditions, and whether you have a directional bias. For example, short, out-of-the-money call and put vertical spreads can be used for neutral to directional trades. If you have a neutral bias, you might consider an iron condor, as we highlighted in a recent article. And if implied volatility is low, it may be time to consider a calendar spread.
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