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Trading Strategies for a Sour Stomach

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August 1, 2014

In the world of numbers and analysis, a gut feeling can seem squishy and out of place. But with trading and investing, there’s no denying that our gut instinct can often help. It can make us confident or wary, no matter the analysis we used to determine a bullish or bearish directional bias. And for the record, it’s not that our analysis is wrong. It’s just that our gut remembers past winners and losers and a different part of the brain engages. It’s right brain vs. left brain. In a word, our gut can provide a reality check.

Now, some traders might use their gut as a “go, no-go” indicator. The “go” is all in with long stock, for example. The “no-go” is sit on your hands and do nothing. But there’s a smarter approach that may help fine-tune your trading instincts. Figure out whether your gut is making you slightly confident, semi-confident, or very confident in your bias. Let’s look at a few bullish strategies that may match what your gut might suggest.

The Sort-Of-Confident Bullish Trade

SHORT, OUT-OF-THE-MONEY PUT VERTICAL
When looking at a stock, you might believe it will go up—at least that’s what your analysis is telling you. But your gut isn’t quite as psyched about it. It’s telling you that the stock might not go up, and might drop. Since the out-of-the-money (OTM) put vertical has a defined max loss and defined max profit, it might be an appropriate strategy when you’re sort of confident in the direction you think the underlying will go.

A bullish short OTM put vertical is made up of a short OTM put, and a long OTM put that’s further OTM than the short put. This trade is designed to produce a credit, which is the max profit the trade can make (less transaction costs). The max loss is the difference between the strikes minus that credit (plus transaction costs).

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FIGURE 1: SHORT OTM PUT VERTICAL.

A smaller potential reward with higher probability of success than long verticals, when you’re feeling so-so about the direction of the underlying. For illustrative purposes only

What the short OTM put vertical does is potentially profit not only if the stock rallies, but also if it sits at its current price, or even drops a bit. More than a bit would mean the stock drops below the short strike plus the credit received, in order to incur a loss. As long as the price of the stock is higher than the strike price of the short put at the expiration of the options, this position can be profitable. A long stock position, for example, can’t do that. If the price of the stock doesn’t go up, or drops, the long stock position isn’t profitable (not counting possible dividends). The short put vertical can also have a lower margin requirement than long stock. That means you don’t need to tie up a lot of your trading capital in a sort-of-confident trade.

The Semi-Confident Bullish Trade

NAKED, SHORT OUT-OF-THE-MONEY PUT
Huh? a naked short option if you’re only semi-confident? That may sound risky, but hey, at thinkMoney, we don’t flinch. A short OTM put takes in a credit (the premium received for selling the put), which is its max potential profit (less transaction costs). The max potential loss is the strike price of the put minus the credit you realize for selling it. That’s the loss that would occur if the price of the stock goes to zero. And it’s that large potential loss that might be raising eyebrows for the semi-confident trader. The strategy also includes a high risk of purchasing the underlying stock at the strike price when the market price of the stock will likely be lower.

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FIGURE 2: SHORT OTM PUT.

Wee bit bigger potential reward, lots more risk. Still a higher probability of success than a long vertical position, since you could potentially make money even if the stock stands still. For illustrative purposes only

But think about it. The short put has no more risk than long stock. The losses for both are large if the price of the stock drops sharply, let alone goes to zero. But here’s an advantage for the short OTM put—the price of the stock can sit where it is, or even drop a bit by expiration, and the short OTM put can still be profitable. Long stock can’t do that (save, for possible dividends). A short OTM put also has no greater margin requirement than long stock. In a margin account, the margin on a short put can be lower than on long stock, and in an IRA, the margin on a cash-secured short-put position and a long stock position can be roughly the same.

The short OTM put and the short OTM put vertical share some characteristics. So, what makes the short OTM put the choice for the semi-confident trade? The short OTM put can have a higher credit than a shortput vertical, and thus larger potential profit. If the short put of the short-put vertical and the short put are at the same OTM strike price and same expiration, the credit for the short OTM put vertical will be lower than the credit for the short-put. The difference is the cost of the long-put component of the short-put vertical. The short put gives you potentially more profit than a short-put vertical in exchange for a higher margin requirement and higher potential risk. That’s why it may be a choice if you’re a bit more confident in your bullish bias.

The Confident Bullish Trade

LONG, AT-THE-MONEY CALL VERTICAL
A long, at-the-money (ATM) call vertical could be the choice as a “very confident” trade. A bullish long ATM call vertical is made up of a long slightly, in-the-money (ITM) call and a short OTM call in the same expiration. You pay a debit when you do this trade, and the debit of the long ATM vertical is its max possible loss. The max potential profit is the difference between the strike prices, minus the debit paid, including transaction costs, and occurs when the stock price is higher than the strike price of the short OTM call at expiration. That means the price of the stock has to go higher for the ATM vertical to profit. It can’t just stay at the same price or drop, like it can for the short OTM put, or short OTM put vertical. If the stock drops, the long ATM vertical will likely lose some money, and the max loss happens when the price of the stock drops below the strike price of the long call at expiration.

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FIGURE 3: LONG ATM CALL VERTICAL.

The lowest probability of success among the three strategies discussed here, but the greatest possible reward when you’re feeling warm and fuzzy about the direction of the trend. For illustrative purposes only

The long ATM call vertical may be a confident choice because it can have a higher delta than an OTM short put vertical, or even a short put—meaning, it can be more responsive to a rise in the stock price. But if you’re so confident, why not just buy stock, or a long call for that matter? Neither caps your upside potential, so why choose it?

Compared to long stock, the long ATM call vertical can have less potential risk, for one. Nothing is guaranteed to go higher. If the stock does drop sharply, the loss on the long stock can be much greater than on the long vertical. Also, the long ATM call vertical can have a lower margin requirement than long stock. That means that you tie up less of your trading capital with verticals.

Compared to a long call, the long ATM vertical can be less sensitive to changes in volatility (vega) and time (theta), because the vertical has both a long and short option in it. The negative vega in the short option offsets the positive vega in the long option, resulting in a net-lower vega than a single long option. Likewise, the negative theta of the long option is offset by the positive theta of the short option, resulting in a net-lower time decay than a single long option.

The key is understanding that your gut drives strategy, not trade size. The smart way to implement confident analysis is with a strategy that not only reflects that confidence, but also can have lower risk, lower margin requirements, and opportunity to profit if you’re directional bias proves wrong. Remember, your gut gets you in the game. Your brain hopefully gets you paid.

Before You Gut

Find trades your gut feels good about. Fire up thinkorswim’s “MOST ACTIVES” lists to get some ideas. From the MarketWatch tab, go to the Quotes sub-tab. Click the little gear icon to the far right to see a menu of predefined lists, such as “Lovers and Losers” and “Top 10,” featuring the day’s hits and misses.
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