Archivio mensile:Ottobre 2022

Analyzing of your options trading results

How can you evaluate your options trading results?
If you have a higher level of tolerable risk, you should assess your overall profit amount, and if consistency is more important than general earnings, the proportion of trades successful is a better statistic for success.

The measures that you are most likely to find useful will differ depending on your trading strategy.

What results should you focus on?

Total net profit: attempting to assess if the plan or approach adopted was a success or failure at the highest level feasible.
Profit factor: the amount you are likely to gain for every dollar invested with your strategy, providing all else remains constant.
Profit percentage: Think of your plan’s profit percentage as the possibility of winning on a specific transaction.
Other clues will become apparent as you go through the article.

Although the temptation to create daily trading totals for yourself will be high, know that this will simply encourage bad trading habits that will ultimately do you more harm than good.

Having this data will ultimately help you determine if the plan you have created is going to be effective in the long term.

Depending on your own trading style, you will likely discover more relevant measures that tend to place a greater emphasis on overall earnings or the percentage of profitable deals.

If you have a higher amount of acceptable risk, then you will likely want to consider your total profit amount and if you are prioritizing consistency over general profits then percentage of trades successful is a better metric for success.

Create a performance report

You will use the data you have record to create a performance report relating to the trading plan or strategy that you are currently using.

This report will let you take a critical look at the rules you are using the determine your trades and determine how it is likely going to continue performing over a set period of time. Creating a performance report will help you understand the historical volatility of your plan.

When getting started with a performance report, the best place to start is by creating a summary of the metrics that you have collected over the past few weeks.

Ideally, we would like to include information on each completed trade, whether it was a put or a call, the time and data at which it occurred, and the overall results of the trade. While it will be tempting, you will find that avoiding daily data will make it easier to see the forest for the trees.

Keeping a broader focus will help you determine not just the amount you are making overall but also why certain trades failed while others succeeded. Taking the time to do so can make it easier for you to turn fluke instances of success into patterns instead.

To determine your performance, you will also need to check the graph of your performance. This graph can be viewed as a bar graph or as the so-called equity curve, although the bar graph will be illustrative enough to tell you right away what you need to know.

Options trading results to focus on

When it comes to sorting through all of the data that is available to you, you will find it easier to focus of a few major indicators and then let the rest fall in line as expected.

Total net profit: When it comes to determining your total net profit, you are looking to determine at the highest possible level if the plan or strategy that you were using was a success or failure because it determines whether or not you made more money than you lost. To find this number you simply take your total amount of gains and subtract from that the total amount you lost while also taking into account commission costs and any other relevant fees. This will tell you if you are on the right course or if you need to scrap everything and start fresh.

Profit factor: Once your total net profit is facing the right way, the next thing you are going to need to consider how much you are likely to make on your plan per dollar spent assuming everything else remains equal. To find this number, you simply take your total profit number and divide it by the total amount of any losses you had. This number needs to be above 1 in order to indicate a profitable plan and anything higher is extremely profitable.

Percent profitable: You can think of the percent your plan is profitable as how likely you are to win at any given trade. To determine what the number is you simply take the number of trades that ended in success and divide it by the total number of trades that you attempted. There is no target number in this scenario, as the right number depends on whether you prefer major gains and higher risks, in which case you should aim for few trades with higher margins; or you will want a high number if you prefer lots of small, safe trades.

Trade average net profit: The trade average net profit is the amount you are likely to make on each trade you complete, given your past history of trading. To find this number all you need to do is divide the total amount of profit you made by the total number of trades, regardless of whether or not they were ultimately successful. This number should be positive, and ideally, the higher the better.

If the number ends up being negative, then you need to stop trading until you come up with a plan that is somewhat more effective. If you want to calculate this number, it is important to exclude all operations performed that were extremely anomalous with respect to all other operations, as they can alter this number to the point of irrelevance.

Different types of Options

There are several types of options that have come into existence as traders and companies become more competitive. It is a rapidly growing market and offers the opportunity to speculate while potentially making a lot of money. Of course, it is also possible to lose money!

One Touch

If you purchase this option, you will be offered a fixed amount. If the share price touches or goes over that figure at any point during the period before the expiration date you will receive the agreed maturity value. Of course, if it does not touch the figure you will lose your investment.

Binary Options

This is a more challenging option and will require more knowledge of the market. When you purchase a binary range option you will need to tell the seller the range that the share price will stay within, throughout the course of the option. If the share price moves outside your chosen range at any point between the time of purchase and the expiration date you lose your investment. If it stays within the range you will receive the agreed maturity amount. The longer the period until expiration the more difficult this is!

One of the greatest advantages of this type of trading is that you always know what you have at risk. The most you can lose on any one transaction is the figure you purchased the binary option for. You will stand to gain the exact figure you have agreed before you started trading. This should men you never risk more than you can afford, and, if you stick to a plan, can actually generate a good rate of return.

The obvious risk is that the addiction to winning will mean you keep purchasing binary options long after you should have stopped; it can cost you a significant amount of money.

As most binary options offer a reward of less than the initial investment you will need to be right more times than wrong to stand a chance of breaking even or returning a profit. Discipline is essential to achieve this.

As with any type if investing, this particular version of options trading has advantages and disadvantages; this should not stop it being a part of your investment strategy and overall portfolio. But it must be approached as a professional in a business manner; there is no room for a frivolous attitude to this type on investing; it will end up costing your money!

Trading Levels: A Comprehensive Guide

Options trading levels are a system put in place by brokerages to regulate the amount of trading that can be done by traders. The levels are divided into different tiers, with each tier having its own specific requirements for trading. The levels are designed to help prevent traders from taking on too much risk and to ensure that traders have the necessary knowledge and experience to handle the level of trading they are engaging in.

Trading levels are important because they help to ensure that traders are not taking on too much risk. They also help traders to build their knowledge and experience as they progress through the different levels. By starting at a lower level and working their way up, traders can gain a better understanding of the options trading market and learn how to make more informed trading decisions.

The level you are assigned determines what types of trades you are allowed to take part in. Specific details may vary from broker to broker, but they tend to follow the same rules.

There are generally four different levels of options trading, each with its own specific requirements. These levels are:

Level 1: Covered Calls
Level 2: Long Calls and Puts
Level 3: Spreads
Level 4: Advanced Options Strategies

Level 1 Covered Calls

The first level is very restrictive, in fact, it only allows you to sell to open options contracts under strict conditions. In the first case, you can do what is known as a covered call. This means you are going to sell a call option that is covered, meaning it is backed by 100 shares of stock. In other words, you have to own the shares of stock before you can sell a covered call. As we will see, many people who own shares of stock use covered calls to earn monthly income from their investments.

Level 1 traders can also sell to open a protected put. A protected put is an option that is backed by the cash needed to buy the shares of stock should the option get exercised.

While a protected put has the benefit of providing financial security should the option be exercised, it requires a large amount of capital in your account. It turns out there are other ways to sell puts with relatively low risk, so it’s hard to imagine many people selling protected puts.

To qualify for Level 1 options trading, you will need to have a margin account with your broker, and your account must be approved for options trading.

Level 2 Long Calls and Puts

A level 2 trader can buy and sell long calls and puts. Level 2 traders cannot engage in advanced trading techniques like spreads. Moreover, they are not officially allowed to enter into strangles and straddles, although they can do them indirectly by purchasing options on an individual basis.

Most readers are probably hoping to be at least a level 2 trader. Becoming a level 2 trader requires you to submit to an interview process by the broker. The good news is that the “interview” is done via computer these days, and it is pretty easy to get approval as long as you know what to say. The two main things you need to be aware of before undergoing the interview is that the broker will want to know your investment goals and time horizons. Your answers will need to assure the broker that you understand how options work.

Firstly, they are going to ask you if your goals are long-term capital appreciation or short-term profits. Even if you have a stock portfolio or IRA you are managing for your retirement, you need to tell the broker your investment goal is to make short term profits. Secondly, they are going to ask if you are interested in speculating or investing. You need to tell them that you are interested in speculating. That means that you are buying financial securities with the hopes of selling them for a profit in 1 year or less. Again, what your real goals are overall is not important – you need to tell the broker what they want to hear if you are planning on trading options.

To qualify for Level 2 options trading, you will need to have a margin account with your broker, and your account must be approved for Level 2 options trading.

Level 3: spread

If you have not done any options trading, you are probably going to have to spend a few months at level 2 and buy and sell some options before you are approved for level 3. Level 3 opens up some new possibilities for you. As a level 3 trader, most brokerages are going to allow you to engage in certain options strategies that help minimize risk and increase the odds of profit. You will be able to sell options even without cash or owning the stock – as part of one of the pre-defined strategies. The strategies that level 3 traders can use include credit and debit spreads, straddles, strangles, and more complicated trades like an iron condor. Some of these strategies involve the simultaneous sale and purchase of options, and they can even involve call and put options simultaneously. Many brokers set them up for you and will give you the estimated profit and loss in each case.

To qualify for Level 3 options trading, you will need to have a margin account with your broker, and your account must be approved for Level 3 options trading.

Level 4: Advanced Options Strategies

Level 4 is the highest trading level at most brokerages. This allows you to engage in any type of options trading, including selling “naked”.

This means that you can sell options which are not backed by any cash or collateral. However, that is not strictly accurate, as brokerages require a margin account to engage in that type of trading. In order to open a margin account, you must deposit $2,000 cash.

Then, the broker uses a formula to determine the fraction of capital you must have in your account to cover a trade. Keep in mind the money is never spent, it is kept in the account as insurance. While a “protected put” might require you to put $10,000 in your account, for a “naked put” you might only need $1,500. The specifics depend on the specific strike price, underlying stock and other conditions.

Level 4 traders also have access to more advanced trading strategies. These include using multiple legs and special strategies such as a “butterfly” or iron butterfly. Each additional level of trading gives access to anything a lower level trader can do, so a level 3 trader also has the powers of a level 1 and level 2 trader. For junior traders, it is best to trade some options in a straightforward manner at level 2, before moving up to advanced levels.

To qualify for Level 4 options trading, you will need to have a margin account with your broker, and your account must be approved for Level 4 options trading.

To increase your options trading level, you can start by gaining experience with the lower levels of options trading. As you gain more experience and build up your capital, you can then apply for a higher level of options trading with your broker.

It’s important to note that each broker may have slightly different requirements for each level of options trading. So, it’s always a good idea to check with your broker to understand the specific requirements they have in place.

Option Price Model and Markets

Here are a few pricing models to adopt when attempting to determine the price of an option. You only need to grasp a few good models thoroughly, and then use an online calculator. Each segment will go over some of the basic models and how you can understand them.

The Black-Scholes Model

In 1973, as a computing option premium, Robert Merton, Myron Scholes, and Fischer Black developed the Black-Scholes pricing model. This model has become the most famous since that period. Indeed, two years after Black died in 1995, Merton and Scholes received a Nobel Prize in Economics. Nevertheless, Black was still remembered for his work, although he was not given the Nobel Prize because only living people are awarded the Nobel Prize.

The Black-Scholes formula applies only to European calls; both call and put, and in its estimation does not include paid dividends. Nevertheless, using the asset’s ex-dividend value can still be used.

The model assumes that when it expires, the option can only be exercised. So that’s why they’re considering only European solutions. In fact, apart from not including paid dividends, no fees are also taken into account in this process.

It also means the economy is productive and market movements are not reliable. Volatility and interest rates that are risk-free are stable and well known. Finally, the Black-Scholes model assumes normal distribution of returns.

This alternative takes only one volatile asset, such as a portfolio, and then a risk-free asset, such as cash, into account. There is no settlement option with this, but with this arrangement there is a way for someone to borrow money at a risk-free basis. With this model, you can buy any stock, even a fraction of it, without any hidden fees or expenses. The options are calculated at the moment with this decision, as well as the payout. With a short investment option, you can create a long stock investment.

The Black-Scholes model requires the following to measure the option value:

Risk-free interest rate
Implied volatility
Timing (expressed as a percentage of the year)
Strike price
Current asset price

The mathematical formula is complicated. To use it, an average person can be scared. Fortunately, online calculators are available that can be used to measure the price using this pattern. In fact, trading platforms have analytical tools that can be used to determine the price.

This is a good way to get an investing estimate, but it’s not the only thing you’re going to rely on. It may lead you to subject yourself to some major risks due to market fluctuations, liquidity risks, and sudden changes and threats. There are also drastic fluctuations in prices, and most of the time money in the real world does not come with an unchanging interest. It’s a good way to get an idea of what you’re about to do, but you shouldn’t rely entirely on it at the same time.

The Cox-Rubinstein Binomial Option Pricing Model

Mark Edward Rubenstein, Stephen Ross, and Carrington Cox created a variant of the Black-Scholes pattern, the Cox-Ross-Rubenstein model. This model’s primary advantage is that it uses a lattice-based model and over time takes into account the price movement of the underlying asset. A lattice-based model calculates the option’s lifetime shifts in multiple variables. Consequently, the effect is a more accurate price choice. It looks like a tree, and the depletion of the stock is advancing in that direction.

Used for American options, this model. This implies that all are immune to risk so that returns are equal to risk-free interest rate.

The Cox-Ross-Rubenstein model therefore states that because the economy is perfectly efficient, arbitration is not feasible. The underlying asset’s price can never go up and down at the same time. At any given time, it can only go in one direction. During the life of the contract, different points in time can be defined. Because of that, a binomial tree can be formed.

It is usually calculated from the start of the option to the end of the option, and then back again. Once this is done, it is then measured along with adjustments in option rates along with the parameters of the increases in dividend prices. All this is collectively calculated and put into a theoretical model to help others understand where their money will go.

The greatest benefit to this is that it works on American stocks. One downside is that it also allows you to see precisely where a stock is at a particular point. You should take a look at this, and you’ll learn about where that stock will be in the future through its empirical properties. In this way, it is beneficial.

But the biggest limitation is that calculating takes forever. All at the same time you are analyzing a lot of numbers, and many of the older computers can’t do that. However, with the technological changes, algorithms should keep up with the rate of changing numbers. You should get an online calculator to see where a stock is going to be at a certain point in time. Like the Cox-Ross-Rubenstein model, online price calculators and trading site analytical tools can be used to know the price of the contract.

The Put/Call Parity

Hans Stoll introduced the put/call parity as a pricing concept in 1969. There is a relationship between the European call and place options with similar strike price and expiry date, according to his study.

This implies that there is a specific fixed option value for each call option value at a given strike price. The same applies to the values of the option. There is a matching call option value at a common strike price for a put option value. The relationship exists because a position is generated that is the same as the underlying asset when there is a mixture of alternatives for positioning and calling.

The returns for the underlying asset and right must be identical in order to avoid arbitration. If the opportunity arises, traders and investors who take advantage of arbitration will make a profit.

The parity put/call is used to check EU options pricing models. If the parity test is not satisfied with the result of the pricing model, it means that negotiation will take place and the model must be dismissed as a pricing strategy. There are several methods to measure the parity of the place / call.

Thankfully, certain trading platforms provide tools for analysis. Which offer simulation of the parity of the place/call. But you don’t have to memorize all the pricing models completely, of course. Just choose one that suits your situation, have a handy online pricing model calculator, and let the numbers move for you.

How to Develop an Options Trading Exit Strategy

If you find that you’re more of a “fast-and-loose” stock market investor, rather than the type of person who meticulously acts only after weighing the pros and cons of each potential outcome, then there might be a chance that you do not even currently have an options trading exit strategy in place.

Why is an Exit Strategy Important?

Firstly, it’s important to understand that some of the biggest reasons why investors need an exit strategy are emotional in nature. Factors such as greed, fear, and even the rush of the investment game itself are some of the circumstances that can take hold of an investor and cause him or her to make rash and otherwise inadvisable decisions with their money. Due to the fast-paced and sometimes one-sided nature of options trading, it is one of the most susceptible areas of the stock market to an investor’s emotional wear-and-tear. Additionally, another important reason why every investor should be considering an exit strategy is because of the fact that it helps with money management. Again, being an expert at managing your money is another area where many options traders fail at the task at which they’re trying to accomplish. These are two of the most important factors that you need to keep in mind when you’re developing your options strategy, especially because you may not even be realizing how these factors are currently influencing your options trading decisions, for better or for worse.

Exit Strategies and Timing for Options Traders

One of the reasons why options trading is unique is because it requires investors to think about how time in influencing the value of an investment. Each option is going to mature and expire, and the reality is that time is going to cause the value of the option to deteriorate as the maturation date grows nearer and nearer. It’s never a good idea to decide on a whim that it’s the right time to sell or purchase a new option. Instead, consider setting time stamps for yourself along the life of the option that will indicate whether or not it’s time to sell. If you set specific intervals along the life of the stock, you’ll be able to look at the option more objectively than otherwise might be possible. Doing this and sticking to these guidelines for each option that you purchase, or sell will help you to become more emotionless and less logical in your trading patterns.

Rolling an Option

In addition to thinking about the constrains of time in the most objective way possible, another good tip for developing an options trading exit strategy is to partake in what’s known as “rolling out”. If you were to do this, you would first decide to close your options that are currently open under a particular underlying asset. Instead of being done after this, you would open new options within the same underlying asset, only with different terms than the ones that you previously sold. Essentially what you are doing is moving your options to a new strike price, without losing out on the gains that you can make from selling entirely. More specifically, this means moving your options so that they are either positioned vertically or horizontally. If you ultimately decide that you’re going to move them vertically, this means that you’re going to renew your options within the same month under the same underlying stock. If you ultimately decide that you’re going to move your options horizontally, this means that you’re going to renew them within a different month. Of course, when you roll an option you also have the ability to partake in both types of this movement, buying some vertically and others horizontally.

Rolling an Option before the Expiration Date

It should be obvious to you by now that time is a unique indicator of worth for an option. This being the case, the rolling option exit strategy attempts to use time decay to its advantage rather than to its detriment. Broadly speaking and depending on the time that the specific option has until expiration, there are certain times and days that are more significant than others from the perspective of how much an option is worth. The chart below should help to clarify this point:

As you can see from the chart above, the option begins to lose its value more quickly as it heads towards day sixty, and then decays even more rapidly around day thirty. When a person who is holding an option sees this deceleration, it might be within the parameters of his or her exit strategy to even go ahead and roll their option over before the expiration date has come to fruition. This way, they are leaving themselves and their money open for a situation to occur where they can potentially earn back some of the money that they’ve already paid to hold the option. You might be wondering whether or not there are times when an investor will decide that he or she is not going to use the rolling exit strategy, but it appears that this does not happen very often. The idea behind avoiding rolling over an option is that the investor is for some reason under the impression that the stock is going to appreciate more prior to the expiration date. Of course, there are some instances where this does in fact seem to be the outcome, but from a general perspective an option is going to lose value towards the end of its life, rather than see appreciation at the end of its tenure.

Protecting Capital and Managing Money

Your mindset provides you with a strong opportunity to hedge yourself against risk in your trades, but it is not the only way that you can protect yourself. You also need to make sure that you are protecting yourself in practical ways against risks in the market so that you are taking advantage of all of the tools available to help you succeed.

When it comes to trading, you can never be too careful, and you should always be exercising every technique possible to protect yourself against risks in the market.

Protecting Through Diversifying

One of the best things you can do to protect yourself when you are trading is to diversify your portfolio. Diversifying your portfolio means that you are investing your capital into multiple different trade deals so that you are invested in several different areas. The reason why diversification hedges you against risk is that it prevents you from the likelihood of total losses.

In this case, if one of your trades does not perform well, another one of your trades is likely to outperform it and make up for that loss. As long as you are doing your best to research every single trade and trade with confidence, you are likely to see success in many of your trades if you use this strategy, and the losses you do see will not be nearly as catastrophic.

People who want to earn a serious profit with trading are virtually always invested in multiple deals at once to ensure their success, as this increases your potential for maximizing profits, as well.

When it comes to diversifying, there are three ways that you can do it. The first way is to become involved in multiple trade deals that are all fairly similar in nature, for example, getting involved in multiple different options trades.

If you are brand new to trading, it is advisable that you use this diversification style first and that you master trading options before you move on to any other form of investing or trading. This way, you are able to develop your confidence and skill in options first before venturing off into a new trading strategy.

The other two types of diversification that you can engage in with trades include diversifying with non-correlating assets and diversifying your risk category. Both of these are going to help you limit your risk while also improving your money management skills, which will ultimately help you become a smart and successful trader.

Diversifying Your Risk Category

The other way that you can and should diversify your portfolio is through diversifying your risk category. When it comes to trading, there are three risk categories that you can fall into including conservative, moderate, and high. Conservative trades allow you to guarantee a profit from your gains, however, the amount being guaranteed is often very small and does not generally have room for significant growth.

Moderate trades do carry a higher risk with them; however, they also earn you bigger profits in the long run. If you trade moderately, a strong trading strategy can help you succeed with those trades which will increase your chances of securing your profits. High-risk category trades are those that have a high potential to fail, but if they do succeed they will carry massive profits with them. These tend to be the most stressful investments because of how large the risk is, but if they go through the returns you get can be huge.

Generally, every trader has a risk category that they tend to stick to with most of their trades. This category will likely fluctuate as they grow older, as the older you get, the more you are going to need to have your profits available for you to use, and the less time you will have to recover from any losses you incur in your trades. For this reason, it is advised that you actually use your age to help you determine what risk category you should be trading with when you are making trades.

The easiest way to determine your category is to subtract your age from 100. The value of your age should be the percentage of your funds invested into conservative investments, whereas the value remaining is free to be invested in moderate or high-risk investments. Ideally, you should further apply this rule to decide which percentage should be invested in moderate risk versus which should be invested in high risk, so that your money is always being invested in a way that is appropriate for your age.

For example, if you are 25, then 25% of your overall investment capital should be invested in conservative investments. Then, 25% of your remaining investment capital should be invested in moderate investments, with your other 75% being invested in high-risk investments.

If you are 60, then 60% of your overall investment capital should be invested in conservative profiles, and 60% of your remaining investment capital should be invested in moderate investments, and the rest can be invested in high-risk investments. You can always adapt your chosen strategy based on what you feel your needs are and what level of risk you are willing to incur but using this as a guideline is a great way to ensure that you are managing your money properly.

This way, you are able to maximize your profits while also ensuring that the capital you need will be accessible when you need it at any period in your life.

Diversifying With Non-Correlating Assets

Diversifying with non-correlating assets is a strategy that you can execute almost right away when you begin trading options. The key to this diversification is that the underlying assets that you are trading are different from all of your trades. For example, some of your trades may involve assets such as bonds and ETFs, whereas others might include commodities and currencies.

By changing the underlying assets that are being traded, you hedge yourself not only against fluctuations in the specific stock that you are investing in but also in the industry that this stock is a part of. In this case, if the industry itself takes a hit, you are not at risk of having every single trade deal you have made suffer due to it. Instead, you can feel confident that a strong portion of your portfolio remains unhindered from that fluctuation and you have no reason to panic.

If you want to take this a step further, after you have grown confident in options, you can begin to diversify your trading style by investing some of your funds elsewhere.

I will not elaborate too much into this as it is not relevant to swing trading with options, however, do understand that it can protect you in your investment portfolio overall while also giving you the greatest earning potential with your capital.

The 5% Risk Account

Some people think that a trade deal should only include the capital that was required to buy into that trade deal including the cost per share and the commissions that you pay to the brokerage to make your deal. While it is true that this is the only money you require to get involved in a trade, it is not true that it is the only amount that you should set aside for a trade.

If you want to manage your money effectively and hedge yourself against risk, you should always invest 5% of a total investment amount into a “risk account.” This account ensures that you have enough capital to recover the losses should one occur, enabling you to carry on trading. Without it, you might find that some of your losses have catastrophic impacts on your bottom line and significantly reduce the number of trades you can afford to engage in actively, which directly damages your profitability.

Keeping that risk account open with 5% of your total investment capital (or more if you are engaging in riskier trades) will ensure that you are protected and that you can continue to make trades even if you experience a loss.

The 2% Rule Of Money Management

In addition to ensuring that your portfolio is diversified with different investments and risk categories, you also want to make sure that you are managing your capital with each individual trade that you make. Ideally, you should never be trading more than 2% of your overall investment capital into any single trade. So, if you have 5000 to invest, you should never be investing more than $100 into any given bare bones.

This ensures that you are diversifying your portfolio enough to protect yourself against risks while also increasing your likelihood of gaining profits from each trade. If you trade more than 2% of your investment capital into any given risk, you massively expose yourself to losses which can devastate your portfolio and your investments.

Realizing this rule and putting it to work in your own trading portfolio might seem overwhelming early on when you are brand new to trading. You might find yourself concerned that you will not be able to effectively manage all 50 trades, which is a reasonable fear when it comes to starting out as a trader. Understand that enacting this rule does not mean that you are obligated to get started in 50 different trades all at once, effectively overwhelming yourself with attempting to manage them all.

Instead, you can start with managing just 1 trade, and then increase to managing 3-5 trades, and then continue increasing until all of your investment capital is sunk into different investments.

Gradually increasing the number of trades, you are involved in will not only help you grow used to managing all of these trades, but it will also prevent you from becoming fearful or overwhelmed and making emotional trade deals. Early on, it is perfectly okay to start small and build your way up as your confidence grows, as this can be a powerful opportunity to increase your success in trades.

Keeping 30% Of Profits

When you begin trading, it is important that you always keep a percentage of the profits that you are earning from each trade deal. It might feel like a good idea to sink all of your profits back into your trades and profit even more but trust me when I say this is not the best idea. Investing all of your profits back into trades can make trading feel fruitless and can actually work against your desire to stay committed and persistent with your trades.

With all of the effort that you are putting into making those profits happen, if you are not at least sometimes rewarding yourself by cashing out on some of them so that you can experience the tangible benefits, it might begin to feel pointless.

If you are trading as a way to increase your capital and not as a way to replace your income, you might only want to keep 10-25% of your overall profits for yourself in your trades. This capital should be put toward fulfilling the goal that you outlined before you began investing, such as setting aside money to buy a house or paying off debt. This way, you are achieving your purpose with trading while continually investing even more into your trades so that you can do even more in the future. If you are trading with the intention of replacing your income entirely, you want to use the right strategy to get there so that you can comfortably leave your job while still having enough to afford the cost of living. In this case, you would want to cash out about 30% of your overall profits from each trade and apply that toward your cost of living.

Options Trading: How to Place an Order

You have learned different aspects in regard to all the factors that go into making a good options trade, it’s time to start putting your new knowledge into action. This is a two-part process, the first part of which is coming up with the right plan and the second is executing that plan in the right way.

Work out a plan

Before you can begin trading successfully, the first thing you are going to need to consider is creating your own personalized trading plan. This plan will include several facets that are unique to you and proceeding without taking the time to create your own plan is a good way to kill your options trading career before it starts.

Start by considering your skills: When it comes to ensuring you have the right options trading plan, the first thing you are going to want to do is take a look at your overall skill level and familiarity with trading in general, if not options trading specifically. Many new options traders are tempted to overestimate their skills early on, but this will do nothing but hold you back in the long run. Be honest and accurately catalog your strengths and weaknesses. Specifically, you want to have a clear idea of how likely you are going to ignore your plan in favor of following your emotions. This is always a folly and if you know it is your tendency you are going to have to plan around it.

Think about other challenges: When it comes to determining what plan or system works for you, it will be important to take into account any other potential challenges that you might need to face in order to achieve the level of success that you are hoping for. These types of challenges could be anything from a lack of resources or planning to something more complicated and personal. The point is, anything outside of the normal market inconsistencies that prevent options trading from being purely profitable should be accounted for to ensure your success rate remains as high as possible.

Consider the right amount of risk for you: When it comes to deciding how much risk is the right amount for you, the first thing you are going to want to do is decide how much your total investment budget is going to be. If you have never invested anything before then this investment budget can be seen as your portfolio. Never put more than 5%of your total into any one trade which makes it difficult to lose anything too substantial all at once. What’s more, you are going to want to determine if the trade is worth the effort by ensuring it is going to pay off at least 300% when compared with the initial investment.

This is what is known as the risk/reward ratio and it can be found when it comes to any options trade by simply taking the amount of estimated profit and dividing it by the amount of the investment. If the result is greater than or equal to 3 the trade will be worth your time if it pays out. Remember, the return will only happen if the trade works in your favor, however, which can be determined by finding your own level of tolerance when it comes to investment risk.

Finding your own tolerance level when it comes to risk can be accomplished by taking the amount of time you have available to work on investing versus the amount of potential returns you are looking for. This means that the less time you are willing to spend on investing in options, the more risk you are going to have to be willing to accept if you are hoping to make more than a moderate amount of money from doing so.

Do your homework: Each and every day in the hours before the market opens you need to plan on being in front of some type of screen, learning about everything that happened while you were sleeping and deciding how you think it is going to affect the markets you are interested in the most. This means checking foreign markets, the premarket forecast and the index futures to name a few, all in the name of deciding what the market’s mood of the day is going to be after the day gets going properly and trading actually begins.

You will also want always to be aware of any upcoming due dates for earning data to be reported which will always disrupt the market in question in one way or another. Companies have to report their earnings in comparison to their projections 4 times a year and the results are almost always going to affect the market in a serious way. The right choice in these instances is to wait until the rash of panic trading has passed and get in once things begin to stabilize but not so much so that there is no longer a profit to be made by doing so.

Decide on an exit strategy: No matter what plan or strategy you settle on, it is important to have a clear idea of what an acceptable level of profit or loss means to you and setting a firm exit strategy accordingly. While it can be tempting to wait on an underlying stock to rebound before exercise your option or walking away, the results are rarely going to end in your favor and it can lead to a bad habit of hanging on to sub-par trades that could possibly cost you big in the long term. The right exit strategy for you will vary based on how much risk you can accept, coupled with how many trades you are planning to make each day and what level of micromanaging you are comfortable with. Regardless, the point at which you decide to bail on a bad trade should be the same for all of your trades.

Setting up an effective exit strategy begins by deciding where the appropriate point to set what is known as a stop loss is. A stop loss is an automated order that you put in when you purchase the option which indicates at what point you want the option to be sold automatically. It is used to minimize your losses if a trade suddenly starts heading in the opposite direction you were hoping it would. You should avoid setting stop losses on options with extremely volatile because they are likely going to fluctuate too much to make them truly effective in this instance.

Stop orders are useful if you are the writer as well as the holder because they can be used to ensure that additional options are purchased if the price rises instead. You will also sometimes find it useful to use a secondary stop order which will sell if the price then hits a secondary amount. This is considered the price target and it is the amount that you can most expect to make on the trade in question. When you hit a price target you are going to want to sell off half of your total holdings and move the first stop point up to this point. This maximizes both your profit potential as well as minimizes your total risk.

For example, if you have a pair of options totaling 200 shares of a stock that is worth $20 to start. You would set a stop loss at $19.75 to prevent yourself from losing much money. If the stock then hits your price target of $30, then the best course of action is to sell 100 shares to ensure you see some profit from your price target before holding on to the remaining shares and setting a new stop loss of $30. This way you are guaranteed to see the profits of your previous price target while at the same time leaving yourself open for additional profits assuming the positive trend in the underlying stock continues.

Find a point of entry: Once you know when you are going to want to get while the getting is good, you will next want to determine when you are generally going to want to jump in on a profitable option trade. Start by considering your acceptable risk and then decide what you want to do when you find an option that falls within your risk level. The most common entry decision is to buy a single option. Depending on your level of risk, you are also going to want to consider secondary factors, as you want your entry point to be discerning enough to weed out lousy propositions but no so stringent that the good ones also fail to get through. It will get easier to find the perfect entry point, the more practice you obtain at trading options.

Ask yourself about your goals: When it comes to creating the type of trading system that is right for you, it is important to have a clear idea of just what you hope to accomplish when it comes to long term trading so you then have a better idea of how each individual trade can help you come one small step closer to your goals. You want to keep any limiting factors in mind when it comes to determining your goals, but you also want to keep your goals realistic as well as what is known as SMART.

S: The best goals are specific in that they make it clear why you want to reach the goal in question as which requirements stand in the way of your success. It will also make it clear when the goal is likely to be completed, where the completion will take place and who besides yourself you are going to need to call upon to complete it successfully. Specific goals are important because they are far more likely to be completed than those that are general.

M: The best goals are measurable which means they have several points that can provide distinct feedback as to the overall success or failure of the goal as a whole. If you clearly know when you have reached a new milestone, then your goal is measurable.

A: The best goals are attainable when all of your unique challenges are taken into account. No matter your intentions, a goal that is unattainable is never a good goal.

R: The best goals are realistic, which means that not only are they attainable, they can be completed based on the amount of time and effort you are going to be able to put forth on average.

Timely: The best goals are those which have a specific, but reasonable, timetable for completion. Goals that are too strict when it comes to a timetable will never come to fruition in time; meanwhile, goals that are too vague when it comes to a timetable will also never see success because it is too easy to put them off indefinitely. Keenly track your progress: If you are new to options trading, you will likely find it useful to keep extremely precise notes when it comes to the trades you made, the mental state you were in when you made them, and the ultimate outcome of each. Keep track of the metrics throughout your day, every day, but to also to avoid pouring over them at the end of each day with the goal of passing judgment on your system. A good system needs at least a few weeks to determine if it is at all worthwhile, and then another 2 weeks if its results are near 50 percent or better. Nothing is gained by looking for results where there are none that are strong enough to be accurate seen. Be patient and the information you have to analyze will be much more useful.

Building Portfolio

The ideal portfolio should contain between 25 and 30 different securities. This is the perfect way of ensuring that the risk levels are drastically reduced and the only expected outcomes are profitability.

Diversification is a popular strategy that is used by both traders and investors. It makes use of a wide variety of securities in order to improve yield and mitigate against inherent and potential risks.

It is advisable to invest or trade in a variety of assets and not all from one class. For instance, a properly diversified portfolio should include assets such as currencies, options, stocks, bonds, and so on. This approach will increase the chances of profitability and minimize risks and exposure. Diversification is even better if assets are acquired across geographical regions as well.

Best Diversification Approach

Diversification focuses on asset allocation. It consists of a plan that endeavors to allocate funds or assets appropriately across a variety of investments. When an investor diversifies his or her portfolio, then there is some level of risk that has to be accepted. However, it is also advisable to devise an exit strategy so that the investor is able to let go of the asset and recoup their funds. This becomes necessary when a specific asset class is not yielding any worthwhile returns compared to others.

If an investor is able to create an aptly diversified portfolio, their investment will be adequately covered. An adequately diversified portfolio also allows room for growth. Appropriate asset allocation is highly recommended as it allows investors a chance to leverage risk and manage any possible portfolio volatility because different assets have varying reactions to adverse market conditions.

Investor Opinions On Diversifications

Different investors have varying opinions regarding the type of investment scenarios they consider being ideal. Numerous investors believe that a properly diversified portfolio will likely bring in a double-digit return despite prevailing market conditions. They also agree that in the worst-case situation will be simply a general decrease in the value of the different assets. Yet with all this information out there, very few investors are actually able to achieve portfolio diversification.

So why are investors unable to simply diversify their portfolios appropriately? The answers are varied and diverse. The challenges encountered by investors in diversification include weighting imbalance, hidden correlation, underlying devaluation, and false returns, among others. While these challenges sound rather technical, they can easily be solved. The solution is also rather simple. By hacking these challenges, an investor will then be able to benefit from an aptly diversified platform.

The Process Of Asset Class Allocation

There are different ways of allocating investments to assets. According to studies, most investors, including professional investors, portfolio managers, and seasoned traders actually rarely beat the indexes within their preferred asset class. It is also important to note that there is a visible correlation between the performance of an underlying asset class and the returns that an investor receives. In general, professional investors tend to perform more or less the same as an index within the same class asset.

Investment returns from a diversified portfolio can generally be expected to imitate the related asset class closely. Therefore, asset class choice is considered an extremely crucial aspect of an investment. In fact, it is the single more crucial aspect for the success of a particular asset class. Other factors, such as individual asset selection and market timing, only contribute about 6% of the variance in investment outcomes.

Wide Diversifications Between Various Asset Classes

Diversification to numerous investors simply implies spreading their funds through a wide variety of stocks in different sectors such as health care, financial, energy, as well as medium caps, small, and large-cap companies. This is the opinion of your average investor. However, a closer look at this approach reveals that investors are simply putting their money in different sectors of stocks class. These asset classes can very easily fall and rise when the markets do.

A reliably diversified portfolio is one where the investor or even the manager is watchful and alert because of the hidden correlation that exists between different asset classes. This correlation can easily change with time, and there are several reasons for this. One reason is international markets. Many investors often choose to diversify their portfolios with international stocks.

However, there is also a noticeable correlation across the different global financial markets. This correlation is clearly visible not just across European markets but also in emerging markets from around the world. There is also a clear correlation between equities and fixed income markets, which are generally the hallmarks of diversification.

This correlation is actually a challenge and is probably a result of the relationship between structured financing and investment banking. Another factor that contributes to this correlation is the rapid growth and popularity of hedge funds. Take the case where a large international organization such as a hedge fund suffers losses in a particular asset class.

Should this happen, then the firm may have to dispose of some assets across the different asset classes. This will have a multiplier effect as numerous other investments, and other investors will, therefore, be affected even though they had diversified their portfolios appropriately. This is a challenge that affects numerous investors who are probably unaware of its existence. They are also probably unaware of how it should be rectified or avoided.

Realignment Of Asset Classes

One of the best approaches to solving the correlation challenge is to focus on class realignment. Basically, asset allocation should not be considered as a static process. Asset class imbalance is a phenomenon that occurs when the securities markets develop, and different asset classes exhibit varied performance.

After a while, investors should assess their investments then diversify out of underperforming assets and instead shift this investment to other asset classes that are performing well and are profitable in the long term. Even then, it is advisable to be vigilant so that no one single asset class is over-weighted as other standard risks are still inherent. Also, a prolonged bullish market can result in overweighting one of the different asset classes which could be ready for a correction.

Diversification And The Relative Value

Investors sometimes find asset returns to be misleading, including veteran investors. As such, it is advisable to interpret asset returns in relation to the specific asset class performance. The interpretation should also take into consideration the risks that this asset class is exposed to and even the underlying currency.

When diversifying investments, it is important to think about diversifying into asset classes that come with different risk profiles. These should also be held in a variety of currencies. You should not expect to enjoy the same outcomes when investing in government bonds and technology stocks. However, it is recommended to endeavor to understand how each suits the larger investment objective.

Using such an approach, it will be possible to benefit more from a small gain from an asset within a market where the currency is increasing in value. This is as compared to a large gain from an asset within a market where the currency is in decline. As such, huge gains can translate into losses when the gains are reverted back to the stronger currency. This is the reason why it is advisable to ensure that proper research and evaluation of different asset classes are conducted.

Currencies Should Be Considered

Currency considerations are crucial when selecting asset classes to diversify in. take the Swiss franc for instance. It is one of the world’s most stable currencies and has been that way since the 1940s. Because of this reason, this particular currency can be safely and reliably used to measure the performance of other currencies.

However, private investors sometimes take too long to choose and trading stocks. Such activities are both overwhelming and time-consuming. This is why, in such instances, it is advisable to approach this differently and focus more on the asset class. With this kind of approach, it is possible to be even more profitable. Proper asset allocation is crucial to successful investing. It enables investors to mitigate any investment risks as well as portfolio volatility. The reason is that different asset classes have different reactions to all the different market conditions.

Constructing a well-thought-out and aptly diversified portfolio, it is possible to have a stable and profitable portfolio that even outperforms the index of assets. Investors also have the opportunity to leverage against any potential risks because of different reactions by the different market conditions.

An Example

An investor has a total of $100,000 to invest. The best approach is to put the funds in a diversified portfolio, but the challenge is properly or adequately balancing the portfolio. The first step is to check out market conditions and then conduct an assessment of possible returns versus any likely risks. As such, the investor can choose to invest in very secure investments that are likely to produce long-term income.

Such an investment can include between 10 and 12 stocks that are highly diversified. These are generally stocks from different sectors, industries, and countries. This kind of diversification helps to leverage against any possible risks and also ensures the portfolio is thoroughly mixed.

Portfolio Diversification Approach

Disciplined Investing is a Must

Everyone is in agreement that diversification is basically the right approach. However, as an investor, there is a need to be disciplined even as you invest and diversify your investments. Investing is an art form. Put your money in equities but not all your money. Instead, think of yourself as a mutual fund manager then come up with a list of companies to invest in. You can also invest in funds and trusts like REITs or real estate investment trusts and exchange-traded funds. It is also advisable to go beyond local borders and invest globally. This way, you spread your risk around and stand chances of enjoying much better returns.

Consider Investing in Bonds and Index Funds

Apart from investing in stocks across numerous sectors, a trader may also want to invest your funds in certain fixed-income or index funds. When you invest in securities that closely keep an eye on a major index is highly recommended as you will be able to monitor progress and known when to make adjustments and so on. Such funds charge very low fees, and you will be able to track your investments easily.

Portfolio Building is a Continuous Process

Try always to grow your investments. If you receive some cash from somewhere, you can consider investing part or the entire amount into your investment portfolio. Also, keep adding regular amounts to your portfolio. You can, for instance, add about $500 each month to this portfolio to grow it at a much faster pace.

Learn the Best Exit Times Sometimes we tend to get comfortable with the purchase-and-hold approach. This is true, especially when our investments are on autopilot. Yet a smart investor you need to keep looking out for events and special moments. Always remain abreast of events and be ready to act depending on the nature of the event. This way, you will be prepared for the moment when you have to cut your losses and exit your trades.

Options Risk and Reward: the importance of money management

Options trading can be a great way to make money, but it comes with its own set of risks and rewards. Options trading is not for everyone, but for those who are willing to take the risks, it can be a profitable venture.

Options Trading Risk

Like any other investment, options trading carries its own set of risks. Here are some of the risks associated with options trading:

Limited Timeframe – Options have a limited timeframe, typically ranging from a few weeks to a few months. This means that if you don’t make the right move within the given timeframe, you could lose your investment.
High Volatility – Options trading can be very volatile. This means that the price of the underlying asset can fluctuate rapidly, making it difficult to predict the outcome of your trade.
High Risk – Options trading is considered a high-risk investment. This is because the price of the underlying asset can fluctuate rapidly, and the value of the option can decrease quickly.

Options Trading Reward

Options trading can be a very rewarding venture if done correctly. Here are some of the rewards associated with options trading:

High Returns – Options trading has the potential for high returns. This is because options trading allows you to leverage your investment, meaning you can control a larger amount of the underlying asset with a smaller investment.
Flexibility – Options trading offers flexibility in terms of the underlying asset you can trade. You can trade options on stocks, commodities, currencies, and more.
Hedging – Options trading can be used as a hedging strategy. This means that you can use options to offset losses in other investments.

The Importance of Effective Money Management

Money management is only included in the trading plan by about one-tenth of all private traders. Just because a trader does not have a lot of capital does not mean that he cannot apply the principles of money management. Many traders are of the opinion that these ideas can only be used by large asset managers and institutions.

Money management also implies that the potential risk, taking into account the preferences of the trader, is set in relation to the expected profit. The goal is to set a desirable yield rate and then minimize the associated risk.

Trading generally requires four decisions:

Buy/sell (system or strategy)?
Which security is traded?
How many contracts or shares of value are traded?
What is the share of capital risked on a trade?

The first decision is about the trading process itself without taking into account money management. The other three decisions involve maximizing profit and minimizing risk directly. The foundations of risk and reward should be considered from the start in the development of a trading system and must become an integral part of the system.

If a trader works profitably right from the start and has thus increased his trading capital, then he cannot be ruined by four losses (as long as his bet remains the same). Although the number of consecutive losses that would lead to ruin increases with time, so does the likelihood of multiple losses follow one another. The following formula calculates the probability of ultimate ruin (WR) over time:

WR = (1-VT / 1 + VT) AH

VT stands for the trader’s advantage (percentage winners – percent losers), and AH is the initial trading units. If the initial capital of a trader is $ 20,000 and his bet per trade is $ 5,000 then AH = 4. The following example calculates the probability of ultimate ruin:

Total Capital§ 20,000 Total Capital$ 20,000

Deployment$ 5,000 Deployment§ 2,500

Advantage of the Trade10% Trades’ Advantage10%

Chance of Ruin44.8% Chance of Ruin20.1%

Total Capital$ 20,000 Total Capital$ 20,000

Bet$ 2,000 Bet$ 1,000

Advantage of the Trade10% Advantage of the Trade10%

Chance of Ruin13.4% Chance of Ruin1.8%

These numbers apply only when you trade one contract at a time. With changing contract numbers, the risk of ruin changes dramatically. Moreover, these calculations assume that, in the case of a profit, the amount is always the same and corresponds to the loss in the negative case. As mentioned above, the risk of ruin is determined by the percentage of winners, the ratio between winners and losers, and the size of the bet. So far, we have disregarded the relationship between winners and losers. In real life, most successful trading systems score less than 50% winners and win-loss ratios above 1.2.

The risk of ruin is an interesting indicator, but it does not give much insight into how to use or manage capital efficiently. For self-preservation, it is best not to put everything on one card. If you choose your bets well and follow a system with a positive bias, the risk of ruin is very low.

The Capital Allocation Model

Now you know the tools you need to understand our capital allocation model. First, we’ll show how capital is allocated to a one-market portfolio using a small selection of data.

As you know, our goal is to maximize profit while minimizing risk. This goal must be achieved without exceeding the limits of justifiable risk. To reach the goal, we need to know how much capital is to be allocated to each market and what number of contracts should be traded. In this model, capital is calculated from the market value of the account, the average monthly returns, and the market risk. The market value is simply the starting capital with which we begin our trading. In these examples, the returns do not add up; we use the initial capital for all calculations. The average monthly income is the capital that we can expect to gain from our system. Market risk is the amount we can lose per day on a trade. Asset managers use a variety of metrics to assess market risk:

• Mean Range: The average of the ranges of the last three to 50 Days, which is converted into a monetary amount in US $. For example, if the average spread is 40 points for the Swiss franc over the past 10 days and the Swiss franc is $ 12.50, the market risk is $ 500. The likely amount of market movement is the average spread of the last x days. This does not always have to be right, but the capital allocation model needs to be built on certain probabilities.

• The average change in closing prices: The average change in closing prices over the last three to 50 days says more about the risk, as this value indicates the expected risk if the position is held.

• Mean change in positive closing prices versus negative closing prices: the average change in the negative closing prices over a period suggests the risk of holding a long position.

• The standard deviation of closing prices: The standard deviation of the closing prices gives a more accurate picture of the risk, as the daily deviation is displayed with a probability of 68%. This calculation is a bit more complex, but it does not cause any problems with the computers available today.

In whatever way we measure the risk, it is the most important variable to watch and the most important component of the capital allocation model.

A Market Portfolio

Whether the system trades futures or stocks makes no difference. Before we can allocate capital, the average monthly income and market risk must be determined on the basis of a contract. We also need to determine how much of our capital we are willing to risk per trade. But we cannot know that yet, because that’s exactly what we want to find out.

Cumulating Of Results

Cumulating means here the process of capital allocation based on the current portfolio or deposit value. The current portfolio value results from the start-up capital as well as the already completed positive and negative trades. When it comes to large sums of money, accumulation is very good: the capital invested increases or decreases depending on the current value of the deposit. If a trading plan is successful, then each trade will be given more capital; but if it is bad, then there is less capital available for each trade. Note that we have found that cumulating is very good when it comes to large sums. This limitation stems from the belief that the allocation should not be extended until the seed capital of smaller accounts has not been at least doubled or tripled. Even good systems can crash after a series of wins, and if a smaller account does not cumulate, there is still some capital left for bad times. If accumulation is of interest to you (and it should, if you have significant sums of money), then you can build it into the capital allocation model with a small change. In the formula, do not use seed capital as total capital (GK), but use the current value of the deposit.

The Iron Condor

Let’s take a minute for an important aside before we show you how to setup the trade. There are two kinds of options traders. One type of options traders is a profit seeking trader. Of course, all traders hope to make profits, but a profit seeking trader is one who makes bets on what the stock is going to do, and they roll the dice and gamble hoping to make profits.

The other type of options trader is an income trader. This type of options trader seeks to minimize risk and setup trades so that they can earn regular income from the markets. There are many different ways to do this, and most of them involve selling rather than buying options. When you are a regular options trader, you buy to open your positions. So, you are going to be running your business buying low and selling high in order to make profits.

An income trader sells to open their positions. They seek to make money selling options and while you have been concerned about things like theta and time decay so far, as an income trader you actually value time decay and can’t wait for options to expire.

An iron condor is the first type of strategy that we are going to consider that works in this fashion. When you trade an iron condor, you are going to sell it to open your position. Then you are going to make money from the time decay. As long as the stock stays within the range that you use to define the iron condor, you will earn a profit. If it moves outside the range of the iron condor, then you are going to lose money.

So, let’s see how its setup. The idea of an iron condor is to set boundaries on the stock price, so we are going to be looking for a ranging stock price as shown in the graph above. To set upper bounds, we are going to use call options. The lower bounds of the range are going to be set by using put options.

A single iron condor isn’t going to make you a huge amount of money. The basic philosophy behind it is that this is a limited risk – limited profit type of trade. It eliminates having to guess which direction the stock is going to move, and instead we are only going to estimate the bounds of stock price movement over the lifetime of the option. Under normal conditions this type of bet is going to work in most cases. Of course, if there is unexpected news, such as bad news coming out about the company that can cause prices to move outside the bounds of the iron condor and turn the trade into a loser. Unexpectedly bad news about the economy or political situation can have the same effect.

To create an iron condor, we are going to trade 4 options at once. We are going to sell two options and buy two options. First let’s look at the high price range for the trade. First, we want to sell a call option with a lower strike price. The strike price used for the call option sets the upper boundary of the iron condor. So, you are setting this up with the belief that the stock price is not going to exceed the strike price of the call option that you select.

Second, we are going to buy a call option that has a higher strike price than the first call option. This is done because we are going to use it to hedge our risks a little bit. Let’s see how that would work. For our example, we will assume that the stock price is $200.

We could sell a call option with a strike price of $205. This means we are setting up our iron condor with the belief that from now until the expiration date of the option, the price of the stock is not going to rise above $205. If there are 30 days to expiration, and volatility is a relatively low 15%, the price of a call option with a $205 strike price is going to be $1.55.

The breakeven price is found by adding the cost of the call option to the strike price, which would give $206.55. As long as the share price stays at $206.55 or below, it’s not worth it for the option to be exercised. However, if the share price goes above that value, the option can be exercised. In the case of a call option, as the options seller, this means that you have to sell 100 shares of stock at the strike price of $205 a share.

So how would that work in practice? The way it actually works is your broker buys the shares at the market price, sells the shares to the counterparty to the option contract to close the transaction at the lower strike price, and then they stick you with the losses. So, if the share price were $208, you would have a $3 loss per share, or a total loss of $300 for each contract that would cover 100 shares of stock.

Of course, stock prices can rise to any value, at least in theory. So, you could be getting into real trouble if the stock price rose much higher. The iron condor caps maximum losses by including a second call option, with a higher strike price. You buy this call option, which means you cap possible profits because you have this added expense. But besides limiting possible profits, it will also cap possible losses.

Since you are buying a call option, you can exercise your rights on that option and buy shares of stock at that strike price that you can sell at the higher market price to make up for some of the loss.

Using our price setup, we could choose $210 as the second-strike price. Suppose that the stock price rises to $212. In this situation, the first option with the $205 strike price is going to be exercised. So, we have to buy shares at $212 and then sell them to the counterparty of the $205 option at $205 a share, giving us a net loss of $7 a share.

But now we can exercise the second call option that we have purchased. In this case, we buy shares of stock at $210, but then we sell them on the market for $212, giving us a net $2 a share. This helps mitigate the total losses, reducing the total loss to $5 a share, or a total loss of $500. The loss is capped. It’s going to be the difference between the two strike prices chosen for our options.

Now let’s turn our attention to the other side of the trade. This time, we will have two put options. First we set the lower boundary for the iron condor by selling a put option. We can make it any value we want, but to have a nice symmetrical iron condor we will choose a strike price of $195. Generally speaking, a ten-dollar range is a very good one to have for an iron condor. The probability of the stock price going outside a range of ten dollars is relatively low, assuming you have correctly picked a low volatility situation.

The options that you sell are the ones that set the boundaries for the iron condor. In this case, we have the call option with a strike price at $205, and a put option with a strike price of $195. That means as long as the stock price stays in between $195 and $205 between the time we sell to open this position and when the options expire, we will earn a profit.

In addition to selling a put option, we will attempt to mitigate risk in the same way that we did with our setup of the call options. This means that we are going to buy a put option with a lower strike price in order to set the final lower boundary for the iron condor. Again, it can be any value, but for the sake of clarity we will put it at the same $5 distance.

Now let’s take a look at what would happen if the stock price went outside the range we have setup to the downside. We have sold a put option with a strike price of $195 and purchased a put option with a strike price of $190. If the share price of the stock falls below $195 but remains above $190, the put option that we sold is can be exercised. When a put option is exercised that means that we will be forced to buy shares of stock at the strike price. So, we have to buy shares at $195 a share even though the price on the market is between $190 and $195, let’s say for the sake of example it’s $192. We then have to sell the shares at the market price. So, if we sell the shares for $192, we are out $3 a share for a total loss of $3 a share.

If the stock price kept dropping, we would find ourselves with ever increasing losses. But that is why we buy the second put option, it serves the same purpose as the second call option in mitigating our losses. So, if the share price drops to say $170, our losses will be capped at the difference between the strike prices of the two put options. Instead of being forced to sell the shares at the market price of $170 a share, we would be able to exercise the second put option and sell the shares at $190 a share. So, we had to buy them at $195 a share even though the market price was $170 a share, but then we are able to sell them to someone else for $190 a share.

I’ve actually simplified the discussion a little bit, because you have to incorporate the net costs of entering the positions. Since you get a credit for entering an iron condor – you sell it to open – this actually mitigates your risk even further. Let’s see what the prices are for each of the options in this case:

$210 Call Option (BUY): $0.57

$205 Call Option (SELL): $1.55

$195 Put Option (SELL): $1.45

$190 Put Option (BUY): $0.47

The cost of buying the two options is $0.57 + $0.47 = $1.04. But, we receive a credit from selling the other two options of $1.55 + $1.45 = $3. Our net credit is $3-$1.04 = $1.96.

We start out ahead by $1.96. So, if we end up losing on the trade because the stock breaks one way or another, our losses which were already capped at $5 are actually reduced by this amount, and so our total possible loss in any situation is $5 – $1.96 = $3.04. That means the maximum possible loss is $304 (for the total of 100 shares) and the maximum profit, which is fixed, is $196. This type of situation is shown in an iron condor graph:

The above example shows an iron condor with inner strike prices of $40 and $50 for a lower priced stock, with a max profit of $100 and max loss of $400. In the two examples we’ve discoursed so far, the losses seem to outstrip the gains. However, that is a deceiving way to look at the trade. With an iron condor, the probability of winning on the trade – provided that you’ve done your homework and picked a stock in a low volatility situation, means that your probability of winning on the trade is high. The key to succeeding with an iron condor is carefully studying and choosing your trades. Don’t just randomly pick a stock and then enter an iron condor.

Strangles and Saddles

Options allow you to create strategies that simply are not possible when investing in stocks. There are two ways that you can do this, they are known as strangles and straddles. This is a more complex strategy than simply buying a long call option or a long put. But it’s not really that complicated, you just have to understand some basics on how to set them up in order to make a profit.

The strategy that is used in this case is dependent on a large move by the stock. There are many situations where this might be appropriate. But mainly, this is something you will consider using when you are looking to profit from an earnings call.

Earnings calls cause major price shifts in the big stocks. The price shift is largely determined by what the analyst’s “expectations” are for earnings, and so this is not always a rational process. If the company beats the analyst expectations when it comes to earnings per share, this creates a positive “surprise” that will usually send the stock soaring. The amount of “surprise” is given by the percentage difference between the actual value and the expected value. So, in this case, if you had bought a call option, you could make amazing levels of profit from the option by selling it in the next day or two, as long as the new higher price level is maintained.

But the problem is, you have no idea beforehand whether the earnings are going to exceed or fail to meet the analyst expectations. The silly thing about this (from a common-sense perspective) is that even if the company is profitable, if they fail to meet analyst expectations, this results in massive disappointment. So, you might see share prices drop from a sell-off even if the company is profitable. This is “surprise” in a negative way.

The impact of failing to meet expectations can be magnified if the company also has some bad news to share. A recent example was an earnings call from Netflix, where they revealed that over the past quarter, they had lost subscribers. This news hit Netflix stock hard, it dropped by a walloping $42. If you had purchased a put option, that could have meant a $4000 profit.

The problem is that you don’t know ahead of time which way the stock is going to go. It’s one thing to look back and say well you could have had a put option and made $4k in a day, but often companies reveal information in earnings calls that have been under wraps. Nobody had any inkling that Netflix was going to be losing subscribers until the earnings call.

Second, analyst expectations are somewhat arbitrary. Defining success or failure in terms of them is actually pretty silly, but that is the way things work right now. But the point is it’s really impossible to know whether or not these arbitrary expectations are met prior to the earnings call. It’s also impossible to gauge the level of reaction that is going to be seen from exceeding or failing to meet expectations.

Since we don’t know which way the stock is going to move, it would seem that a good strategy to use is to buy a call and a put at the same time. That is precisely the idea behind a straddle and a strangle.

That way, you profit no matter what happens, as long as the price on the market changes fairly strongly in one direction or another. When you set up a straddle or a strangle, there is a middle “red zone” that bounds the current share price over which you are going to lose money. But if the share price either goes above the boundaries of this zone or below it, you will make profits.

If the stock shoots upward, this means that the put option is going to drop massively in value. So, it’s basically a write off for you. But if the stock makes a strong move, as they often do after positive earnings calls, you stand to make enough profits from the call option that was a part of your trade to more than make up for the loss of the put. The potential upside gain is in theory unlimited. Of course, in practice, share prices don’t rise without limit, but they might rise, $10, $20, or $40, and that could potentially earn profits of roughly $1,000-$4,000, more than covering any loss from the now worthless put option.

The opposite situation applies as well. If the stock drops by a large amount, you make profits. Profits to the downside are capped because a stock price cannot decline below zero. That said, if the stock drops by a significant amount, you can still make hundreds to thousands of dollars per contract virtually overnight.

Doing this requires some attention on your part. You are going to have to think ahead in order to implement this strategy and profit from it. Remember that you can use a straddle or strangle any time that you think the stock is going to make a major shift one way or the other. An example of a non-earning season situation, where this could be a useful strategy, would be a new product announcement. Think Apple. If Apple is having one of their big presentations, if the new phone that comes out disappoints the analysts, share prices are probably going to drop by a large amount. On the other hand, if it ends up surprising viewers with a lot of new features that make it the must-have phone again, this would send Apple stock soaring. The problem here is you really don’t know which way it’s going to go. There are going to be leaks and rumors but basing your trading decisions on that is probably not a good approach, often, the rumors are wrong. A strangle or straddle allows you to avoid that kind of situation and make money either way.

The same events that might warrant buying a long call such as a GDP number or jobs report, for options on index funds, are also appropriate for strangles and straddles.

What Is A Long Straddle?

To set up a straddle, you buy a put option and a call option simultaneously (buy = take a long position). The maximum loss that you can incur is the sum of the cost to buy the call option plus the sum of the cost to buy the put option. This loss is incurred when you enter the trade.

With a straddle, you buy a call option and a put option together. And they would be with the same strike price. By necessity, this means that one option is going to be in the money and one option is going to be out of the money. When approaching an earnings call, the prices can be kind of steep, because you want to price them close to the current share price. That way, it gives us some room to profit either way the stock price moves. A maximum loss is only incurred if you hold the position to expiration. You can always choose to sell it early, if it looks like it’s not going to work out and take a loss that is less than the maximum.

There is a total premium paid for entering into the position. This is the amount of cash paid for buying the call added to the money paid for buying the put. This is called the total premium. There are two breakeven points:

To the upside, the breakeven point is the strike price + total premium paid.
On the downside, the breakeven point is the strike price – total premium paid.

It the price of the stock moves up past the breakeven point, the put is worthless. However, the call option would earn substantial profits. On the other hand, if the stock price moved down past the lower price point, that would be the breakeven, the call option would be worthless and the put option would earn substantial profits.

For example, suppose that we buy a $207.5 straddle on Apple 7 days to expiration with an implied volatility of 35%, and the underlying price is $207. The total cost to enter the position is $8.03 ($803 total). At 1 day to expiration, the share price breaks up to $220 a share after the earnings call. The put expires worthless, but the call jumps to $12.50. The net profit is then $12.50 – $8.03 = $4.47, or $447 in total per contract.

If instead, the share price had dropped to $190, the call expires worthless, and the put jumps to $17.50 per share. The net profit, in this case, is then $17.50 – $8.03 = $9.47 per share or a total of $947.

This isn’t to say that the straddle would be more profitable for a stock decrease, it is not. The profit will be the same no matter which way the share price moves, in our examples, we used two different sized moves. The point is to illustrate that no matter which direction the stock moves, you can profit. If the stock is at the money at expiration, we could still recoup some of the investment and sell the straddle for a loss. In this case, the call and the put would both be priced at $152. We’d still be at a loss, but we could recoup $304 by selling both at $152.

Short Straddle

If you sell a straddle, then you are taking the opposite position, which means you would be betting that the share price stays inside the range and hope that the stock didn’t make a big move to the upside or the downside. To sell a straddle you’d have to either be able to do a covered call and protected put or be a level 4 trader who could sell naked options.

Long Strangle

A strangle is similar to a straddle, but in this case, the strike prices are different. In this case, you will buy a just barely out of the money call option, while simultaneously buying a slightly out of the money put option. The two options will have the same expiration date. The breakeven points for a strangle are going to be calculated in a similar way as the breakeven prices for a straddle, but you are going to use the individual strike prices for the call and put because they are different. So, you calculate the total premium paid, which is the total amount paid for the call option plus the premium paid for the put option. Then the breakeven points are given by the following formulas:

To the upside, the breakeven point is the strike price of the call + total premium paid.
On the downside, the breakeven point is the strike price of the put – total premium paid.

In a similar fashion as compared to a long straddle, the maximum loss is going to occur when the share price ends up in between the two strike prices. Therefore, you might want to choose strike prices that are relatively close, in order to minimize the range over which the loss can occur. Of course, there is a tradeoff here because the closer in range the strike prices are, the more expensive it is going to be in order to enter the position. But, it’s going to increase your probability of profit because if the strike prices are tight about the current share price, there is a higher probability that the share prices are going to exceed the call strike + premium paid, or decrease below the put strike price less the price paid to enter the contract the premium.