Effective Stock Option Trading with Think-or-Swim
This article is for those who have at least some experience with options and willing to learn something new.
After more then 30 years trading stocks and options, I found the most dependable method of managing trades with the "Think or Swim" platform.
This trading tool shows all the important market information that helps increase the odds by determining successful trades. But a full understanding of the information is necessary to put it to use with proper trading methods.
I learned these methods from the TastyTrade Network. I don’t claim to be an expert, but thanks to TastyTrade, I have a clear understanding of the rules.
To mention a few: Selling when Implied Volatility Percentile is high, buying when IV Percentile is low, defining risk, and managing winners mechanically. There are many other important formulas that make options trading a better than 50/50 scenario.
If these terms sound foreign to you, consider the fact that many options traders don’t understand them either. This is why most people find options dangerous and risky. This is really not the case when used correctly.
Effective Methods of Trading Options
When buying stocks, there is always a 50/50 change of success. A stock can only go up or down. With only two possible results, it’s a 50% chance of success.
Stock options, on the other hand, provide the opportunity to improve the odds since there is more than one way to have a profitable trade. With the proper strategy, you can be wrong with the direction and still make money.
Uneducated traders think that options are dangerous and that one can lose all their money. They say options lose value quickly and expire worthless.
All this is true, but that’s the beauty of it. Allow me to explain:
If one knows how options work, they can be used to make money with much less risk than buying stocks.
A complete understanding of what I’m about to discuss, requires knowledge of the terms I’ll be using. If you don’t know what option premium erosion is, or option Greeks, or implied volatility -- don’t feel helpless. Many options traders don’t fully understand these things either.
I hope that will not deter you from simply using your intelligence to make the best of the rest of this article. Just ignore anything you don’t understand. You will see that you will still grasp the crux of what I’m saying. I assure you. I know you can.
The Process of Selling Option Premium
The idea is to sell worthless options to people who are willing to pay a premium for them. When the trade is adjusted properly as I’ll explain later, it leaves a 68% change of expiring with a profit.
Remember, buying stocks has only a 50/50 chance of a profit. In addition, when you buy a stock you are risking all your money. But selling option premium can be achieved with defined risk.
Risk is defined by buying an option further out of the money for much less than the premium received.
An analogy will make this clear:
You sell an option to someone who wants to buy it for one of two reasons…
- They think it will move in their direction by a certain amount within a certain time. This is pure gambling. But you are on the other side of the trade and it’s always in favor of the house. And YOU are the house.
- They buy a PUT option as insurance against losing on a long stock. Or they buy a CALL as insurance to be able to buy a stock at a particular price.
Either way, you are selling insurance. And you keep the premium if things don’t go their way.
Note that I am not talking about buying options. Options lose value over time. Buying options in hopes of picking the correct direction is a loser’s game.
What I am talking about is selling premium, not just selling options. That’s another mistake uneducated options traders make. They sell options thinking that they get to keep all the money when the option expires worthless. This works until the day comes that you bet wrong and get a margin call from your broker.
However, selling with defined risk allows you to stay in the game even when you are wrong. You can never get a margin call because you have defined how much you risk when you enter the trade. It can’t ever get worse, no matter how wrong you are.
So, staying in the game offers a great opportunity. When you are wrong, you can roll a losing trade forward another month, sometimes with a credit. That credit reduces your cost-basis.
The Rules of Success with Options
When a trade is set up right, 68% of the trades will be profitable. This is done with strict entry parameters:
- You need to look for a stock that has options trading with an Implied Volatility Percentile higher than the average for that stock.
- Options to consider should be expiring in roughly 20 to 50 days. This is the best period to realize profit from theta decay. (Theta is one of the option Greeks that help so much with doing things right).
- You need to sell an option more than one standard deviation away from the present stock price. This will have a Delta of 20 or less. (Delta is another of the option Greeks. The Think or Swim Platform makes this easy).
- You need to define your risk by buying insurance. How? Simply by buying a similar option further out of the money. This is known as a spread trade. It reduces the premium you receive, but it sets (or defines) a maximum risk.
- You need to take a credit of at least 1/3 the spread. Remember that you’re selling, not buying. So you get a credit for the trade. Example: If the spread is $10 between the option you sell and the option you purchase for insurance, then you want a credit of $3.33. That’s 1/3 the spread. So you risk $10 to make $3.33. But after commissions, let’s make it an even $3. So if you want to make $300 profit, you risk $1000. (When can you make $300 on a $1000 stock investment in one month?)
The Most Important Rule
If you can’t enter a trade with all the parameters I just mentioned, move on.
There are many people who try to squeeze out a bad trade out of greed. Or they simply don’t pay attention to all the rules. Then when they lose, they bad-mouth TastyTrade. These are the people who will misguide you. Don’t learn from them.
There will always be another opportunity for a trade that works. The beauty of Think or Swim is that it shows you all the parameters needed to know if it’s a good trade or not.
When you stick to making good trades you will be in the 68% category. Sure, you will lose the other 32% of the time. But I like those odds.
There is one other rule of thumb that has been proven to increase profits beyond the 68%/32% success ratio.
Rather than waiting for a trade to expire so that you keep 100% of the premium received, take profits when you have a 50% gain or greater.
If you wait for a home run, it can turn against you due to volatility. Someone once said, “I never lost money by closing a trade too soon.”
In addition, closing a trade early frees up the risk so that you can enter another trade when you find a good opportunity.
There are many options plays that can be performed, such as Iron Condors, Calendar Spreads, Butterflies, Straddles, and Strangles. I only showed you an example with a Spread. But even that has different methods (Put Spread vs. Call Spread) that I left out since my focus here was on the rules of success rather than the types of strategies.
Strategies can be learned from many sources. But I find that the rules of success are best learned from the TastyTrade Network.
If you like how I explain things, see "More in this Series" below.
Video: Robyn's evolution as a TastyTrader
© 2013 Glenn Stok