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Effective Stock Option Trading with Think-or-Swim

Updated on November 8, 2015
Glenn Stok profile image

With 40 years experience trading stocks, options and futures, Glenn Stok writes about strategies and controlling risk that he has perfected.

Stocks are risky. But risk can be controlled with options.
Stocks are risky. But risk can be controlled with options. | Source

Introduction

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.

Options can be used to make money with much less risk than buying stocks, when used correctly.
Options can be used to make money with much less risk than buying stocks, when used correctly. | Source

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.

When you're on the other side of the trade, the odds are in your favor.
When you're on the other side of the trade, the odds are in your favor. | Source

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…

  1. 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.

  2. 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.



Defining Risk


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:

  1. You need to look for a stock that has options trading with an Implied Volatility Percentile higher than the average for that stock.

  2. 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).

  3. 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).

  4. 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.

  5. 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?)



If you can’t enter a trade with all the correct parameters, just wait for another opportunity for your trading portfolio.
If you can’t enter a trade with all the correct parameters, just wait for another opportunity for your trading portfolio. | Source

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.


 Taking profits when you have only a 50% gain can improve overall success.
Taking profits when you have only a 50% gain can improve overall success. | Source

Managing Profits


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.


Conclusion


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

Comments

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    • TheDigitalOption profile image

      Justin Delano 3 years ago from Everett

      A very solid introduction to the subject. It can be a bit overwhelming at first, I know it was for me years ago. Cheers!

    • profile image

      Old Poolman 21 months ago

      I'm a little late to this party but thought I would comment anyway. As a new options trader I thought this was a great hub. I also use Tasty Trade and TOS and find them valuable tools. I think I am actually am beginning to understand what I am doing and have actually made a little profit selling premium.

      Thanks for sharing your knowledge.

    • Glenn Stok profile image
      Author

      Glenn Stok 21 months ago from Long Island, NY

      Old Poolman - Congratulations on your use of Tasty Trade methods. Another thing you can do when you sell premium is to enter your trade two standard deviations away. That raises your probability of profit to 95%. That's what "Karen the super trader" says she does. Catch her interviews on Tasty Trade.

    • profile image

      Old Poolman 21 months ago

      Glenn - I pick really good trades with a high POP on Tasty Trade, then go to TOS and find out there is no open interest at those strikes. It would be great if Dough could show open interest but using TOS works OK for me. No matter how great the trade looks, it isn't a good trade if nobody is buying or selling is it?

      I have a lot of learning to do and sometimes the light comes on in my head only to go out again later that day. I have won a few and lost a few, but so far I am about even.

      My biggest problem is finding something to trade where the strikes are not too far apart and the POP is good.

      Right now I am sticking to selling credit spreads but will try some other strategies in the near future. I need more knowledge on how to best exit a bad trade before I get too wild.

      I wish I had your knowledge and experience.

    • Glenn Stok profile image
      Author

      Glenn Stok 21 months ago from Long Island, NY

      Old Poolman - You're right. If there is no volume in it then the bid/ask spreads are too wide and it's best to stay away from those.

      As for the looses, examine how you entered the losing trade. When I do that I see what I did wrong and I avoid repeating the same mistake. The best method is entering trades two standard deviations away. When I'm greedy and sell within one standard deviation just to make more money, I get burnt sometimes. But even in those cases I buy more time by rolling forward. I learned that from Tasty Trade. Eventually you get your money back even when you're wrong. You must need to stay small (as Tom keeps saying) so you can stay in the game until the trade comes to you.

      As for finding trades where the strikes are not too far apart, stick with only high volume stocks or futures. TOS is great for showing us the volume. I also look at the delta on TOS to know the probability of profit. A Delta of 5 is a 95% chance of success. I never sell premium on anything less than a delta of 10, which is still a 90% change of POP.

      As for exiting bad trades, consider rolling forward at break-even or a small credit. You could be right and just have the timing wrong. So buying more time gives you a second chance. And usually you can roll at a credit because there is more premium another month out. So there is no cost in buying more time. You're just holding your risk for another month.

      Knowledge and experience comes with time. I was trading most of my adult life. But it sounds to me that you are very knowledgeable since you can articulate your concerns very well. You know what you're doing and you know what you're saying. Do you know how many people I talk to who don't even understand that we can sell what we don't own? The have no clue about selling premium.

    • profile image

      Old Poolman 21 months ago

      Fortunately I keep my trades small enough not to get hurt too bad while I'm learning. I finally got my first Iron Condor filled today, but had to break it into two separate trades to get it filled but I read where that is OK.

      I use the Dough Trading Platform and that makes it easier to find good possibilities. Also it saves on commissions to enter trades through their platform. Not sure why this is but I'll take any discounts I can get.

      I try to shoot for a delta between 16 and 25 for selling premium. I never thought about rolling the losers for a credit, thanks for the advice.

      I'll keep in touch and let you know how I am doing.

    • Glenn Stok profile image
      Author

      Glenn Stok 21 months ago from Long Island, NY

      Old Poolman - you mentioned you shoot for a delta of 16 to 25. Keep in mind that even though that gives you more profit that a delta between 5 and 10, the probability of profit is only between 75% to 84%. That's real good, but after a year of using tasty trade methods, and learning from Karen when Tom interviews her, I decided to enter trades between delta 5 and 10. There definitely is a lot to learn. I'm still learning new things as I go along. It never ends.

    • profile image

      Old Poolman 21 months ago

      I think I got that 16 to 25 delta from another one of the Tasty Trades videos. I will sure start looking in the 5 to 10 range starting tomorrow. I use TOS to show me the open interest at the different deltas and another video said don't trade if OI is less than 500. I have been sort of following that advice but am open to most any suggestions.

      Perhaps I am once again confused about just collecting premium and actually trying to make money with the option.

      I find it interesting that people are actually willing to buy that option that is so far out of the money, but they do. I have looked at charts and could see that a stock has never traded that high as far back as the chart goes, but someone will buy an option at that strike price. No wonder some lose large sums of money trading options. You just can't make a stock head for the moon just because you bought that call option.

      I was dubious at first, but now I see how one can make money with options if the market goes up, down, or sideways. That doesn't apply to stocks and I doubt I will ever buy stock again.

    • Glenn Stok profile image
      Author

      Glenn Stok 21 months ago from Long Island, NY

      Old Poolman - Yes you did get it from Tom's videos. He taught his daughter Case that method. It's still better odds as I mentioned earlier. But you need to watch Tom's interview of Karen the super trader. I'm only doing trades now as she taught, and I only had one losing trade this year. I only lost what I made in the prior week. That means I was only set back one week.

    • profile image

      Old Poolman 21 months ago

      Glenn - Thanks and I will watch that today. That is an awesome trading record by the way.

      Just wondering if you happen to know any other Tasty Traders where we could get a little private round table discussion going? Learning from others mistakes is a good way to improve your own skills.

    • Glenn Stok profile image
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      Glenn Stok 21 months ago from Long Island, NY

      Old Poolman - Since you like to trade spreads and Iron Condors, you should also watch Liz & Jny. If you have an iPhone or iPad, you can find local Tasty Traders with the "Where's Bob" app. It's their social media app to find others in your area.

    • profile image

      Old Poolman 21 months ago

      I found the app, that is awesome.

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