Glenn Stok writes about investment and risk-control strategies that he has perfected during 45 years trading stocks, options, and futures.
After 40 years of trading, I've learned that a lot of useless tricks professionals teach us don’t really work.
The professional's choices are no better than that of the rest of us. No matter what happens, what the charts show, what’s going on in the world, or what a stock traded at yesterday, it always has just a 50% chance of going up or down from where it is.
But your odds of success can be improved by using the method I explain in this article.
I found a better way than trying to predict the market is to make all my trades "neutral" by applying a mathematical method that puts the odds in your favor. Directional trading only has a 50% chance of success.
So what is neutral trading? How do you do it? I’ll explain it.
Sell "Premium" to Improve Success
Instead of buying or selling stocks, the method that puts the odds in your favor is to sell "premium." That is the value people place on fear and greed.
When other people think something is going to happen that will affect a stock or commodity price, they place a higher premium on it. They are willing to pay this premium in hopes that they are right.
Remember that any movement of a stock’s price always has a 50/50 chance of going up or down. Buyers of stock can’t be right more than 50% of the time.
This is where you come in. You sell into that fear or greed. The buyer is willing to pay a premium to indulge in their fear or greed. Fine. Sell it to them. I’ll explain how in a moment. It’s important that I set the stage so you’ll understand once I get into the method.
Let’s begin with a quick explanation of options, because that’s what you’ll use to sell “premium.” Then I’ll describe selling options short, which is also the key to selling “premium.”
A Quick Explanation of Options
There are two kinds of options: a PUT and a CALL. People who buy a PUT option on a stock are hoping it will go down. This option gives the buyer the right to sell the stock at the agreed price (called the strike price). Remember, you are not the buyer.
People who buy CALL options are hoping the underlying stock will go up. This option gives the buyer the right to buy the stock at the agreed strike price. Once again, you are not the buyer.
Since you are the seller, you received that payment (or premium) for the options. In case you’re wondering, you buy and sell options just like you buy and sell stocks.
When you sell an option, you are making a contract that obligates you to let the buyer put the stock to you or call the stock from you in the case that the stock price moved past the agreed strike price. That’s why they are called PUTs and CALLs.
Options are contracts to buy or sell a stock at a particular strike price and for a limited period. After that time, they expire.
At this point, you may be saying this is getting too complicated. It always sounds complicated at the beginning—until you get to know and understand the terminology. You made it this far, pat yourself on the back and hang in there. It’s going to get interesting.
Sell Options Short to Gain on Erosion
Okay, this is where you might say, “Forget it! This guy is leading me down a failing path. Options are dangerous!”
You are right. Most people lose when they buy options because the premium on options tends to erode as they get closer to expiration. However, I’m not talking about buying options. I’m talking about selling "premium." You do that by selling options, not by buying options. When you sell first, you are selling short.
Since options tend to lose value, that premium you sold erodes, and you keep the difference. That’s where the profit comes in. You can buy back your short option position at a lower price or let it expire and keep the entire premium received. If the underlying stock never crosses the option’s strike price, the option becomes worthless. Remember, that’s what you want.
Here’s an analogy:
Imagine you sell insurance. You sell someone car accident insurance for a term of six months. They pay you a premium for that, and as the six months go by, the value of that insurance contract goes down.
By the time the six months are up, and the driver never had an accident, the premium has eroded to zero. The insurance is worthless. The driver can’t come back to you and say, “I never had an accident, so I want my premium back.”
In the case of selling premium on stocks, you do it by selling options.
Neutral Trading by Selling Premium on Both Sides
Okay, so now you know the prerequisite to understand how to remain neutral with your trading strategy. This is where the non-directional position comes into existence.
You can sell premium on both sides at the same time—above the stock price and below it. You do that by selling PUT and CALL options at the same time. It’s called selling short.
Whenever you sell a stock, an option, or a commodity that you don’t own, it’s considered selling short. With a short sale, you are obligated to buy it back in the future.
In the case of options, you may not always have to buy them back—if they expire worthless.
No matter if the stock goes up or down, the premium on one side or the other will erode to zero. If the stock stays between the two extremes that you sold options on, then both sides erode to zero.
Even if the stock price moves past one side or the other, the erosion can work in your favor as long as it’s not an extreme move. Don’t let that frighten you. There is a way to manage that, as I’ll explain:
If you sell the premium far enough above and below the stock price, you reduce the chances of losing on the tested side (the side that’s going against you), and that means you can actually make money off both sides.
That’s what I mean by making a neutral trade. It won’t matter if the stock goes up or down.
The following image shows a bell-shaped curve representing this type of trade on a stock trading at $12.50. If you sell premium with a PUT option at $11.75 and a CALL option at $13.25 with a term of 40 days to expiration, the probability of making a profit (POP) is 68%. Technically, this is considered one standard deviation above and below the strike price, but that’s just a mathematical term, don’t let it scare you.
Selling Premium With a Strangle
The options trading method I used in the example is called a “Strangle.” It involves selling a CALL above stock’s strike price and selling a PUT below the strike price.
The nice thing about selling options short is that even when you are a little wrong, the premium can still erode because the option tends to lose value as it approaches expiration.
Professional options traders get to appreciate that. You can’t ever be a little wrong with stocks and still make money.
I’m not saying you can’t lose with this method, but the wider you make your strikes, the less chance there is for the stock to move that far in the time you give it. I usually sell options with a 40 to 50 day expiration period.
Take Small Profits More Often
You can increase your chance of a profit by taking a smaller gain. If you expand that range wider, to two standard deviations (which is $11 and $14 in this example), you can see in that bell curve that profit on both sides is smaller but still positive. The probability of profit (POP), however, is now 95%.
Those inner vertical dotted lines represent one standard deviation and show where the POP is 68%. The outer dotted lines indicate the range of two standard deviations. That gives you a 95% success rate.
The higher you choose for your POP, the less profit you make. That’s because the amount of profit is inversely proportional to the probability of success.
It’s all mathematical, but you don’t need to calculate these things yourself if you use a platform that does the work for you. I use Tastyworks. It’s a new platform from the originators of Think-or-Swim.
When you place a trade, you decide how far out you want to go. It’s less risky when you are not greedy. Keep that I mind. It took me years to learn that, and it helps tremendously. Who cares if you make less money as long as you can repeat the successful trades 95% of the time? Right?
Define Your Risk
In addition to deciding on the probability of profit, you can define your risk by setting up a trade in such a way as to limit the max loss in case things go horribly wrong.
Of course, there is always a risk, but using options the right way will allow you to define your risk by locking in how much you can lose in the worst case.
You can define your risk by buying cheap options (as insurance) farther out. That type of options trade is called an “Iron Condor” when you do it on both sides.
The difference between the strike price of the option you sell and the option you buy (called the spread) locks in the max loss. That is how you define your risk.
The following table shows the strategy for both trade types I discussed here. There are many more.
|Type of Trade||Method||Risk|
Sell PUT and CALL
Sell PUT and CALL, and buy protective PUT and CALL
Limited by spread
Manage Your Trades
You may recall I mentioned that short options could go to zero, and you never have to buy them back. They expire, and you keep the entire premium. However, I don’t recommend waiting for that to happen.
Even though the suggested time period for each of these trades is around a month, things can go wrong. The best and proven method is to buy back the options at half the price at which you sold them. That means you close the trade when you have a 50% profit.
There are several benefits to doing this:
- You free up your capital to use with another trade.
- You lock in your profit when you have it.
- You avoid losing the gain you have in case the market turns on you.
Another reason for closing a trade early (at 50% gain) is that your risk remains the same for the second half of the ride, but you only can get another 50%. That’s why it’s better to free up your capital that was at risk and use it for another trade.
Let me remind you that when you buy a stock, you are risking 100% of your capital for the entire time you hold that stock. In addition, at any point in time that stock has only a 50% chance of going in one direction—hopefully up.
When you sell option premium above and below the strike price of a stock, you increase your probability of profit, and you can even define how much risk you take.
I consider it worthwhile to get to know and understand these methods. Since you made it all the way through this article, you obviously have what it takes. The knowledge will come as you continue studying these methods. There are a lot of resources available to learn this.
Now you know a few tricks to do non-directional trading for a better probability of profit.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2017 Glenn Stok
Glenn Stok (author) from Long Island, NY on November 03, 2017:
Hi Sean McNally, Buying options during earnings season is a good way to lose money.
This is because you are paying a premium. Options are overpriced due to anticipated earnings.
That's why its better to be a seller during earnings season. But you also need to protect yourself by defining your risk with a spread trade. That locks you in to a maximum amount you can lose.
Yes, Please do keep me posted on your success.
Sean McNally on November 03, 2017:
Hi Glenn, I appreciate the easy-to-read options strategy. I've been trading paper options as the buyer and have not been successful (turmoil worsened during earnings season). I prefer this method. Yes, the returns are not as profitable but I can sleep better at night as the writer of an option than as a buyer (paradoxically). Excited to attempt trading options as the writer...
Will keep you posted!
Glenn Stok (author) from Long Island, NY on February 25, 2017:
Good for you Dora. Not many people know that they can make money from stocks without requiring being right with direction.
Dora Weithers from The Caribbean on February 23, 2017:
Thanks for the lesson. I think that I understand what it means to make a neutral trade, and it can only get better if I reread, which I probably will. I appreciate the explanations.