“Options for Playing a Sell Off”

Several days ago there was a post made on Minyanville.com for playing a possible sell-off. There were three strategies discussed: puts, ratio back spreads, and long verticals. I don’t know much about the “Option Smith” other than the last article a I reviewed from him that was completely incoherent. However, this does a good job at providing some considerations for how to approach these trades. Below I want to provide some considerations for choosing the “best” trade for a given circumstance.

http://news.moneycentral.msn.com/ticker/article.aspx?Feed=MY&Date=20100408&ID=11385181&Symbol=IBM

1. Does the strategy fit your profile as a trader?

Ultimately you need to trade within yourself. A lot of new traders want to know what strategies “work” rather than which strategies work for them. If a trader primarily likes the high probability aspect of option trading, but decides to take a big bet by buying single options, they will likely make mistakes. I see it all of the time. They buy call or puts and tweak their system in order to be right a lot. The net result is to take limited profits, but allowing for large losses. The result is a system that has a lopsided risk/reward. It will work for a while as the market is directional, but things quickly turn and they give back their gains and then some–fast. I’m sure that there are many in this position right now, but don’t really know it–yet. Know yourself, and whether you like the idea of higher probability or speculation. Whether you have time to be active or comfortable making adjustments. Identify strategies that match your profile based on your interests in trading. I think you’ll find more success in the end.

2. Trade your Outlook.

This article does a good job at characterizing long options. If you approach long call and put options from the point of view that you’ll be wrong more often than you’re right, you put yourself in a frame of mind to make these trades work. Unfortunately too many traders think that if they use technical analysis that they will be able to turn the odds in their favor. I believe that this partly true, but  not in the way people think. Technical analysis is key in your ability to determine direction, targets and timeframe–all of which are critical to success. This provides an edge, but that does not mean that the odds will be turned on its face and you’ll be right a lot.

Having an awareness of the low probability of making money will naturally lead you to wanting a better risk/reward situation when buying options. Whether or not you need a 2-1 or 3-1 depends on a lot of factors, but one things is certain, you need to expect to make more than you plan to risk. The number he threw out was 15% for IBM, but realize that because of the differing volatility levels of stocks the opti0ns themselves are priced differently. In the end, run the numbers.

Tying this back to trading your outlook, larger projected moves and higher R/R would naturally favor the long put trade theoretically. If you’re expecting the market to drop, but want to provide some opportunity for gain if the trade goes against you significantly do the ratio back spread for a credit. If you want to make a purely directional play with a small amount of risk you’ll want to do the vertical.

Putting it together

In theory you can determine your target, timeframe, expectations for future implied, etc. However, balance that with what you trade best and execute consistently. You may see great opportunity based on your analysis, but if you haven’t tested or have a detailed plan for trading a strategy, consider doing something different. For example, if you prefer high probability approaches such as selling vertical spreads and find a theoretically opportune time to buy a put without having traded one previously–trade the vertical. If you see an opportunity to do a ratio back spread and typically lack patience due to your speculative nature, trade the put if it makes sense.

Although I make these points about balancing the idea of trading within yourself and matching the strategy with your outlook, that’s not to say you cant work on making other strategies your own as well. If you “own” a strategy you’ll make sure that both of these points are in place, which puts you in the best position to be successful.