1. Defined risk
2. Positive time decay
3. Favorable odds
Let’s break each one down.
AS A KID, DID YOU EVER DREAM
Short answer: No.
Longer answer: Absolutely no.
1. Defined Risk
This means no matter what the stock or index does,
whether it goes up big, down big, or nowhere at all,
your maximum potential loss is known before you even
do the trade. For example, a short call vertical has
defined risk. A short naked call does not. With the
short vertical, the max loss is the difference between
the strike prices minus the credit received. That’s it.
With a naked short call, you don’t really know what
your maximum loss might be. Even if you think you’ll
use a stop order to buy the short call back if the loss
gets too great, what if the stock gaps up overnight,
when you can’t trade? Stick with defined-risk trades.
What those stories haven’t told you is that the recent
sharp swings in volatility have forced many who
develop computerized trading to rethink their strategies. The short-term, back-and-forth price movements
that computerized trading is supposed to capture have
been more uni-directional, and have left some traders
with large losing positions.
Okay then, you ask, if not high-frequency, computerized trading, then what? You need a strategy-based
approach to trading, so that regardless of the stock or
index, regardless of the market environment, you have
an approach to finding and executing trades that makes
sense. In other words, a system. This means you need
to create a set of rules that you follow for getting in and
out of trades every time, rather than simply shooting
from the hip. Your system may not always turn out as
you expected, or always make money, but you’ll have a
plan for placing trades. You may not get your picture in
the financial news, but maybe you’ll pay your bills and
still have time to be a normal person.
2. Positive Time Decay
Besides death and taxes, the only other thing you can
count on is time passing. And if it doesn’t, we’ve all got
bigger problems. Because of that inevitability, you want
time passing on your side. That means you want your
positions to have positive time decay, so that all other
things being equal, one day passing means your position is worth a little bit more. Positive time decay generally comes from having a short option somewhere in
the position. It doesn’t have to be a naked short (see
criterion #1), but as part of a spread like a short vertical, long calendar, or short iron condor, a short option
will put time on your side.
3. Favorable odds
No matter how much research you do, the probability
of a stock or index moving up or down is 50%. But
you don’t want your trading to depend on the flip of a
coin. The way to tip the odds in your favor is with
smarter strategy selection. That begins by searching
the option chain for a shorter-term expiration and a
high probability of expiring worthless. This will let
you create spreads that depend less on being right on
direction and more on premium decay.
BUILD A 1- 2-3 SYSTEM
So, how do you do it? Well, for starters, if you already
have the thinkorswim platform loaded on your lap-
top, you have tools
at your disposal
that are designed to
offer more than
what most of the
Wall Street nerds
And you’re going to
use those tools to
find trades that
meet the following
OKAY, NOW WHAT?
FIGURE 1: In thinkorswim, view the probability of an option
(ITM). Here, a call with
a 34% probability of
expiring ITM is the
same as saying it has
a 66% probability of