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  • Why Options Are Different Than Other Markets
  • How Options Are Priced
  • How You Can Make Money On Option Price Changes
  • My Favorite Trading Strategies
  • …And Much More!

5 Myths That Prove Option Selling Isn’t The Only Way To Make Money

Zeus was always short gamma.

Zeus was always short gamma.

I’m not a fan of dogma when it comes to trading.

My own trading style is a mix of income trades and swing trades, both option longs and option shorts.

And I’ve witnessed profitable traders in stocks, futures, forex, and bonds. And I’ve seen many other make money with every kind of option strategy under the sun.

I don’t have a problem if all you do is short options. You do what works for you.

I do have a problem if you think that only shorting options is the only way to make money and you make sure to tell everyone you know about it.

The US markets have been range bound for over 6 months, and some of you out there are getting cocky, so it’s time to take some of the air out of option selling strategies.

The Opex Myth

One of the most overused and probably made up statistics in the options world is the fact that nearly all options expire worthless.

Well, duh.

Think about the nature of the options market. Very rarely do investors use options for assignment, nor do they exercise contracts. It’s too margin intensive and it’s just easier to trade based off the value of the contract.

Think about it… let’s say you have a short option that’s in the money going into expiration.

What are you going to do? Take assignment and end up with a sizeable stock position going into the next week?

That’s no fun. It’s easier to either roll the contracts out in time, or just buy to close the option.

This happens on a massive scale as we head into opex. If an option trader has short options that are in the money, they’ll get closed or rolled.

That doesn’t mean every single option that was bought didn’t make money. If a trader sees enough movement, they will close or reduce risk in a long option position.

The Fat Premium Myth

Way too many traders get sucked into the idea that if the premiums are so high on options, it makes it an obvious sale.

And then it doesn’t matter what the overall market does because you have such a high premium and your odds are so high, that it’s a sure bet.

Right?

Back in late 2014, the oil markets were collapsing. Not just the commodity but also oil companies.

And because of this big selloff, investors were hedging through options. That helped to drive option premiums through the roof.

Many traders then started to sell that premium because, hey, the IVRank was at 100% so it’s a layup…

… except you forgot to think about the ACTUAL volatility in the market. As well as the trend, which was down.

So many got smoked on this specific short premium trade.

The “I’ll Make It Back Up With Theta” Myth

Here’s the thing… if we want to really dive down into the option greeks, you’ll see that market timing matters so much more than what the implied volatility is or how much theta you can expect to pull out of a trade.

Let’s consider a short put in AAPL right now:

This short put can be sold for around 2.15 and has a delta of 0.30. That means the odds priced into the market that this will be a profitable trade is right around 70%. We can figure that out by subtracting the delta from 1.

Assuming AAPL stays above the strike price of this short option, you look to collect $215 per contract. Not bad right?

Well think about this. The option delta is .30, which means for every $1 move in the stock, the option value will change $30.

That’s nearly a 14% swing in the value of the option. Just from a one point move.

And AAPL right now is swinging right around 2.25 points in a day, which means that this option can move around $65 per day.

What if you get two down days in a row? Then you’re sitting at a much worse spot.

This means that even if you do want to believe that the theta will catch up, it’s still a much better idea to have some form of market timing working for you instead of blindly selling options because you think the odds are in your favor.

The Option Odds Myth

Since we’re talking about odds, let’s talk about how just looking at the odds of success is a terrible idea.

Some traders call this “probability of profit.” Abbreviated as PoP.

It means if you look at a 50 delta option, it has about a 50% chance of expiring out of the money.

A 30 delta option will have a 30% chance, and so on.

There’s a few flaws in using this as your only source of trading information.

These probabilities are based off the current option values. The extrinsic value of an option drives the implied volatility, which does some fancy voodoo that gives us these PoP numbers.

The problem here is that the pricing assumes lognormal distribution. It assumes Brownian motion, which means that the change in stock price movement resembles a bell curve.

Any experience in the markets tells you otherwise. Stocks and markets trend much more than you think. The introduction of external catalysts drive levy flight, which is really, really hard to price in.

Option pricing ignores trends, and we can’t afford to do that.

The Random Walk Myth

Efficient markets require one thing to be true: infinite liquidity.

We don’t have that, so markets aren’t efficient.

On a long enough timeframe and in a super liquid market, behavior will approach full efficiency.

But on individual stocks that’s nowhere near the case.

This is important to understand because many option sellers out there think that since you can’t beat the market that you have no choice but to sell premium.

Except we just determined that selling one-sided premium can be a very aggressive directional trade. And that option pricing can be hilariously bad at predicting price movement.

It’s not that it’s impossible to time the market, it’s that it is really hard to do. And you just might not be good at it.

It can, however, be slightly easier to time individual stocks, especially those that just had catalysts. Post earnings announcement drift (PEAD) is one of the most well documented phenomenon in the markets and is exploitable using options.

What’s The Solution?

This doesn’t make option selling in and of itself a terrible idea. Many of the trades we take at IWO Premium are net short options.

But you can’t view it in a vacuum. You MUST take into account what the underlying stock is doing, and you gotta have another kind of risk management strategy other than “I’ll make it back when the premium gets sucked out.”

At IWO Premium, we run a combination of statistical trades and directional trades– they tend to complement each other very well and it leads my clients and me to be profitable option traders. Want to learn more? Go here.

The Trend Drought In US Stocks

rocksThe past 6 months for the S&P 500…

…I wouldn’t call it quiet…

…but the market has gone nowhere since November.

This is most likely a reaction to the Fed’s non-reaction, and how any new piece of economic data gets boiled down to a “will they or won’t they” projection onto what the Fed will do into rate hike decision.

But while the market hasn’t made movement, it sure has been spinning it’s wheels.

Below is a chart of the SPX with a trendiness indicator on the lower end.

trendiness

This reading shows us how much of the price action has been trend-based and how much has been range-based. It’s part of my Market Cycles approach to trading.

Generally, when this reading gets too low, it means the market has been rangebound for too long and stocks are due for a move.

And if this reading gets too high, it means the market has moved in one direction too quickly and is ready for reversion.

The “Trendiness” indicator is trend-agnostic, meaning it doesn’t indicate which way the market will break– it’s more suited for how much size option traders should put on in different strategies.

What’s extraordinary here is the amount of time we’ve spent in a non-trending environment.

Something is going to give here. There’s only so long that market participants can hold their breath before they exhale and start probing for new prices.

Here’s what this means for options traders:

1. Start looking for long vol positions 2-3 months out. Options are cheap in certain areas… if you’re playing to the long side of things consider buying call sinstead of stocks, and only sell volatility after you see a large move in a stock.

2. If you’re income trading, buy some upside hedges. By way of their structure, income trades tend to start net short. I’m not concerned about downside tail risk but upside so look for ways to either reduce size or hedge so you don’t get smoked on the long side.

3. Stress test your portfolio. We’ve had an amazing period of low-ish correlations so you could get away with taking exposure in a bunch of different assets. But if we start to see more fundamental catalysts, we could hop back on the Great Macro Conveyor belt and end up with the same kinds of risks across many different markets.

Remember: this is not some kind of massive bearish call– there could be “risk” on the upside as well if a macro catalyst presents itself. It’s been really easy to sell premium and I’ve demonstrated quantifiably that it won’t persist for much longer.

Playing Both Sides: Another Case Study in GOOGL

googl-both-sidesIf you just made a successful trade in a stock, that doesn’t mean you should take it off your watchlist.

Instead, you should look for new opportunities as you may have a good feel for how the stock trades.

After this amazing call in the breakout in GOOGL, I became more short biased and looked to fade the move.

And after the stock dipped, I went in and played the pullback in the stock.

Watch this case study on the move in GOOGL to see two different trades we took:

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Banking on Bull Call Spreads: A Case Study in GOOGL

HOW TO TRADE BASING PATTERNSDoing well in options trading isn’t just about picking the right stocks and hoping for the best.

It’s about understanding what option strategy is best given the current situation.

A few weeks ago, I became bullish on GOOGL as it failed to breakdown and had a good earnings reaction.

But instead of buying calls straight up, I got better risk-adjusted returns by trading bull call spreads.

Watch this case study on the move in GOOGL to see how I traded it:

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The Best Option Trading Strategy for New Traders

best option trading strategyIt’s gotta be overwhelming if you are just starting out.

The options market allows you to take different opinions on a stock…

… not just bullish or bearish, but how fast the stock will move and how long it will take.

So you crack open the closest option trading book out there and you see there’s about 25 different option trading strategies to choose from.

Where do you start?

Here’s the thing– there’s no single best strategy that works every single time.

But what you need to find is one strategy that works for you.

Especially if you’re brand new to options trading.

Through my work with hundreds of clients, I’ve discovered the best option trading strategy for new options traders.

Watch this video to see what it is:

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