Options Traders View Things Differently

Option Traders Have a Different ViewWhile stock traders basically can only take a long or a short view on an underlying stock or ETF, options traders are given much more flexibility in the way they invest and assume risk.  Headlines can be motivators for many investors to buy, sell, or hold, and they can also create, change, and/or exacerbate sentiments and manias, both bullish and bearish, which can add to volatility in the marketplace and consequently the profit/loss profiles of many investors.

Stock traders, whether long or short, will have one-to-one exposure to each dollar change in the stock itself.  Because of this, stock traders may have to be more precise in their thesis and or timing of their trades.  Options traders certainly need to be correct as well, but with some strategies, options traders can be only “partially correct” and still achieve success. Let me explain.

Let’s assume you were bullish on Goldman Sachs GS as a stock trader, but you were a bit nervous about the sector, FINREG, and the company’s current legal situation.  Of course, one option is to buy the stock at $139.00, which gives you unlimited upside and $139.00 of downside risk.  For every dollar move in the stock, you will gain/lose $1.00 for every share you own. Therefore, if you decided to purchase 100 shares, you would gain/lose $100.00 for every dollar advance/decline in the stock.

If you were only moderately bullish and wanted to use options to reduce risk, you might explore a bull put spread strategy in July.  The following is not a buy, sell or hold recommendation, just an example of how vertical spreads behave.  Because of the lower delta of a vertical spread, the spread’s sensitivity to the underlying stock movement will typically be much less than the stock, meaning that your P&L will have less volatility.

Some traders use short put spreads to limit risk and increase probability of success in a trade.  These attributes come at a price, however, and that price is limited profit.  Out-of-the-money short vertical spreads typically have a higher probability of success because the stock doesn’t have to necessarily move higher for the trade to be profitable.  This is not the case with a long stock position.

Bullish Put Spread Example:

If you were to hypothetically sell the July 125/115 put spread for $2.05 (which means selling the 125 put and buying the 115 put), you are limiting your risk to the width of the strikes ($10),  minus the credit received ($2.05), which gives you a total downside risk in this example of $7.95.

The breakeven, or the point at which you will not make or lose money, on expiration, is $122.95.  This means that GS could hypothetically fall to that level and on expiration you would still break even in the trade.  Because of this characteristic, you have a statistical success advantage.  This doesn’t mean that if GS were to sell off you couldn’t lose money in the weeks or days before the options expire.

Another advantage of this trade is the fact that GS could actually drop as far as $125 by July expiration and you would still retain the $2.05 credit, which is a 25% return on your risk.   The disadvantage is that the $2.05 credit you receive is the maximum profit you can potentially make in the trade — not a penny more.  For some stock traders, this factor may be hard to deal with.  Greed, for many of us, is a tough emotion to control.

So if you are relatively bullish, content with a limited return potential, and want to increase your probability of success, you may want to examine the bull put spread strategy.

Bearish Call Spread Example:

If, however, you are bearish and want the same characteristics, an out-of-the-money bear call spread has similar characteristics.

A bearish example would be selling the July 155/165 call spread for $2.10, (which means selling the 155 call and buying the 165 call).  Here you are limiting your risk to the width of the strikes ($10) minus the credit received ($2.10), giving total UPSIDE risk in this example of $7.90.

The breakeven, or the point at which you will not make or lose money, at expiration, is $157.10.  This means that GS could hypothetically rise to that level and when the options expire, you would break even in the trade (excluding commissions).  Because of this characteristic, like the put spread example, you have a statistical success advantage because the stock can be trading anywhere from $157.10 down to zero and you can potentially profit.  This doesn’t mean that if GS were to rally you couldn’t lose money ahead of expiration.

Another advantage of this trade is the fact that GS could actually rally to $155 by July expiration and you would still retain the $2.10 credit, which is a 27% return on your risk.   The disadvantage is that the $2.10 credit you receive is the maximum you can potentially make in the trade.

By widening vertical spreads, you can increase your potential return (because the long strike will be cheaper), but you will increase your risk. By tightening your spreads, you will reduce your potential return, but lower your risk, generally speaking.  If you are selling wider spreads, you are most likely more confident in your thesis on direction.

Bullish or bearish, options traders have alternatives when it comes to investing.

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Related posts:

  1. Analyzing Alcoa (AA) Options Strategies Ahead of Earnings Reports: Bull Put Spread and a Short Iron Condor
  2. Looking at FedEx Options Strategies After an Upgrade
  3. Trading Options in a High-Volatility Environment

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