Jeff,

I used to follow the advice of Investools and only trade ITM options. However, since following your blog and classes, I have switched my system to the following:

1) Trade OTM options (1 strike out) when the expected move is large, implied volatility is low and heading up, and i can buy 1 more month of time than i need

2) Trade ITM options when there is a smaller expected move or the OTM options are too expensive.

Not rocket science, but i noticed several things improve for me:

1) My positions were smaller, allowing me to take smaller losses quickly. Perhaps this is psychological, but this really helped me out. Plus, this also left me much more cash to trade with (not tying up more for the ITM options).

2) I could buy many more contracts, magnifying the moves I was getting. My profits were gigantic compared to the ones I received from ITM options.

I'm still working on the system, but I have found this to really work for me. I really appreciate your insights, Jeff, as you have been a fantastic trading mentor for me.

Jeff,

I trade extremely similar, if not identical, to this thought process (except, my lack of experience surely keeps my winnings far from identical to yours, lol).

One question I have, do you use the CBOE web page to take volatility into account? If the volatility chart for a stock shows that it is currently high (for that particular stock), will that play a part in whether you take a trade? This would mean you are paying more for time value. Sometimes, the OTM prices can be quite high if the Volatility Chart is high.

I don't use the Black-Scholes calculator, (perhaps I should start) but I will often look at the volatility chart on the CBOE web page for a particular stock prior to getting into an option trade. If I see that the volatility is high for that stock compared to past time periods, I concern myself with faster time decay as the volatility starts to come back down.

I hope this is written explicable enough...what are you thoughts on the volatility chart? Perhaps this would be better asked in Master Talk….

Keith

Jeff,

I have been checking your blog every day for the past several months and have received some great advice from you.

This post, to me, takes some of the great individual strategies you have mentioned and puts them into the big picture that I have been desperately trying to figure out for myself. It helps to see your strategy as I continue to develop my own trading style (which sometimes feels like banging my head against a wall). Thank you so much for this invaluable information.

Jeff,
I have not really worked out the breakout trade yet. but I trade the flag patterns. Based on the size of the moves I also trade 1 strike OTM (as long as the moves is past the strike price). I have seen good results so far but my stops/exits are still not very good. I put a 50% stop on the option as a rule but I like your idea of reducing the position size to compensate for the stop loss. I do have written stops but my big struggle is how to adjust them as the price moves in my direction like using trailing stops etc. I could use some help there.

But I do like and understand the reason behind you trading OTM.

Mahmood

Great article. I am new to trading options (6 months) and as I try to zero in on a trading style that works for me it is good to look at the details of someone who has found their niche. I have been trying to simulate your style as a trial with poor results. I have been trying to figure out what I am doing wrong and several questions present themselves. First, I have a day job and many times can only look at my positions after hours. If someone tied your hands and you could only look at your positions after hours how would this hurt your system, if at all? Perhaps it is a good thing to base decisions only on closing prices? I also have a small account and I am in only 5 or 6 positions at a time. I assume you cast a much larger net? I wonder if with a low probability system as I look at 10 different opportunities and don't jump on all 10 and just pick 2 or 3 at a time I am just grabbing the losers? Do you think your number of positions may influence you success? Diversification (or lack there of) may also be hurting me? I rode more than one gold miner down and now wonder about not jumping on multiple retailers at once? Also perhaps developing an individual style or system that works for you or me takes longer than 6 months. I don't want to become the "master of none"?
Thanks

Jeff,
BRAVO! Great post. Thank you so much for revisiting this with such clarity.
I too traded the Investools taught ITM options for quite some time and it was a struggle to get anywhere. I always cut my losses short, but that seemed to add up. I know that there's no free lunch with OTM options, but I see the logic now more clearly on when and why to use them. It's no coincidence, surely, that many options chains show a higher O.I. on the OTM strikes. It's just disappointing that Investools workshops seem to present that as being because those people are just stupid and want to be "out of money."
Coincidentally, I believe that Tim Knight trades with essentially the same approach as you with regard to strike and month selection. Of course, he goes bearish in any and all circumstances. From a hard core technician, I don't quite understand that.
Anyway, thanks so much for sharing your process and experience with us.
Matt

Jeff and other commenters: This, for me at least, is the best blog Jeff has posted, and the astute comments as well.

Thanks, Jeff.

---Doug---

Jeff, can you provide just a little more information? In the case of buying a call I presume I would want the Implied Volatility to be less than the historical. At the same time, what makes a preferred Implied Volatility threshold.

You rock!

Dan,

I would scroll down a bit further and read some of my posts on implied volatility. This ought to catch you up to speed on what to look for.

Thanks,

Jeff

Hi Jeff,

In reference to your blog 10-17-06 ... WDJD... I couldn't agree with you more. This agreement didn't come about by me not by wanting to pay less for my options or wanting to lose my money.

I run reward to risk ratios on ALL my trades. I also paper trade the strikes I don't play at times to see the difference in profits AND losses. I have found that I am a support/resistance (depending on trend) bounce swing trader. This is what fits my trading brain. This came about primarily because of the pre and post trade analysis I have been doing. I especially like to pick apart the trades I exited with less profit than I projected. (My only "bad trades" or "losers" are those where I didn't follow my rules). I found some interesting dynamics. One was the volatility play you referred to...Nothing like creeping into earnings volatiltity spikes. I also found that unles your trading 6 figures the dollar returns are not inviting selling calls and puts.

One thing I realized after attending the 4 day in SLC was that the key to this game was to control my risk. I was picking position size buy the dollar amount of each trade and not the amount of risk in the trade. This led to some healthy corrections to my account. It also led my to playing OTM options....Delta at the entry was the key that opened a very profitable door for me. (I also have to extend credit and a thanks to Wayne Montiereth for helping me iron this trading truth out).

Since I am all about controlling risk and my entry point and stop are always at the same point on the chart regardles of the strike I buy the delta will play a major role in the amount of risk in the trade. Round # example...
Stock price $67
Support at $66.20
Stop at 65.85
Stock risk =$1.15 +spread in & out
NOV 65 call $3.60 delta 0.70
NOV 70 call $0.85 delta 0.30
(I used HOG for prices)
Lets say your max loss per trade is $500.
Option risk...
65's = 1.15 x 0.70 = 0.80
= 6 contracts w/$500 risk
70's = 1.15 x 0.30 = 0.35
= 14 contracts w/$500 risk
Quiz for duck...
1. which trade carried more risk?
2. Which trade have a better RRR?

Lets say your stopped out on this trade by an insane unforseeable price swing intraday (again I refer to HOG). your in the same financial boat.

Lets say it moves to your $72 target and you exit...not in the same financial boat anymore because those 14 contracts walked all over the 6 in profitability.

65's gain 4.30x600=$2580 (119%)
70's gain 2.75x1400=$3850(323%)

Same risk...greater reward...am I missing something?

What's the debate?


Craig Goodmanson

How did you derive at the 1.15 risk? taking the risk x's the delta give you number you need to figure out how many contracts you can purchase? I don't see how you ended up at 2.75 as your gain. If the option was worth 85 and the delta was .30 meaning 30 cents on the dollar your option with the $2 move would be worth 1.45. It is probably my fuzzy math, an explanation would help.
2.75 x 1400 how did you calculate these numbers? Have a good one.

now I stay tuned!

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Jeff's article to the addiction to the options is really promoting the
Options Trading. He tells us the optimal use of the options trading. The cheap investments are to be made to get the security.

am glad you organized your site so we know how to look on your past articles. Thanks Jeff for doing that because I knew only part of your trading style from 3 DL class,but definitely you did a great explanation here so now I have the complete picture. Will review your other articles specially the one on Implied volatility.

This comment has been removed by the author.

This post is certainly a good read. I've learned so many things about stock trading and options.

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