If you have been following this blog for a while, then you probably have a good taste for how I trade. I trade quickly and I trade aggressively. Do you really want my secret reciepe? I trade low probability trades on high probability set-up's that have high reward potential. Did everyone get that? In English, I trade cheap options on potentially big price moves. Does that sound better?

I love the debate about option buying versus option selling. I love the argument! Do you trade high probabilities of success in exchange for small rewards, or do you trade low probabilities of success in exchange for large rewards? Every person answers that question differently for their own reasons. Me...Personally I love to gamble with winners for hopes of landing "the big fish." You will never do this in a selling based strategy, since the only gains you collect are small premiums up front where you stand a higher probability of collecting that premium. Not to mention a very small probability of taking the mother of all losses.

Option traders will mostly tell you that options are meant to be sold. This statement is partially true, if you think about it. This is said only due to the fact that premium melts. The only way to overcome this is to have directional price movement make up for the loss of time decay. Most professional traders have concluded that picking market direction is impossible and irrational. Would you agree with them?

A student of technical analysis who use simple price charts to illustrate how prices move in trends would disagree. I think speculation is possible, but not always probable. Big difference. When I mentioned I like to trade high probability set-up's, or potentially big price moves, this means I like to trade breakouts. Stocks that are reaching new highs, or breaking out of patterns into new territory equipped with volume, is a high probability event in my eyes. I still trade trends, but not as aggressively. I don't consider a support bounce as high of a probability as I do a breakout.

Trading breakouts has evolved the way I trade options. Because I trade higher probability events, I justify buying options with a lower probability of success. That's what I said...I trade out-the-money options! *But Jeff...I heard if you trade OTM options, eventually you'll be out-of-money!!! LOL!!!* Since an OTM option requires price movement to be successful, if you are not careful you could lose all your money. This is why I normally go one strike out, and give myself between 15-45 days of time to be successful. (Most breakouts I trade, I am only in for a couple weeks on average.)

Think of it this way, when I trade a breakout I am expecting this OTM option to become ATM or ITM. I am also expecting this to happen very quickly. Let me refer to the Black Scholes calculator to give a general example of a typical scenario you might see as I trade this way.

Let's say that ABC stock is trading for $52 per share. I am expecting a $4 move on this stock to take place over two-three weeks. Let's assume I buy an option one strike out that has 40 days until it expires, and volatility is at an average level of 30%. Here is what the price of the option would look like.

I am paying $1.05 for the call. Since this option has no inherent value, the price will fluctuate quite a bit. This is why I can't use a stop here. I would trigger a loss almost every time I trade. I use a mental stop based on the stock, but I position this trade so that I expect to lose 100% of the premium. However, if 100% is lost, I only lose 1% of my account...this means I need to be wrong 100 times in a row to wipe myself out. Possible?

I must admit, I am wrong a lot. Last year I would quote being right only 35-40% of the time I traded. It was a tougher market, but this win/loss percent is nothing to brag about, right? What if I told you I returned 285% last year. Would you still think I was a bad trader?

Back to my example. Let's say I get this price movement I was expecting. Only a $4 move in about 20 days let's say. Is this possible? This is easy! I'm not expecting too much, just a nice breakout. Changing my new stock price to $56, and subtracting half the time, take a look at the return.
This is just an "average" example of a win. I don't always win, and the losses can be a good portion of the premium paid. On average 40-60% of the premium paid. But there are also big winners to add to this equation. Someone e-mailed me a quote a while back that I think would fit nicely here.
"In any given trade there are five possible outcomes."
A Huge Loss
A Loss
Breakeven
A Gain
A Huge Gain

I do my best to try and eliminate huge losses through money management, position sizing, and strike rules of exit. By eliminating the huge losses, I am now left with four potential outcomes. The odds of making money are now more in my favor by subtracting this outcome.

Since we have also talked about trading volatility as it rises, here is a look at how that profit would change if we added a slight increase in volatility.

In review of what I have discussed with you, hopefully this justifies my irrational, aggressive approach to trading options. I trade OTM options on breakouts. I buy a month or two of time, and exit after I have reached my price target. I take losses as small as I can, but size my position around the assumption that 100% of the premium is on the line.

I write this because there are still piles of e-mails asking how I trade, or if I would sell my trading rules, or why I take this approach. Hopefully I have shed some light and examples of what my thought process is. I will monitor the "comments" left about this post to see what you felt I left out of this equation.

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 -

Great Post!

Through listening to your Master Talk sessions, Price Pattern Sessions and reading the blog, my trading has been shifting to OTM options. I am tending to exclusively play price breakouts. I understand why we need to first learn the ITM method but OTM options for 1% of portfolio is allowing me to get great returns and at the same time get out (when needed!) with minimal loss. This is the post that pulled it all together!

Thanks,

Lina

Jeff,

Absolutely the BEST post you have ever done!!! This is NOT to take away from all the other wonderful posts BUT this is IT!!! You have opened your world to us - your loyal fans!!! You have confirmed what I have been doing for a couple of months now as I have been trying to fine tune my particular style. While I have realized some minor losses - I have also HAD some terrific GAINS!!! Thank you for your tremendous efforts to train us and to challenge us.

Randy

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

Craig,

I enjoyed reading your informative post. I am interested in learning how do you determine the correct Delta to enter at? Do you have a set amount/range for the Delta or is it directly tied to the individual Option? How do you determine your entry/exit point? You say that it is always the same regardless of the strike price. I am having pretty good results in my method but would like to tighten my method to maintain better RRR.

Thanks,

Randy

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.

I 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.

Alessandra

now I stay tuned!

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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.

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...I'M AN OPTION ADDICT...I'M AN OPTION ADDICT...I'M AN OPTION ADDICT... ...I'M AN OPTION ADDICT...I'M AN OPTION ADDICT...I'M AN OPTION ADDICT...

About me

  • I'm Option Addict
  • From Saratoga Springs, Utah, United States
  • I am a professional trader and an instructor for Investools. I've had relations with the markets for 9 years. Born in Concord, CA, but reside in Saratoga Springs, Utah. Father of THREE, Husband of one.
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