After two and a half years of trying to be a penny stock trader, an intra-day trader (without the benefit of having either all day to trade, nor enough capital to get past the pattern day-trader limit), a trend follower, a bio-med short seller, and an options trader (without knowing anything about options), I have finally found a trading strategy that works for me.
I am now primarily an options seller. I came across this strategy when I decided to educate myself on options after blowing up my account trading like an Old West bank robber with a bundle of dynamite. Fortunately for me, one of the first videos I came across was by Kirk Du Plessis of Option Alpha.
(If you have any interest in the world of options trading, I cannot recommend Kirk’s website and videos highly enough. Everything I do with options trading basically comes from what I learned through his videos, podcast, and website.)
I quickly learned all of the reasons why almost none of my previous options trades had worked out. I was using options all wrong.
What Are Options?
Here is my quick and dirty rundown on stock options:
A stock option is a contract a trader can buy or sell. A single contract gives the owner of it the ‘option’ to buy or sell 100 shares of a company’s stock at the time the option expires. Options were invented as a way to hedge and protect currently held positions, as such buying an option is way cheaper than buying the actual shares of a company. This cheaper price also allows for option trader to control a greater portion of shares for much less capital.
The tricky thing with options is that they expire. As soon as you buy an options contract, you are on a timer. Every day the contract loses a little more value. It can also gain value if the underlying stock moves in the right direction relative to your position, but all other things staying equal, an options contract will steadily lose value.
I could go on and on, and many people have. People write books on this topic. If you would like to dive deeper into what an options contract is, check out this great video by the aforementioned Kirk Du Plessis.
Remember what I said about options losing value? Well, that is the key to my trading strategy. As an options seller, I will be taking on a larger portion of risk to make a statistically more likely profit. Think about it like a casino. They have the statistical edge on all of their games. That means over time, given enough instances of a gambler making a bet, the casino will always come out ahead. I do the same thing.
Right now I only sell risk-defined positions. For example, if company DIVBRO is trading at $50 dollars a share I can sell a contract for the $53 strike price and buy a contract for the $54 strike price. This is called a credit spread. Let’s say I receive $35 credit from selling the $53 contract, and I’m debited $10 for the $54 contract. I receive the difference of those two contracts, and my maximum risk is the spread between the two contracts minus that credit.
I understand this can take some time to wrap your head around. In the example above, I will have made $25 and risked $75. If that doesn’t sound like a good risk/reward ratio to you, you are not wrong. But here is the key to this strategy: if you do this correctly you can define your statistical likelihood of being correct and keeping that $25 credit. You wouldn’t make this trade if it only had a 20% chance of working would you? What about if it had an 75 or 80% chance of succeeding?
Another piece of this strategy that boosts the statistics in my favor is taking advantage of the difference between Implied Volatility (IV) and Historical Volatility. Again, many people have written and made videos on this topic as well, but here is my quick summary:
IV is the prediction of how much the price of a stock will move in a given period of time. Historical Volatility is how much the stock actually moved in that timeframe. Generally (although not always), IV is overstated and the price does not move as much as expected. The things is, IV has a huge effect on the price of options contracts. All else being equal, an increase in IV will make an option’s price go way up.
So the second factor I consider when I sell options is what is the IV of this contact? If it is very low, I might reconsider. If it is very high, I have an increased statistical likelihood of making a profit. Because if I sell an option when the IV is high, even if nothing else changes, as soon as the IV goes down my position becomes profitable.
Of course, my trading strategy isn’t foolproof. The 20% of the time it goes against me, my losses are going to be bigger than my wins. That’s where risk management comes in. Just like a casino, I’m not looking to make big winning bets. I want to do this again and again with the smallest amount of capital I can so that the statistics have time to play out in my favor.
My risk management strategy breaks down like this:
- Never risk more than 5% of my total capital in one position.
- Never have more than 50% of my capital in trades.
- Spread my trades over uncorrelated positions.
- Keep my portfolio as market neutral as possible.
- Only sell options on ETF’s.
Track My Progress
I’ll be making weekly updates on my progress over on my Trading Journal page. Follow along and see if what I’m doing actually works!
If you are interested in beginning your own journey into the fascinating world of the stock market, use my referral link below to sign up with Robinhood. If you do we will both receive 1 free share of a company’s stock!