Today we are going to look at how to make your trades fly by adding wings. Not only will this technique reduce your capital requirement, but it will also help your win rate and average P&L.
You have noticed on your path to learning to trade options that much of trading involves the act of balancing the use of your capital and your desire to earn a decent reward for the risk you need to take.
In a recent post we discussed how to set up a low-risk options trade. And in that post, we showed how your profit target and risk and reward go hand in hand.
Using wings is an integral part of accomplishing that goal.
What are wings?
Wings are simply a time-tested method you can use to alter the risk dynamic of a trade by adding protection. You can change an undefined risk strategy into a defined risk trade by adding long wings.
For new traders with smaller accounts selling undefined risk naked short options may be more than your account can handle. Remember a short put has unlimited risk to the downside and, a naked call subjects you to unlimited risk to the upside. If the underlying asset you trade makes a significant move in the wrong direction, the losses you may incur could be significant, and take a serious bite out your account value
How to use Wings
Let’s say you want to trade the S&P 500 Index (SPY) but you don’t feel comfortable putting in the capital required to sell a short put. By adding a wing, you define the risk and turn the undefined short put into a defined risk spread. The wing that you use will affect the other metrics in varying ways.
The undefined risk has greater profit potential, but with corresponding risk. Adding the wings significantly lowers your buying power requirement and offers the additional benefit of a defined risk trade.
Improve your return on capital
Compared to a naked short put, adding various width wings can improve your return on capital and win rate. The farther away the wing is placed, the less protection is available to you. Consequently, more buying power is required to place the trade.
Image courtesy tastrytrade
Risk and Reward is a balancing act
Every options trade is a balancing act. Adding wings will have a direct effect on Average P&L, win rate, and buying power effect. If you want to make more money, you must risk more capital. There is no free lunch in options trading. In addition, if you are looking for a higher win rate and higher P&L, you would need to widen the wings.
Wings are an integral part of options trading. If you decide to add them to a naked option, you can create a trade better suited to your overall trade parameters. Even though you may reduce potential profits, adding wings can improve buying power reduction and improve your overall return on capital. Options trading is all about finding the right balance between risk and reward and how much capital you are willing to spend to reach your investment goals.