If you struggle with deciding the best strategy to use to capture a profitable move in your favorite stock, then the 3 Easy Steps I’m about to share with you will give you a consistent set of rules you can use every time you decide to place a trade.
No more staring at the computer screen trying to guess which strike and expiration date to use, you will know immediately the best option to choose and exactly how much you need to risk and the probability of being successful.
This process will become second nature and you won’t need to worry if you make the right decision. The decision you make will always fit perfectly with your trading style and never be more than you can comfortably put into the trade. This process is so simple you’ll wonder why you never used it before.
There’s nothing magical or mysterious about setting up trades. In fact, it’s only common sense. By the time you have finished this post, you will be able to sit down at your computer and set up a trade that is right for you. Not every trade will be a winner. That isn’t the way the markets work. But the trades that don’t work out will never cost you more than you were willing to invest. That’s a good bargain, wouldn’t you say?
So instead of just talking about these steps, let’s get into how this all goes together so you can begin putting on trades that can help you reach your financial goals.
Setting up low risk Options trade involves following three easy, but very important steps
1.Choose a directional bias
2.Use the right options to Structure the trade
3.Determine how much capital to put to work and your risk/reward parameters
Step 1 – Directional Bias
In order to build a trade, you must have a directional bias for the underlying you plan to trade. No trade is possible without a directional bias. You will need to decide if you are bullish, bearish, or neutral on the future movement of the underlying security. Without having a directional bias about you won’t be able to choose the right options to structure the trade.
I am going to assume you have a grasp of the basics of puts and calls and buying and selling options.
I have touched on these basics before (here) and will cover them again in a future post.
For the time being let’s say you are bullish on XYZ, and you want to collect credit for selling an option contract on this underlying.
Once we have determined our directional bias, we can proceed to step two.
Step 2 – How to Structure the trade
By structuring a trade, we mean choosing the option strikes that will enable us to carry out our directional bias. If you are bullish on a stock, you would NOT want to buy a long put. As a new trader it is prudent to start with defined risk strategies. You will know at the outset your max profit and max loss.
There is no reason to take on more risk than you are comfortable as you begin to trade.
One way to take advantage of your bullish bias and receive a credit is to sell a short put vertical spread.
To use this strategy, you sell an out of the money short put and simultaneously buy a farther out of the money long put to reduce the risk. The short put is sold below the current market price. Since you are bullish on your underlying, you want the price to rise, and your option will remain out of the money and expire worthless. If this occurs, you keep the full credit.
Just selling a naked put is bullish but carries unlimited risk to the downside. You are a new trader and certainly don’t need to take that risk. It could easily wipe out your account if you bought the wrong stock and the price goes against you.
The best way to hedge this risk is to buy a long put at a strike farther out of the money.
The research done by the team at tasty trade has shown how a long strike $5 away from the short strike is an optimal strike.
In addition, further research has shown that receiving a credit ⅓ the width of the strikes is an optimal credit to look for in a spread strategy. .
Your max profit is the credit you receive, and the max loss is the width of the strikes less the credit received.
When structuring a vertical spread a good starting point is to use a short strike at the 1 standard deviation mark. This will give you a 68 % probability of being successful.
So, you have a directional bias, and you will use a defined risk short put vertical spread strategy to trade your directional assumption. You have defined your risk and determined your max profit and max loss.
Step 3 – Capital requirement and Risk and Reward
The final step is to determine whether or not the capital required to trade this strategy is worth the risk you are willing to take.
The capital you will use to put on this trade is called the buying power requirement. It is the amount of money your broker will hold as security for placing the trade.
A higher priced security will require more buying power then a low priced security. This makes sense. Ultimately your broker is taking the risk of the trade if you renege on the contract. They determine the buying power requirement before you actually place the trade.
Let’s say you have a $5000 account but the stock you want to trade requires $2500 of buying power. In addition, let’s say you can receive a credit of $2.50, ($250.00). The return on this trade is 10%.
Not bad for a 45 day trade. But you will be using 50% of your buying power.
This is way too much capital to be using on a single trade for a new trader. Granted, by using less buying power you limit yourself to lower priced stocks, but remember, you are looking for low risk Ideas as you learn how to trade and not trying to go all in on one trade.
Ideally for smaller accounts you would want to use no more than 5 – 10% of your available buying power on a single trade. You could also set your buying power requirement to an amount your are willing to risk and not trade stocks that require more than that amount.
By taking this step-by-step process you are creating low risk trades.
Final thoughts
In options trading and in any financial transaction you can control some things and not others.
You always want to control what you can and these will keep you out of trouble.
In this post we saw how having a directional bias, deciding the structure of the trade and how much capital to use are the Ideas you can control.
The next time you sit down to put on a trade follow these steps. Don’t get all bogged down about it. Just do the best you can. Soon these steps will be automatic and you will free your time and energy to gain more skills.
If you find you are getting stumped, and need some help, or have a general question, add a comment below and I’ll get back to you right away.
If you have any questions or suggestion, please leave them in the comments section below.
