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Most option traders begin their journey by purchasing long options. It’s an easy thing to do and the prospects of unlimited profits are really enticing. The only problem is that they typically find themselves losing money. You see, the options market prices in the future expected movement of the stock and the price you pay is based on those expectations. As a result, many find themselves trying to find an edge in predicting what the stock price will do. Do you expect to consistently out-guess the market through predicting larger movement in less time? What if you could use the market’s expectations to put yourself in a position to win more consistently and trade with a pricing advantage? In/Out spreads provide just that opportunity and it can be executed in even the smallest of trading accounts. Now that we’ve got your attention, let’s dive into the specifics. Starting From the Beginning In order to appreciate what In/Out spreads provide, you need to first understand why buying single leg options is a strategy that lets most traders down. Long Calls & Puts A long call gives the trader the right to buy the stock at a set price for a period of time. A long put gives you the right to sell the stock at a set price for a period of time. These options have value at expiration if you’re able to buy the stock at a lower price than it is trading (calls) or sell a stock for more than it is trading (puts). This sounds good until you realize that there is a cost associated with this opportunity and having an option expire slightly in-the-money results in near max loss on the trade. THE PERFEC T TR ADE FOR VOL ATILE TIME S 4
When you buy an option, the price that you pay represents the expected movement in the stock price and how much time there is to expiration. This is what’s called “extrinsic value.” The extrinsic value diminishes over time as the window of opportunity closes as the expiration approaches. Option Values If an option is in-the-money (ITM), part of the option’s price includes what’s called “intrinsic value.” This value is derived from the ability to buy the stock for less than the current price (calls) or sell it for more than the current price (puts). If there is no intrinsic value in the strike price chosen, it’s means that the option is out-of-the-money (OTM). For the option buyer, all the premiums paid for the option are extrinsic value. THE PERFEC T TR ADE FOR VOL ATILE TIME S 5
What all of this means is that you’re on the clock the moment you purchase the option. Every day the option loses some value and you’re hoping that the price can move enough to overcome the daily loss. This loss is represented, in part, through time decay. However, there are other risks that we’re going to outline such as implied volatility. Theta—Feel the Burn The first thing you need to do when buying an option is picking a strike price and an expiration. The strike represents the price the stock can be bought or sold, and the expiration is when that right expires. However, few option buyers expect to hold the option until expiration. They plan to sell the option back to the market, which may include some part of the extrinsic value they originally purchased. You can’t expect to be able to sell all extrinsic value back since a certain amount of time has passed and there is less opportunity for the stock price to move. This daily decay that happens when buying an option is referred to as “time decay” and is represented by the Greek letter “theta.” The rate at which your option decays accelerates as you approach expiration. A good visual of this is taking an ice cube and moving it closer and closer to a fire. The ice cube begins to melt more rapidly as it moves closer until it is consumed. This is what is happening with the extrinsic value of the option you bought. The chart below shows the percentage of extrinsic value remaining over time. This is theta decay! THE PERFEC T TR ADE FOR VOL ATILE TIME S 6
Implied Volatility—It’s All About Exposure
The concept of time decay is relatively straight forward while implied volatility can be baffling for inexperienced traders. Have you ever bought an option and got the move you were expecting only to lose money? If so, you have experienced this risk. Time value of an option is calculated given the stock price, strike price and time to expiration. It is orderly in how it’s priced and how it decays. This is not true with implied volatility since it is based on the ever changing outlook for the price of a stock. Put simply, implied volatility represents the future expected movement of the stock and is represented as an annualized percentage. The sensitivity of the option price to changes in implied volatility is represented by the option Greek “vega.” I know, vega isn’t a Greek letter, but it’s considered one for option trading purposes. When you buy an option, you obviously want the price of the option to increase so you can sell it for a higher price. This is true whether you’re a call or put buyer. As an option buyer, you’re vega positive. That means that you want the implied volatility to go up. Going back to the question of whether you lost money as the stock moved favorably, it was likely a result of the implied volatility falling and the option losing extrinsic value. A good example of this is when a company announces their earnings. The uncertainty of the event means that implied volatility is high, and the options are expensive. However, once the announcement is made and the price movement becomes more certain, the implied volatility falls. Even if you got the direction right, you can still lose money If the stock price didn’t move more than expected. THE PERFEC T TR ADE FOR VOL ATILE TIME S 7
Right but Wrong
The hardest thing about being an option buyer is that you can be right a lot and still lose money. What does that mean? It means that you got the direction right, but it took too long to get there. Another example is when you got the move you were expecting, but it wasn’t enough to make money as it was already priced in and the implied volatility fell. While most new option traders love the prospects of unlimited profits, they soon grow weary over the frequency of losses. This is a result of the harsh realities of the low probability nature of buying options. Now that you understand some long option basics, let’s discuss probabilities. THE PERFEC T TR ADE FOR VOL ATILE TIME S 8
Probability—It’s About How Often More Than How Much
At this point we understand that buying options is a low probability trade. That means that you’ll lose more than you win, and this can’t be made up by getting better at predicting the movement of the stock. Unfortunately, this doesn’t stop people from trying to overcome the odds and their portfolio soon feels the impact of the risks outweighing the rewards. An important concept in option trading is understanding the probability of expiring. The probability of expiring refers to the probability of the stock or index will be above or below a certain price at expiration. The probability numbers themselves are based on formulas that use current stock price, the target or strike price, interest rates, days to expiration and volatility. Probability of expiring (POE) is not defined as making or losing money but the chance of each unique option falling in the money or out of the money by one penny or more on the corresponding expiration date. For long options, this means that break even price has less than a 50% probability of the price closing above or below that level at expiration. Using Delta and POE Some brokers will have the probability of expiring ITM as a feature of their software. However, if they don’t, you can use the options delta as an approximation for probability of expiring. Let’s walk through an example of using POE and delta. In the image below, you’ll see an example of buying a slightly ITM call at the $51 strike price on Intel Corp (INTC). Looking at the option chain you’ll see the layout includes both delta and POE. You may notice that the delta and POE are very close for the $51 call option. Also, notice the probability of the option reaching its break even by expiration is 36.73%. Yikes!
Understanding the probability of a call expiring ITM also helps us understand the probability of a put as well. In the example below you’ll see that the price of INTC is trading at almost exactly $52. Using the at-the-money option at the $52 strike price, you’ll see that the probability of the put and call expiring ITM is about 50%. That makes intuitive sense since the price is sitting on the fence and has a 50/50 shot of falling on one side or the other. As a result, the put and call have a 50% probability of expiring ITM. THE PERFEC T TR ADE FOR VOL ATILE TIME S 9
Defying to Laws of Probability
I get it, you’re probably thinking to yourself that you can predict the price movement of the stock well enough to make money. Also, you don’t plan on holding it to expiration or take a max loss. Many traders even decide to use stops as a means of controlling risk. This makes sense in the abstract since you can theoretically achieve a favorable reward-to-risk. This may seem like a path to get reduced risk while maintaining unlimited upside. The issue is that the probabilities have completely changed with the introduction of a stop loss. Instead of probability of expiring, you need to consider probability of touching. The probability of touching is the probability of an individual options strike being touched or surpassed ANYTIME between now and expiration. The probability of touching has no directional bias and is approximately double the option delta. Let’s take a closer look at how stops are impacted by the probabilities of touching. In this example, you purchase a stock for $60 and you set your target at $62 with your stop at $59. What is the probability in the next 29 days that you’ll be stopped out versus hitting your target price? As you’ll see illustrated in the example below, you have a 78% chance of being stopped out and a 43% chance of reaching your target. That means you have a much higher chance of being stopped out compared to reaching your target. The result is an even lower probability of success whether buying the stock or option. No wonder “stop” is a four-letter word. THE PERFEC T TR ADE FOR VOL ATILE TIME S 10
In/Out Spreads—The Best of Both Worlds
You’ve been reading a lot about the risks of buying options and the probabilities. The intent isn’t to scare you away from options but better understand them. You see, successful options trading is made through a series of small wins not one big one. What if you could minimize the risk of time decay and implied volatility while putting the probability of touching in your favor? Is that appealing? Oh yeah, and you’ll also be targeting a 55% return on the trade. Does that do anything for you? What is being described is the power of spread trading! However, just setting up a spread and letting it go doesn’t turn just any trade into gold. You need a comprehensive approach that balances the probability of expiring, the Greeks and the Probability of Touching. You also need an indicator that uses the market’s expectations to know the timing and direction to take in the trade. This is the approach that Don Kaufman has developed over his 20-plus years of trading and his previous role as head of trading education for TD Ameritrade’s 7 million clients. In/Out Spread Highlights An In/Out spread is a long vertical spread where one strike is bought In the Money (ITM) and one is sold Out of the Money (OTM). The strikes end up straddling the stock price and can be done using calls or puts for bullish or bearish trades, respectively. Since the spread is straddling the stock price, the result is a risk one to make one trade with a 50% probability of expiring. You may be wondering after our discussion on probabilities if spreads can be used to create even higher probability trades. The answer is yes. However, if you have a strong directional bias, you want strong rewards with the least amount of risk. THE PERFEC T TR ADE FOR VOL ATILE TIME S 11
In/Out Spread Example
In the image above, you’ll see an example of an In/Out spread on the Select Sector SPDR Energy ETF (XLE). With the stock price near $60, you’ll be buying the $59 call strike price and selling the $61 for $1. That makes the break even on the trade $60, which is the stock price in the example. That means you have a 50% probability of making money in the trade with total trade risk of $100 per contract. Since this trade involves buying and selling options that are equidistant from the stock price, you’ve negated the impact of theta and vega. That means that the trade is only impacted by the stock price movement when the stock price is positioned between the strike prices. In order to better understand how you will make money in this trade, let’s take a look at the risk profile. In the chart below, you’ll see your current profit/loss (purple line) and the profit/ loss at expiration (cyan line). You’ll notice that the risk and reward are capped at $100. That means that the trade has the possibility of making 100% return by expiration. However, the In/ Out strategy plans to take profits before you get to max gain.
In/Out Spread Trade Management
You just learned about the impact of stops on trades. The great thing about the low cost, defined risk nature of In/Out spreads is that you don’t need stops. That means that you have a chance to realize the probabilities. In fact, you can flip the stop script on its head by taking your profits early. What does that mean? By taking your profits before it reaches max gain, you put yourself in the position of increasing your probabilities above 50%! We’ve now turned this trade into a higher probability strategy! Apart from closing at 55% of max gain, there are other advantages that can be gained through understanding skew and the Expected Move indicator. Incorporating these other points of analysis will either reduce the initial cost and break even or provide the direction of the trade. Combining these points with the In/Out spread management is a very profitable combination. THE PERFEC T TR ADE FOR VOL ATILE TIME S 12
Conclusion Trading is hard enough without placing yourself in a position of losing a high percentage of the time. The idea isn’t to go against the odds, but rather place the odds in your favor. Making money in option trading is about smaller wins and more consistency. It’s about finding an edge that can be exploited over-and-over again. This is exactly what In/Out spreads are designed to do. By incorporating rules for proper setup, pricing factors, timing of entry and trade management it will allow you to grow your account comfortably and confidently. You can do all of this and risk as little as $50 per trade! That means it’s a strategy that anyone can do. Earn While You Learn Grab Don’s In/Out Advantage alert service for 1 year for $49. You’ll receive 1 new IN/OUT trade alert every week, personally-vetted and rubber-stamped by Don Kaufman himself - that’s at least 52 “IN/OUT” trade alerts over the next year, guaranteed! FREE BONUS #1 - REAL LIFE VALUE $297 GUIDE TO SMALL ACCOUNT GROWTH WITH IN/OUT SPREADS MASTER CLASS FREE BONUS #2 - REAL LIFE VALUE $297 QUICK START BEGINNER’S GUIDE FREE BONUS #3 - REAL LIFE VALUE $67 IN/OUT TRADE TRACKER
