General rules
I usually trades options that expire in greater than 2 weeks, which is often the “front month” (the closest month of expiration). Monthly options expire the 3rd Friday of every month, but there are weekly options for many listed securities also. I normally do not trade weekly options, as they are more volatile and there is not enough time for the trade to work for you. If there is a high probability trade, sometimes I will make an exception to that rule.
I normally trade options that are 1-3% in the money. What does that mean?
That means if a stock is selling for $500, I would look at the strikes that are $5-$15 (1-3%) below the market price of the stock. In this case, that would be the 495,490 or 485 strikes. I would now be looking at March contracts, as the February options expire this Friday(3rd Friday this month). Usually a 3% in the money(ITM) strike will give me a .70 delta . What is that? Delta is the ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative. This means the option should move 70% of the move of the underlying stock. The more ITM the options are, the higher the delta.
Example: A stock is trading for 500, and you buy ITM calls by 3% (485 strike) at $18/contract and the stock gains +10 (to 510). Your 485 calls should move .70 x 10 , or $7 (to $25 or +38%) So, using this example if your stop was 490 (10 stop in the stock), you would place your stop in the option at .70 x 10=7 below the entry price. So, if you bought those calls for $18, then your stop would be 18-7=$11.00 ( -38% loss) This was just an example of the huge risk, and huge reward in options. That is why I scale out a portion of my position relatively fast(after the option has moved 3-5% in my favor), to reduce risk. If you scale out of 1/2 the position, you reduce risk and are still involved with the trade (your runner).
Also, there is time decay with every option. This will affect the price of the option with the fluctuation of the underlying security. This is referred to as Theta. Theta is a measure of the rate of decline in the value of an option due to the passage of time. The Delta will change based on the time expiration of your options. So, if you go out past the front month expiration, the 3% ITM options will have a lower Delta than .70(depending on how far you go out).
The above scenario was just an example. It is very important to understand trading options is very risky.
Lately with some stocks (i.e. JPM, XLE,etc…) and the market in the 9th inning, I’ve been buying very near At-The-Money front month options because the delta has been approximately 50. So I’d buy 10 or 20 contracts and for every 2 cent move in the stock price it essentially equals to a 1 cent move in the option price. After the option moves approximately 20% to 25% I will sell 3/4 postion (7 or 15 contracts) and keep the 1/4 position (3 or 5 contracts) as a runner. And given the 50 delta I can withstand these most recent violent shakeouts / pullbacks.
Keep up with the great picks.
Under what circumstances do you prefer to use spreads as opposed to purchasing less contracts?
Edit Comment DavidCraig,You need to place “stop market” orders. (not stop limit orders). This will get stopped with a stop market.
Stick with ITM with around .70 delta, and if the spreads are wide, use the equity.
Edit Comment DavidYou need to keep your trading account above 25k
Edit Comment MattHi David,If you are trading options as a swing/momentum trader, when would consider scaling profits for these situations? Due to my job, I do not have the ability to day trade and pay that close attention every day.
Thank you very much.
Edit Comment DavidPlease see the “scaling” post.I scale profits at +1% and +2% (general guidelines), and then hold my runner verse my entry cost.
question about stops on options and risk reward.
Let’s assume someone always allocate same amount of money into each trade (i.e $1000). You buy whatever number of contracts for that amount and assume you choose delta .7. Now, rules for taking profit are clear and if someone books half of the profit after underlying price goes 1-1.5% it translates usually to 20% in options. Remaining 1/4 and optional runner might go up but assume it stays around same price. So at the end you booked ~%20 of your initial amount ($200).
If price goes down, suggested STOP is usually 2-3%. I assume you have to exit whole position at that price since there is no guidance for scaling down. That translates to ~%40 loss (-$400)
So, could you explain little bit more your approach when things go wrong?
Much appreciated.
thanksthanks
Edit Comment DavidWe obviously have more winners than losers, and holding your winners with runners balances out the small amount of losing trades. Go back and look at the blog on all the winning trades >+200%.Great question though.
Edit Comment JaimeDavid,Just to make sure i have the stops on the options prices right. Lets assume today QCOM engaged. price of july 65 puts was 3.85 with a delta of .86. Will my stop on this contract be at 2.31 assuming that we are stopped out on the stock at 63.11
Thanks
Jaime
Edit Comment DavidThat is a good estimate for your stop.Remember, it is important to have a physical stop order in. You can always change to market order, if stock hits the stop, but your options did not.
Edit Comment rindelHi David,How do I convert your stop prices on stocks to stop prices on the equivalent option? e.g. NXPI has a trigger of 35.93 and stop price of 33.64.
Edit Comment DavidYou estimate your stop based on the delta/theta.Or you can place a conditional stop order (if you are using Think or Swim, or Interactive Brokers)
Edit Comment rindelDavid,Why do you go out only two weeks for option trades on your engagement sheet (amzn, nke)? What is your general rule about far ahead you buy your buy options?
Edit Comment DavidThe general rule is 2 weeks or more.You can switch to Sept now, or trade Aug until next week(and then roll em