Using options as speculative investment tools is a common play. After all,
options trading investors know that options provide excellent leverage and thus
the possibility of turning a few hundred dollars into several thousand. Just
like a mini-lottery. In my opinion, the methods chosen for speculation are too
simplistic, too optimistic and often lean to losses even when the trader makes
the correct directional call. Let's see if we can increase the probability of
making money on speculation. One reason for taking this approach is because it
is often far better to trade options than stock. Trades can be arranged to offer
high leverage, or high probability of profit, or limited loss. Lets use Apple
(NASDAQ: AAPL ). For the sake of this example, let's not use real time quotes
so we can better focus on the concept of speculating, not the hope of making
money on this trade. Let's state some basics: assume AAPL is $335 a share. the
volatility skew can de defined simply as a steady but non-linear change in the
implied volatility of each strike price, with IV moving higher as the strike
price declines. Assume the volatility skew is accurately represented by the
calculator offered by the Chicago Board Options Exchange, and there are 41 days
until the options expire and that you want to take a bullish (bearish) stance.
All option prices come from an options pricing model, and not from real-life
quotes. All set? A typical play for many traders is to buy the AAPL May 345 Call
(or AAPL May 325 Put ), paying $9.00 ($9.35). These plays are fairly simple.
If the stock makes a major move and the option moves well in-the-money (ITM),
then the profits can be substantial. That's the dream of the call or put
buyer. However, large moves are not that common and it is more likely that there
will be conflict between the passage of time (bad) and the stock moving in the
right direction for the speculator (good). The important point to understand is
that such positions do not have to be held to expiration and can be sold early
to take profits or cut losses. The problem is that each of these trades comes
with negative expectation, unless there is a change in AAPL's price fairly
quickly. Alternative to simple option purchase The bullish (bearish) trader can
select an alternative strategy one with a much higher probability of success,
even though it comes with a limited profit potential. For example, the credit
spread. The bullish trader sells a put spread (The bearish trader sells a call
spread). For example: Trade 1) Bullish play: Buy AAPL May 300 P Sell AAPL May
310 P Collect $180 credit for each spread. Maximum profit is limited to $180.
Maximum loss is $820. Let's not get into risk management here (although it
should never be ignored). There is a 78% chance that AAPL will be above 310 at
expiration and that the options will expire worthless. That $180 represents a
significant profit on the margin requirement ($820). Trade 2) Bearish play: Buy
AAPL May 380 C Sell AAPL May 370 C Collect $100 credit per spread. This time the
maximum profit is only $100 and the largest possible loss is $900. However, the
probability is 85% that the stock will be below the 370 strike price when
expiration arrives. Note: Probability at expiration comes from the option delta.
As a fairly good estimate, the delta of an option (ignoring its positive or
negative sign) represents the probability that the option will finish in the
money (ITM) at expiration. Obviously these numbers are based on accepting the
current implied volatility as a good estimate of the stock's future (between
now and expiration) volatility. This strategy is flexible because the trader may
choose any strike prices and expiration month that suits his/her fancy (or
market expectations). True, the dream of the 10-bagger is gone when making this
play, but the chances of earning some profit are substantially increased. The
point is not to convince anyone to sell a credit spread rather than buy an
option. It is to alert speculators to the fact that there is more than one way
to play the game. Follow Mark Wolfinger on his Options for Rookies blog:
http://blog.mdwoptions.com .
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