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Speculating on Market Direction for One Stock

Option spread trades can raise your profit probability


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.

Let’s 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:

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