- The paradox of choice in options can be overcome by knowing what you hope or expect to happen, and then keeping things simple.
- A small quiver of some common multi-leg trades and when and why to use them.
The majority of options trades made are to express a directional view. "I think XXX is going higher." But unlike stock, options are a decaying asset with a specific time frame. That can lead to a lot of confusion on the best way to express a view. Strikes, expirations, theta, vega? Where does one even begin?
Some people love solving puzzles, and options have lots of puzzles to be solved. This is not the post for that. This is about options as most people use them. Expressing a directional view, over a period of time.
Ways to Play
Here's cheat sheet based on 3 directional views, bullish, bearish and neutral. I'll dive into each below.
We focus on 4 common (defined risk, multi-leg) options trades. Call spreads, put spreads, butterflies and condors and when to use them based on your expectations versus the crowd's.
- For more information on an easy way to understand credit vs debit spreads read this.
- And for more information on the expected move, read this.
The Expected Move
The expected move is your friend here for a lot of these trades. The options market has done the dirty work for you, it has priced an average consensus over time. That does not mean it will go higher or lower by that amount. It is simply saying that's where options traders are pricing that move.
If you are looking for a move, it can be used as a cheat-code for strike and expiration selection, and as an actionable representation of implied volatility. It is your baseline to bet with, or against.
Here's a visual representation, from Options AI technology :
Let's start with a very simple decision tree for a bullish view, and a breadown of each below
Generally Bullish - Sometimes you just think a stock is going higher in the near future, and you don't really have a price in mind. You could buy a call, but that's an awfully blunt instrument to use when more efficiency is available.
Use the options market to your advantage, understand what it is pricing, and then making sure to take what it is giving you. Start with the expected move, the chances of a stock not moving beyond its expected move is typically ~75%.
That means if you simply think a stock will go higher, the expected move is a good place to target, because it allows you the ability to finance the purchase of a call, with the sale of a call past the expected move. That increases your chances of success, by lowering your breakeven and increasing your probability of profit.
For instance, if I'm bullish in CRM (the chart above), the prior highs over the past month seem like a pretty good area to target. In this case, the options market thinks the same thing, with a 1 month expected move (~$185) that lines up with the recent highs. There's a strike right at that level. Should that 185 strike be bought? No, if you are simply bullish, it should be sold, to help finance the call you buy, nearer to the current stock price.
Here's how a call spread to that level looks, the July 2nd 172.50/185 call spread, buying the at the money call (stock $173), and selling the call at the expected move ($185):
The call spread created is often similar in price to an out of the money call with much lower probability. And you're not shopping for a lotto ticket, so why would you buy one when you can sell one to help pay for your better odds?
Bullish Beyond the Crowd (a specific price higher than the bulls) - If your idea is more specific, like maybe you think CRM could go beyond consensus, to $190 over the next month, you're really bullish. Here's how that trade would look, selling the 190 call against either the 175 call, or selling the 190 call versus the 185 call (at the expected move). From OptionsAI technology:
In both cases, this is an expression of a view that the options market has mis-priced the move, that volatility is priced too low. But even with that view, the price target is important, because the options market is allowing you to lower your cost on a move to a level that is possible, albeit unlikely ($190), by selling the 190 call.
Simply Not Bearish - And finally, sometimes you are bullish, but more-so, "not bearish". You don't have any specific target higher in the stock but you're pretty sure it is going higher or at least not going lower. The options market has an easy to understand, and high probability trade to express that view – shorting a put spread. Here's how that looks in CRM using Options AI technology:
In this case, selling a put spread expresses a bullish view, but a bullish view that makes money as long as the stock does not go down. In this trade you are literally "selling to the bears". Your breakeven is below where the stock is trading, anything above that breakeven on expiration and you make money. That lower breakeven gives you a more than 50% chance of making a profit. Anything above the green is a max profit on the trade.
The decision tree for bearish is simply the mirror image of the bullish above:
For example, here's how a "generally" bearish trade to the expected move looks like for July 2nd in CRM:
Again, it is using a sale of the put strike at the bearish consensus to help finance an at the money put purchase.
The third direction possible direction for this exercise is Neutral trades. This is very similar to the instances of "selling to the bears" when bullish, or "selling to the bulls" when bearish. But selling to both the bulls and the bears at the same time.
Although condors and flies can they can be centered to express somewhat bullish or bearish views, they are typically, and best, implemented as a neutral strategy.
They are the purest use of the expected move as an expression of implied volatility and when the breakevens of the trade line up with that expected move it is essentially saying "both the bulls and the bears have overpriced this move"
They are profitable if the stock stays within the trade (in the guts) on expiration. A move outside the expected move (beyond the wings) means the trade loses money on expiration. The fly targets a specific price, with profits trailing off in either direction, and the condor has max profit as long as the stock stays within a range.
You'll hear many traders refer to setting their condor strikes at a 25 delta (or similar). What they are essentially doing is placing their trade at or near the expected move.
Here is a look at a condor and a fly in ADBE and their relationship to the expected move, from OptionsAI:
This is by no means an exhaustive list of potential trades. But these are a great starting point for those looking to use some smarter trade structures to express directional views. Strikes can of course be adjusted to slightly alter each trade. For instance, a call spread to the expected move can be set to be more in the money to get the breakeven in line with the stock, creating something quite similar to a stock alternative. Here's an example of how that works.
See a part of OptionsAI technology with your own price target and demo trades in AAPL HERE