As traders and investors, we often see outcomes through the prism of win or lose. We will have both over time; trading is not a game of perfect. That focus on winning or losing is one of the toughest emotions to overcome. So instead, maybe we should look at time or volatility and used advanced options trading strategies.
There are three basic strategies for options trading: direction, volatility and time. We can set up various structures from the most basic (straight buys on puts or calls) to more complex ideas (ratio spreads or skip strike butterflies). Yet, when we seek to find the right structure or combination we often make errors in style and wind up getting hurt when we very easily could have cleared a nice winner.
Let’s take a look at an example. Last month, a good friend of mine, an excellent trader who produces some extraordinary results, told me about an opportunity in Ophthotech (OPHT). This small biotech company was due to deliver news about a promising drug in December. I did some research while keeping in mind that there is always the chance approval could be denied.
The stock was trading in the mid $30’s, and many were saying the drug, if approved, could push this stock into the $80’s. The downside? It seemed the company was betting all of its chips on this one drug.
My friend took a short put spread position, which is bullish. He sold the 40 Dec put and bought the 30 put for a $4 credit. Total risk on the trade was another $6 if the stock tanked below 30, but his risk is defined. This was clearly a directional bet to the upside; if the stock got over 40 and stayed there he would keep the entire $4 credit.
These biotechs often find themselves in a binary situation, especially when one drug can make or break its future. This was the case with Ophthotech. The stock surged on promise over the past couple of years. It dropped a bit in October but still held steady in the 30’s. But was this directional bet the right play? I looked at implied volatility, the expected move of the market, and it was enormous – over 275%.
Normal volatility for this stock was in the 40% range, but the market was setting up for a big move and option prices were reflecting this high premium. In a situation like this, a binary event is typically on the horizon. However, as is often the case when IV is high, we need to take BOTH sides of the trade regardless of the price. Hence, a straddle or strangle was the right play, not a bull put spread or even a calendar. (Many traders would suggest selling that premium, but I have seen too many traders punished and sent out to pasture for taking this stance.)
A strangle is a purchase of a call and put out of the money. You make money with an extreme move up or down beyond the expected market move. In the case of OPHT a $45 call and $25 put buy would have been about $6.50 at the time for December expirations (early November). The stock was in the mid $30’s at the time.
I suggested to my friend that he purchase a Dec put, like the 25 strike, for $3. Now, selling the put spread at $4 and buying a put at $3 doesn’t seem worth the trouble, right? Yet, who can actually know how the stock would react on the news? Putting this structure together would cost a total of $9 plus the $4 credit if the stock, say, went to between $30-35. Above 40 and the $1 is his, but below $20 would yield huge gains (because protection is in place).
Intuitively you might be thinking, “How can I make money playing both sides? Isn’t it like betting on both teams to win the same game?” That analogy doesn’t work, because in a sports game, you can’t measure volatility.
As it turned out, OPHT got hammered last week. It is now trading at $4.85 after dropping from $39 or so. My friend actually closed the trade a few weeks back and broke even. How did the $6.50 strangle work out? The call is zero but the put is worth $20, so that’s a 200% gain. My friend’s trade would have yielded the same if he included the long put with his bull put spread.
The lesson here: Assess the situation objectively so you can use the right style for the trade. When presented with opportunity, no matter the cost, take risk into consideration. Raise your game to another level by utilizing all the tools in your bag including advanced options trading strategies. It may pay off handsomely, even if you don’t see it from the start.
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