10 Keys to Trading Options Like Liz & Jenny | tradeTALK Series
Mar 29, 2021
By: Mike Butler
Successful trading begins and ends with sticking to a set of solid mechanics. Ideally, those mechanics enable a trader to enhance profitability, reduce volatility, and keep emotions in check. Through the years, tastytrade’s Liz Dierking and Jenny Andrews have built their own set of options trading guidelines based on their experience. Get their advice in their tradeTalk presentation and learn more about each concept below.
The more narrow the bid-ask spread, the more we can expect to get fair fill prices both entering and exiting trades. We avoid wide bid-ask spreads to avoid slippage.
Just like the stock market, the options market has certain liquidity characteristics we like to see before placing a trade. The most important is the bid-ask spread. This options trading basic is essentially the difference between where we can sell the option we’re looking at (bid) and where we can buy the option (ask).
The bigger the difference between these values, the more uncertainty there is in regards to actually getting filled at the mid-price, which is the average price between these two values. If I am looking at selling a put spread in XYZ, with a bid-ask spread of $3.14-3.17, the spread is $0.03 wide.
If I am selling the spread on the bid, and I have to buy it back on the ask to close immediately, that could result in an instant loss of $0.03. This is known as slippage, which is the loss of value during the transaction due to the bid-ask spread being too wide.
Cost basis reduction allows us to focus on the things we can control, instead of the things that we cannot, and improves our probability of success along the way.
Cost basis reduction is a staple in the tastytrade ideology, because it allows us to focus on the things we can control. Nobody knows where XYZ stock is going tomorrow, but I do know that if I sell a call against 100 shares of stock and collect extrinsic value premium (covered call strategy), I am effectively reducing the cost basis of my shares.
If I buy 100 shares of XYZ stock at $100 per share, and the stock doesn’t move, I would not make a profit on the trade. If I sell a call at the $105 strike for $2.00, I collect $ 200 real dollars which reduces my cost basis on the shares to $9800. Now, if the stock doesn’t move I make $200. If the stock drops to $98 at the expiration of my call contract, I would not lose money either.
If I never sold the call, I would have a $200 loss, where the covered call would result in a scratch. This focus on cost basis reduction improves our probability of success in the long run.
Premium selling is generally a high probability trading endeavor, because we are betting against the stock moving against us, rather than betting on a stock to move in a particular direction in a finite amount of time.
Our options trading strategies revolve around selling premium, because they are high probability trades. Instead of betting on a stock price moving in a certain direction to be successful, when selling premium we are betting against the movement of a stock.
If XYZ is trading at $100 per share and I am bullish, meaning I think the stock will go up, I may consider buying a call. If I buy the $105 strike call for $2.00, I need XYZ to climb to $107 at expiration just to breakeven, since I need my call to have $2.00 of intrinsic value to offset my initial cost on entry.
If I sell a $95 put instead for $2.00, I’m now betting against the movement of the stock price to the downside. As long as XYZ stays above $95 at expiration, I will make $2.00 or $200 real dollars.
That means the stock can go up, stay the same, or even go down a little bit and I would still be profitable at expiration. This all results in a much higher probability trade than buying an OTM (out of the money) call if we’re holding both to expiration.
High implied volatility results in a wider standard deviation of potential outcomes, and we can move our short premium strikes further from the stock price in this environment compared to a low IV environment, while still collecting a nice extrinsic value premium.
Standard Deviation (SD) and Implied Volatility (IV) are both very important concepts to master when trading options. From a premium selling perspective, having a high implied volatility, which results in a wide standard deviation, means we can get much further away from the stock price and still collect a decent credit for selling options than if we were trading in a low IV environment.
If a short put in XYZ at the $95 strike is trading for $2.00 in a low IV environment, it might trade for $4.00 in a high IV environment. This means a higher max profit if I’m right, but also a lower cost basis if I’m wrong.
Alternatively, maybe my goal is just to collect $2.00. In a high IV environment, I may be able to achieve that premium on the $85 strike, instead of the $95 strike.
IV Rank allows us to put context around the current IV level relative to the past year of data for different underlyings, as different underlyings have different IV ranges.
We prefer high IV environments when we are selling options, because they allow us to collect a higher extrinsic value credit and/or move our strikes further from the stock price, but not all stocks have the same IV range. This is where IV Rank comes into play.
IV Rank takes the high point of IV and low point of IV over the past 52 weeks, and gives us context around where current IV is. This helps us see where true extremes lie, and where we may want to be more patient in hopes for an IV expansion before placing our trades.
Having a decent amount of time for trades to work out in our favor means we are less binary with our strategies, we have some wiggle room for the stock to move because we can get further from the stock price with our strikes, and we still collect a decent amount of extrinsic value credit when selling options. We prefer the 45DTE window over longer or shorter durations.
Choosing a duration for options trades can be tricky, but we have found that the 45 DTE range gives us a healthy blend of time to be right on the trade, an increase in extrinsic value decay, and getting a nice distance away from the stock price for our premium selling strategies. Anywhere between 30-60DTE is where we typically sell options, with 45 DTE being our sweet spot.
Theta is the rate of decay of an option’s extrinsic value given a one day passage of time, all else equal. This is an asset for premium sellers, and a liability for premium buyers.
Theta decay is the rate of decay of an option’s extrinsic value given a 1 day passage of time, all else equal.
For premium selling strategies, this is a positive number, as all options will lose their extrinsic value by expiration, and that is beneficial for a short premium trader that already collected the extrinsic value premium when entering the trade.
For premium buyers, this means they have a ticking clock working against them, as many OTM long premium strategies require options to move ITM (in the money) to replace the extrinsic value with intrinsic value by expiration.
The opposite is true for premium selling strategies - every day the stock doesn’t move towards our strike, extrinsic value creeps closer to $0.00.
Managing winners refers to closing trades at less than 100% max profit, as the more unrealized profit we see in premium selling strategies, the less we can make moving forward, which skews our risk:reward against us. We like to close trades at no more than 50% of our max profit to keep this in check.
With premium selling strategies, like selling an OTM put for example, the most we can make is the extrinsic value we sold the option for. That means we have a capped profit potential, and the more unrealized profit we see, the less of a reason we have to continue to hold the position.
In the previous example where we sold the $95 strike put for $2.00 with the stock at $100, the most we can make on the trade is $2.00 or $200 real dollars. If the option decreases in value to $0.50, we see an unrealized profit of $1.50 out of the total $2.00, and we can only make another $0.50. We still hold all the risk of the initial position, plus the unrealized gain of $1.50.
As you can see, the more unrealized profit we see with premium selling strategies, the less additional value we can make on the trade, but we still hold all the risk. This skews our risk:reward out of our favor, which is why we typically close premium selling trades around 50% of our max profit. This allows us to lock in the profit, and move our risk to a more opportunistic trade.
Managing risk is very important to premium sellers, and we typically have a plan in place prior to entering a trade so that we remove emotion from the equation. This usually means we plan to roll the trade if it goes against us, or we close it at a multiple of our credit received to put a soft cap on our risk.
Risk management is one of the most important concepts in the premium selling world, because our profits are capped and our loss is sometimes undefined. We have to have a gameplan up front in terms of our loss threshold, and/or a plan to mitigate losses by rolling trades out in time.
We may decide to close a losing short premium trade if it reaches 2-3x our initial credit received, to ensure that our risk doesn’t get too large. If I collect $2.00 to sell a put, that may mean buying back the put if it reaches $6-8, resulting in a net loss of $4-6, which locks in the loss, but prevents it from getting larger.
Alternatively, we may decide to roll the put out in time to add more extrinsic value to the trade, add time to be right, and improve our probability of success from that point forward. If I sell a put for $2.00 and roll it out another month for another $1.00 in extrinsic value premium, my net credit is now $3.00 instead of $2.00.
This means I can now make more money if the strike expires OTM, but I reduce my max loss and cost basis as well with the extra $1.00 in extrinsic value premium.
Since options trading is working with imperfect information, we account for the high level of variance by keeping our risk small, and generating a large number of occurrences over time. The more occurrences we have, the closer we can expect to get to our expected probabilities and win-rate.
Anything that involves probabilistic outcomes includes a high level of variance in the short term. If you flip a coin 10 times, they might all land on heads. That doesn’t mean that the coin is rigged, it just means that there are not enough occurrences for the results to balance out more equally for landing on heads and tails.
This concept applies options trading as well, and really anything that involves probabilities. We keep our individual position risk under 5% of our account size to account for this high variance in the short term.
The lower the % of risk we have relative to our account size, the more variance we can withstand. The more we trade, and the more number of occurrences we generate, the closer we can expect our realized probabilities to line up with our expected probabilities and win-rate.
When combined, these options trading practices serve a variety of purposes including reducing emotion and volatility of Profit/Loss, boosting trade success rate, and identifying the best trading opportunities. Learn more about stock and options trading basics on tastytrade.com.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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