There are two key ingredients in any successful options position. The first is trade location. This is the most difficult step even for experienced traders. Just look at most any price chart and it seems like a series of random moves in either direction. I have spent many years trying to interpret those price moves and I have found that most of those moves are impossible to interpret with any degree of confidence. However, by identifying certain tells in price action, there are occasions when a chart offers a reasonably good entry point into a trade. INTC offered one such opportunity this past week. When the price of a stock or ETF that has a large float moves that much that quickly there is some big volume being transacted. Some large institution or group of institutions are changing their position. The volume profile for Thursday showed it best.
Friday immediately confirmed that somebody big was dumping the stock! Institutions don’t like to dump stocks. They would rather move it down slowly so they get the best price for the stock that they’re selling. This price action told us something else was happening!
The weak auction on Thursday was enough of a tell that price would likely continue lower to buy some Puts. That brings me to the second ingredient of successful option trading: trade structure. You’re probably thinking that just buying some Puts as I did here doesn’t seem like a very unique trade structure and you’d be right! It’s what I did after buying the Puts that increased my odds of having a profitable position. By Friday I was already looking to reduce my risk in the trade. It’s not that I expected price to rally, it’s that reducing risk in a trade is the best way to build a profitable option portfolio! I was using a standard target for a potential reversal of a declining stock that has been in an uptrend.
Below I tweeted that I had adjusted my offer to better line up with the rising 20-day SMA.
When price reached the rising 20-day SMA I was able to fill the order to turn the long 50 Puts into the 50/47 Vertical Put Spread for a 50% reduction in the original cost of the trade. Price barely paused there and continued lower still.
That gave me another opportunity to further reduce cost by selling some 47/45 Put Vertical Credit Spreads. That turned the position into a Broken Wing Butterfly (BWB) with a net cost reduction of more than 88% of the original position cost. Below is what the current risk profile of the position looks like.
I now own a Put BWB with an open profit of over a 500% return on the current cost. The position’s maximum return on net cost is over 1600%. If the price on INTC just keeps dropping and is below 45 at expiry the return will be 470%. When I’m able to populate my portfolio with numerous positions with similar characteristics I stand a very good chance of having a profitable portfolio.
Here are all of the fills from this position.
The bottom line of this type of trading is that I’m taking advantage of opportunities that price gives me to reduce or eliminate the cost of the original position. In many cases I’m actually able to lock in a small profit while maintaining the potential of a much larger profit down the road. And what happens if price doesn’t follow thru in the anticipated direction? I stop out of the trade with a relatively small loss. If I haven’t been able to Delta hedge a position in my portfolio within a few days I typically will move on to another position. I also use well defined stops so that I limit the loss on any position that moves against me from the start.
Questions or comments? Tweet @VegaOptions.