As traders and investors, we often see outcomes through the prism of win or lose. We will all have both over time, trading is not a game of perfect.The goal of course is to win more than you lose. Some measure their success where they make it into the win/loss column, and while it’s true we can only grow our accounts with more wins than losses, to me it’s not the only measure of success. But one of the toughest emotions to overcome is a bias toward direction, when what really needs to be examined is whether we should be looking at time or volatility.
There three basic strategies for option 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 such as 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 mentioned to me an opportunity in Ophthotech (OPHT). This company is a small biotech that was due to deliver some news on a promising drug in December. I did some research on this drug and it seemed to have promise, but still there is always the chance an approval would 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, so bullish. Downside to the trade? It’s a bit unclear but certainly the company was betting all of their chips on this one drug – so that had me concerned about some heavy downside. 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, as 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/break their future. This was the case with Ophthotech, as the stock surged on promise over the past couple of years. The stock 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. Now, this is typical when a binary event is on the horizon, so I was not surprised. However, as is often the case in high IV we need to take BOTH sides of the trade regardless of the price. Hence, a straddle or strangle was the right play and not a bull put spread or even a calendar. Now, many would suggest to sell that premium or high juice, but I have seen more 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 if he wanted to keep that bull put spread on to at least purchase a Dec put, like the 25 strike. The was costing $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 bucks plus the $4 credit if the stock say went to between 30-25. Above 40 and the $1 is kept, but below $20 would yield huge gains as the protection was 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 is an incorrect assessment, because in a game there is no measured volatility or expectation on either side to have an enormous advantage over the opponent.
As it turned out, the stock was pasted last week as news about the drug was poor. We see this stock trading now at 4.85 after dropping from $39 or so. My friend actually closed the trade a few weeks back, taking a breakeven before the news came out (better safe than sorry). How did the $6.50 strangle work out? The call is zero but the put is worth $20, so a 200% gainer. My friend’s trade would have yielded the same if he included the long put with his bull put spread.
Lesson here: Understand situations and be able to trade differently regardless of bias if the conditions warrant a different style of trade. When presented with opportunity, no matter the cost the risk should be taken. Raise your game to another level by utilizing more tools in your bag, more than you ever knew existed. It may pay off handsomely, even if you don’t see it from the start.
Learn more about Bob’s newsletter at www.explosiveoptions.net He is an in-demand educator and speaker on trading education, speaking to a wide variety of groups on a wide range of educational and trading topics, including technical analysis, options trade selection, and the psychology of trading effectively