An option is a financial instrument. Like stocks and bonds, options can be bought and sold with the intent to profit from price movements. While options are designed to provide optionality they also have the potential to generate a stream of income. It goes without saying they have the potential to lose money, too.
A typical trading strategy will aim to achieve:
- High Return – generating the most income per trade
- Low Volatility – generating similar amounts of money per trade
- Repeatable – consistently repeating the two goals above
Let’s look at brokerage selection, opening positions and managing positions to see if there’s an optimal approach to achieving these goals.
If you search “options trading strategies” you’ll find no shortage of content, both free and paid. Some websites offer sensationalized “secrets” and promises of returns. Others offer matter-of-fact details that explain various trading tools and how each one works.
The problem with sensationalized claims and tool explanations is that they don’t explain how each claim or tool performs. There is no data. I’m not willing to risk my hard-earned money in something that isn’t evidence based and consistently repeatable.
Without transparent data available on the internet I was forced to do my own research. I decided to publish my findings and use the insights gained to outline a systematic, repeatable, quantifiable approach to options trading.
This guide assumes a working knowledge of options and their mechanics. Let’s review the high-level concepts in a brief refresher.
When buying or selling a stock there is a single dimension: price. After placing a stock trade, the price will either go up or down based on unpredictable market dynamics. There is a 50/50 chance of making money.
When buying or selling an option three additional dimensions are introduced: strike price, time and volatility. Each dimension can influence the price of the option and consequently the probability of making money. Options have probabilities ranging from 99.9% likely to make money to 99.9% likely to lose money. More on this in a little bit.
The strike price is the price at which an option contract can be exercised. The relationship between strike price and the price of the underlying stock upon which the contract is based determines an option’s intrinsic value.
Options are expiring assets with a defined lifetime ranging from less than a day to nearly three years. The value of the time remaining until an option expires determines an option’s extrinsic value. The farther away an option’s expiration date, the more extrinsic value an option will have. As time passes and an option’s expiration date nears, an option’s extrinsic value approaches zero at an exponentially accelerating rate. This rate of decay is represented by theta.
Together, strike price and time, or intrinsic and extrinsic value, determine an option’s price which is called premium.
Volatility determines the price per unit of time and uses probabilities to estimate how far an underlying’s price is expected to move over the next 52 weeks. The Black Scholes model is an academic formula the describes how the time value and probabilities are calculated. Modern brokerages use other models such as splines, to implement interpolation for determining value.
Like buying or selling a property or stock, each purchase, sale, exercise, or assignment of an option may incur a transaction cost. For options they are the: base trade fee, per-contract commission and exercise and assignment fee. In addition to trading fees, some brokerages charge monthly subscription fees for access to real-time options market data.
A brokerage account is the starting point for placing trades. We’ll want to utilize a brokerage with the lowest trading fees. For the purposes of this ranking we will be looking at the:
- cost associated to open and close a single stock option contract with a premium over $0.10
- fee associated with option exercise and assignment
- market-data subscription fee, if any
The top three brokerages for options trading based on fees are (these are NOT affiliate links):
#1 Robinhood – FREE
Robinhood has $0 base trade fee to open or close a position, $0 per-contract commission and $0 exercise and assignment fee. Real-time market data is also $0. They also offer $0 trade fees on equities, too. Both equity and option trades are executed in real time.
Is there a catch? No. However, if you intend to use Robinhood for purposes other than trading options, such as for margin loans or housing your retirement accounts, there are better alternatives.
#2 tastyworks – $1.20
tastyworks has a $1 base trade fee to open a position and $0 fee to close a position, $0.10 per-contract commission to open and close a position, and $5 exercise and assignment fee. Real-time market data is FREE.
#3 Interactive Brokers – $2.00
Interactive Brokers has a $0 base trade fee to open or close a position, $0.70 per-contract commission to open and close a position with a $1/trade minimum, and $0 exercise and assignment fee (the stock trade fee minimum of $1 is assessed). Real-time options market data is $1.50/month and is waived if monthly trade commissions total $20 or more. Interactive Brokers is known for having the lowest margin rates in the industry.
When trading an option we have to pick an underlying, determine whether we want to buy or sell, select contract duration, identify what delta we want to trade at, evaluate the volatility of the underlying, and finally choose an instrument. Phew! Let’s look at each one and see if there’s an optimal approach.
When choosing an option underlying there are two key attributes to consider:
Liquidity is hands down the most important attribute of an option. It’s what allows a trader to get in and out of a position at a fair price. Liquid options also have more accurate probabilities, per the Black Scholes model, than illiquid options. Option liquidity is typically measured by volume and open interest. Highly-liquid options will usually have a tight bid-ask spread, often times as narrow as a penny or two.
Options on SPY are by far the most liquid options on the market, having a volume multiples higher than the next most liquid underlying. Barchart.com freely lists the volume of options trades for various underlying.
Liquidity winner: SPY
The total risk of an investment is comprised of two elements: systematic risk, sometimes also referred to as market or undiversifiable risk, and unsystematic risk, sometimes also referred to as specific, diversifiable, residual, or idiosyncratic risk.
Systematic risk is risk the entire market will experience – interest rate changes, recession, natural disasters, political unrest etc.
Unsystematic risk is risk specific to an individual stock, industry or sector – a company cooking its books (Enron), airline industry scares (Boeing 737 MAX) and tech and housing sector bubbles. Unsystematic risk can be mitigated through broad diversification, effectively lowering the total risk of the trade.
Risk winner: any broad market ETF such as SPY, and to a lesser extent, sector-specific ETFs such as EEM and XLF.
There are two possible actions: buy an option or sell an option.
An option seller can be profitable in 3 scenarios – when the underlying price:
- stays the same
- moves favorably
- moves slightly unfavorably
An option buyer can be profitable in 1 scenario – when the underlying price:
- moves favorably fast enough to overcome theta
The option seller has 3x the opportunities to be successful than the option buyer and isn’t racing against the clock.
When we sell options we are selling assets that depreciate in value as time passes. We can sell an option for $100 today then buy it back at a later date for, say, $75 making $25 on the trade. This depreciation factor allows us to sit back and profit from the passage of time.
As an option’s expiration date approaches it loses value faster. Great! Let’s sell the shortest duration options we can find so we can make money as fast as possible.
Not so fast!
As an option approaches expiration, its price becomes more volatile and behaves less like the stable unwinding of a clock. That’s not what we want. In fact, much of the potential profit (theta) that’s available near option expiration is lost due to this volatility (gamma).
Let’s look at the performance of selling 45 DTE strangles and closing the trade early at various increments.
By closing the positions at 21 DTE, 21 days before they expire and avoiding the fastest decay time period, profits are actually higher than participating in seemingly most profitable time to hold an option.
Ok, so should we instead aim for the longest duration option to have a slow and steady profit? That’s not quite ideal either.
Let’s hypothetically sell 16 delta strangles on SPY on the first trading day of every month for 10 years, starting in 2005. We’ll do this with 45 DTE, 75 DTE, and 110 DTE positions.
It turns out the 45 DTE options had the greatest P/L.
To identify the optimal duration we want to find the point on the option premium time curve where additional time results in a diminishing return of premium received.
This happens to be around 45 DTE for a 16 delta put on the SPY. Selling options of this duration allows us to partake in the sharpest declines in option price while exhibiting the greatest daily P/L.
Winner: closest to 45 DTE
Delta is a number that says a lot about how an option behaves. For our purposes we will be looking at its usefulness in determining the probability of having a winning trade.
To calculate the probability of profit (POP) or win rate when selling options:
- ignore the +/- sign in front of the delta value
- subtract the delta value from 100
An option with a delta of 50 means there is a 50% chance the trade will be profitable when held to expiration. A delta of 5 means there is a 95% chance the trade will be profitable when held to expiration. A delta of 90? Only a 10% POP.
Over the span of ~3100 trades the realized win rates tend to align with expectations.
As a general rule, when win rate increases the premium collected when selling an option goes down. Less risk, less reward.
Winner: dependent on trader’s risk and return targets.
Volatility is rooted in the concepts of probability. Remember the standard (bell) curve from high-school math class? No? You were sleeping or skipping? Here’s your SparkNotes:
Options have an attribute called implied volatility or simply IV. IV is a percentage value that describes the expected annualized price range of a one-standard-deviation move of an underlying. That’s a mouth full. Let’s make this easier with an example and picture.
Suppose we have a stock, XYZ, that’s worth $100 and it has an IV of 25%. This means there is a ~68% chance (one standard deviation) XYZ’s price will be between $75 and $125 12 months from now. Depicted visually, it looks like this:
Why do we care about volatility? When IV increases, the price per unit of time increases. This means we can:
- receive greater compensation for trading at the same delta (POP)
- trade at a lower delta (i.e. higher POP) and receive the same amount of premium
Examples of strategies that are based on volatility include trading when IV is above / below a target and trading continuously without regard for IV.
Winner: dependent on trader’s risk and return targets
There are two instrument choices when it comes to options: call and put. These instruments can be used on their own or they can be used as building blocks for more complex strategies such as a strangle or straddle.
Let’s evaluate the basic instruments. More complex instruments provide additional “features” such as defined risk but come at a P/L cost and incur additional frictions.
When selling puts, profits are made when the market rises, stays the same, or falls slightly. Selling puts tends to be profitable in bull markets.
When selling calls, profits are made when the market falls, stays the same, or rises slightly. Selling calls tends to be profitable in bear markets.
Since we do not know the kind of market we’re in until after it occurs it is not possible to optimize instrument selection at the time of order entry. However, knowing how each instrument performs in all markets helps us select an instrument for “all purpose” use.
Puts are consistently profitable over time no matter which strategy is implemented. Meanwhile, selling calls is essentially unprofitable unless leverage is used and even then it’s still a potentially-unprofitable strategy.
Managing positions is all about proactively and mechanically acting on trades to improve win rate and P/L. As we’ll soon see, the Wall Street proverb “cut your losses but let your profits run” isn’t always the best strategy.
The concept of profit targets is simple: take profits when trades are profitable. No one ever went broke taking profits.
A typical strategy for managing positions is the “stop loss.” When a position falls below a certain P/L value, close the position as a loss and move on to the next trade. Managing winners does the exact opposite. When a position crosses a specific profit target, close the position as a winner and move on to the next trade.
Think about it for a second – markets ebb and flow all the time. Using a stop loss ensures we exit during a market lull while using a profit taker ensures we exit during a high point.
Of course, this concept means nothing without data to support it. Let’s take a second look at the chart from the instrument section above.
The first 3 rows show us the performance of taking profits early – at 25% of max, 50% and 75%. When compared to using various stop losses early management improves total P/L across the board.
Early management increases the win rate vs using a stop loss more often than not.
Managing trades early improves risk-adjusted returns vs using a stop loss more often than not.
Winner: use profit targets
Managing winners has the benefit of closing trades earlier, avoiding the most volatile time for an option. We want to spend most of our time in the boxed area, letting the option calmly depreciate in value so we can buy it back later for less.
Let’s take a second look at the P/L chart from the duration section earlier in this guide.
Using the 21 DTE and 7 DTE strategies, it was consistently more profitable to both set a profit target and close the trade before expiration than to use a profit target alone.
This means some positions will be closed without them ever reaching profit targets. In fact, they may even be closed at a loss.
Winner: close trades before expiration.
Setting up a trade requires making many decisions. The following configuration appears to lend itself to the greatest likelihood of success:
- Brokerage: Robinhood
- Underlying: SPY
- Action: Sell
- Duration: closest to 45 DTE
- Delta: dependent on trader’s risk and return targets
- Volatility: dependent on trader’s risk and return targets
- Instrument: Put
There are systematic, data-driven mechanics that can be applied to open positions to improve trade profitability and consistency of profits:
- Close trades at profit targets
- Close trades early if profit target is not reached
- Manage risk at order entry by selecting delta and number of contracts, as opposed to after the fact using stop loss orders
A key tenant to success is eliminating the emotional side of trading. Staying mechanical will help ensure the probabilities play out.
Check out part 2 which covers leverage, capital allocation, overstatement of delta premium, overstatement of duration premium and tax-efficient scaling. Part 3 covers trade occurrences, capital efficiency and the Micro e-Mini Futures product.