Successful options traders understand the importance of managing risk. This concept is even more critical for financial advisors dealing with clients who have a penchant for aggressive trading strategies. So, if you accept that risk management is paramount, then you should consider options as the primary tool to manage risk when taking bullish or bearish positions in an underlying security.
Take the current environment as a case in point. For the past few years, individual investors have been fixated on short-term trades that, by definition, are motivated by emotions: greed inspiring optimism; fear sparking pessimism. But a short-term focus refutes any serious analytical effort. Results rest entirely on momentum, which can push a stock’s price above or below some variant of its fair value.
Successful traders balance upside potential against downside risk, with the mitigating factor being strategy selection. Options strategy bands offer strategies that best mirror your view on the underlying stock while mitigating risk against well-founded dynamics such as reversion to the mean and efficient market theory.
To understand the interplay of these twin objectives, consider the following example: suppose you are looking to wager on the outcome of a hockey game between the Montreal Canadiens and the Toronto Maple Leafs. We also will assume that it is the first game of the season, so the record for both teams is zero wins and zero losses.
At this point, without recent historical data, a decision to back one team vs the other is predicated on personal bias. By that, I mean that Leafs fans would wager on the Leafs, while Canadiens fans would wager on that team. Short-term trades are often influenced in much the same way: traders invest in Apple Inc. because they own an iPhone, or in Toronto-Dominion Bank because that’s where they bank.
@page_break@Taking it a step further – with appropriate apologies to Canadiens fans – let’s assume that early into the season, the Leafs have a record of 10 wins and zero losses, while Montreal is zero and 10. With this data, past performance becomes another branch in your decision tree; but does it add value, in terms of your assessment of the upcoming game?
Investors would consider the Leafs’ record much as they might view a momentum-driven stock’s record. Buying into momentum requires you to accept basic precepts that “the trend is your friend” or “the path of least resistance is up.” These are sentiment indicators that prey on investor behaviour.
Options strategy bands augment your short-term market view by softening unintended risks through strategy selection. For example, if you are bullish about the prospects for an underlying stock, should you buy calls, sell covered calls or use a spread?
Options strategy bands take into account the risk metrics that determine an option’s price and use those to frame an implied trading range around the underlying stock’s fair value. I use the 50-day simple moving average (SMA) to represent a stock’s fair value – while recognizing that a 50-day SMA is simplistic, subjective and obviously open for debate.
To simplify the user interface, options strategy bands follow the same approach taken by John Bollinger’s bands – the difference being that I am using Bollinger bands to establish a trading range that implies greater risk when a stock is at the top band and lower risk when at the bottom band.
I then offer a series of options strategies drawing from work done by the late Jim Yates in his book, The Option Strategy Spectrum. But unlike Yates’ spectrum, in which strategies are based solely on the stock’s current position within the bands, I am positing a series of strategies based on: (a) your view about the underlying stock; and (b) where the stock currently is positioned within the bands.
So, at a high level, if you are bullish on the outlook for an underlying security, you would focus on bullish options strategies; conversely, you would look at bearish options strategies to complement a bearish view about an underlying security.
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