The Greatest Options Strategy Ever Made
One of the great scenes in the movie Jaws is when the three protagonists get drunk and compare scars. Richard Dreyfuss and Robert Shaw display a variety they’ve received battling sharks. Roy Schneider, being the “newbie” to this dangerous game, has only his appendectomy scar to show for their amusement.
This scene comes to mind because something similar plays out when veteran traders get together to tell tales. They almost always share trades resulting in painful losses. It’s the losers, not the winners, which are remembered most vividly. It’s through mistakes the important lessons are learned, knowledge is gained and a level of expertise is achieved which allows us, now having survived and prospered, to look back and laugh.
So, it is with some reluctance I present the following as the “greatest trading strategy”, because it comes not without having incurred past scars, of which there will likely be more in the future. That’s reality.
But what I can also promise is this strategy delivers profits. It is built on my experience and based on a few simple concepts, adaptable to all market conditions with a proven track record of success. It has become my number one go to options strategy for building wealth and I want share it with you here.
If you follow the process and adhere to basic rules outlines below and in the live presentation, I’m certain you too will be catching winners on a consistent basis - while minimizing risk, even in what appear to be treacherous waters
Most people coming to options follow a basic progression of trades as they build up their knowledge and experience. It usually starts with the outright purchase or sale of call or put options and then moves on to “spreads.”
Option spreads come in all flavors, formats and fancy names (condors, butterflies, oh my) but what they have in common is simple:
A spread position is entered by buying and selling an equal number of options of the same class on the same underlying security, but with different strike prices or expiration dates.
The reasoning behind all spreads is to use offsetting positions to accomplish one or more goals:
Reducing/limiting risk.
Increasing probability of profit.
Harnessing the impact of time decay.
Harnessing the impact of implied volatility.
An efficient use of capital.
Our strategy accomplishes all of the above.
The strategy we focus on is called a diagonal spread. Don’t let the name scare you into thinking it’s complicated or for options experts only. I have introduced “newbies” who not only trade alongside me, but have quickly started executing trades on their own.
What makes it unique to other basic spreads you might be familiar with is it involves both different strikes and different expiration periods.
Spreads Months Strikes
Vertical Same Different
Horizontal Different Same
Diagonal Different Different
We stick with a one type of diagonal spread; a long or debit approach, which involves:
The purchase of a later-dated option.
The sale of a shorter-dated option with a strike that's further out-of-the money.
That’s it.
We can construct diagonals using calls, for a bullish position benefiting from an increase in the underlying share price, or puts, which benefit from a decline in the underlying share price.
Here is the basic risk/reward graph for a bullish call diagonal spread.
Note the maximum profit is achieved at a specific price; the short strike. But through a process called “rolling” which we’ll get to later, we expand the profit zone.
Example #1: Let’s create a bullish diagonal spread in Apple (AAPL) given the known below:
Date: February 17, 2017.
Share Price: $137.70
-Buy 1 contract April (4/21) 135 Call for $4.15
-Sell 1 contract March (3/03) 138 Call $0.75
We always enter the trades as a single transaction with a specified price limit. In this case it is done for $3.40 Net Debit. That is $340 per one contract spread. This is how the order ticket would look on a typical brokers option-trading platform.
We would realize the maximum profit if shares of AAPL are at $138 on the March 3rd expiration. But again, to enhance our returns we plan on rolling the position through multiple expirations.
What we love and makes diagonals so attractive is they deliver profits through both income generation and capital appreciation.
An important element in the diagonal spread’s power is understanding the role of time decay in an options value. An option is a decaying asset - as it approaches expiration the time premium awarded erodes at an accelerated rate, which is known as theta.
This can work in your favor if you’re short an option, or against you if you are long an option. But note, there are some subtleties as to whether the option’s in-or-out of the money that need to be considered, especially when using spreads.
We often use the landlord analogy. Think of the long dated option you purchased as the entire building.
The short dated options you sold are an apartment within the building.
You collect “rent” on the apartment via time decay. This is your income stream. If the overall value of the building increases (stock price goes up) this will be the capital appreciation.
Because of the slope of time decay, or theta, the option we sold will decay faster than the option we own. We want to own “A” and rent out “C” on the theta slope.
Each time we rent an apartment (sell a weekly option) we reduce the cost basis of the long dated option we own. Think of is as paying down your mortgage.
If we can rent out the apartment a sufficient number of times we can eventually have a zero cost basis - owning the building free and clear.
In structuring the initial trade there are two items we use as guidelines to help us improve both the probability and profitability of the position.
We want the net debit of the initial trade to be approximately equal to the width between the strike prices. In the Apple example we paid $3.35 for a $3 wide spread (135/138 strikes). That is within our threshold.
We want to be able pay off our debit within 7 weeks, or rolls.
We reduce our cost basis through a process called “rolling.” This simply means buying back the option you sold short just prior to its expiration, when it has little value, and selling another option that still has time value of a week or more.
In our Apple trade from above, come March 3rd, if shares of AAPL are still below $138 we can expect the 138 call we sold for $0.75 to be nearly worthless. We would then sell the 138 call that expires the following week, March 10, and we’d expect to collect an additional $0.50 or more.
As you can see from the Apple option chain below one can expect to collect approximately $0.60 per week by selling a slightly out-of-the-money call. * We typically roll the Thursday prior to the weekly expiration. The chain below reflects still four trading days until expiration.
At this rate we would need approximately 6 ($0.60 X6= $3.60) weekly “rolls” to completely pay off the cost of April $135 call we own and have a “free” (actually a net credit) position. There are 7 weeks available to us prior to the April 21 expiration. So this trade meets our guidelines.
Diagonals are dynamic positions, in that their risk/reward profile changes not only with the underlying price, but also over time. We use our expertise to manage the position to maximize profit while minimizing risk. This means sometimes choosing strikes that will emphasize income generation and other times for capital appreciation. During the life of any given position we often do both.
If shares of AAPL move higher quickly we might exit the position for a profit prior to the April expiration.
Start with the Chart
Before constructing the trade and choosing strikes and expirations we need to identify a good candidate we think can deliver solid capital appreciation.
This is where team member Christian Tharp proves invaluable. Mr. Tharp is a Certified Market Technician (CMT). This means he a master at reading charts and identifying support and resistance levels offering attractive points for entering trades. He also helps us manage risk for exiting trades on the very few occasions we are wrong.
Let’s walk through a recent example of a trade we did in NVidia (NVDA) to show how all the pieces came together for one of the greatest trades ever.
During our live weekly call on January 19th Mr. Tharp noted shares of NVDA had created a double bottom near $100 and had now moved back above the support/resistance, around the $105 level.
We noted the company was set to report earnings on February 8th and given the attractive technical set up we believed the stock would continue to trend higher leading into the event.
Note, we did not plan on holding the position through the actually earnings but we did want to take advantage of the fact any option whose expiration encompassed the event would enjoy inflated premiums through the increase in implied volatility.
We targeted the February 10th expiration for the call option we wished to purchase. We went right at-the-money and bought the 105 strike call. The option we sold was the following week (Jan 27) at the 107 strike. We paid a $2.50 net debit.
The initial Alert to initiate the trade in NVidia was given on January 19th as:
In this case we didn’t mind paying a bit more than the width between strikes as we knew the option we owned would more than retain its value leading up to the 2/08 earnings release.
It also meant the time frame would be shorter than usual and we didn’t need to worry about fully paying down the position through rolls.
In fact we liked the way the shares were performing the next week on January 27 we rolled up from the short 107 call up and out to the February (2/03) 108 strike collecting $0.59. The Alert was thus:
By rolling up a strike we expanded the width, or profit potential, of the spread by $3 to emphasize capital appreciation rather than income generation. Our new cost basis was down to $1.91 and the width between strikes was now $3.00 so structure of the position was now very attractive.
In fact, the very next day when shares of NVDA climbed above $138 we exited the entire trade as shown here.
We realized over a 100% gain in just under two weeks! This is just one recent example of how we use the diagonals to achieve great results.
