Levels of Risk

Risk is everywhere. There is, in reality, nowhere without risk. Every thought can trigger risk. Every act can be risky. Every result, happy or sad, is a balance between risk and reward.

For any trade, low risk to high risk, there are two rules that rule them all:

1. Have a defined rule for entering a position.
2. Have a defined rule for exiting a position.

I’ve traded outside of those universal rules on occasion, and have always regretted it.

High Risk: Options Contracts

Most of my options trading rules are straight out of research conducted by Tom Sosnoff‘s Tastytrade financial network, with the exception of the exits rules, where I’ve expanded on his methods. The rules are intended for smaller accounts, and has the goal of many base hits rather than the occasional home run amid a lot of strikeouts. The Long Options rules are entirely my own.

Trading Rules

Short Vertical or Iron Condor Spreads.

• Set the short leg or legs somewhere where needed to get sufficient return; from delta 16 to 30 is optimal. The higher the delta, the greater the risk and the smaller the odds of success.
• Select an underlying stock; the higher the Implied Volatility Rank, the greater the potential return. (This is similar to the IV Percentile found on many trading platforms.) An IVR of 30% or greater is best.
• Set the width of the wings at 10% to 20% of the stock price, adjusting to produce a risk/reward ratio that’s in the trader’s comfort zone.

Entry timing: As close as possible to 45 days prior to expiration, giving preference to monthly options. Generally, I won’t enter after 43 days prior to expiration.

Due diligence before entry:

• Avoid ex-dividend days
• Ensure that the potential loss is within the trader’s guidelines for managing trading funds.

Exit rules:

• Up to 21 days prior to the options expiration
  • Exit at 50% of maximum potential profit (25% for earnings plays).
  • Exit at 50% of maximum potential loss.
• 21 days prior to the options’ expiration
  • Exit if profitable.
  • Hold the position if unprofitable.
•  Fewer than 21 days prior to the options’s expiration
  • Exit if the position returns to profitability or at expiration.

By Tim Bovee, August 23, 2023, Portland, Oregon

Earnings Plays

• Enter a position on the final trading day before the earnings announcement.
• Select highly liquid stocks with options having an implied volatility rank of 30% or higher.
• Select liquid monthly options.
• Pick a direction for the expected move. There are many ways to do this. I use stock analyst opinion as tracked by Zacks Investment Research out of Chicago.
  • My method: I choose stocks with a Zacks Rank, a longer term measure, that’s 1 or 2 for a bullish trade, or 4 or 5 for bearish. A 3 rank means hold and so is neutral and I avoid it. I also use the Zacks Expected Surprise Prediction (ESP), which relies on analysts changing their evaluation shortly before earnings. It is stated as a percentage, positive for bullish and negative for bearish.  Zacks says that the tool is 70% accurate positive surprises, less for negative surprises. 
  • Other methods: Since traders bid the price of a stock up or down prior to earnings, a momentum indicator such as the RSI or MACD or Bollinger Bands can also be used as directional indicators, as can fundamental analysis or looking directly at analyst assessments
• Directional strategies: For lower risk (and lower returns), use short bull put spreads if a rise is expected, short bear call spreads if a fall is expected. For higher risk (and higher returns), short puts if a rise is expected, short calls if a fall is expected.
• If the stock has no clear directional bias, avoid the trade.
• The short strikes for each strategy ideally will placed be far enough out of the money to enclose the expected move. However, I will sometimes move closer in to improve the risk/reward ratio.

The expected move is calculated by taking the value of three positions and weighting them according to their distance from the at-the-money (ATM) mark.

1. Using the options closest to expiration…
2. take the price of an ATM short straddle and multiply it by 60% (0.6)…
3. take the price of strangle one strike price away from ATM, and multiply it by 30% (0.3)…
4. and take the price of a strange two strikes away from ATM, and multiply it by 10% (0.1).
5. The expected move is the average of the weighted prices — add them together and divide by 3.
6. Note that the expected move doesn’t anticipate the direction of the move — could be up, could be down.

By Tim Bovee, May 1, 2022, Portland, Oregon

Long Options

• Upon receipt of a buy signal, a long call or long put position should be entered no fewer than 70 days prior to the position’s last day of trading.
  • The closer to the last day of trading an option is, the cheaper the option’s price will be.
• The option traded should be out of the money with a strike price as close possible to 70% of the current market price.
• The option must be sold upon receipt of an exit signal or upon reaching the goal set upon entry into the position.
• A position must be managed no fewer than 40 days prior to the contract’s last day of trading.
  • Management consists of exiting the trade, whether it produces a profit or a loss.
  • If the stock is expected to continue to moving in a profitable direction for the option, then the position can be reestablished with a later expiration date.

See my essay “Trading Rules: Long Options” for an explanation of my thinking behind this ruleset.

By Tim Bovee, July 16, 2023, Portland, Oregon

Short Naked Puts and Calls

• Set the strike price somewhere from delta 16 to 30. The higher the delta, the greater the risk and the smaller the odds of success.
• Select an underlying stock whose Implied Volatility Rank (IVR) is 25% or greater. The higher the IVR, the greater the potential return. (This is similar to the IV Percentile found on many trading platforms.

Entry timing: As close as possible to 45 days prior to expiration, giving preference to monthly options. Generally, I won’t enter after 43 days prior to expiration.

Due dilligence before entry:

• Avoid earnings announcements
• Avoid ex-dividend days
• Ensure that the potential loss is within the trader’s guidelines for managing trading funds.

Exit rules:

• Up to 21 days prior to the options expiration
  • Exit at 50% of maximum potential profit.
  • Exit at 50% of maximum potential loss.
• If one these conditions occurs — a loss that is twice the credit received, a move beyond the short strike price, or 21 days prior to the options’ expiration — consider taking one of the following actions:
  • If profitable, exit the position
  • If unprofitable, do one of the following,
    • Exit the position.
    • Roll the position to the same strike price a month later, if doing so produces a net credit after the loss on the current condition is subtracted.
    • Buy options that will offset the short options, converting the position into a defined risk trade.

By Tim Bovee, August 6, 2021, Portland, Oregon

Diagonal Spreads

Unlike the short vertical spreads that have long been the bread-and-butter of my trading, diagonal spreads work well regardless of the implied volatility rank. They’re a good alternative to short vertical spreads in periods when IVR is low across the market.

A long diagonal spread is built from a short option closer in time and a long option with a different strike further out in time. If the options are calls, then the position is bullish. If puts, then bearish.

Here are the rules:

• Buy a long option
  • 90 to 120 days before expiration
  • Delta around 80
• Sell a short option
  • 30 to 60 days before expiration, with 45 days being optimal
  • Delta 30 to 50
  • Ensure that the premium of the short option is  equal to or greater than the extrinsic value of the long option. This becomes easier to obtain the deeper in the money the long options is placed.
• Ensure that the net debit is around 50% of the spread and that it never exceeds 75% of the width.
• Exit for a win if the stock price moves significantly in the direction of the trade,  rises (for calls) or falls (for puts).
• Roll the short option to a lower strike (for calls) or higher strike (for puts) if the share price moves significantly against the direction of the trade. (“Significantly” is undefined; I look at the potential loss, the trend on the chart, and then follow my intuition.)

Although maximum profit cannot be determined precisely, it can be estimated by subtracting the net debit paid from the width of the strikes. 

The breakeven point can be calculated by subtracting the net debit paid from the long strike price.

By Tim Bovee, August 8, 2021, Portland, Oregon

Lower Risk: Shares

Shares are considered to be lower risk than options because they can be traded without leverage and are generally have lower volatility.

On the other other hand, options positions can be positioned in a way that limits the possible loss if the price moves against the trader. Shares can drop to zero. I’ve had it happen.

In trading shares I use the same mix of techniques that I use in trading options in connection with earnings announcements (see the “Earnings Plays” section, above).

In broad terms, I select candidates using a broad indicator of some sort, based on something other than the chart. To time my entry, I use a narrower chart-based indicator — technical analysis — to guide my opening of the position. To time my exit, I use the broad indicator. For entries and exits, I confirm the indicators through Elliott wave analysis of the chart.

My preferences are to use analyst opinions, tracked by Zacks Research, for the broad indicator. I select trade candidates from stocks that have a bullish rank, a score of 1 or 2 on the Zacks analysis. I also give preference to stocks awarded a high momentum score — A or B — under the Zacks method.

For the narrower chart-based indicator, I use the Fisher Transform. It’s not widely available — I’ve seen it on one of the brokerage platforms I use, TDAmeritrade. But any technical indicator can be used. Where the Fisher is unavailable, I tend to use the RSI.

Here are my trading rules:

• Buy long shares
  • Zacks score is 1 or 2
  • Zacks moment indicator is A or B
  • The technical indicator (Fisher Transform or RSI) has just switched to uptrending from below the base line (0 on the Fisher and 30 on the RSI)
• Place a trailing stop loss of 20%
  • If the technical indicator gives a downtrending signal
  • If Zacks score becomes greater than 2.

The best tool that shares offer to mitigate that risk is the stop-loss; setting a price at which shares will be sold if the market price reaches that level.

I use a trailing-stop loss. For long shares, if I set a, say, 3% stop-loss, and the price of the shares rises, then the stop-loss will also rise, remaining 3% below the peak price.

I will use 3% occasionally as a very short-term insurance to limit loss, but my normal practice is to give shares room to maneuver. For that purpose, I use a 20% trailing stop. I’ve based based choice on three research papers:

Han, Yufeng and Zhou, Guofu and Zhu, Yingzi, Taming Momentum Crashes: A Simple Stop-Loss Strategy (September 24, 2016). Available at SSRN: https://ssrn.com/abstract=2407199 or http://dx.doi.org/10.2139/ssrn.2407199

Yusupov, Garib and Shorrason, Bergsveinn, Performance of Stop-Loss Rules vs. Buy-and-Hold Strategy (2009). Available at Lund University: https://www.lunduniversity.lu.se/lup/publication/1474565

Kaminski, Kathryn and Lo, Andrew W., When Do Stop-Loss Rules Stop Losses? (January 3, 2007). EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=968338 or http://dx.doi.org/10.2139/ssrn.968338

By Tim Bovee, March 31, 2022, Portland, Oregon

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

License

All content on Tim Bovee, Private Trader by Timothy K. Bovee is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.

Based on a work at www.timbovee.com.