OAP 122: The “Big Rocks” That Should Be A Priority For All Options Traders

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As options traders we need to focus on the levers that really move the needle in terms of generating income and cash flow for our portfolio. There's no point in doing something if it doesn't contribute to the overall profitability of the portfolio right? It'd be like shoveling your driveway before a huge snow storm. Or washing your car before it rains. The wrong activity for the sake of being active serves no purpose. Today's show resets the foundation for options traders by focusing on the "big rocks" that should take priority. Get this right and you'll set yourself up for success.

Key Points from Today's Show:

The concept of "Big Rocks" is best explained when you think about filling up a jar.

  • If you want to fill up a jar, you start by putting in the big rocks first because they take up the most amount of space.
  • Next, you take smaller rocks to fill in all the spaces in between the big rocks. 
  • After that, you pour sand into the jar to fill in even more of the space that surrounds all the rocks. 
  • Then finally you pour water into the jar, which truly fills it up all the way. 
  • The key is that you have to take care of the big rocks first, before taking care of everything else. 

1. Position Size

  • Position size is all based on the ticker that you are trading. 
  • If your max position size in any ticker is $5,000, you can break that down into 5 trades of $1,000 of risk.
  • This helps to spread the trade (and the risk) out over time and laddering into different positions. 

2. Frequency

  • When you increase the frequency of your trades over time, market direction becomes meaningless. 
  • If you could only trade one time per year, that one opportunity has all the weight on it and you have to get it right.
  • However, when you trade multiple times a month (trading 100's of positions and contracts) then each individual contract carries less weight. 
  • This allows you to gravitate towards the expected probabilities and the expected outcomes. 
  • The more often you trade, the better success you are going to have and the more market direction becomes meaningless. 

3. Options Selling

  • In any trade that you do, you have to be an options seller because option buying is a losing proposition. 
  • Implied volatility is always overstated long-term, and does not present itself until expiration. 
  • You have to wait for the IV over-expectation to mature.
  • It requires patience and thick skin to be an option seller and let the market move against you in some cases.

4. Keep Your Portfolio Balanced

  • Your options selling cannot be a one-directional.
  • A balanced portfolio has the potential to be profitable in any direction within a range. 
  • Essentially, you want to be in a position where if the market moves or stays the same, you have a chance to make money. 
  • Always come back and revisit your portfolio balance to remain generally neutral. 

5. Diversify Your Underlyings

  • To diversify, you have to trade uncorrelated (as much as possible) securities. 
  • Spread out your risk so that you are not consolidated in any one industry, ETF, or sector.
  • There is no magic formal for diversification; the idea is to trade several different tickers.
  • The key is to spread the risk out over different tickers so that no one ticker controls your whole portfolio. 

6. Have Directional Ignorance

  • Don't assume that you can predict where the market is going - be ignorant!
  • There is no standard in the market because it is always evolving and always changing.
  • Build positions and trades that focus on the things that you can control instead. 

7. Consistency

  • Time commitment and consistency is often a huge hurdle to cross over.
  • However, none of the strategies will work unless you stick with it on a consistent basis.
  • Trading is a long-term wealth-building system.
  • Be consistent in your trading, because that is what it takes to be a successful trader. 

Option Alpha Podcast Show Notes[FREE Download] Podcast Show Notes & Transcript PDF: No time to read the show notes right now? We've made it incredibly easy for you to save time by giving you instant access to the complete digital version of today's show. Click Here to Download Your FREE Copy

Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]: Honestly, this module isn't just for professional traders; it's for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

Option Trader Q&A w/ Chris

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from Chris, who asks:

My questions today are a bit in the weeds. I have a very good understanding of why we sell premium in high IV environments. I also understand that generally speaking, implied volatility overstates reality or historical volatility. What I'm curious about is the ration between IV and HV? It would seem to be that we would be wise to look for underlyings that have a high IV to HV ratio as it would seem to indicate that options are generally priced farther above reality, giving us a greater edge. What little I've found on this topic has seemed to indicated it's a valuable metric. Has the OA team done any research on this? Is there any actual value to this metric? Do you know a way that we can get this metric on a trading platform?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

Thank You for Listening!

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.