In this episode I want to present four great alternative trades to some of the more common unlimited risk options strategies and help you learn how to convert these trades into their synthetic counterparts. The goal of these conversions is to turn a trade from unlimited risk to defined risk so that the broker will allow it in your account based on your options approval level. I think that you'll find after you listen to today's show it's much easier to trade unlimited risk strategies using their synthetic, risk-defined alternative than you might have thought.
- There are only four types of strategies that create an "unlimited risk" type of option strategy.
- The term "unlimited risk" is often misleading and can frighten traders when it really shouldn't.
- These types of trades are naked positions: short puts, short calls, short straddles, and short strangles.
- While you could have a significant loss in these for sure, it is not always the case and rarely happens.
- When you control position size and don't get too aggressive with the contracts you are selling, you can manage your level of risk as well.
Why Convert Trades?
1.If you are a beginner or new to options trading.
- You might want to convert trades from unlimited-risk to defined-risk if you are a beginner and don’t want to trade a naked position.
- You can turn them into alternative, synthetic positions.
2. If you are trading in an IRA or a retirement account.
- Many IRA's and retirement accounts will not allow you to trade undefined-risk positions.
- You have to be doing some sort of spread, buying and selling options, if you are going to be taking in a net credit.
4 Great Alternatives to Unlimited Risk Strategies
1. SHORT PUT OPTIONS CONVERTING INTO PUT CREDIT SPREADS
- A short put option strategy involves selling a naked put option, usually below the market.
- The easy way to convert a naked put option into a risk-defined position is to buy a put option at a lower strike.
- Essentially, the short put can be converted into a put credit spread.
Example: If the stock is trading at $100, you might sell the $95 strike put options. You could then buy the 94 strike put options, which are just a little bit lower and therefore create what's called a put credit spread or a bull put spread. This converts the short put into a risk-defined credit spread.
- When converting the trade over to a risk-defined strategy or alternative trade, you are giving up premium in exchange for capping the risk of your position.
Example: Continuing the example, if you sold the short $95 put option for $100 and you bought the $94 put option for $80, then the difference between the two contracts is just $20. You are still an option seller, net short options. Still, you had to give up some of your premium to get the benefit of having a defined-risk position — you had to take $80 out of your $100 initial credit on the $95 short put. You had to use $80 to buy the $94 put option at a lower strike price, creating a spread effect in trading.
2. SHORT CALL OPTION CONVERTING INTO A CALL CREDIT SPREAD
- If you want to trade a short call option, do the same thing as with the short put option, just on the opposite side.
- For both the short put and the short call, the wider you make your spread, the more margin you have to put up for the trade, but the more net premium you will collect.
- The further you get out of the money, the less and less expensive the credit spread conversion.
- The wider the spread, the more it will mimic the short options contracts/synthetic options contract, the higher the premium you will take in.
- Ultimately, it depends on the market situation as to how wide you should go (see trade optimizer software).
Example: If you have a stock trading at $100, you might sell the $105 call option and if you want to create an alternative or risk-defined trade, buy an option contract at a strike price higher than the one you sold. If you sold the $105 call, buy the $107 call or buy the $106 call option to create a risk-defined position. When you buy the contract, you give up some of the premium that you took in on the short $105 call in exchange for capping your risk.
3. SHORT STRANGLE CONVERTING INTO IRON CONDOR
- The first two strategies are the building blocks for the last two strategies — short strangles and short straddles.
- With the short strangle, you are selling options on both sides of the market — selling a call option and selling a put option.
- To convert a short strangle into an iron condor, buy options even further out than where you are selling options.
Example: If the stock is trading at $100, sell the $95 put option and sell the $105 call option. To convert it into an iron condor, buy the $94 put option and buy the $106 call option. In both cases, buy options contracts just $1 further out than our short strikes or our "inside legs". This converts the undefined risk position into its defined-risk counterpart.
4. SHORT STRADDLE CONVERTING INTO IRON BUTTERFLY
- With a short straddle, you are selling options with the exact same strike on both sides.
- Converting this trade uses the same concept as with the iron condor, but with an iron butterfly, you want to go a little further out.
- Your break-even points are a little bit further out from where your short strikes were sold.
Example: If the stock is trading at $100, you are selling the $100 strike put, the $100 strike call to take in a massive credit. Now you want to buy options even further out again: buy the $108 call option and buy the $92 put option to make the iron butterfly really wide and capture a big potential profit range.
- In all of these cases, there is the same basic mentality around all of them: you buy options at strike prices further out than your inside or short legs to create a risk-defined scenario.
- The wider you make the spreads and the further out you buy options, the cheaper they become.
- This allows you to take in more net credit for your position, which potentially means more capital and slightly higher win rates, but you sacrifice putting up a bit of margin in advance.