OAP 109: Say Good-Bye to Unlimited Risk Option Strategies Forever

Download The "Ultimate" Options Strategy Guide

Unlimited risk option strategies get a bad rap in the investing community among newbie traders. And while our backtesting research has shown that unlimited risk positions like short straddles and short strangles generate the best overall returns, you might be restricted in trading them because of your account type or just fear the big potential drawdowns. In either case, on today's podcast I want to conceptually walk through how you could covert these strategies into their risk-defined counterparts and limit your exposure. As always, there's no free lunch in the market so if you limit your risk you have to give up something else and we'll discuss the trade-offs on the show together.

Key Points from Today's Show:

  • Unlimited risk strategies have a bad reputation within the industry.
  • Although they seem unlimited, they can be limited by your own position size. 
  • Trading multiple positions across multiple ticker symbols is preferred rather than one position across one ETF.
  • Spread your risk and keep your position size down so that no one individual trade can knock you out. 
  • Unlimited risk strategies are the most profitable and generate the highest returns with the smoothes portfolio graph of mostly any strategy out there (see show 100).
  • You receive more compensation with unlimited risk strategies, despite the extra risk taken on. 

Case Study

IWM is trading at $184.27. We do a regular short strangle in IWM, selling the 139 puts at 15 Delta. On the call side, sell the 15 Delta, which is the 155 alls. You would collect $122 premium to do this. In this case, the margin required is 2,260, which is a given number. 

  • Brokers calculate their margin at expected move thresholds that the stock could potentially go in the future. 
  • If the stock does make a big move, brokers want to protect themselves against these further STD extremes.
  • Therefore, by using the buying power effect, you can control your risk. 
  • The return at expiration, if held for the full period, would be 5.39%.

Defined Risk Strategy:

If you wanted to do this as a defined risk strategy, simply buy options further out than your short strikes. Use the $122 credit you collected from selling the short strangle to buy options further out. Do a $5 wide spread on either end, buying the $160 calls and selling the $139 puts to buy the $134 puts below the market. 

Key: go out as far enough as you feel comfortable with your risk and your position size, to take in enough credit that makes it worth doing.

With a $5 wide spread on either side, credit gets reduced down to $69. This is now where you start to see the trade off, collecting less premium because you are getting a defined risk position. However, in this case it still works out to be a decent setup. The margin that is required to hold this position is just the difference between the strike prices less the premium collect, equalling $435 after commissions. 

Return jumps up to 15.86% on this position.

Key: You have to determine whether you are more comfortable collecting less money but having a higher return on your trade.

Iron Condors and Iron Butterflies:

Iron condors and iron butterflies in low implied volatility markets tend to work better because they have higher returns with defined risk and you can effectively create a scenario where you have the same marginable risk as a short strangle and collect way more money in doing so. The only trade off is that your break-even points are much more narrow. This will affect the position in the sense that if the stock starts to move against you, you do not have as much cushion. 

With a risk-defined strategy, you will not generally get the quicker profits as you would with a straddle or strangle. 

  • Straddles and strangles are just single contracts, trading the short puts and the short calls. 
  • As time decay and volatility contracts, those options will see a quicker, more violent reduction in their premium. 

Iron Condor Turned Defined Risk:

With an iron condor, when its turned into a defined risk strategy, because you're not selling and buying options at the same time, the premium decays at a much slower pace. Back testing shows that short strangles and short straddles can be held for short periods of time. Therefore you have the ability to potentially recycle that capital at a faster pace. The iron condor has a higher ROI to begin with, but it also means that you have to hold the trade much longer — two or three times longer than the original short strangle. 

At this point you can start adjusting your long strikes. If you want to take in the higher credit, go up to the 165 calls with a $10 wide strike on either end. That now moves the credit up to 91 cents from 69 cents. It may not be work going that wide. If you go $10 out on either end and take in credit of $91, the margin required to hold this position after commissions is $913. The return drops down to 9.9%. As you start to replicate more of the original strangle position, you start to see that the return starts to edge down towards the 5.39% original return. 

Key Takeaways:

  • No one strategy is better than the other.
  • The key is understanding the tradeoff between the different strategies.
  • Also, be aware that you do not have to do any undefined risk strategies.
  • You can do defined risk strategies if you have a smaller account. 
  • By controlling your position size and controlling your risk, you can still generate decent returns along the way.

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/ Mark

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 Mark, who asks:

I have been trading options now for six months on a Paper account. I have a question about good option pricing. In your video you show that you use the probability in the money to calculate good option pricing. When you use 20% of probability in the money in your first example, you need a credit of at least $1. Instead, if I use Delta, I need a credit of at least $1.15. When I can get a credit of $1.05, in your example, using probability in the money you are good. If I use Delta it would not be okay. How can I use deltas to calculate good option pricing?

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!

I'm humbled that you took the time out of your day to listen to our show, and I never take that for granted. If you have any tips, suggestions or comments about this episode or topics you'd like to hear me cover, just add your thoughts below in the comment section.

Want automatic updates when new shows go live? Subscribe to the Option Alpha Podcast on iTunes, Google PlaySoundCloud, iHeart Radio or Stitcher right now before you forget - it's fast and easy.

Did You Enjoy the Show?

Please kindly consider taking just 60-seconds to leave an honest Review on iTunes for The Option Alpha Podcast. Ratings and reviews are extremely helpful and greatly appreciated. They do matter in the rankings of the show, and I read each and every one of them!

Also, if you think someone else in your social circle could benefit from the topic covered today, please share the show using the social media buttons you see. This helps spread the word about what we are trying to accomplish here at Option Alpha, and personal referrals like this always have the greatest impact.

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.