Options are an incredibly versatile asset class that provide an unrivalled amount of flexibility… but only when you know what you are doing and how to do it.
For many beginning option traders, leverage is the main lure into this domain. It is the exciting world of using only small amounts of capital to control much larger holdings, sometimes excessively large.
Unfortunately these ideals also normally nurture a mentality of ‘profits first, risk later’ which is extremely dangerous to account balances. Overall, time and time again the misuse of options has led many investors to simply dismissing using options altogether.
So why do we use Options?
If you were to ask any professional level options trader, you will quickly learn that the main benefit of using options is the ability to clearly define the risk, and their probabilities, across a wide variety of strategies to target a wide range of market conditions… not just shares going up or down. In one word… flexibility!
Furthermore, with active position management, you can even establish trades through what is known as ‘adjustments’, where your worst case scenario is a profitable outcome. Sound interesting?
What is an option adjustment?
Adjustments are small tweaks that we make to option strategies during the trade, with the intention of removing or shifting risk to suit our developing outlook on the market. The markets aren’t static, so our risk exposure shouldn’t be either.
A basic example is that if a Call Option trader that enters the following trade;
Buy 15 Contracts of a 3 month $10 strike call options for $1 = $1500 investment
After 1 month, the stock has moved up as the trader expected, and is now worth $3 or $4,500. The trader still expects higher prices and wants to keep trade open. However the trader also does not want to risk their initial $1500 investment.
Using an adjustment, the trader could Sell 5 of the original Calls at $3 each, receiving back the initial $1,500 investment and now leaving the remainder of the trades 10 contracts essentially risk free.
Yes the trade could lose the unrealised profit, but the risk of the initial capital has been removed. Most importantly, no matter what happens, you will live to fight another day!
While this is a very basic example, it highlights the idea of being able to lower/adjust risk, and still maintain the ability to generate additional profit out of a trade. This is the domain of the advanced options trader.
Risk Reduction Adjustments – a real example using ASX200 Index Options
Let’s now take a look at a real life trade example, where we have applied this philosophy of making risk reduction adjustments. The trade was closed just this Thursday 16th Jan for a 316% profit over an investment horizon of 55 days.
22 Nov 2014: First Entry Point… Jan 2014 Put Butterfly Spread
In last Nov we were concerned that the ASX200 Index may continue to see some weakness into December and Jan, and therefore wanted a low risk way to take advantage of this outlook.
The entry trade involved the following transactions;
Buying 1 x XJO Jan 5350 Put,
Selling 2 x XJO Jan 5200 Puts and
Buying 1 x XJO Jan 5050 Put
This is known as the Butterfly Strategy, which offers the trader limited risk and limited reward within a defined range of price. In this case, the closer to 5200 the index was by January the better. The outlay was 24 points, or $240 for each contract. The max risk was only $240 however the upside was capped at $1260. A favourable 5 to 1 risk reward ratio right from the start.
11 Dec 2014: First Adjustment… shifting our risk profile
In the first two weeks of the trade we saw a stronger than expected decline in the ASX200 Index. We were now trading around 5100, down 250 points (4.67%) in 2 and half weeks. Our assumptions had now changed however, and our outlook was now that the risk was for the market to recover back up towards 5300 or more before Jan.
So, we made an options adjustment that shifted the risk away from losing value if the market recovered too much, and added it to the downside risk on this trade. This is illustrated in the below risk charts.
This adjustment involved;
Buying 1 x XJO Jan 5200 Put,
Selling 1 x XJO Jan 5300 Put
The above trades were completed for a 70 point / $700 credit. This means we actually were paid a $700 credit to reduce our upside risk.
20 Dec 2014: Second Adjustment… capital risk removed!
Now only 9 days later, and again much sooner than expected, we saw a market recover back up to 5270. This was a real gift from the market, as we now were able to make our second and final adjustment. This adjustment was the opposite of our last, removing the risk now to the downside, and arriving at a position (outlined in green below) were our worst case scenario became a $260 profit, and at best case a $760 profit if the ASX200 Index was at any price between 5300 and 5100 on the 16th Jan. That’s right, you read it properly, at any index level we will now be able to make a $260 profit.
This adjustment involved;
Buying 1 x XJO Jan 5200 Put; and
Selling 1 x XJO Jan 5100 Put
The above trades were completed for a 20 point / $200 debit, and left the overall breakeven of the trade as a 26pt / $260 credit.
16 Jan 2014: Index Options Expiration Day
The ASX200 Index settled at 5277.4 on its options expiry, leading to the trade landing within its max profit range. The Bought 5050 and Sold 5100 strike Puts expired worthless, while 5300 Sold and 5350 Bought Puts were cash settled for a total 50pt credit. This added to the 26pts of total credits that we have collected along the way and the trade was now closed.
Overall, the gross profit for this trade was a 76 point credit or $760 gross, which was made against an initial capital investment of only $240. This equates to a 316.7% yield over the 55 day life of the trade.
However it is not the 316% return, while sounding impressive that is the key advantage here. But rather it is the fact that after only two adjustments, a trade that initially required $240 risk was transformed into a strategy where no matter where the Index had been on 16th Jan, the trader would have walked away from at least $260 profit or more.
Contact Us if you would like to learn more about advanced option strategy management or simply sharpen your option skills and knowledge.