Posts

Options Trading Strategies: Which One Should You Choose?

/in /by

Options trading can be a complicated game. There are many strategies out there, and it’s hard to know which one is best for you. One strategy that has gained popularity lately is the “covered call.” This strategy was designed for investors who wanted to make money on stocks they already own (known as long stocks). When deciding which option trading strategies best suit your needs, here are some things to think about:

  • What is my risk tolerance?
  • What is my trading timeline?
  • What is my ROI expectation?

Risk Tolerance

Lower Risk Strategies

These strategies typically have lower expected returns but help you sleep at night. Examples of these types of strategies are covered calls, protective puts, and collars.

As you can see, these strategies typically involve owning the underlying asset (stock, ETF, etc).

Covered Calls – This strategy involves owning an underlying asset while simultaneously selling call options on that same stock or ETF at a specific strike price. The goal of this strategy is to create income from your long position.

Protective Puts – This strategy involves buying an underlying asset and simultaneously purchasing protective puts at specific strike prices to limit the investor’s downside risks. The goal of this strategy is to protect against large losses in an underlying asset.

Collars – This strategy involves buying an underlying stock or ETF and simultaneously selling covered calls against that same position while also purchasing protective put options to limit downside risk. The goal of this strategy is to reduce costs associated with the long-stock position by offsetting the premium paid on the call option sold while limiting losses from a large drop in the underlying asset.

Medium Risk Strategies

These options trading strategies have higher expected returns but also involve more risk. Examples of these types of best options strategies are covered strangles, short puts, and bull call spreads.

Covered Strangle – This strategy involves selling an out-of-the-money (OTM) put and an out-of-the-money (OTM) call on the same underlying stock or ETF. The goal of this options strategy is to create income from a long position in an underlying asset while limiting downside risk.

Short Puts – This options trading strategy involves selling a put with a specific strike price and expiration date, without owning the underlying asset. The goal of this options trading strategy is to create income from selling put premium. If assigned with the underlying stock, the Wheel Strategy can be deployed.

Bull Call Spread – This options strategy involves buying a call with a specific strike price and expiration date, while simultaneously writing (selling) another call on the same stock or ETF with a higher strike price but also at the same expiration date. The goal of the strategy is to create income from call premium while limiting downside risk by utilizing the short call’s time decay.

Higher Risk Strategies

These options trading strategies involve high levels of risks, but also have the highest expected returns. Examples include selling naked calls/puts and selling strangles.

Selling Naked Calls/Puts – This options strategy involves writing (selling) an out-of-the-money call or put on a specific underlying stock or ETF without owning the underlying asset. The goal of this options trading strategy is to create income from selling premium, while also taking advantage of time decay for short calls and puts.

Selling Strangles – This options trading strategy involves selling OTM put and call options on the same underlying stock or ETF. It’s essentially a combination of selling naked put and call at the same time. The goal of this strategy is to create income from premiums. The Tasty Trade method utilizes this strategy.

My Take on Risk Tolerance

When it comes to how much risk we are willing to take, a lot of it is phycological and what is perceived as risks.

For example, selling a naked call is considered the most dangerous form of options trading because it has unlimited risk. However, when managed properly, the actual risk is not as high as someone thinks.

Having said that though, in practice, knowing that it has unlimited risk, you might not be able to act properly to make the trade profitable. Trust me, I have encountered this many times.

This is why I try to find a strategy that matches my risk perception and the actual risk. In other words, a trading strategy that matches my personality.

Trading Timeline

Since options have an expiration, depending on which side of the trade you are on (buying or selling), time decay can be on your side or against you.

If you are selling options, time decay is on your side. If you are buying options, then the passage of time can be against you as it will decrease the value of your option premium.

My Take on Trading Timeline

I personally prefer strategies that sell option premium because even if the stock doesn’t move in the expected direction, the options could expire worthless for me to make money.

ROI Expectation

Many options traders started out trading stocks but eventually moved on to trade options because when trading options, it is possible to generate a consistent income without the need for directional moves of the underlying stock. Whereas stock traders need the stocks they are trading to move one way or the other to make money.

On the other hand, there are traders who want to bet on a directional move by using options to amplify returns on their limited capital rather than buying the underlying stocks.

My Take on ROI Expectations

As I mentioned, I personally prefer to sell option premium rather than buying options.

The downside to these kinds of options strategies is that they tend to have lower ROI compared to strategies that buy options.

So what is the Best Option Strategy?

I think the best options strategy is one that fits your personality and risk tolerance. I am not as concerned with ROI because even if ROI from each trade is low, just simply repeat the same type of trades will generate enough ROI to get me excited.

For me, I would choose to sell option premium because it gives me consistent income even if there are no directional movements in the underlying stock or ETF.

Stock Market Sentiment Analysis – Why Care About It?

/0 Comments/in /by

It’s that time of the year again when stocks typically underperform. The end of Summer and the beginning of Fall. Don’t ask me why but that’s what the data tells us (see graphs below).

There are multiple theories as to why this happens every year and as a human, we like to attach a simple reason to the outcome that we see, even though a lot of time the actual reasons are much more complicated than that.

seasonality_month_spx

seasonality_month_nasdaq

Studying market sentiment is like reading someone’s face and trying to understand what they are thinking and feeling. It’s not always 100% accurate, but at least we could get a sense of whether the person is happy or sad based on the facial expression, then act accordingly.

I started looking into Market Sentiment Analysis because I knew the winning streak of my Wheel Strategy tradings would not last and I needed more tools to guide me on how aggressively I should (or should not) participate in the market.

One of the places I looked for obviously was the typical Chart Technical Analysis as it could tell us what people are thinking and doing. For example, when a clear divergence is observed between the price movement and a technical indicator (in this case Money Flow Index), it tells us that even though the price is going down overall, there is a positive (buying) money flow for whatever reason.

ptra money flow divergence

While this is very useful and can be applied to Stock Indices to get a sense of what’s going on in a broader market, the amount of data is somewhat limited as we are primarily looking at only the price and volume. It is good for making short term trading decisions but doesn’t give me a broader perspective of what’s going on in the market and answer some of my questions such as

  • How confident people are about the market?
  • Is the market environment changing?
  • What is the current market environment compared to previously? Say right before a large recession drop?
  • Is there a way to predict the next market downturn?

What is Stock Market Sentiment Analysis?

Stock market sentiment analysis is the process of analyzing and interpreting investors’ emotions, opinions, and attitudes toward a particular stock or the overall market. It involves using various techniques and data sources to determine whether investors are bullish (optimistic) or bearish (pessimistic) about a stock’s future performance.

Technical analysis focuses on studying past price movements and patterns to predict future price changes. It relies on charts, indicators, and other technical tools to identify trends and make trading decisions.

On the other hand, stock market sentiment analysis takes into account the opinions and emotions of investors towards a particular stock or market. It considers factors such as news headlines, social media activity, and surveys to gauge investor sentiment.

Introducing Sentimentrader.com

I came across Sentimentrader.com while watching a YouTube video dissecting an SPX chart. The video showed a graph of the % of stocks that are above 50 days Moving Average (MA) similar to the one shown below.

The message of the video was that there is a clear divergence between “SPX price” and “Stocks > 50% MA”. This is not a definitive sign of a market collapse, but an indication that a lot of the stocks are now moving sideways or start to decline.

The data below is only up to June 4th, 2021 and interestingly enough, SPX has since climbed even higher with only two minor dips in June and July.

However, my Wheel Strategy profitability has declined substantially in the last couple of months, which tells me that the market condition is definitely shifting in some ways. To find out more, I decided to signup and dig a little deeper to see what the site has to offer.

As it turned out, there are several indicators that could be pretty useful.

Industry Breadth (% _ 50 Day Avg)

1) Smart Money / Dumb Money Confidence

These data show the correlation between Smart Money (Blue) and Dumb Money (Brown) in regards to the market.

When the Dumb Money Confidence is dominating (the red boxes), the market seems to continue on an uptrend overall with some minor sideways move. This could be the time to go big, deploy more capital without worrying about hedging.

When the Dumb Money line is crossing over with Smart Money, it’s time to be cautious and it could lead to a large decline (red arrows).

Obviously, this is only one of the many data points we need to look at and decide how to trade but this could also be useful at confirming what is going in the market.

For example, both Dumb and Smart Money lines have crossed each other a couple of times in the last couple of months, which indicates it’s time to be cautious. My declined trading profit in the last couple of months indicates that I am getting assigned more with the Wheel Strategy, in other words, more stocks are declining in price. The Wheel Strategy is a positive Beta strategy so clearly, the market condition is changing despite the fact that SPX continues to climb higher.

Smart Dumb Money Confidence

2) ROBO Put/Call Ratio

ROBO stands for Retail-Only, Buy-to-Open. It looks at transactions that are buy-to-open only for trades that are under 10 contracts of Put and Call options.

In theory, this ratio focuses on small traders to get a better feel for what they are trying to do. Put is generally used to speculate price decline for small traders so the Put/Call ratio generally goes up when the market is in decline.

The ROBO Put/Call ratio is right now below 0.5 and the last time it was hovering around this level, was between 2004 – 2008 before the financial crisis (red boxes).

This doesn’t mean we are going to have another market decline like in 2008 but, it certainly shows how confident the small traders are with the current market.

Robo Put Call Ratio

3) NYSE Net High-Low %

Similar to the graph of the % of stocks that are above 50 days Moving Average (MA) described earlier, this data shows the net percentage of NYSE securities trading at a 52-week high minus the percentage trading at a 52-week low (blue line).

When there is a divergence between the SPX price and the NYSE Net High-Low ratio (red arrows), a market dip occurred sometime after it (yellow arrows). Obviously, there have been divergences that did not follow with a market dip, but it certainly is one of the signs to watch out for.

I overlayed the Smart Money / Dumb Money Confidence Spread (brown line) and there is a clear correlation that can be seen.

NYSE Net High-Low %

4) Sector and Country Sentiment Overview

China recently started regulating its tech industry BIG TIME. As a result, many of the Chinese stocks started to decline, including non-tech-related ones. Probably not a good time to open any Chinese stock-related positions, or it could also be a great opportunity if you are a contrarian.

China Optix

The Delta variant COVID-19 is causing yet another surge in infection cases and after moving sideways in May and June, the Health Care sector has started moving up again.

XLV Optix

It’s not always as clear-cut or as easy to explain why the changes in sentiment for certain sectors or countries, but keeping an eye on these data could provide an early warning sign or potential trade opportunities.

What is the Takeaway?

When I just started trading stocks and options, I always wondered how experienced stock/options traders could tell when to buy and sell, and stay calm even when the market was dropping like a sharp knife.

As I gained more experience and studied more, I came to learn that there are tools that could help us understand what is going on in the market and make educated decisions.

One of the challenges that we have as a trader is to truly understand how each of the trading strategies would perform under different market conditions.

For example, the Wheel Strategy is a Beta positive strategy so it is more profitable when the market goes up, and less when the market goes down.

I managed to get a 10% one-month return several times earlier this year and looking at the sentiment data that we discussed earlier, it becomes clear that there was a perfect uptrend market condition for this to happen. In other words, this would not have happened in other market conditions. This means I need to act more cautiously and be more defensive during non-uptrend market conditions.

By learning how to read the market sentiment, I am now able to not panic when the Wheel Strategy is not performing, knowing that the underperformance is because of the changes in market condition and not because of my trading errors.

My technical and fundamental analysis could still be correct, but if the market is in a phase that nobody cares about the usual technical or fundamental data, then of course no matter how correct I am, I would not be able to get the results that I hoped for.

Under such poor market conditions, the best I could do is to control what I can (be more conservative with position sizing and risk-taking) and hope for the best.