Basic Options Strategy (and More)

I was sitting on a plane to Vegas earlier this week thinking about what is most important for option traders, and I ended up having one of those moments of clarity. The best basic options strategy is to follow the rules (see side note at bottom).

Basic Strategy in Blackjack

If you play blackjack and don’t get totally cleaned out every time, one of the things you probably incorporate into your playing is what is simply called “basic strategy.” Blackjack basic strategy is this pretty brilliant matrix someone figured out one day that says basically (see what I did there, “basically”? Ha!) if your cards have X point value and the dealer’s face-up card is Y then do “this” (“this” being hit, stay, split or double).

Yeah. Someone actually sat down and figured out the math to see what is statistically the superior move given every permutation of hands that can be dealt. If you think about it, it’s not a real monumental feat because the player’s (your) cards can only add up to a value from 2 to 21 and the dealer can only show a card that is 2 through ace. So, it’s not a massive number of permutations really.

To be fair, even if you play basic strategy, you’re still at a disadvantage because you give up a small edge to the house, but you’re sacrificing way less edge than those random, wild gamblers who don’t use it. To have a true edge over the house, which IS POSSIBLE, you also need a betting strategy and a card counting system (which is NOT illegal; it’s just, “frowned upon” by the casinos, which will have their, umm, nice security people kindly escort you off the premises—best-case scenario). But in a nutshell, that’s how you win at blackjack.

Well, guess what? Options trading pretty much works the same way.

Basic Options Strategy and Getting Edge

If you’ve been with the Market Taker Family for a long time, you’ve heard both John and I harp on having a plan and setting your exit strategy at the time you enter the trade. If you’re new to the Market Taker Family, well, you’re about to hear John and me harp on about having a plan and setting exits for the foreseeable future. (You’ll thank us later. Right, older MTM generation?) Rounding out our analogy, it basically goes like this…

We don’t really separate out the basic strategy from the edge with trading. They end up being one and the same. So, there’s the slight difference. Reason being, no one has ever done some sort of decisive, universal, statistical analysis based on a fixed number of permutations. That’s because, well, unfortunately, there’s not a simple fixed number of permutations in trading, especially option trading.

This endeavor becomes the job of the trader—to create a set of if-then rules that should yield a profit if traded over and over again. To create a basic strategy of sorts designed to give edge so you have a greater likelihood of making money with a focus on the combination of odds of success and the risk-reward ratio. (That’s your job. It’s John’s and my job to do a lot of that work for you and make this task easier for you.) Let’s look at how this works in real life.

How to Get Edge on Put Credit Spreads

Let’s talk put credit spreads for this example. We would logically put them on when we think a stock is not going below the short strike price. But why? Is it because we hope it’ll go up, akin to the novice blackjack player who hopes he’ll get less than a 3 so his 18 gets closer to 21 even though the dealer has a 6 showing? No. It’s because we have some edge-building reason for making the trade.

One of those edge-building reasons could be that there is support at or below the short strike level. The existence of stock support changes the pure randomness of the assumed lognormal distribution stocks supposedly adhere to. That’s because support (or resistance for that matter) has a somewhat better chance of holding than not. So in placing your short strike at or below support, guess what? You just gave yourself an edge.

Another is that we avoid selling spreads “too cheap.” At MTM we have the 10% Rule that states you should never sell a credit spread for less than 10% of the strike width. This rule is rooted in some mathematical / statistical discoveries about the stock market that actually have been done.

Stock price distribution is leptokurtic, meaning its probability distribution has “fat tails.” Still need plain English? Big unexpected moves happen more often than normal statistics say they should. Fat tails throw off the probability-vs.-risk-reward nature of these trades, rendering selling credit spreads too far from the money—and consequently too cheap—a bad play.

Edge-Based Trading Systems (What They Can and Can’t Do)

Many of you subscribe to the Credit Spread Genius system I created. (If not, here’s a link to a recording of the training in which I explain how it works. To clear up any misunderstanding of the system, the “trade trigger” component is a small part of the edge. Those trades that pop up are made by the “smart money,” so there’s an assumption they might be good.

But a lot of the edge comes from simply following the basic strategy laid out in the coursework. The edge builders in that system are both on the setup (like support and resistance and the 10% rule) as well as the risk management (like being conservative and closing the spreads long before expiration to take profits, and taking a loss or adjusting if the stock goes through the short strike).  

Edge-based trading systems don’t aim to predict anything. They make things more likely, give better risk reward, or both. They create a system in which if you play that specific opportunity by those specific rules enough times, you make money.

As for My Side Note…

I arrived on this topic because I booked my flight to Vegas at the last minute and ended up with a middle seat. The guy in the aisle seat insisted on resting his elbow on the armrest between us. This is a clear violation of the unspoken “gentlemen’s agreement” that the middle seat passenger gets the armrest. Window seat gets the nice view and head rest, aisle seat gets the uncrowdedness and ease of getting up to go to the restroom, and the middle seat gets the armrests. Any experienced traveler knows this. I would have assumed this guy was not an experienced traveler and been more forgiving, but he had some pro-tip travel gear conveniences. AND we were seated in “Poor-Man’s First Class,” the exit row, which experienced travelers know gives you extra leg room. To boot, we were in the back-most exit row of the two over the wing—the one where the seats recline unlike the front one. (To be clear, we’re talking row 21 on a 737 on United flights.) So, obviously, he knew the rules but chose to violate them. Do you believe this guy? So, yeah. Rules, man. They are important.

Dan Passarelli
Founder and President
Market Taker Mentoring

 

4 Responses

    1. Hi Ken. I have a sick family member there. It’s good that you never saw option strategy as gambling. It’s not. There are some lessons to be learned from it though to apply to trading.

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