Options as a Conservative Trading Strategy
Each trade involves risk; be it trading stocks, ETFs, mutual funds or options. This article will demonstrate that options can be traded to diminish risk. Think about the following factors and learn how to quantify risk and differentiate strategies.
Prior to analyzing our strategies we require a means of evaluating the quality of a strategy. Profit Factor is generally used by analysts to determine which trading strategies have the best reward to risk ratios. It requires a record of trades to calculate. Profit Factor [PF] is the sum of the winning trades divided by the sum of the losing trades.
PF = £ Winning Trades / £ Losing Trades
For example,
PF = 3 would imply each dollar risked would result in three dollars reward. Obviously, the higher PF, the better.Successive Losing TradesProfit Factor, by itself, is not adequate to judge better strategies. The market is always changing. One sector, such as semiconductors, might be hot for a time and cool during another; value stocks have had their moments of favor; even internet stocks without any tangible assets have had their bubble. We need to be prepared for the likeliness of successive losing trades. Not only are successive losing trades damaging to resources, but they are also debilitating emotionally and can inhibit our will to follow our strategy.A Stock Trading Strategy - Rooster TailFor this article let us consider a proprietary strategy called Rooster Tail. It trades 5 stocks with a market timer, SPXTimer from October 2006 to September 2010 only in bull markets. In addition to the timer, exits are controlled via gain and loss stops. The initial investment was $100,000 or $20,000 per position. Profits are reinvested.As you can see, its back-trading statistics are very good:
Profit Factor: 2.8
Successive losing trades: 6
Gain: 218.21% [$100,000 ¨ $313,212]
Annual Rate of Return: 56.29%
% Wining Trades: 62.23%Rooster Tail Traded With OptionsOptions are strange beasts that have many interesting properties. Often it is possible to buy an option for less than 10% of the price of the stock. This is an important association. Were we willing to trade the stock with a 10% stop it would mean risking at least a 10% loss. On the other hand, using the option in lieu of the stock limits the loss to at at most 10% - it cannot be more than that. As you can see, options offer the opportunity to gain more and lose less than if you just purchased the stock.. Employing options this way eliminates the need for stops.Options, also, reward wins better than it penalizes losses. For example, if we compare a stock gain versus an equivalent loss, we would expect the corresponding option dollar gain to be greater than the loss. This is because the option loss can be no more than its cost. Like a stock, the upward potential for an option is unlimited.As a result, if at least 50% of your stock trades would be winners, the options would present a huge advantage. Why? Because your gains would be much greater with options and the losses would be less. Furthermore, if the average win was greater than the average stock loss it would further improve the odds.Stops are often recommended as a tool for managing risk. They are insufficient. See 'Is it Possible to Invest Profitably Without Stops?'. This strategy does not employ stops.In our simulation, each trade of Rooster Tail is replaced with an option trade of the stocks. The options were entered at the same time the stock was bought and exited at the same time as the stock was sold. The strike price was the stock price rounded up to the next dollar; initial duration was 60 days unless the stock trade was longer - then it was 90 days; volatility was a fixed 35%. We want to limit the investment allocation to the options portion of our portfolio to 10% of the bank. Therefore, the initial option allocation was $10,000 or $2,000 per position. Profits and losses are applied to the bank. All investments were for a fixed amount during a signal.The statistics with options are even better:
Profit Factor: 3.4
Successive losing trades: 6
Gain: 273.71% [$100,000 ¨ $373,707]
Annual Rate of Return: 70.6%
% Wining Trades: 56.8%ConclusionIf used properly, options can be traded profitably as a conservative investment strategy. With this strategy, 90% of your capital always remains in cash. This is the ultimate hedge against successive losing trades. Stocks cannot match this strategy in terms of Profit Factor, Annual Rate of Return or safety. Furthermore, this option strategy can be employed in IRAs.
