As we repeatedly state here on www.traders101.com, controlling risk is key to winning long-term in the stock market. An effective money management strategy is the bedrock on which ANY successful trading strategy is built. Having accepted that point, let's take a look at my favorite trading strategy using Options (instruments originally designed solely to control risk!!!).
Most markets sped the majority of time channelling sideways, according to long term research at www.traders101.com. A typical security or index might spend 80% of the time between two boundaries that define the range the market participants accept as 'fair value. Only rarely do markets breakout upwards or downwards, moving rapidly to a new channel that becomes the new 'fair value' (this phenomenon is explained in a little more detail in this article:- http://www.traders101.com/stock-trading-articles/Stock-Trading-with-Market-Profile-20050104.html).
As the market tends to prefer to remain within a channel (usually plus or minus about 5% of the current price almost 90% of the time!) it is possible to construct a really simple yet effective options 'credit spread' that can make you money most of the time while offering you a strictly defined risk. Here's how we do it. Given the figures above, we SELL a CALL at 5% above the current market price. We simultaneously SELL a 'PUT' at 5% below the current market price (a CALL is the right, but not the obligation, to buy at the strike price. A PUT is the right but not the obligation, to sell at the strike price). The nearest options contract is the one to go for.
Because we are SELLING these options, we will receive a payment for 'taking on the risk'. On the S&P, trading at $250 a point, the value to us of the CALL and the PUT will usually be in the region of roughly $600 right now, minus commissions, of course. We accept the RISK of the market moving outside these bands in return for the cash, which we can keep IF the market stays within the defined bounds. If the market does break out, losses are potentially unlimited, so what do we do? Hedge our position!
We also BUY a CALL one strike price further out than the CALL we sold. We also BUY a PUT one strike price further out than the one we sold. The cost of these calls should be less than the amount you made from selling the options in the first place as they are perceived by the market to be more 'unlikely' than the ones you sold (obviously, if it isn't the case, you don't bother). The cost of buying the cover will usually be about 2/3 the price you made from selling, so you just made a cool 1/3 cash for taking a strictly controlled position!
As research at www.traders101.com leads us to believe that we can expect this trade to win at least 80% of the time, and our losses are limited to the difference between out 2 PUTS or our 2 CALLS, you have to ask, 'is this free money?'. The answer is no. The downside is the cost of the options. Even at a deep deep DEEP discount broker fee of $10 a round trip, that's 4 of them - i.e. $40. If you don't choose the right strikes, you could still end up losing money (basically, the profit less commissions needs to be at least a quarter the size of the potential losses to break even on an 80-20 rule).
Does it scale? Yes. Do I use it? No. There are actually easier ways to make money day trading! Whatever you do, CONTROL THE RISK FIRST, SECOND, AND THIRD.
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