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Options Theory: Finding Your Directional Bias

August 9, 2018

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All newcomers to the options arena face a challenge when selecting from the strategy buffet. There is so much to choose from! Bulls can buy calls, sell puts, or deploy any number of spreads. Bears can buy puts, sell calls, or play with their version of spreads.

To bring order to the chaos we provide some guidelines to help you. Some use implied volatility levels to determine what is best. Others let the desired probability and payoff be their guide. And then there are those that make their directional bias drive the process.

Today we’re going to focus on how to determine your directional bias.

Pick a Bucket

First, we group each strategy into three broad buckets: bull, bear, neutral.

Eventually, you’ll add a fourth bucket for bi-directional strategies, but we’re keeping today’s discussion simple. To test your comprehension, here’s a list of strategies in random order. See if you can match which ones belong in each category.

bull call, long put, bear put, short call, bull put, bear call, short strangle, short put, covered call, iron condor

Before divulging the answers let me elaborate on why it’s helpful to have multiple strategies for each category. First, it allows you to diversify your portfolio among different probabilities and payoffs. Some strategies offer a high probability of capturing a small reward. Others provide a low probability of receiving a big reward. In some situations, market conditions may be so ripe that you can’t help but swing for the fence. Other times you’ll take the high probability route and settle on base hits.

Second, some strategies are better equipped for high volatility environments while others favor low volatility environments. Having both in your bag of tricks allows for more precision in trade building.

Okay. Here are the answers:

Bull: long call, short put, bull call, bull put, covered call

Neutral: iron condor, short strangle

Bear: long put, short call, bear call, bear put

Determining if you’re bullish or bearish is easy enough. Just go with the trend. It’s the next step that trips up traders. Sometimes you’ll see us divide bullish into three sub-sections (1,2,3).

1 is mildly bullish, naked puts belong here

2 is moderately bullish, bull calls belong here

3 is aggressively bullish, long calls belong here

Now, why are we muddying the waters? Why bother with subdividing bullish into three tiers? Is it because we believe that we mere mortals can consistently predict when a stock is going to be mildly bullish versus aggressively bullish ahead of time?

Heavens no!

It’s hard enough to just get the bull or bear part right. Only liars and lucky ducks will say they can tell you if a stock will move up a little or up a lot.

The Purpose

The purpose of the numbering is to clarify in which environment that particular strategy will end up being the best. For example, let’s say you sell a put and the stock moves aggressively bullish (a 3). Will you make money? Yes! Will you be happy? Probably! Was the naked put the best way to capitalize on the aggressively bullish move? No! You would have been better off buying a call option.

Here’s another. You buy a call, and the stock barely rises (a 1). Will you make money? Maybe a tiny bit, but you’ll probably break even or lose slightly. Will you be happy? No! Was the long call the best way to capitalize on this mildly bullish move? No! You would have been better off selling a put instead.

The numbering system is designed in part to help you make a more informed decision, to know exactly which outcome will be best for each strategy.

For myself, I just view bullish as bullish and bearish as bearish. If I’m bullish on a stock, I choose which strategy to use based partly on implied volatility on partly on if I want a high probability or low probability play. I usually favor high probability plays so my most common strategy is naked puts and bull puts.

The last thing I do is obsess over the price chart and delude myself into thinking I can accurately guess if GOOGL (one of this week’s Option Report picks) is going to make a mildly bullish, moderately bullish, or aggressively bullish move.

 

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