From Our September 2015 E-mail Archives: Our Head Trader, Robb, replied to an e-mail from one of Maverick's traders who had a question about trade triggers and another question about choosing strike prices for vertical spreads.*
-----Original Message-----
From: Thomas G.
Subject: Trades
Robb,
I have two quick questions today.
- Trade Triggers – When you are entering a trade, if you get a higher high, but its a doji candle on the day, do you consider this a trigger to enter a new trade or not? I'm sure the answer is the same as you have told me before, that it evens out in the end if I do it 1,000 times.
- In Sunday's Trading Room, you gave an example of Sempra Energy (SRE) 100/97.5 Bear Call. The stock is low basing and you get around 1:1 Reward-to-Risk Ratio with a high probability. My question is, "Why 100/97.5? Why not 100/95 or 97.5/95?" I know that it was just for an example and you would put it through your personal trading plan before actually making the trade. However, I'd like to know, when you see a low base on a chart, do you go slightly in-the-money (ITM) as a rule.
Thomas
-----Reply Message-----
Hi Thomas,
- Trade Triggers – First of all, you are right in the fact that there is not likely to be much statistical difference between entering or not entering over the long run (say, 1,000 trades). You really need to decide which method feels most comfortable to you; that is, the entry rule that you are most likely to follow religiously.
Personally, I like to get into trades a bit earlier than most people, but I have to recognize that sometimes I will get “head-faked” and would have been better off had I waited for more confirmation. On the other hand, one of our traders, Joe Jensen, always waits for confirmation. By default, Joe has a higher Win/Loss % than me, but he also has a lower R/R ratio. In the end, both of our strategies work for us and will work better in some market environments and worse in others.
- Whenever you are looking at a vertical spread (any of the four vertical strategies…actually, any option strategy), there is a teeter-totter of Win/Loss % and R/R Ratio. I’m sure you’ve heard me reference it in many of the training sessions. If you want a higher statistical Win/Loss %, then you must accept a lower R/R and vice versa. Options pricing models are 100% statistical in nature and there is no way to get both a high Win/Loss % coupled with a high R/R ratio. That’s why we use market and stock volatility to tell us which strikes to use.
For example, over the February to August 2015 period, we kept saying in the Sunday Trading Room sessions that “you can’t ask too much of the underlying stock in this low volatility environment.” So, we used tight spreads and option strikes that were closer to at-the-money (ATM) since the odds of having a substantial move weren’t that great. In a high volatility environment, you actually want to be more aggressive on vertical spreads since the odds of closing at a max gain or loss are much higher.
If there was a stock at $100 in a low volatility environment (or I was looking for a lower volatility trade) and I was bearish, then I would go with the 100/97.50 Bear Call Spread since my underlying won’t need to move as much. This trade would have a higher W/L% than other trades, but would also carry a lower R/R.
In contrast, for the same $100 stock in a high volatility environment, I would go with the 100/95 or 97.50/95 Bear Call Spread since the odds of a big move would be much higher. I would have higher R/R on these spreads than the 100/97.50. Remember, rising or high volatility simply means that a spread has a greater chance to achieve max gain or loss. It’s up to you to analyze the market, sector and stock to make sure that you are on the right side of the trade.
Robb
* NOTE: Some original wording has been modified for legibility.
