Creating an Option-Based Portfolio



Was since 2020 when, in a revolutionary decision, the main US brokers (Ameritrade, Fidelity, Charles Schwab, eTrade) decide to offer zero-commission in stocks, ETFs, and options trading, that the stock market's control changed forever: now the retail traders, can decide face to face with institutional and hedge funds, the trend it will take.  Seems unbelievable, but is a fact. Just remember recent phenomena like Robinhood and the meme stocks, with their exaggerated volume trading and yields, in which buying the dip is almost a religion for novice traders, and using OTM's cheap calls its bible. 

On the other side, for retailers that maintain a month-rebalanced long-term portfolio, it was a great opportunity to start trading options like a pro, with a portfolio not only merely of stocks, as now commissions are no longer cutting dramatically the profits. And I think the best way is to use two great and powerful option instruments: the ITM options and the credit spreads, in order to create an option-based portfolio. Below, I share here some tips for taking advantage of these two options tools.


Options as a substitute for Stocks: choose Delta > 0.80


Substituting stocks with options has two unique advantages: only options bring leverage and protection.

- Options provide tremendous financial leverage to users when they are used in a conservative way: you can control the same amount of shares with less money, and mainly, the % returns are much higher when you trade with options. This carries another advantage: with more money available you can diversify better your portfolio.

- And options provide protection. With the appropriate strategy, in case of a devastating fall of the stock, your maximum loss is always limited to the amount of the call or put purchase.  The use of stop-loss in stock trading works reasonably well but does not always prevent losses due to frequent morning gaps. Stop-loss orders offer protection that is path-dependent (depends on the "path" the stock takes), while options offer time-dependent protection (and never trigger you out of the position just because of the path the stock, as stop-loss did).

Options are two-dimensional assets: you must guess correctly the direction and the speed of the underlying stock. When stock trader becomes an option-trader they often buy at-the-money call options (since they are cheaper) as a substitute for the stock. Doing so subjects them to a two-dimensional asset when they are used to trading stocks, a one-dimensional asset. When you start out, buy short-term options in-the-money (ITM), calls with relatively high deltas in the 0.80-0.85 range and you will have an asset that behaves similarly to the stock you are trading. They are more expensive than ATM or OTM options, but less risky.

The reason is that a call option with a delta of 1.0 is no longer considered an option, it's a perfect stock substitute. There is no time-premium there, and a lot of intrinsic value that we would rather not pay for. So you don't need to find a delta of 1.0 but should get close, and the 0.80-0.85 range will suit your needs. On the other side, if you buy a higher strike, there is too much time premium in the option and it may not respond to smaller changes in the stock price.

Tip 1
You can create an option-based portfolio, with 1 to 3-month expiration options of stock/ETFs, selecting the correct (ITM) call or put, depending on your bias, with a delta greater than 0.80. Finally, it's about the same as a classic portfolio with stocks and ETFs, but with all the advantages described above. Rebalancing (rolling up/down it) every quarter, or month when volatility increases, is key to beating the market.

Tip 2
And if you like long-term positions (longer than a year), consider for your portfolio the use of LEAPS options. Select stock/ETFs with a price below $20, better I believe in the cost-benefit ratio. In this case, search for its ATM/OTM call or puts, due to its lower premium.







The only Built-in-Edge trading tool


As you know, trade options are more complicated than stocks. Again, you need to guess not only the direction of the stock but also how quickly the stock's price will get there (the speed). We can combine two concepts for a solution, selling puts and a vertical spread, to create a great trading tool, the bullish credit put spread. Two concepts originate it:

1- You can create a bullish trade not only by buying calls: you can sell puts. A short put, being on the opposite side of a trade of a long put, is bullish. Most traders, who are bullish, are tempted to immediately reach for the long calls, also due to its unlimited gains, but they need the stock to move. A short put also makes money if the stock rises. But more importantly, also make money if the stock standstill. It's a big difference that by selling puts you don´t need the stock rise for us to make money: you just can't have it fall. You eliminated the speed component of the option.

2- Sell puts create an unlimited downside risk that you could control by creating an option spread, that's combining two different option strikes as part of a limited-risk strategy.  This is called a vertical spread, consider buying and selling a call, a call spread, or buying and selling a put, a put spread, of the same expiration but different strikes Essentially, trading put credit spreads is very similar to a short put. Preserves its advantages, but without its dangerous downside risk. And that's great!

Then, as with any other typical option, a vertical spread can be bullish or bearish and can be for a debit or a credit
- A short (credit) vertical spread is a short option position (credit) and a long position (hedge). Is positive-theta: great! 
- A long (debit) vertical spread is a long option position (debit) and a short position (credit). Is negative-theta: bad!
Here I will only review the main features of my favorite of these four cases: the credit put spread, the only built-in-edge stock trading instrument.


Typical P/L (profit/loss) chart of an ITM credit put spread. That month I'm bullish on silver (follow by the ETF SLV), trading at $16.77. The spread was created with two legs: sell put 17 and buy put 16, for a net credit of $0.49. 

If SLV rallies, the put credit will decrease in value and result in a profit. 
Conversely, a sell-off results in a loss. As max-gain is similar to max-loss ($500), we had an neutral risk/reward ratio of 1. When the expiration date is near, the spread will benefit from theta decay, unless the legs are completely ITM. 



As you verify in the chart above, a credit put spread has important features and advantages against other option strategies. Let's summarize them:

- Environment: the credit put spread is ideal when you have a bullish, neutral, or slightly bearish position and don´t need a great move in the stock price. Analyze: sell credit spreads is the better winning strategy, as any stock only does five things and with credit spreads you win in four!

- Cost and Profits: spreads reduce the cost of overpriced options, and re-adjust breakeven price better than a single option. With debit spreads you eventually can have high rewards, but with a high risk. But with credit spreads, you have low rewards but much profit odds. 

- Strikes: choose your strikes due to your comfort zone, that's your preferred risk/reward ratio. The probability of success depends on how far your (main) short strike is from ATM. Further, more chances, but less credit. More close, the opposite. 
Then, preferring strikes with the "Probability to close OTM" > 80% in each leg, seems a good play. As you notice, options trading in all about probabilities...


- Maximum profit: limited, and is the credit or premium received.

- Maximum loss: limited, and is the difference between the two strikes minus the premium received.

- Risk Level: low, if you use a risk/reward ratio near 1.0 or less. You could get it with one ATM strike and the other slightly OTM.

- Break-Even: is the strike price of the short pull minus the premium received. You will be in profit if the stock price is above this level. If move below the break-even, you will be in losses. As it's a bullish trade, the lower the break-even, the higher probability your trade will end in a profitable trade.

- Legs: two, a bullish short put ATM (the main) and, further away, a bearish long put OTM (the protection).

- Goal: receive credit and hope both legs expired worthless, or the same, the stock price stays above the short put strike, as you can review in the chart above.

- Stock Volatility: as it affects both legs at the same time, its effect is mitigated.

- Implied Volatility: in terms of cost, and considering volatility reversion to the mean, for high IV (high premiums) buy credit put spreads. For low IV (low premiums) is better to buy a debit call spread. In both cases, if you are bullish.

- Time decay: acts in favor of a put credit spread, as short put gains with the passage of time, and its theta offsets the long option theta.

- Close Position: as other options, a spread could be closed at any moment, better prior to expiration if it reached its max-profit or your support/resistance target. Sometimes you only need to close the short put since it can't gain more and leave the long put in case it rises. And if you reach the max loss, wait: always there's a chance that the position turn in your favor.

- Stop Loss: it's usually a topic of discussion. My opinion: since debit and ATM/ITM credit spreads are strategies that already have a lower risk defined and assumed, a stop loss isn't necessary when opening the position. A sudden change in volatility in just one of the legs can take you out of the spread immediately. With OTM credit spreads it's different due to its usual major risk/reward: I usually place a one-stop-loss (for the whole spread) set to trigger at a net loss of a minimum of 2x the initial credit.

- Expiration Risk: be careful if the underlying expires within the short and long strikes, or the short ITM and the long OTM. You have the obligation to buy 100 shares of stock for each short put. If buying power isn't enough it will activate a margin call from your broker. Remember the theory: long options have rights, short options have obligations.

- Synthetic View: synthetically a credit put spread chart is the same as the call debit spread. They differ in their Open Interest: in OTM put strikes OI are always higher than ITM call strikes, so more liquidity, so better for trade. Finally, as a guide, for credit spreads better choose to buy/sell strikes with a tight bid-ask spread in popular liquid stocks/ETFs in a high-volatility environment.




Some useful Tips when trading Credit Put Spreads


Tip1: 
For a slightly bullish bias in a stock that is consolidating in a range after a nice trend and creates strong support, all in a high-volatility market environment, consider the spread Buy OTM Put / Sell ATM Put, using a level near that support level for the higher strike price. The other leg also called the protection, that's the lower strike price, is determined by the maximum risk you can accept. 
This called OTM credit spread may not have a high reward-risk ratio (usually below 1 in this case) but it has a pretty high win rate. Using in a short-expiration period (one month, ideal) you also have time decay working in your favor. As you see, technical analysis is crucial for trade credit spreads.

Tip2:
For credit spreads use underlying with a high IVPercentile (measures how many of the past 1-year IV values are lower than the current IV value). Option premiums are higher when IVP is elevated (and the expected move is larger), so when you sell the credit received is higher. As implied volatility always reverts to the mean, premium decreases and you can profit quickly on that larger move.
Another key advantage of create vertical spreads on high IVP underlying is the fact that your short strike can be positioned further away from at-the-money while retaining the same prob of profit as compared to one with low IVP.

Tip3
Selling options strategies with a favorable risk-reward and a high probability of success is the way an Income Trader works. Think like them and treat your portfolio as an insurance company: they live selling policies (options) for a premium, a successful business. And better in high implied volatility environments. The goal is to do the same: collect as much premium income as possible and never pay out the policies. 
So, maximize the number of credit trades, diversifying between indexes, ETFs, and stocks, in different sectors, through bull or bear market conditions, analyzing only the stock direction. Now that brokers offer commission-free trades, it's reasonably possible.

This practical chart summarizes what options strategies work better depending on market direction and implied volatility size. 

- If the market is in a low-volatility environment, use a Debit Spread, that's a call spread (buy call ATM/ sell call OTM) if you're bullish, or a put spread (buy put ATM/ sell put OTM) if you're bearish.

- And if the market is in a high-volatility environment, use Credit Spread, that`s a put spread (sell put  ATM, buy put OTM) if you're bullish, or a call spread (sell call ATM/ buy call OTM) if you`re bearish.

Straddle, Strangles, Butterflies, and Calendars are not treated in this post, but in some next.


A step forward is another popular risk-defined option strategy, the iron condor, that combines two credit verticals (a bearish call spread and a bullish put spread), for use when you have a neutral bias in the underlying. 

Good trading,
@BravoTrader

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