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Four Tips For Trading Income Option Spreads

06/10/11 08:50:54 AM
by Billy Williams

If stock trading can be compared to playing checkers, then option trading is like playing chess with the market.

Security:   INFA
Position:   Hold

In trading the stock market, stock traders are limited to a certain set of strategies, in large part because price action on stocks are limited to three types: bullish, bearish, and range bound. For a stock trader to make money, a stock has to be in some form of trend relative to the strategy since movement must be involved in the price action in order to profit from a stock's rise or decline. Even in a rangebound market, where price is going back and forth between support and resistance, price must still move from the two price levels in order for the stock trader to profit.

But if price is adrift and stuck between two very narrow price levels, then you have to make a choice of whether to trade or stay on the sidelines.

This can be an extremely frustrating experience when the market is trading on thin volume, where even the strongest leaders in the stock market start to just drift aimlessly as if to refuse offering any kind of price movement that could resemble a trend of any kind to stock traders to make a living.

In situations like this, it is the option trader who is skilled in spread trading that has a distinctive edge over other traders and, in particular, range-bound markets; in trading, it can be said that trading stocks is like checkers but trading options is like playing chess.

The reason for this saying is that in range-bound markets where many stocks are adrift within small ranges, option spread traders can implement unique combinations of different options to exploit even the lack of price movement by placing income spread strategies that profit even if the stock is neutral in its price action while still protecting themselves from any downside. But there are four key concepts you must understand before attempting any type of income option position. See Figure 1.

FIGURE 1: INFA. Contracted price ranges like the one here are perfect areas for an income option strategy. The stock is trading above its 200-day SMA and has a clear line of support. While stock traders are forced to wait it out until the stock resumes its upward trend, you can still earn income from its rang-bound price action with option spreads using four key tips as a guide.
Graphic provided by:
First, make sure that you understand what ATM, ITM, and OTM mean in relation to option trading because these abbreviations have a fundamental part in helping you understand which option you must trade in each segment of each strategy. ATM means "at-the-money," meaning that the option you are trading has a strike price at the current price of the underlying stock, ITM means "in-the-money" tells you that the underlying stock of the option is beyond the current strike price, and OTM means "out-of-the-money" telling you that the underlying stock's current price is out of the range of the option's strike price.

Next, make sure you use the right strategy that will make money whether you are mildly bullish to neutral or mildly bearish to neutral. While there are a variety of option spread positions that you can implement, it is vital that you use a strategy that puts the odds on your side by exploiting with whatever directional bias the market currently has, but even if that bias doesn't follow through, then your strategy should still profit even if price remains flat.

Third, understand what directional bias the market has and then trade accordingly. Seasonal patterns, trendlines, technical analysis, and plenty of other methods can help reveal what direction the market is currently leaning toward. Perhaps the simplest is using the 200-day simple moving average (SMA), which has shown a statistical edge in showing that a stock has a bullish or bearish short-term bias, depending on whether price is trading above the 200-day SMA for bullish or below the 200-day SMA for bearish.

And finally, don't be afraid to take a "fast nickel over a slow dime." If the stock's price goes immediately in your favor, then don't be afraid to liquidate the position if you gain a quick short-term profit. There is no rule that says you must absolutely wait until the expiration date for an option income strategy and that actually by taking quick profits, you can use the principle of velocity by quickly putting your money in another trade to keep turning profits over quicker and rack up larger returns over time.

Keep these four tips in mind as you begin to assemble effective income strategies to help round out your trading approach. Just as many financial planners talk about diversifying your stock portfolio in order to help control risk and volatility, so can having multiple trading strategies help you diversify your approach in order to adapt to any changes in the stock market and help you avoid risk while giving you more tools to profit.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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