The next step you will need to perform is to apply for an Options Trading Account. Anyone can trade options in their brokerage account, if approved. This requires completing an options application that asks questions about your financial situation and investing experience, as well as reading and signing an options agreement. For beginners, I recommend a Level 2 (Tier 2) account. This will allow you to trade credit spreads. Since all the Put Path strategy trades are Put Credit Spreads, this is all you need. More advanced traders may select a Level 3 (Tier 3) account. A Level 3 account typically allows you to sell uncovered (naked) calls/puts and short straddles.
Options trading for beginners is complicated. With that understanding, as part of the options application, you may be required to read the booklet “Characteristics and Risks of Standardized Options“, which is essential to understanding the basics about trading options. It is highly recommended that you read this booklet to provide the foundation that you need to move forward. It may take a couple of days to get your options application approved and to fund your account. You will need to understand some concepts and definitions of terms in order to know the basics about what you are doing and how to navigate your app(s).
I will provide a quick overview here of the basics of options. An option is a financial derivative as its price is based on the value of the underlying asset. An option holder has the right, but not the obligation, to buy or sell some amount of an underlying asset (stock or ETF) at a particular price on or before a future date. Options contracts control a quantity of 100 of the underlying assets. So, when you see an option that costs $1.00 it is really $100 in value since you trade them in lots of 100.
Credit Spreads are formed by transacting two legs simultaneously; you sell one option (put or call) while buying another similar type of option with less premium. Since you sell the higher priced option and buy the lower priced option, it results in a net credit to your account. This strategy eliminates the unlimited risk that occurs when you sell a naked option (put or call). We create the Credit Spread by selling and buying in the same vertical calendar serial timeframe. Some people trade Calendar spreads which trade in horizontal calendar timeframes which sell one option in one expiration date and buy the other in a different expiration due date (but that is not what we focus on here). We trade weekly options contracts which gives us the opportunity to trade 52 times a year. Some underlyings only trade monthly but we avoid those in order to increase frequency of trading. We also only trade in highly liquid markets with a huge number of buyers and sellers. We don’t want to get caught in low volume options that don’t have good entry pricing and are hard to buy back to get out of (close) the trade.
It’s important to realize that approximately 70% of options expire worthless so we try to play the percentages and sell these options in a strategic way. So let’s walk through an example. As discussed, weekly credit spreads have two legs, the short leg (which is sold) and the long leg (which is bought). However, most options traders are just gambling that the stock will move directionally higher or lower within in the timeframe of their expiration. It’s typically easier for new options traders to understand the call side so let’s walk through an example. If XYZ is trading at $100 and they think the stock will go up sharply in the next 30 days, they may buy the $105 call option for a price of $1.00. There are basically three outcomes over the 30 days. If the stock stays below $105, they lose the whole $1.00. If the option is partially profitable, the stock would need to go up between $105.01 to $105.99. For example, if the stock goes to $105.49, the long call option holder would receive $.49, and therefore they lose $.51 ($1.00-$0.49), which is actually $51 loss since this represents 100 shares of the underlying ($0.51×100). Or the stock goes above $106, which makes the trade profitable. If the stock goes up to $109, they will make $300 ($109-$105=$4 less the premium $1 times 100).
So, for us, we take advantage of the fact that typically the market does not move with enough velocity within the option buyer’s timeframe to make it profitable. For example, we would be the counterparty to the trade above. We would be selling the call option for $105. That is the higher percentage play, and it is more profitable over the long term. In this example, we would also buy a higher priced call in order to not have unlimited upside loss potential. We could buy the $106 call for protection. In this example, we would receive the $1.00 for premium from the $105 sale and then pay maybe $0.65 for the $106 call. So, we would profit $0.35 for each lot of this Call Credit Spread. If you do that and it’s a winner, we will make $35. Now if you do that enough times with enough lot size, those wins start to really add up. Now, in this system, we focus on the Put side of the curve. The Put side has several advantages; like Put Skew on pricing and you are not fighting the continual grind higher of this perpetual bull market.
An example of a Put Credit Spread would lay out as follows: we would look for an underlying that we typically sell, like DIA. We would then look out 28 days to expiration. Then we would find a put option that has an 85% probability of profit. For example, if DIA is currently trading at $465.35, we would look up the 85% POP option, which could be around $445. So, we would Sell To Open the $445 and Buy To Open the $440 for downside protection ($5 wide). In this example, would sell our put option for $4.70 and buy our put option for $4.30, for a net credit of $0.40. If DIA stays above $445 over the next 28 days, then we make the full $40. That’s it, that’s the whole way we make profit. It may seem a little complicated to beginners, but once you get the concepts, you’ll realize this is one of the simplest options strategies out there. If you follow the Put Path System specifically as I’ve laid out, it simplifies everything and creates consistent profits over time! Stay with me and I’ll get into more advanced concepts, statistics, models and some of the math behind the Put Path Options System in future posts.