A Dynamic Trading Strategy
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Dynamic Trading Strategy, for lack of a better name, is a trading philosophy which utilizes Put and Call options in combination with the underlying stock or futures contract to achieve limited risk, unlimited profit, and maximum flexibility in any trading situation while avoiding the trader’s ‘death trap’ of being constantly ‘whipsawed’ out of one’s position. Given that there are only three things a stock can do (go up, down, or sidewise) a dynamic trading strategy is rather straightforward.
For instance, if you decide a stock is probably headed significantly higher, first, determine the amount of risk involved for 100 shares. To do this, look for a ‘suitably priced’, nearest in-the-money strike price Put option with a reasonable expiration date. Risk = stock + put – strike. (Note: Risk = time value of the Put option, in this situation.) This combination of long stock and long Put is known as a ‘synthetic’ Call.
Next, add three times the ‘risk’ to the price of the stock. If the resulting ‘target’ price seems ‘reasonable’, you have found a ‘suitably priced’ option. Three to one is a proper initial reward/risk ratio.
Money management dictates the amount and size of the position. To do this, determine the maximum dollar amount to be risked on the trade. This should be a percentage of total capital. Many traders consider 2% to be reasonable.
Dividing the maximum risk amount by the risk involved for 100 shares determines the number of trading units or ‘size’ of the position.
Dynamic Trading Strategy, without risking any capital, has just answered the three questions every trader must know before putting on a trade:
1. How much can I lose, if I’m wrong?
2. How much can I win, if I’m right?
3. How long will it take to find out?
Not needing to place ‘stop loss’ orders, thereby avoiding the fate of becoming a victim of ‘search and destroy’ missions (that is to say ‘ambushes’, the object of which is to ‘whipsaw’ traders out of their positions) means getting a good night’s sleep every night, regardless of what the market does to try to defeat you (and it will try).
However, because your ‘worst case’ scenario is known going in, it cannot due you further harm, no matter what. Even if the stock should go to ‘zero’, your Put protection is total.
Dynamic Trading Strategy is flexible
When, how, and under what circumstances to close out one’s position is a matter of style and personal choice.
One can choose to close out the position all at once or take it off in stages.
Strategist’s, for instance, have been known to phase out their positions in thirds:
The first third when the profit covers the ‘risk amount’ of the entire position. Accomplishing this leaves the remaining position ‘risk free’. (Note: From this point forward, trailing stop orders, actual or mental, can be used.)
The second third at a predetermined target of the trader’s choosing. This is where the trader can make use of ‘contingent’ orders, such as OCO’s (one-cancels-other).
The final third is where the trader ‘tries for the fences’, allowing the market to take out the position with a trailing ‘stop’ order or, if the ‘tape’ is indicating evidence that a ‘top’ is being put in, simply exit the position.
Alternatively, at the discretion of the trader, the position could ‘morph’ into a ‘fence’ by selling Call options. Keep in mind that all that is needed to turn the position into a ‘risk free’ situation is to take in enough Call premium to cover the time value of the Put options owned.
On another tack, if volatility is low, one might initially buy Call options as a substitute for a long stock position. Again, maximum risk is limited while profit potential is unlimited.
On any decent rally, the stock could be ‘shorted’ with out risk. If the stock declines, the ‘short’ stock position would be bought in or ‘covered’. The trader then waits for the next rally and ‘shorts’ the stock again.
The first time the profits from the ‘shorting’ operations exceeds the cost of the Call options owned the position, from that time forward, becomes ‘risk free’.
If the stock continues to rise after being ‘shorted’, the trader simply ‘exercises’ or ‘calls’ the stock to close out the position. The profit was locked in the moment the underlying stock was ‘shorted’. The combination of long Calls and short stock is known as a ‘synthetic’ Put.
All of the above can be applied just as easily in reverse to declining market scenarios by shorting stock and buying Call options (synthetic Put) or simply using a Put option as a substitute for being short stock.
A long Put position can ‘morph’ into a synthetic Call position simply by adding long stock.
The synthetic Call can morph into a ‘bearish fence’ by adding short Put options to the position.
The moment long stock is added to a profitable long Put position, the position becomes ‘risk free’. The stock can be bought on a significant decline with impunity. Profits can be taken on rallys or exercised on further declines. The trader wins, either way.
As a trading philosophy, a dynamic trading strategy is hard to beat, wouldn’t you agree?
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Source by Don Heggen
