One of our readers, Cecelia, sent in the following question after watching our SMB Options Trade of the Week which, covered the bearish butterfly trade that has become popular recently: “Will this trade work for indexes only? Do you recommend this for individual stocks such as AAPL?”
We get this question a lot and the answer is important for many reasons.
I have never seen an options strategy that works for only one index or stock. If it works for one vehicle, there is a good chance that it works quite well with many others.
However, it is a pretty big mistake to run out and try to apply a strategy that works well for one trader in one vehicle and apply it for yourself to a different vehicle. It is an even bigger mistake to do that with a large amount of cap-ital. In fact, I’d argue that it is a big mistake to do so with any capital at first.
So here are some questions that you should ask yourself before applying a solid options strategy to a vehicle that you prefer to trade. The answers to these questions may result in your deciding against trading a strategy in your preferred vehicle, or it may cause you to modify the trade concept to fit the vehicle that you prefer to trade:
1. Is it really a well-designed, solid strategy? Establish that the trade is truly solid: Some trades are fundamentally flawed, but the trader gets lucky with it for a few months, and then starts bragging to everyone about it. So satisfy yourself, through back testing the concept with options analysis software, that the trade concept is in fact sound before going any further. I think that three years of back testing is the minimum you’d need to really understand the nuances of a trade strategy. If the trade is in fact, flawed, it’s not going to work well in any vehicle, so abort the mission at this point.
2. Does the vehicle offer the strike prices you will need to implement the strategy: Make sure that the vehicle that you wish to trade has the appropriate strike price separation for the strategy in question. This is important. Some strategies are great in theory, but with certain vehicles there is not a strike price available for an adjustment that the trader may wish to make. For example, IBM has five point strike separation. IBM is a $167 stock. SPY has one point strike separation. SPY is trading at $133. So you can implement much more granular strategies with SPY than IBM.
3. Are you willing to avoid trading the strategy four times per year to stay away from the volatility that takes place around earnings? Indices don’t have earnings once a quarter. Stocks do. Many options spread traders, including me, avoid trading stocks when the short strikes expire after an earnings date in the expiry month of your trade. That means that I will not trade a strategy four out of 12 months of the year using the options of a publicly traded stock. That may or may not satisfy your financial needs and you should think about this issue if you are planning to make this a core trade.
4. Does the vehicle act in a way that is consistent with the strategy? Certain stocks and indices just act funny and don’t lend themselves to certain strategies. I wish I could say this more intellectually, but I can’t. You discover this through back testing, paper trading, or very low capital experimentation.
5. How is execution in the vehicle you are considering versus the vehicle used to develop the strategy in the first place? Certain stocks or indices have lousy execution. With some vehicles, you can regularly expect to be able to trade at the mid-price, with others you struggle to get near mid-prices. That can make the difference between a winning strategy in one vehicle and a losing one in another utilizing the same game plan.
6. How well have you traded that stock or index in the past? Some traders just don’t trade certain stocks or indices well. So you may have a great strategy in a vehicle that you don’t trade well, resulting in a great strategy that loses money consistently.
Once you have answered these questions to your satisfaction, then I’d recommend trading the strategy in the vehicle of your choice for a few months in a paper trading account with your online broker. If things turn out as expected through that process, then you can proceed to trade the strategy with a VERY small amount of live capital. You will only then, truly, know how effective the strategy is when traded in that particular index or stock, and you will also get a glimpse of how you will react emotionally with larger levels of capital at stake.
So in summary, Cecilia, yes you may be able to trade the bearish butterfly strategy in AAPL, or many other stocks or indices, but please consider all of these issues first before doing so. That’s the smart way to approach options spread trading.
Director, SMB Options Training Program