Irrefutable Law of Trading Success #6: Options Equal Outperformance

 Let's talk about options equal outperformance. This is one of the big edges that I constantly harp on people to develop and it's a true edge. Everybody in the world is trying to figure out if the markets going up or markets going down and how to manage that mean reversion or how to manage that trend, so they can maximize the move. But I always come back to options equal outperformance. It's not just about getting the direction right, you can actually make much more money if you understand how to use options to express your idea. Now if we're just lazy and we just buy something, thinking it's gonna go up, options are probably not the right thing for you. But if you take the time to understand not just that something is going to go up, but the path that it would take to do so. If you can understand the direction and the path, options open up a whole new world to potentially massively outperform being long underlying alone. 

We'll walk through and talk through a couple examples here. First, let's look at a support level. You have your way of identifying support, I have my way of identifying support. When we identify a support level, that support level can do two different things, it can kind of have two different paths. People don't really think about this. The first path is the support level could hold and the market rally off of it and start going higher, maybe a lot higher. But essentially what we see is we see the market break to that support, the support holds, and then the market reverses direction and heads up. The second way of looking at support is support the market can come down to support and support can hold. Maybe it doesn't really, maybe it rallies a little bit, but it doesn't rally all the way back. You might have had trades like this, you've got long in support. You had a resistance level above and if you get a move from support to resistance, you've got a nice trade. So you see yourself by the support, you see the support hold. You're excited for the market to rally all the way up to a resistance level and have a nice trade. But then what ends up happening is the support holds, but the market never really rallies, it just kind of hangs out above that support level. Well, if you're long flat price, you're not going to make much money, you might make a little but it's not gonna be anything to write home about. Now, what if instead of that, what if I knew that support level would hold? I think we'll get a bounce but it might not be a very big bounce. I could sell a put spread at support and structure that put spreads so that the most I could lose on my spread is one R and as long as the support level holds, I make an R. In your directional trade maybe you make 0.1, 0.2, 0.3 R, because it never really rallies very far. But because we use an at the money vertical spread, we just need the market to stay above the short strike and even if it goes through the short strike a little bit, we'll still make money. This is a way that we're able to take advantage of a support to generate and use an options trade that outperforms being long the underlying. 

Let's talk about another example. Say we come down to the support and this time we believe this is a strong support and we expect the market to bounce off of this support and do so convincingly. Well of course we can buy underlying or we could be buying calls or out of the money call spreads and by doing that, if we get the bounce that we're looking for, we have leverage. For the same amount of risk and underlying we can hold multiple options and if those multiple options go in the money, they all are going to become underlying. We might be able to buy three options for the same risk buying underlying. If that trade works and the market bounces off like we think, we're long three underlying, not one and so if we get that sharp bounce and the market takes off will make way more money being long the option that we would be long and underlying. In both these cases, we have to have a sense of the path. In the first case. If we sold a put spread and the market has a sharp bounce, we're going to make an R. They'll still be good but you would have been better off to buy the underlying or buy the calls or call spreads because those are going to generate multiple Rs. In a second scenario where we're buying options, well there we do outperform but you see both cases we have some idea not just that it's a support level, but what the path might be. The more you understand your trading system or your trading method, the more you'll understand the path. The more you understand the path, the more options are absolutely one of your greatest edges. 

Okay, so let's look at our third scenario. Our third scenario is you could get into complex spreads, like butterflies, condors iron condors. ratioed butterflies, offset butterflies, these sort of the things. with these are phenomenal for is we can reduce our risk even further because they're cheaper. We can either deploy the same amount of risk with a lot more spreads or we can express the same idea with less risk. But butterflies or condors have fantastic payouts. If we have an idea that we're going to come into a support level, and then we think we're going to rally into maybe an old resistance level, let's just say and we expect the market to kind of die there and let's just say we think that's going to happen in two weeks. Okay, we can buy an out of the money butterfly, with roughly two weeks to go, that has phenomenal reward to risk. I'm talking about 5 to 1, 10 to 1, 20 to 1 depending on what you do. Same thing you could substitute a condor for it. Now, since we have a sense of the path, we can put the spread on. If the support breaks, our risk is defined. We know what we can lose, it's the value of the flies. Therefore we don't need to stop, we'll come back that in a moment. But if the market rallies like we think and it glides up into that short strike, at expiration, we can have a monster winning trade. I had one of these recently in JP Morgan. This is another way, that trade will massively outperform being long underlying alone. 

A fourth aspect of this, which I just hinted at, one of my big things that I teach my students is whenever possible, we want to get rid of stops. This is one of the 10 Irrefutable Laws you'll be seeing it, stops kill performance. We don't want to have stops in the market. What's great is we can use options in place of stops and because we have options we don't need a stop. This helps us trade from a position of strength, to be mentally strong, to be mentally comfortable. Because we know at any given point we have an exit. When we buy butterflies, our risk is contained to one R, we don't need to stop. If we buy calls, our calls can be contained to one R and we don't need to stop or another we can do is we can have a stop and maybe let's just say we're risking half the premium. Okay, well we know that we can get out if we lose half the premium. This allows us to double our leverage and then if the market trades down there, we can evaluate it and decide do we want to get out or not? If our rules say get out, we'll get out. But sometimes you get down there where you're getting an exit signal then you look and it might not be exactly like how the rules say it actually might be incentivizing you to stay with the trade. Now, in this case, we just looked at the great thing is the most that we can lose is two R. Now if we lost two Rs, that's not great. But I can tell you one thing, if two R is the biggest loss you ever take, you're in great shape. You're in great shape. Options help you get rid of stops and because you can get rid of stops, You can trade from a position of strength and then you can also get outperformance because you're mentally strong. 

What goes through your mind when I discussed this with you? Do you use options in these ways? Have you thought about it? How well do you understand your method or your system? Do you understand it well enough, if you do this could be phenomenal for you. These are the sorts of things that I teach in our option and trading classes. I teach my students how to trade from a position of strength, how not to have stops, how to use options to outperform. If you ever interested in that check us out at tradingmatrix.com In the interim, as we do on Trader Tip Tuesday, I brought you tips to help you take your performance to an elite level. I'll see you next Tuesday.