If you have been following this blog for a while, then you probably have a good taste for how I trade. I trade quickly and I trade aggressively. Do you really want my secret reciepe? I trade low probability trades on high probability set-up's that have high reward potential. Did everyone get that? In English, I trade cheap options on potentially big price moves. Does that sound better?

I love the debate about option buying versus option selling. I love the argument! Do you trade high probabilities of success in exchange for small rewards, or do you trade low probabilities of success in exchange for large rewards? Every person answers that question differently for their own reasons. Me...Personally I love to gamble with winners for hopes of landing "the big fish." You will never do this in a selling based strategy, since the only gains you collect are small premiums up front where you stand a higher probability of collecting that premium. Not to mention a very small probability of taking the mother of all losses.

Option traders will mostly tell you that options are meant to be sold. This statement is partially true, if you think about it. This is said only due to the fact that premium melts. The only way to overcome this is to have directional price movement make up for the loss of time decay. Most professional traders have concluded that picking market direction is impossible and irrational. Would you agree with them?

A student of technical analysis who use simple price charts to illustrate how prices move in trends would disagree. I think speculation is possible, but not always probable. Big difference. When I mentioned I like to trade high probability set-up's, or potentially big price moves, this means I like to trade breakouts. Stocks that are reaching new highs, or breaking out of patterns into new territory equipped with volume, is a high probability event in my eyes. I still trade trends, but not as aggressively. I don't consider a support bounce as high of a probability as I do a breakout.

Trading breakouts has evolved the way I trade options. Because I trade higher probability events, I justify buying options with a lower probability of success. That's what I said...I trade out-the-money options! *But Jeff...I heard if you trade OTM options, eventually you'll be out-of-money!!! LOL!!!* Since an OTM option requires price movement to be successful, if you are not careful you could lose all your money. This is why I normally go one strike out, and give myself between 15-45 days of time to be successful. (Most breakouts I trade, I am only in for a couple weeks on average.)

Think of it this way, when I trade a breakout I am expecting this OTM option to become ATM or ITM. I am also expecting this to happen very quickly. Let me refer to the Black Scholes calculator to give a general example of a typical scenario you might see as I trade this way.

Let's say that ABC stock is trading for $52 per share. I am expecting a $4 move on this stock to take place over two-three weeks. Let's assume I buy an option one strike out that has 40 days until it expires, and volatility is at an average level of 30%. Here is what the price of the option would look like.

I am paying $1.05 for the call. Since this option has no inherent value, the price will fluctuate quite a bit. This is why I can't use a stop here. I would trigger a loss almost every time I trade. I use a mental stop based on the stock, but I position this trade so that I expect to lose 100% of the premium. However, if 100% is lost, I only lose 1% of my account...this means I need to be wrong 100 times in a row to wipe myself out. Possible?

I must admit, I am wrong a lot. Last year I would quote being right only 35-40% of the time I traded. It was a tougher market, but this win/loss percent is nothing to brag about, right? What if I told you I returned 285% last year. Would you still think I was a bad trader?

Back to my example. Let's say I get this price movement I was expecting. Only a $4 move in about 20 days let's say. Is this possible? This is easy! I'm not expecting too much, just a nice breakout. Changing my new stock price to $56, and subtracting half the time, take a look at the return.
This is just an "average" example of a win. I don't always win, and the losses can be a good portion of the premium paid. On average 40-60% of the premium paid. But there are also big winners to add to this equation. Someone e-mailed me a quote a while back that I think would fit nicely here.

I do my best to try and eliminate huge losses through money management, position sizing, and strike rules of exit. By eliminating the huge losses, I am now left with four potential outcomes. The odds of making money are now more in my favor by subtracting this outcome.

Since we have also talked about trading volatility as it rises, here is a look at how that profit would change if we added a slight increase in volatility.

In review of what I have discussed with you, hopefully this justifies my irrational, aggressive approach to trading options. I trade OTM options on breakouts. I buy a month or two of time, and exit after I have reached my price target. I take losses as small as I can, but size my position around the assumption that 100% of the premium is on the line.

I write this because there are still piles of e-mails asking how I trade, or if I would sell my trading rules, or why I take this approach. Hopefully I have shed some light and examples of what my thought process is. I will monitor the "comments" left about this post to see what you felt I left out of this equation.