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I recently started reading George Kleinman’s¹ book about Futures and Options trading and I was fascinated by his writing style and how clearly he explains complex concepts.

In this article I want to share with you a passage about Options trading and what to do and to avoid in Mr. Kleinman’s opinion, based on his vast trading experience.

The rules

Here are listed the 8 empirical rules that Mr. Kleinman follows when trading Options. In order to avoid being too verbose, I will attach a link with simple explanations to each technical term I will use.

Rule 1: Avoid deep in-the-money Options

The first Mr. Kleinman’s rule is to avoid both buying and selling deep in-the-money (ITM) Options. He states that you want to buy Options in order to get advantage of the leverage. When buying deep ITM Option, you need a major movement in order to generate a consistent profit, and hence this cuts down your leverage. Being the premium of an ITM Option composed of both intrinsic and extrisic value, you are using money to buy a costly premium instead of using it for another opportunity.

Similarly, to sell deep ITM Options you need to lock in a significant amount of money (margin) that could be used elsewhere. Moreover, you can’t profit from time decay as much as in OTM or ATM Options.

Rule 2: Avoid deep out-of-the-money Options

Being deep OTM Options the opposite of deep ITM Options, one could think that the inverse reasoning applies with respect to the Rule 1. However, the probability of it expiring in the money is really low. The premium is certainly cheap, but if you buy an Option with a longer Maturity you will pay a bigger premium for it. Moreover in general this kind of Options are not liquid and their slippage cost can be significant.

Should you then sell them? Mr. Kleinman advises you not to, since you can be right most of the time, but the very small premium you get for such a big risk is not worth it. Remember that crashes happen!

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Rule 3: Trade slightly out-of-the-money, at-the-money, or slightly in-the-money Options

If deep OTM and ITM Options are to avoid, it’s reasonable to say that slightly OTM and ITM (and ATM) Options are more appealing for a trader. In fact, when you buy such an Option, the chances that it will turn profitable are plausible. Moreover, this kind of Options usually is the most liquid, meaning that you would pay a smaller slippage and spread.

When selling this kind of Options you must understand if the premium received is fair related to the risk. For example, you could sell OTM Options when implied volatility is high, and hence the Option premium is costly. In such cases, you could still profit even if the market moves in the opposite direction of your bet.

Rule 4: There is a time for all seasons

This rule states that you should have a prior idea about market conditions before trading any Option strategy. Is the market in a high volatility regime? Is it flat? Where do you expect it will be in the next days or weeks?

You have to know your market. Don’t sell premiums that seem too small for the risk they bear. Don’t sell rising volatility, since the increased premium you would receive is not matched by the increased risk that is working on buyers favor. You should sell when volatility reaches suspicious or wild ranges, suggesting that it will soon revert.

Rule 5: Write Covered Call / Put when expecting low volatility

Here Mr. Kleinman straightforward suggests a strategy to implement. You can learn more about Covered Call writing here, but long story short it consists of a long Futures and a short Call on that Futures. You should implement this strategy when you expect the market to remain stable, i.e. low levels of volatility.

As I mentioned in Rule 3, you could profit even if the market moves opposite with respect to your bet, in fact the premium you obtained from selling the Call can cover some part of the losses. See the figure here for reference, in which you wrote a 100 Strike Call for 5$ and bought a Futures on the same underlying. The Option Maturity should be before the Futures delivery (or in general, you should have both positions opened at any time and be able to close them together. Your “cover” will vanish if you are left with just one leg of the strategy!). As you can see from the payoff profile, your profits are capped at 5$, but they are positive up until the Futures gets to 95$.

Rule 6: Write Straddles and Strangles in “normal” markets

Here Mr. Kleinman defines “normal” as something you should get a feeling about, insight that you develop by knowing your market and with experience. In my opinion this occurs when volatility is aligned to its historical value. In these market conditions the premium you get when writing straddles and strangles is sufficiently high for the risk taken. He suggests to close your position when you notice that the volatility levels are rising.

Here some resources to learn about Straddles and Strangles. In these strategies you sell both a Put and a Call on the same underlying with the same Maturity and with given Strikes. You receive the premium and you profit if the prices don’t move too much (the risk is given by volatility levels, the Maturity of the Options and the Strikes). Since your loss potential is unlimited, as the author suggests, you should close your position if you sense that the volatility levels are rising and the premium you received has become too small for the risk taken.

In the figure below, you can see an example of a Short Strangle:

Rule 7: Find opportunities to Backspread

Backspread is an Option strategy that consists in selling a Call (Put) at a Strike and buying a greater number of Calls (Puts) at an higher (lower) Strike. This strategy has a limited risk and can be profitable even if you are wrong. Moreover, it has unlimited profit potential and its is particularly suited when you expect a big movement.

As you can see from the figure below, a Call Backspread offers unlimited gain potential if the underlying asset’s value increases. However, if the underlying decreases in value, your gain is still positive and equal to the premium received from selling the lower Strike Call minus the premium paid for the higher Strike Call.

Rule 8: Use Options to hedge a profitable Futures position

We saw that during high volatility periods the Options premiums are expensive. Sometimes, however, paying for a costly premium can be useful, expecially when you want to hedge an already profitable position.

If you think that the price movement has not extinguished yet and you don’t want to close the position, you can hedge it and give a part of your profits to have a fixed minimum. This could save you from sudden price movements in the opposite direction.

Further steps

Even if I knew most of the strategies Mr. Kleinman discusses, his narrative is really catching and prompted me to write about it. Options trading can be really profitable, but if you don’t know what you are doing you could get severely burnt in a couple of bad trades. Following these 8 rules, you should be able to limit your losses and maximize your gains potential.

I highly suggest you to give Mr. Kleinman’s book a look, it is suited for all levels of preparation. You can find it here.