Options Trading Wisdom from the Art of War

Many of you may know that my “day job” (which I actually do at night) is that I’m a martial arts instructor.

For this reason, often martial arts lingo and principles find their way into how and what I teach about trading options.

Today I’ll demonstrate an example of trading that’s in line with a classic of Chinese literature that great generals from many nations have read: The Art of War by Sun Tzu.

Oh, and make no mistake about it… trading IS war¬†ūüėČ

In Sun Tzu’s classic, one of the founding principles of how to make war effectively is to FIRST shore up one’s position so that it’s very difficult to attack. THEN, after making it hard for the enemy to do any real damage to your main force, you take small units and do little skirmishes here and there that have a high likelihood of success, while risking very little.

I know what you’re thinking… “Sounds great, Kurt, IF I were a general commanding a force in war…”

Oh, but you ARE. See, every dollar you have in your account is a soldier. And your strategy for winning in the long term has GOT to be centered around making it hard to penetrate the defenses. IN this post¬†I will be sharing how to do just that… how to shore up the defenses around your “force”. But another, VERY important part is the minor skirmishes that have a high probability of success, and very little risk if you are wrong.

I think you’ll be excited to see a “skirmish” I completed just recently… a Bear Call Spread done with ZERO risk. That sounds a little weird, I know… but it’s true. In a certain context I can show you how to put together a bear call spread trade at a credit that wins if your stock stays flat or goes down… but if¬†the stock¬†goes¬†up there are none of the consequences normally attached to a¬†bear call spread.

Interesting? Yer darn tootin’ it is! First, let’s look at the “fortified position”. Sun Tzu would be proud. You can click the picture to see the details larger:

Married Put on CTSH

On January 7, 2011 NTAP was trading at $56.50 and the June 2011 $65 put options were at $11.00 even.

By purchasing them BOTH at the same time, one could guarantee maximum risk to their capital of only 3.7%. That’s not a “stop” order, which folks caught by the so-called ‘flash crash’ know adds no real measure of safety…

No, this put option is a legal and binding contract guaranteeing a minimum sales price of $65 for an asset whose total per-share price is $67.50. Total AT RISK is the difference of $2.50 per share, or $1,000 total if we have 400 shares protected by 4 put option contracts.

Take a look at the graphic representation of this kind of trade. While there is a “floor” for the possible losses, there is

Married Put on CTSH
Married Put on NTAP: Limited Risk, UNlimited Upside Potential

no ceiling!

The most exciting part of owning a married put is being able to sleep at night, knowing that no matter what happens to the underlying stock, the damage will be absolutely contained if it goes down. On the other hand, there is no limit to how high your profits may run in the case of good news or institutional sponsorship.
Can you imagine going in to an earnings announcement or other anticipated event that has the potential to send your stock EITHER way… and knowing that nothing really that bad can happen, but you CAN end up winning? If you haven’t experienced this peace of mind yet… it’s breathtaking. Upside: UN-limited. Total amount AT RISK: $1,000 even.
Okay, so that’s the Sun Tzu- friendly method I use for defense. I make it so that come what may, my fortifications are keeping my little soldiers safe from harm. But what about the minor skirmishes with a high chance of success? Take a look at the Bear Call Spread. Again, you may click to enlarge the picture:

Bear Call Spread Numbers

Bear Call Spread: More Risk Than Possible Reward

By selling the February $60 calls, while at the same time taking part of the¬†premium received¬†and using it to buy an equal amount of February $65 calls… a Bear Call Spread is formed.
In this case, I picked up $1.26 per spread, or times four, $504 total net credit.
That’s WONDERFUL… unless the stock goes up! I get to keep all the credit if the stock¬†stays flat or goes down, but I have an obligation to make good if¬†NTAP¬†rises.¬†For the privilege of taking that $504 credit, I may have to pay back as much as $2,000 if the stock trades at $65 or better. Total amount AT RISK: $1,496.
Here’s where the analogy to Sun Tzu’s Art of War comes in: what if we did BOTH of these trades? There are two distinct trades in place, with different objectives. One risks $1,000 and is long-term.
Nested Trades

Nested Trades- One Within the Other

The other trade, the Bear Call Spread, risks $1,496 and is short-term. The total amount AT RISK if we add the risk from the¬†$1,000 Married Put trade to the risk of $1,496 from the Bear Call Spread trade is…

$  520??? Can that be RIGHT?
Yes. Because for the Bear Call Spread to go as bad as it possibly can against us, the stock has to go… UP. And we OWN the stock, remember? It’s usually a good thing if your stock goes up when you own it ūüėČ
By doing this “nested” trade, which I call Income Method #6,¬†we have effectively canceled almost half of the risk that was in the trade to begin with. If the stock stays down, we get to keep 100% of the premium generated by the Bear Call Spread… and guess what?

The 'HeartBeat': Adding a Bear Call Spread Breathes in LIFE

This is a February play, but the Married Put keeps us safe clear out to June. Can we do it again? Yessir, you betcha.

Repeated applications of this technique can lead to the coveted state that we refer to as “Bulletproof”: when the cost basis of your stock plus put is LOWER than the strike price of the put. Unlimited upside still, but NO way to lose.
SO there we go peeps… the merger of two great ideas from Sun Tzu’s Art of War. First, make yourself invincible. Then, attack the enemy with small detachments with a high likelihood of success and low consequences if they fail.
Last expiration Friday, this Bear Call Spread (Income Method #6) play expired totally worthless, so I was able to set the total credit against the cost basis of the stock in the Married Put play. Pretty cool? My new AT RISK amount is no longer 3.7%, but 1.9%. And there is still an unlimited upside in case the stock recovers by June.
Oh, and with TEN “Income Method” plays at my disposal… there are more ways to win between now and then. I’ll letcha know how it goes.
Happy Trading,
Kurt

About Kurt Frankenberg

Kurt Frankenberg is an author and speaker about entrepreneurship, martial arts, and trading the stock and options markets. One of several "Biznesses" he founded as a teen, The Freedom School of Martial Arts, has been in continuous operation since 1986. Kurt lives in Colorado Springs with his wife Sabrina, German Shepherd Jovi, and his ninja cat Tabi.