Recently, I came across a 1-1-2 options strategy (which is pretty much a ratio strategy). It is a debit strategy, and the explanation of the strategy is below. In this little post I will explain why I do not trade debit options strategies and why you should avoid them too.

Many investors, usually the new ones, who discover options make a huge mistake trading options as if they were stocks. And trading options as stocks never works. It may work for a while, mostly when the markets are bullish, but at some point, the strategy will stop working and losses can quickly pile up. Wallstreetbets reddit is full of people posting their “loss porn” indicating that many have lost all their savings.

So why you want to avoid debit options strategies?

One reason why you do not want to be buying options is time. Options are time sensitive instrument. They have expiration day and if your narrative was wrong, your option contract will expire worthless no matter how great your story was. Add to it that you must be right on the underlying move magnitude (the stock may move in your direction but you still can lose money) and of course, you must nail the direction.

Three aspects impact your option price: direction, time, and magnitude. Be wrong on one of those and you lose money.

The only exception to buying options is when hedging or protecting your other trades, for example when trading defined risk strategies. Otherwise, avoid trading debit options. You will lose money long term.

What is 112 strategy?

The 112 options trading strategy is a variant of the 1-1-1 options strategy, and it involves buying one call option, buying one put option, and selling two puts. Here’s a detailed explanation of how the 112 strategy works and its purpose:

Components of the 112 Strategy:

Buying One Call Option:

This gives the trader the right to buy the underlying asset at a specified strike price before the expiration date.
It provides potential for unlimited upside profit if the price of the underlying asset rises significantly.

Buying One Put Option:

This gives the trader the right to sell the underlying asset at a specified strike price before the expiration date.
It provides protection against downside risk and allows the trader to profit if the underlying asset’s price falls.

Selling Two Put Options:

 

 

This obligates the trader to buy the underlying asset at a specified strike price if the buyer of the put options decides to exercise their rights.
The premium received from selling these puts helps to offset the cost of buying the call and put options.
It creates a neutral to slightly bullish bias because the maximum profit occurs if the underlying asset’s price remains above the strike price of the sold puts.

Strategy Purpose:

Income Generation: The premiums collected from selling two put options can generate income to help pay for the cost of buying the call and put options, potentially reducing the overall cost of the strategy.

Hedging: The put option provides a hedge against significant downside moves, while the call option offers unlimited upside potential.

Neutral to Bullish Outlook: This strategy is best suited for traders who have a neutral to slightly bullish outlook on the underlying asset. The strategy benefits if the asset’s price remains stable or increases moderately.

Profit and Loss Scenario:

Max Profit: The maximum profit is achieved if the underlying asset’s price increases significantly, as the call option will gain value, and the sold puts will expire worthless.

Max Loss: The maximum loss occurs if the underlying asset’s price falls below the strike price of the sold puts. The loss is limited to the difference between the strike prices of the bought put and sold puts, minus the premiums received.

Breakeven Points:

There are typically two breakeven points in this strategy:

The upper breakeven point is calculated by adding the net premium received to the strike price of the bought call.
The lower breakeven point is calculated by subtracting the net premium received from the strike price of the sold puts.

Example:

Let’s assume an underlying stock is trading at $100, and a trader sets up the 112 strategy as follows:

Buy one call option with a strike price of $110 for a premium of $2.
Buy one put option with a strike price of $90 for a premium of $3.
Sell two put options with a strike price of $85 for a premium of $1 each.

Net Premium Calculation:

Total premium paid = $2 (call) + $3 (put) = $5.
Total premium received = $1 + $1 (two sold puts) = $2.
Net premium paid = $5 – $2 = $3.

Breakeven Points:

Upper breakeven point = $110 (call strike) + $3 (net premium) = $113.
Lower breakeven point = $85 (sold put strike) – $3 (net premium) = $82.
 

“October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”
~Mark Twain