Understanding Option Trading
February 24, 2006
The Smart Profits Report: Issue #286
Friday, February 24, 2006
Understanding Option Trading: Cut Your Losses… And Watch Your Gains Run
By Jim Stanton,
Advisory Panelist, Mt. Vernon Research
From my early days of option trading, I can’t remember the number of times I said to myself, “I was right and still lost money.” I would be correct about the direction of the underlying stock but not the timing. My options expired worthless.
Not long after my misfires, I discovered what all experienced traders realize: If you don’t know how to manage your money, you won’t be in the game long.
This is especially true for options trading because of the inherent time limitations. Not only do you have to decide on the strike price, but also on the expiration date. It’s also important to know how much money to put at risk. Today, let’s get into understanding option trading and how to apply money management to your benefit…
Take A Step Back From the Cliff
It’s human nature to have a “feeling” about a trade. Sometimes you’ve landed on a decent risk/reward play. Other times, a trade appears too good to be true, one in which you “can’t lose.” When that feeling washes over you, my advice is to step away from the cliff. That’s because the “can’t lose” trade usually means risking more money. After all, if you can’t lose, why not score big? Big mistake.
In fact, there are so many variables in options trading that even if it feels like one of those “no lose” situations, you can never be sure, before the fact, which trades will be profitable.
Understanding Option Trading: Your First Money Management Decision
The first money management step you must take is determining the percentage of your portfolio that will be allocated to speculative option trades. Depending on your experience and how comfortable you are in the options arena, I would suggest 10%-20%. For this discussion, we’ll assume a total portfolio value of $300,000 with $45,000 (15%) allocated to option trading, which is the same percentage used in my clients’ portfolios.
Understand first that diversification is the most important aspect of any money management program…but especially with regard to option trading. That’s because, unlike normal stock investments, options are much more volatile and generally have a lower success rate.
So, what is the right percentage that you should allocate to each option trade? I advise 10%, but no more than 15% for each trade. Since we are allocating 15% ($45,000) for options trading, I would suggest using 10% ($4,500) for each trade. That way, if the first trade is a total loss, the drop in the value of the entire portfolio is just 1.5%. These percentages can be higher or lower according to your risk level. But the key is recognizing that you should use the same percentage of available funds for each option trade.
Be Aggressive Without Undue Risk
“Cut your losses and let your profits run” is an old Wall Street adage, but very good advice for option traders. Option traders usually have a lower winning percentage than stock traders. But by sticking with their winners and cutting their losers quickly, they remain in the game.
Once you accept that your winning percentage could be about 50%, you should also realize that at times you might put together a string of losing trades. To withstand a losing streak, there is one final step in money management.
Here’s How To Lower Your Exposure:
Let’s say your first four option trades are losers. Using a fixed amount per trade of $4,500, the value of your option account has now dropped by $18,000, which is a 40% loss. You now have $27,000 remaining in your options account.
What I tell clients is…maintain your 10% trading position. That will lower your risk, but allow you to engage in the same level of options activity. In other words, if you find your portfolio has dropped to $30,000, then drop your option trade to $3,000 (down from $4,500). That reduces your exposure, but permits the aggressive trading that rewards good trades. Similarly, on the way up, if you find your account has blossomed to $60,000, then it’s time to increase your individual option trade to $6,000. This constant emphasis on percentages is the best way to mitigate losses and it will take you less time to become profitable.
I cannot emphasis enough how important money management is in understanding option trading. You’ll come to realize there are many variables beyond your control. But if you can stick with a good set of money management guidelines, half the battle is won.
Good Trading,
Jim
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Today’s Smart Profits Cribsheet
- For an excellent discussion on how to control your portfolio, see Smart Profits # 263, Position Sizing Safeguards: Prevent Corporate Lies From “Cooking” Your Portfolio, by my colleague Karim Rahemtulla. He reveals that investors are sometimes prey for predatory and corrupt corporations, but by using position sizing within your trades you can control your own portfolio’s fate.
- Need a refresher on puts and calls? Visit our free Smart Profits Glossary.
Related Articles:
- “Textbook” Trades Don’t Always Win
- How to Use Puts and Calls: For Systematic Short-Term Profits
- Hedging & Speculating: How to Enjoy Guaranteed Monthly Income With Options
Limit Order Discipline
February 22, 2006
The Smart Profits Report: Issue #285
Wednesday, February 22, 2006
Limit Order Discipline & Two Other Simple Rules For Making Money In Options
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Recently, I have taken to reminding my trading service (LEAPS Option Trader) members about using limit orders for all of their trading. Here’s why: The options market is not nearly as liquid as the stock market. Options also trade in $0.05 increments under $3 and $0.10 increments above $3.
Options quotes are presented by several exchanges and the market makers at each exchange are supposed to make orderly markets in all the options listed. But, like small-cap stocks versus big-cap stocks, supply is only one side of the equation.
If demand is not there, the options market makers will have a field day. Sometimes, even with demand apparent, the market makers can ruin a nice profit or exacerbate a loss.
There are several things you can do to ensure that the price at which you are buying or selling is not exaggerated by the third parties. Let’s take a look…
Discipline Keeps the Market Makers In Check
1. Use limit orders. The first thing you must always do is to use limit orders, buying at or below the offer price. It’s normal human emotion to act quickly on an exciting idea. But most often, this will cost you more.
Understand that options are similar to stocks in one aspect: They are driven in the very short-term by supply and demand. Buying will cause the price to go up and selling will cause prices to go down. It sounds elementary, and it is. But, in practice, investors will still ignore this fact.
Aside from the above-mentioned characteristic common to stocks and options, everything else about options trading is different. Options lose value everyday regardless of the underlying share price. This is because of the time component of options. As decaying assets - options have an expiry date - each day that goes by, the option will lose value slightly as there is less time theoretically for the underlying shares to move in your direction.
Sometimes that decay will seem minimal or masked by upward moves in the share price, but believe me, decay is a fact of options investing. So, if you are hot for a trade, waiting a few days before buying may provide you with a lower entry point.
2. Get quotes from every exchange. The second thing you can do to ensure you’re getting the best deal, besides using limit orders, is to check the prices on all exchanges. This is really the first thing you should do. Exchanges are competitive and they will post prices that are similar, but not the same. Each market maker is driven by his/her own profit targets. Some may be happy with a couple of pennies, others may want more.
I have seen options trades go by in penny increments, even though the prices are quoted in 5-cent or 10-cent increments. You cannot put in an order in penny increments, but you can get filled below the offer or above the bid depending on how much the market maker wants your options, or wants to sell you his options.
Regardless, check each exchange for both price and volume. In my experience, the best execution comes from the International Securities Exchange. If you have the ability, you can also ask your broker to direct your trade to a particular exchange. In no event should you EVER use market orders for options. If you do, you are saying that you want to get filled at any price and are now subject to the whims of the market at that specific time. Limit orders will allow you to get the prices you want.
3. Practice patience. Finally, if you do not get filled, wait. Don’t chase the price. Invariably, in my experience I get filled at my price if I am willing to wait. At the time you put in your limit order, if it’s below the market, the market maker will rarely come to you. But, give him some time. If the shares are trading in a tight range, more often than not, I have found that I will get filled at my limit.
This is especially important when you consider that each nickel or dime difference in the price you pay or receive can amount to a gain of 10% or more because of the low prices of options.
In sum: Do not chase options, use limit orders, take your time, and understand that the guy on the other side is trying to make money off you. Treat options trading like any other shopping that you might do. Look for the best value, and if necessary, be willing to walk away and come back later.
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Today’s Smart Profits Cribsheet
- While we’re on the “best-prices” topic, be sure to check out Steve McDonald’s The Options Bid - The Bid, the Bid, Always the Bid in Smart Profits #279. Steve gives us the lowdown on watching the options bid prices and strategic disciplines, like using limit orders, that can increase your returns.
- You might also want to see his secret to picking option strike prices that have greater chances of making you money and turning your trading statements from deep red to shiny black in Smart Profits #276, Strike Prices - Increase Your Odds by 99%.
- Also, revisit Lee Lowell’s recent advice in his Option Chains - How To Pick Your Ideal Option if You’re Bullish on a Stock, Smart Profits #283, where he reviews how to use option chains in order to assess risk and make educated decisions in options trading.
Good Trading,
Karim
Related Articles:
- How to Limit Your “Excitement” for Winning Trades
- Liquidity & Limit Orders - An Options Balancing Act
- Getting Paid to Place Limit Orders On Your Favorite Stock
IBM and Google Covered Calls
February 17, 2006
The Smart Profits Report: Issue # 284
Friday, February 17, 2006
IBM and Google Covered Calls: Tracking These 2 Giants For An Income Jolt
By Jim Stanton
Advisory Panelist, Mt. Vernon Research
With the baby boom generation entering its retirement years and interest rates at historically low levels, more people are looking at selling covered calls as a way to produce income. That’s smart. But many investors know little about how to get the job done.
So, let’s back up a bit. Covered call writing is a strategy in which an investor writes (sells) a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If this stock is purchased simultaneously with writing the call contract, the strategy is commonly referred to as a “buy-write.” If the shares are already held from a previous purchase, it is commonly referred to as an “overwrite.”
Either way, the stock is usually held in the same brokerage account from which the investor sells the call, and “covers” the obligation by owning the underlying stock.
Writing a covered call is most often used when the investor believes that the stock is almost fully valued and could stay that way for the lifetime of the call contract. The investor wants to generate additional income from shares of the underlying stock, and/or provide limited protection against a decline in underlying stock.
Let’s look at a potential covered call situation on IBM (NYSE: IBM), and a Google (Nasdaq: GOOG) trade that produced the cash flow so many income investors are seeking.
Two Indicators Signaling A Pullback
When it comes to timing covered calls, the two most important risks include 1) getting your stock called away, and 2) experiencing a larger-than-expected drop in the underlying stock once the call is written.
When you enter a long position, you should always have a stop loss price in mind. That applies to a covered call position, as well. If the underlying stock falls below your stop loss level, the stock should be sold and the call bought back. The second risk does not apply to all investors, because some employ a call writing strategy in hopes of having the stock called away, increasing their short-term return.
However, long-term investors with a low cost basis on the underlying stocks who write options to produce income, don’t want their stock called away because it would trigger a taxable event. If you are in this category, (or are just looking to buy some protective put options), there are a couple of technical analysis tools that can help you time your option strategy. Let’s look below at covered call scenarios with IBM and Google…
Charting IBM Covered Calls
Below is a weekly chart of IBM (please keep in mind this is an example, not a recommendation) with Bollinger Bands overlaid on the upper half of the chart (two grey lines) and Slow Stochastics on the bottom of the chart.
Copyright (c)1999-2006 by StockCharts.com Inc., Redmond Washington.
All rights reserved. http://www.stockcharts.com
Stochastics and Bollinger Bands are two technical indicators that show both overbought and oversold conditions. We use these indicators because when you’re writing covered calls, the best time to act is when the underlying stock gets into an overbought situation.
When the stochastics trade above 89, or the stock trades near the upper Bollinger band, the stock is considered overbought. When both occur simultaneously, as indicated by the red marks, the odds favor a correction from that area. The jury is still out on the latest overbought situation here, but the previous two led to selloffs between 15% and 30%.
How We Charted the Google Covered Call Play
A few of my clients who are long-term investors own Google. They recently used this strategy to protect some of their unrealized gains. In mid-January, the stochastics rose above 89, and Google’s stock price hit the upper Bollinger Bands on both the daily and weekly charts. That raised the caution flag, and we prepared for a pullback…see the chart below:
Copyright (c)1999-2006 by StockCharts.com Inc., Redmond Washington.
All rights reserved. http://www.stockcharts.com
As you can see in the daily chart above, on January 19 the stock closed at $436 (below the blue line). Predicting the near-term pullback, we sold the March $440 calls for more than $21.
And it paid off. Google indeed came down sharply, and we recently bought back the covered calls for about $1. That reduced my clients’ cost basis by $20. Multiply that by the number of contracts written, and you’re talking about real money.
Today’s Smart Profits Cribsheet
- In a future Smart Profits Report, I’ll show you a different call writing strategy that will protect your position from a larger-than-expected drop in the underlying security. Stay tuned…
- Check out the Smart Profits Glossary for definitions on option terms like “covered calls” and “option chains.”
- Bollinger Bands and Slow Stochastics are valuable - and pretty common - technical indicators that traders rely on to generate handsome profits. If you do not have access to a charting service, these tools can be located at www.StockCharts.com.
Good Trading,
Jim
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Related Articles:
- Covered Calls: Getting Cash for Stocks You Already Own
- Covered Calls: How to Beat Stocks with Less Risk
- How to Enjoy Guaranteed Monthly Income With Options
Option Chains
February 14, 2006
The Smart Profits Report: Issue # 283
Tuesday, February 14, 2006
Option Chains - How To Pick Your Ideal Option if You’re Bullish on a Stock
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
Let’s say you’re bullish on a company and want to use call options instead of buying the stock because it’s a great way to use leverage and cut down on your risk. That’s true. But few things with a potential upside are risk-free.
That’s why options players always have to assess their risk. Are you the super-leverage type, unaffected by high-stakes betting? Or do you take 90% of your winnings off the table and risk just 10%?
Put another way, how much are you willing to lose? That’s where the strike price and expiration month that you choose within option chains will determine whether you’re a 10-rated highest risk investor or a one-rated, close-to-the-vest player.
These are tough decisions. Who knows how long it might take for the stock to make its intended move? The strike price is a different story, with the same questions about risk. Do you want something that’s going to move almost lockstep with the stock, such as an in-the-money (ITM) call, or do you want to pick a strike that’s farther out-of-the-money, but will cost you less up front?
Once again, it’s up to the individual to make that choice. Let me take you through the concept of option chains…and a few steps that might help you decide on these two tough choices.
Option Chains: Finding The “Sweet Leverage” Play
First, you must look at option chains. There’s no way to know what the options are worth without looking at their prices. For example, say we’re bullish on Intel (Nasdaq: INTC). We need to figure out which options are right for our portfolio, so let’s review the chart below…
The option chain above shows the March 2006 INTC call options, which expire in about five weeks. That’s very short-term. Are you looking for a quick pop in the stock? If so, then these options might be for you. Are you looking to leverage your money to the max? That means you’re looking to get a lot of bang out of your buck. If so, then you can choose an out of the money option (OTM).
Let’s say you opt for the March 2006 $22.50 calls, which have an ask price of $0.30. That means for every option contract you buy, it will only cost $30. Each option contract is the equivalent of 100 shares of stock and the option multiplier is $100, therefore our $0.30 option costs us $30 ($0.30 x $100 multiplier).
What does that get you? Well, for the next five weeks you get to control 100 shares of INTC for every option contract you buy, and it only costs $30 per contract to do so. Pretty sweet leverage.
You’re feeling pretty good that you only spent $30 on your option while everyone else who wants to buy 100 shares of INTC outright has to shell out $2,131 in cash. Plus, your risk is capped at $30 per contract. Not a bad deal at all.
But INTC has to get above $22.80 for you to at least reach break-even by expiration. Break-even is calculated by adding the premium to the strike price ($0.30 + $22.50 = $22.80). You need to remember with an OTM call, you’re buying something that doesn’t have value yet. If INTC trades at $21.31 today, why would you want to buy it at $22.50 (your strike price)? That’s because you’re speculating that INTC will go up in price, but you’re only willing to spend a few dollars to see if it happens.
The only other issue at this point is whether or not your option will perform, and what your chances are of being profitable.
How To Predict Performance by Using the Delta
One of the best ways to tell is by looking at the “Delta” column. For the March $22.50 call, the Delta is listed at .28. This number tells us two things. 1) How much the option price should move in relation to the stock making a $1 move in either direction, and 2) our chances of the option being in-the-money (ITM) by option expiration.
If INTC shoots up one dollar to $22.31/share, your $22.50 call will theoretically only gain $0.28. Not much movement. Also, the Delta is telling us that you only have about a 28% (.28) chance of the option being ITM by expiration. Being ITM is something that you definitely want to happen. Is a .28 Delta good enough for you? Only you can decide. If spending $30 for a 28% opportunity is a good tradeoff, then by all means, you could trade this option.
The next option chain shows us the January 2008 options, which expire just under two years from now. That’s some serious time to be right. Do you want to pick the same $22.50 option strike? Or go with something with more movement? The $22.50 strike will cost you about $320 per option now and it’s got a .60 Delta. The reason these are higher is because of the extended time you have now to be right in your prediction.
You could also look at the $15 call for a viable trade. Yes, it will cost you about $760 (splitting bid/ask) per option, but you’re getting 98% of the movement of INTC. If INTC goes up one dollar, that $15 call should gain very close to one dollar as well. Plus, it’s telling you that you have a 98% chance of your option being ITM at expiration.
Even though the option will cost $760, that’s still the most you can lose. All stockholders still have $2,131 at risk if INTC tanks.
The point is to get you to weigh your timeframe against how much movement of the option you’re willing to pay for. If you’re looking for a quick, cheap, speculative trade, stick to the close-to-expiring options that are slightly OTM. If you need more time to be right and you want solid movement from your option, stick to the LEAPS (long-term equity anticipation securities) that are deep ITM.
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Today’s Smart Profits Report Cribsheet
- For more on Delta and how to maximize your leverage using it, please see Smart Profits # 262, Options Leverage: How to Use Delta to Maximize Leverage. Learning how to apply this criterion can be one of the most intelligent things you can do with your money.
- For more option terms and definitions like “option chain” and “iron condor“, visit the free Smart Profits Glossary.
Good Options Trading,
LeeRelated Articles:
- How to Use Puts and Calls for Systematic Short-Term Profits
- Options Trading Strategy: A Five-Question Screen to Find the Perfect Option
- Position Sizing - The Most Powerful Investment Concept
Option Trading Strategies
February 9, 2006
The Smart Profits Report: Issue #282
Thursday, February 9, 2006
Option Trading Strategies - Option Plays That “Earn” Their Keep… To the Tune of 633%
By Steve McDonald
Advisory Panelist, Mt. Vernon Research
When Cymer (Nasdaq: CYMI), a leading supplier of semiconductor light sources, recently exceeded earnings expectations, its stock spiked, sending one of its options up a delicious 923%.
An option on Novellus Systems (Nasdaq: NVLS) ran up a healthy 526% on positive results. As did an option for Openwave Systems (Nasdaq: OPWV), increasing a relatively modest 450%.
These gains averaged out to 633%, and each of the options made their mark in January, which is one of the biggest earnings reporting seasons of the year.
So, what’s going on here? Why did these options skyrocket? What kinds of option trading strategies could I use? It’s typical to see positive earnings drive prices higher, but these returns were extraordinary, and I wanted to know why. After hunkering down and digging through the numbers, here’s what I found…
No Surprises - Exceeding Expectations Is A Well-Paying Habit
Hopefully, you’ve been around long enough to know that you shouldn’t expect returns of 633% on a regular basis. They do happen occasionally, but rarely in a group, the way these occurred.
As I searched the data to see if I could find a statistical reason for it, I had hoped for some new correlation, or an undiscovered indicator that would make me rich and famous using a specific option trading strategy. Instead, I confirmed what I have known for a long time: Earnings drive the market. But, in this case, a particular earnings history makes a significant impact.
My search revealed that each of the above three companies had exceeded their earning estimates over the last four quarters. In fact, Cymer beat expectations in four straight quarters. And Novellus and Openwave Systems beat the Street in two out of four quarters. The amounts by which they beat the estimates didn’t seem to matter, only the fact that they exceeded them.
This confirmed my belief in earnings as the primary indicator of market success, but it also suggested what I have suspected for a long time: Investors are quick to jump on bandwagons, and they’re even faster to jump off based on their expectations, not the facts.
Since exceeding earnings is the one thing that almost guarantees a run-up in the stock price, it would seem investors expect the three companies mentioned here to exceed their earnings next quarter. Hence the big spike in the option prices. As with all aspects of the market, there are several ways this could play out.
In general, here’s how I have seen stocks react in this type of a situation:
- If the company meets, but doesn’t exceed, its quarterly earnings, chances are the stock will drop slightly.
- If it comes in below expectations, there will be a lot of disappointed investors. The stock will do its falling-rock imitation.
- There is very little chance there will be no movement in the underlying stock price. There has been too much activity to expect nothing to happen.
In the case of these three stocks, it appears the expectation of exceeding earnings again has driven up the calls and crushed the puts. Reasonable, if you buy into my assumption about what investors expect to happen.
Which Option Trading Strategy Is Best?
This was the perfect situation for an option strangle, where you buy the calls and the puts with the same strike prices and expirations - an option trading strategy I use frequently. An option straddle would also have been suitable. Each one allows you to play both sides and take advantage of the law of averages.
The difficulty in using a strangle, of course, is knowing whether to actually wait for the earnings announcement, or take the gains off the table before the new numbers even come out. After almost 25 years of having the market beat sense into me, I say, take the money and run. If I’m sitting on big gains, my rule of thumb is a simple question: When was the last time I had gains like this is less than a month?
Experienced options investors are realists. They don’t allow themselves to be swayed by the herd’s often-irrational behavior.
As the earnings season develops, I will continue to follow up on any big winners and check for further support of the relationship between exceeding earnings estimates and option performance. I’ll let you know what I find.
Keep your expectations in line with the facts, and be disappointed less often.
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Today’s Smart Profits Cribsheet
- What’s the difference between strangles and straddles? Strangles are very close to straddles in the family tree of options strategies… The only difference is that in addition to having the same expiration date, the calls and puts of a straddle must also have the same strike price. For more options terms and definitions, visit the Smart Profits Report Glossary.
- For a step-by-step look at how strangles work, visit Smart Profits #257, Options Strangle Tips - Extracting Three Strangle Tips From a 515% Gain.
Good Trading,
Steve
Related Articles:
- Options Trading Strategy - A Five-Question Screen to Find the Perfect Option
- How to Get the Best Price on Your Options
- Strike Prices - Increase Your Odds by 99%
- Two Ways to Profit Trading Index Options
How to Avoid Panic When the Train Leaves Without You
February 7, 2006
The Smart Profits Report: Issue #281
Tuesday, February 7, 2006
How to Avoid Panic When the Train Leaves Without YouBy Dean Albrecht
Advisory Panelist, Mt. Vernon Research
A few weeks ago, I traveled to meet several clients. I had a few hours between meetings and decided to check out some of the better-known landmarks.
With my dinner meeting fast approaching and no cabs in sight, I decided to take the train back to my hotel. I rarely get to take the train and thought it would be enjoyable. When it arrived, I boarded without knowing exactly where I was headed. I searched for some landmarks and got off at what seemed to be the right stop. And I ended up in a not-too-endearing neighborhood. Only, there was more ‘hood than there were neighbors.
I was in the middle of an empty, boarded-up area on the side of the road next to the train tracks, wearing a Polo, khakis and a baseball cap. The train choo choo’ed away and I was left there, eyebrows cocked, a little smirk on the kisser, thinking, “I need to blow this Popsicle stand… and fast.”
I got on my cell phone to try to arrange a pick-up. On the other end of the phone, my host yelled, “You are where? Holy smokes, guy - we gotta get you outta there!” (Believe me, that didn’t ease my comfort level.)
Saved By Buffett’s Golden Rule
I should have had the patience to find the right station. I should have done my homework prior to getting on the train and put together my algorithms: If the train leaves from this station, and the restaurant I want to get to is in that area, I want to get off here.
If only I had applied the rules I use to make money in the markets…
One of the overriding tenets in investing or trading is to have patience and good planning.
As Warren Buffett says of the market: “It’s a place that offers up opportunity on a daily basis and you don’t have to swing at every pitch.”
Wait for YOUR pitch. You should have a set of rules to lean on before swinging at a pitch. Here are few simple ones…
If the broad markets are in an uptrend, then you would be well served to favor the long side on trades. If you go short on stocks when the market is in an uptrend, you have to be prepared to live with the fact that a rising tide lifts all boats. Likewise, if the market is going down, you would be well served to play the short side predominantly, as a low tide brings all boats down a few feet.
If you are playing the long side of a trade or position, you should take a look at the trend of the sector first. For instance, if the chip sector is moving up, then you should feel confident in taking positions in that sector and you should expect a higher return on the stocks in the sector than in the sector itself.
How to Profit from the Semiconductor Sector
There are times when this doesn’t work out as planned. Admittedly, Intel (Nasdaq: INTC) and Texas Instruments (NYSE: TXN) have had a hard time as of late, but have you seen the mid-tier companies in the semiconductor sector, like XLNX and others? They have been going up nicely. So in this case, if you are a pullback buyer, you buy the SMH to get exposure to the sector, and you buy INTC and or TXN to get exposure to a good company that might be experiencing a short-term “retracement,” as it is called in the technical world.
Furthermore, the semiconductor sector has been in an uptrend since November, and that would have been the time to take your more meaningful positions and buy on pullbacks on the way up.
There is more than one station in this game. If you miss the train at one stop, don’t fret. Just have the patience to get on at the right place.
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Today’s Smart Profits Cribsheet
- Today’s report offers ways to avoid panic in the marketplace. In Smart Profits #264, 1.8 Billion Ways to Improve Your Trades, I give details about back-testing and other winning strategies available in The ESP Profit System.
- And for a quick primer on options success, please read Smart Profits #228, Fundamental Analysis - Three Screens For Technical Traders.
Good Trading,
Dean
Related Articles:
- How I Use The ESP Profit System to Make Millions for My Clients
- How to Use Puts and Calls for Systematic Short-Term Profits
- Short-Term Options - Two Ways to Make Them Work
Spread Trades
February 2, 2006
The Smart Profits Report: Issue #280
Thursday, February 2, 2006
Spread Trades: Bull vs. BearHow To Turn A $50 Bill Into $2,450
By Karim Rahemtulla, Chairman, Mt. Vernon Research
Spread trades are one of my favorite trading vehicles. They reduce your risk by putting less money on the table and they increase your upside. You’re just not going to find too many deals that can do that.
A spread trade is when you buy a call option at one strike price and sell another call option against your position at a higher strike price - this is a bull spread. A bear spread would entail buying a put option at one strike price and selling another put option at a lower strike price.
The purpose of a spread trade is two-fold. First, it bets on the direction that you think a certain stock will go. And second, it reduces your cost of the trade to the difference between what you pay for the option and what you get from selling the second option.
Your profit is the “spread,” or the difference between the two strike prices, minus your cost of the spread.
Let’s look at two trades we executed in one of my trading services. One is a conventional bull spread, and the other is slightly less conventional.
A Fast And Safe 100% Gain with Spread Trades
A few months ago in my LEAPS Options Trader, we entered a conventional bull spread on Placer Dome (NYSE: PDG). We bought the $17.50 LEAPS calls and sold the $25 LEAPS calls against our position. Our net cost was the difference between what we paid for the $17.50 option and what we received for selling the $25 option.
If you follow the gold stocks, you know that late last year Placer agreed to be taken over by Barrick Gold. We made nearly 100% on our spread in a matter of a few months, with low downside risk.
The second type of spread trade is called a legged spread. About a year and a half ago, we bought options in Chesapeake Energy (NYSE: CHK). Once those options increased in value by about 40% in a short period of time, we had a choice: We could either sell the option and take the profits, or we could engage a spread trade AFTER a few months of owning the call option.
So, I looked at the next strike price higher than the one we owned. Based on that price, we could sell the next strike higher and recoup all but 5 cents per contract. Our cost in the option was $2.50, and we received $2.45 for selling the second option. The spread was $2.50 between the two strikes.
Here’s Where the $50 Bill Comes In
The equation is as follows: We are now at risk 5 cents to make $2.50. In real dollars, if you invested $2,500 in the initial trade, you would receive back $2,450, leaving you with a cost of $50. At last January’s expiration, that trade was completed as both options expired.
In sum, those who participated in the spread trade made a net profit of $2,450 on $50 at risk. By using some of the gains from the LEAPS trade for our spread, we multiplied our leverage. Imagine if you had risked several hundred dollars or more.
We closed out three other spreads as well, in Lexar, IGT and IACI, that netted strong double- and triple-digit gains. We also closed out a very profitable spread trade on Goldcorp (NYSE: GG) in the Xcelerated Profits Report for huge short-term profits on the back of soaring gold prices.
Spread trades are not for everyone. They usually have special margin requirements and may require staying in a position for a longer period of time to fully realize the gains. But, with gains like the ones above, there is no doubt in my mind that learning about and using spreads trades is a meaningful addition to your trading arsenal.
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Today’s Smart Profits Cribsheet
- In this issue, I mentioned our gain in Lexar by using the bull spread. To read more about how we made the trade, take a look at Smart Profits #248 Bagging a 66% Bull-Spread Return on Lexar.
- The Goldcorp spread from the Xcelerated Profits Report is just one of the many profitable trades we initiate on a monthly basis. Right now, there are multiple covered call positions in the portfolio and we just realized a 55% gain with a LEAPS option on a tech giant. Learn more about the Xcelerated Profits Report.
- Check out the Smart Profits Glossary, chock full of over 150 option terms, with definitions for words like, “spread trade” or “bear spread” found in today’s article.
Good Trading,
Karim
Related Articles:
- The “Fail Safe” Trading Signals Revealed In Option Chains
- Sell First, Buy Second for 50% Better Odds
- Make 1,000% or More by “Spreading” the Wealth
Hear It From Our Premium Members...
I sold ½ of the stock per your recommendation, which returned my original investment.
I sold the remaining stock under my regular account on 4/13/2008 for $32.19 and a gain of over $4000.
On May 21, 2008, I sold remaining shares in my IRA account at $39.75 for a gain of over $5,000.
Thanks for your recommendation on this stock."
~R. M. Raga
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What Others Have To Say...
I sold ½ of the stock per your recommendation, which returned my original investment.
I sold the remaining stock under my regular account on 4/13/2008 for $32.19 and a gain of over $4000.
On May 21, 2008, I sold remaining shares in my IRA account at $39.75 for a gain of over $5,000.
Thanks for your recommendation on this stock."
~R. M. Raga
