Strike Prices

The Smart Profits Report: Issue #276
Thursday, January 19, 2006

Strike Prices - Increase Your Odds by 99%
By Steve McDonald
Advisory Panelist, Mt. Vernon Research

In 1982, I traded my first option. And that same trade handed me my first loss - a pretty healthy one, too.

As I remember, it was an S&P 100 Index option that ran in exactly the opposite direction of where I thought the market was headed. It was a call, and the market did its best imitation of a falling rock.

The sad fact is that I continued to lose money with options until I learned some simple truths. But perhaps the most important lesson was learning to pick good - and profitable - strike prices. That’s when the ink on my trading statements changed from deep red to shiny black…

Of course, the underlying share price has the biggest impact on your option price. But the strike price will determine the size of your gain or loss… and it can mean the difference between a 1% gain and 200% cause for celebration.

Right now, let’s see how to pick the strike price that has the greatest chance of making you money…

Tight Strike Price Ranges That Payoff

Strike prices just in- or out-of-the-money have always gotten me the best return on my short-term options plays.

Once an option is in the money, it moves dollar-for-dollar with the underlying stock. So, if the options you’re following are about to cross into in-the-money territory, you’ve found a great opportunity to cash in as they make that move.

Last month, anyone holding just in- or our-of-the-money puts on DuPont (NYSE: DD), for example, walked away with a substantial gain…

The night before this writing, January 10, DuPont cut its earnings estimates from $0.25 per share to $0.10 per share.

The stock went from $44 to $41.47 when trading began the next day. Ouch! A 5% drop for a stock like DuPont is huge. Talk about a falling-rock imitation.

Take a look at the option chain for DuPont’s January 2006 puts at the close on the following trading day, January 11, after the market digested the earnings estimates:

DuPont's January 2006 puts on 01/11/06

Remember, these are put contracts, so the black options are out-of-the-money. The blue contracts are in-the-money because they represent the option to sell DuPont for a higher price than what the stock trades at - $41.47 at this writing. The $42.50 contract is considered to be at-the-money, or the first in-the-money option.

Notice that the second option out-of-the-money, with the $37.50 strike, didn’t make a cent, despite the 5% drop in the stock price that day. But the other options made significant moves…

Since I don’t like to take a lot of risk with money, let’s use a conservative strategy to see how we could have positioned ourselves to cash in on a situation like this. Here’s a play you might not have considered…

The Right Strike Price For A 217% Gain

Let’s suppose we have owned DuPont stock for a long time. Our cost basis is very low and we are happy with the company. And we aren’t planning to take our profits in the near future.

About a week ago, we read something in the Journal that gave us a not-so-good feeling for the company, near term, and we wanted to brace ourselves for a pullback.

Buying put options is a good way to go since we own the stock and want some downside protection in the event there is some bad news.

If the stock drops, as it did here, we make a ton of money on the puts we are holding. It softens the blow and reduces our loss.

But choosing the right strike price is where it gets tricky…

Why pay more than $0.05 for an option, right? The $37.50 strike was only a few dollars below the at-the-money and in-the-money options, and it was cheap. We would have had to pay $1 to $2 more per option to get an in-the-money strike. Does a strike price just $2.50 or $5 out-of-the-money make much of a difference?

Absolutely.

As I have said before in previous articles, buying too far out-of-the-money on short-term options reduces your chances of winning by as much as 99%.

Look what the $37.50 option did - a big nothing. It was one step too far and a waste of money. A very easy mistake to make. We all want a bargain.

What about the reverse? What if we bought the $45 strike?

Look At The Percentages…

The $45 strike, which cost $2.20 when the market opened, returned 61% ($3.60 - $1.40 = $2.20, $1.40/$2.20 = 61%). Not bad, but…

The first out-of-the-money option, the $42.50 strike, returned 212%, ($1.35-$0.85 = $0.40, $0.85/$0.40 = 212%). Remember, the stock was about $44 when we bought our options last week, so the $42.50 was the first out-of-the-money strike. The cost of the option was about $0.40.

I’ll take 212% over 61% any day.

I could go through 10 more examples and they’d all produce the same result.

As a novice, I was always shopping for bargains. Buy lots of cheap options for less and really clean up, I thought. Gamble on the stock moving enough to make the play pay. But the only thing that got cleaned out was my brokerage account.

In an average week, I follow about 20 straddles. That’s 40 options. The winning scenario I described above works 90% of the time. Now, those are what I call good odds.

Today’s Smart Profits Cribsheet

Very shortly, I’ll be unveiling a new, exciting trading service that is scoring triple-digit gains. It’s geared for investors who want to profit from overreactions in the market, on the long and short sides. The system, which requires little cash, has been years in the making and already has performed like the successful veteran services. Stay tuned for the release of this elite strategy…
In this letter I discussed how to maximize your upside gains. But as any seasoned options trader knows, protecting your downside can be just as important. To learn more about how to protect your investments, read our Smart Profits #268, How to Defend Your Principal From a 50% Bomb.
Also for any questions about the terminology used in this article, like “strike prices” or “in the money options“, check out our Smart Profits Glossary.

Good Trading,

Steve McDonald

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