Letting your profits run is tough mentally and often leads to traders closing out trades too early. It feels risky, but once you understand that trying to protect every penny of your profit prevents you from making a bigger profit, you will be on the road to success.
Don't sell on fear and impatience. Remember your plan.
Every success with MarketClub, Adam Hewison
Just why are options so great in the first place? If you're still on the fence about trying your hand at options, this is a must-read article provided by Elizabeth Harrow of Schaeffer's Investment Research. If you enjoy this article and want to learn more about options you may even want to check out their options newsletter!
In this economy, everybody's trying to save money. So, forgive me for pandering, but it's a fact that options are significantly less expensive than the securities on which they're based. Each option contract gives you control of 100 shares of equity, yet the cost to purchase an option contract is nowhere near the expense of buying an equivalent chunk of stock.
Premium: The price of an option contract that the buyer of the option pays to the option seller for the rights conveyed by the option contract.
When you purchase an option contract, you pay a premium to enter the trade. This premium is known as the ask price, if you're buying to open, and it's determined in the traditional manner by supply and demand.
By way of example, let's take a look at options on imaginary retailer You-Can't-Afford-It Stores Inc. (POSH). Let's say POSH closed yesterday at $46.39. It would cost you $4,639 to purchase 100 shares. By comparison, POSH's May 47.50 call closed yesterday at $1.83. (Hey, it's my imaginary case study: I get to pick the numbers.) In other words, it would cost you just $183 to purchase this call option granting you control of 100 shares of POSH.
As fair warning, I'm not a math expert, but I'm pretty sure you could save about $4,456 by purchasing the call option rather than investing in the shares outright.
Maximize your profits through the amazing power of leverage.
In addition to being cheaper than stocks, options also provide you with the magic of leverage. This nifty feature allows you to collect profits that are, in the best-case scenario, way out of proportion to your initial investment.
Leverage: The control of a larger number of shares with a smaller amount of capital. Leverage provides an option buyer greater profit potential using fewer dollars compared to holding a long or short stock position.
Sticking with our POSH example from above, let's say that Jill Trader purchased 100 shares at $46.39 for a total cash outlay of $4,639. Meanwhile, Susie Speculator bought to open 1 May $47.50 call for a total outlay of $183 ($1.83 x 100 shares per contract).
OK, bear with me, because we're going to have to use our imaginations for this next bit. Let's pretend that POSH rallies up to $55 per share by May expiration. Jill Trader unloads her 100 shares for $5,500, content in the knowledge that she's netted a profit of $861 (which translates to 18.6% of her initial investment).
Meanwhile, Susie Speculator sells to close her option contract, which is now worth $750. Susie's profit is $567, or 322.7% of her initial investment. Not only did Susie invest less capital than Jill, she more than tripled her trading dollars. Not too shabby, right?
And, if you can believe it, there are even more reasons why options are inherently superior to stocks…
Downside risk is limited in many option strategies.
At the risk of beating a dead horse, let's reverse our earlier scenario. Pretend that POSH shares plunge during the next 6 weeks, and by the time May-dated options expire, they're wallowing at $33 per share.
When you buy to open an option that expires worthless, your loss on the trade is limited to your initial cash outlay.
Our hypothetical investors have a very different reaction to the stock's slide. Jill Trader is panicking, because she's already lost $1,339 on paper, and the decline doesn't show any signs of slowing. She's faced with the choice of swallowing a big loss, or waiting it out and hoping the shares turns around.
Elsewhere, Susie's disappointed, but not devastated. She simply allows her out-of-the-money call to expire worthless, which means that her total loss on the trade amounts to no more than her initial investment of $183. It's not her best trading result ever, but it's definitely a more palatable outcome than Jill's.
Feel free to stop caring about price/earnings ratios.
At this point, I'm going to stop throwing math problems at you. Frankly, I find it exhausting, and I'm quite sure my endlessly patient colleague, Jocelynn Drake, is tired of checking my numbers. However, we will be discussing a few specific figures, namely: price/earnings ratio, price/book ratio, price/sales ratio… the list goes on.
Now, if you're used to investing in stocks, you're no doubt accustomed to researching the aforementioned ratios. These metrics offer clues as to whether a stock is overvalued or undervalued at current levels, and many traders will analyze these fundamentals before entering a position.
For all the reasons mentioned above(plus a few more), you have my full permission to throw these fundamentals out the window(well, mostly) when trading options. The fact is, these metrics simply don't matter as much to an option trader as they do to a buy-and-hold stock investor.
Let me explain. Thanks to your lowered initial investment, as well as the magic of leverage, you have a simple goal when you buy a call option. You want the share price to rise above the strike price prior to expiration, allowing you to collect your profit and exit the trade.
So, since you're not investing in the company for the long run, the traditional trading metrics shouldn't have much bearing on your analysis. So what if POSH's price/earnings ratio of 19 is higher than the average for its peer group? Even if the shares are expensive now, you can still reap a profit as long as they're more expensive by the time your option expires.
Instead, since we want the stock's price to make a fast, aggressive move in the right direction, we favor the Expectational Analysis method. By combining technical analysis with sentiment analysis, you can pinpoint equities that are poised to rally...or plunge, if you're playing puts.
Of course, fundamentals do play a part. If you're buying options ahead of earnings, you should be aware that premiums might be inflated by rising implied volatility. Or, if the pharmaceutical firm that you're buying calls on is due to release trial data within the next week, you should definitely have that event on your radar, too.
But, beyond the basics, you can really stop sweating the fundamentals. If you love crunching the numbers, though, don't worry. With put/call volume ratios, put/call open interest ratios, and more, there are still plenty of metrics for an option trader to play with.
Two of the more common option strategies are horizontal spreads (identical strike prices, different expiration days) and vertical spreads (different strike prices, same expiration day). Other spread types are combinations or variations of these categories: Diagonal spreads are a mixture of horizontal and vertical spreads; butterfly spreads combine two different vertical spreads.
Selling a March 450 S&P call and buying a June 450 S&P call is an example of a horizontal spread, also known as a time, or calendar spread. The object is to profit from the quicker decay of time value of the nearby short option compared to the more distant long option. The trader is, in effect, selling time value. Most time decay occurs in the last three months, and especially the last month, of the contract. This strategy is generally most profitable with equity options than with future options.
If you sell the March option at 7.75 and buy the June option at 11.75, you establish the calendar spread at a 4.00 debit. (Debit spreads are spreads that the trader pays to establish, while in credit spreads the trader collects premium). The March contract then drops to 1.25, while the June option drops to only 10.50. You could then “lift” (offset) the spread, buying the March back at a 6.50 profit and selling the June for a 1.25 loss, for a total profit of 1.25 (5.25 minus the 4.00 paid to establish the spread).
In a vertical spread, the options share the same expiration date but have different strike prices. An example would be buying a March 445 S&P call at 6.50 and selling a March 455 S&P call at 3.00 with the futures at 450.00, for a 3.50 debit on the spread.
In the market rallies, the deeper in-the-money long option would gain more than the short option would lose. If the futures are unchanged at expiration, the 445 call will be worth 5.00 (its intrinsic value) and the 455 call will expire worthless, for a 1.50 profit on the trade. Once the futures price rises above the higher strike, against on the lower strike are offset by losses on the higher strike, so profit is limited. If the market falls, loss is limited to the amount paid for the spread.
Option spreads are characterized as bear or bull strategies depending on whether they will profit in up or down markets. The previous example is a bull call spread, because it would make more money in a rising market. A bear call spread would consist of selling the lower strike option and buying the higher strike option.
Bull and bear spreads also can be established using put options. For example, a bull put spread would consist of buying a December 445 S&P put and selling a December 445 put. Selling the 445 put and buying the 445 put would be a bear put spread. Generally, you should use calls for bull spreads and puts for bear spreads.
You can alter spreads by modifying the number of options, for instance establishing a vertical bull call spread with two short calls for every long call, also known as a ratio spread. Whether all or some of the options in a spread are in-, at- or out-of-the-money also will affect the risk/reward profile of a spread.
Other strategies focus on the magnitude of price movement rather than direction. Straddles and strangles are two strategies traders use to take advantage of volatility swings. A straddle consists of buying at-the-money puts and calls with the same strike price and expiration day, for example, buying a June 100 bond call and a June 100 bond put. The straddle buyer expects a futures price move large enough (in either direction) that they profit on the in-the-money option will be more than the cost of putting on the spread. If you thought the market would remain virtually unchanged, you could sell the straddle (at a credit) and reap the profits as time eroded its value.
A strangle consists of combining out-of-the-money call and puts. With June bonds at 102, a strangle buyer might purchase a June 104 call and a June 100 put, again expecting a sizable move in either direction. (An advantage to this strategy is it is cheaper than a straddle, but the market also has to move more to make it profitable.) For a trader who expects bond prices to stay between 100 and 104, however, selling this straddle offers an excellent opportunity to “sell volatility.” If the market does stay between these prices, the seller will keep his premium.
Traders should be aware that because of higher commissions and increase slippage, a marginally profitable options trade can actually be a loser when all is said and done. Understanding volatility and time decay concepts will help identify strategies with the highest probability of success.
Part 4 will be posted Saturday afternoon (5/14/11). Don't miss the final lesson of this series!
Brian Campbell is the author of the Rapid Forex trading blog and a full-time forex trader by way of "Forex Sailing." Today on the Trader's Blog, he is sharing a few of his forex tips with you.
If you're interested in Brian's techniques, take a look at the Rapid Forex trading blog and find out more about his free 20-day forex training course, plus the soon to be released Forex Sailing Trading Seminar available exclusively on the Rapid Forex blog.
The greatest way to make money that I've ever discovered is online forex trading. As a mobile forex trader you can go anywhere in the world as long as you have a laptop & an internet connection (I also require a hot-tub).
Today I'd like you to welcome Geoffrey A. Smith, from Day Traders Institute. DTI has been a leading the way in trading education for years and I'm very excited to have Geoffrey, the lead instructor from DTI, join us today. Please take time and read the article below on "The 3T's of Trading", then visit the DTI to learn more about them as a company and how they can help you with your trading and investing.
As a trader and instructor, one of the most frequently asked questions I get is “where to take profit”? When I first was asked this, my initial response was “when you are making money”. But after pondering the question for some time, I came to realize that many traders struggle with taking profit hoping that the market would go further in their favor only to get stopped out for a loss. So to help traders with learning to take a profit, we came up with the 3T’s of trading:
Look to trade in thirds, taking 1/3 of your position down at a time. When using the 3T’s, the goal is to first finance the trade and let the last third pay as much as possible. Wouldn’t it be nice to trade with someone else’s money? Well, initially we have to put up the cash to get into the trade and take on the risk of losing money. But if we take enough of the trade off and adjust the protective stop to a point that the trade cannot lose, this eliminates our risk in the trade, relieves the fear of losing, and allows us the legal right to let greed set in.
The first T is the Tick part of the trade. Really it is a scalp, only looking for a small amount. If trading stock, take 1/3 of the position off at $0.30. If trading futures like the Emini S&P, look for 0.50 to 0.75 of a point. This accomplishes two things, it reduces your exposure to the market, and also allows you to pay commission.
The second T is the Trade. Look for twice as much as you got on the Tick part of the trade. Again, if trading stock, look for $0.60 or so. This will elevate 2/3 of the initial position and lock in $0.90. If you adjust your protective stop back $0.50 from current market, then you are on a “free ride”. At this point, you have no more risk in the trade and can concentrate on making money.
Finally is the third T, which is the Trend part of the trade. This is the last 1/3 of the position that we hope will pay the most. Sometimes you will get stopped out on the last 1/3, but other times the market will continue to trend in the direction you are trading and can end up making your whole day.
These price targets are not set in stone but examples of what you might look for. On a stock that is trading at 50, you can’t look for as much profit as one that is trading at 150 because of the price movement. You will need to adjust your profit targets accordingly. I will look at the ATR (average true range) of the stock and set my first target at 10 – 15%, second target at 30 – 40%, and look for the whole ATR on the last third. Some days the stock will get there, other days it will not, but at least the trade was financed on the way.
Give this technique a try and see how you like it. It helps in reducing the fear of losing and allows you to take some profits as the market trends in your direction. It has been my experience that the first target is hit 85% to 90% of the time, with the second target getting filled about 75% to 80% of the time. Not every trade goes in your direction, however, if 1/3 of the trade has been taken out of the market, then the loss has been reduced as well. Remember as traders, we want to make are losses small and our gains big. The 3T’s is one technique to help us get there.