Monday, July 2, 2007
The best hitters in baseball succeed one out of every three times. In fact, any major league ballplayer who can go his entire career with a .333 batting average is almost assured a spot in the Hall of Fame.
The standards are about the same for option traders.
Think about it. There are three possible directions for stock prices – up, down, or "stays the same." So, at best – and without the aid of an infallible crystal ball – traders can expect to be right about one-third of the time. That's a batting average of .333.
But option traders step into the batter's box with the count already one strike against them. You see, whenever you buy an option, the price you pay includes a time premium. The time premium compensates the seller of the option for the probability that the stock may move during the life of the option.
For example, I think airline stocks are in the process of forming a bottom and that they'll be higher within the next couple of months. One of my favorite stocks in the sector is American Airlines (AMR).
AMR currently trades at $26.30... and I'd be willing to bet it'll be higher two months from now. But if you want to make that bet using call options, then you need to be willing to pay up for it.
The AMR August 27.50 calls are trading for $1.40. So the buyer of these calls is willing to pay $1.40 for the right to buy a share of AMR at $27.50 by option expiration day in August. That's a full $1.20 above where the stock is trading today.
For the call option buyer to profit on this trade, AMR needs to rally above $28.90 ($27.50 stock price plus $1.40 option premium) within the next seven weeks. (Yes, I know, a sharp move higher over the next few days will boost the price of the options as well, but let's keep this example simple, shall we?)
That's a gain of $2.60 per share, or nearly 10% over the next seven weeks, just to break even.
So the option buyer needs to be right on the direction of the stock, which is only a 33% probability, and he needs the stock to move high enough to cover the premium he paid for the option.
That's what I mean when I say option buyers are stepping into the batter's box already one strike down in the count. In fact, in the case of AMR, I'd say the options are so expensive that call buyers are more like two strikes down and facing Roger Clemens on the mound.
It's tough to bat .333 in that situation.
But that doesn't mean that you shouldn't step up to the plate. After all, baseball greats like Ty Cobb and Wade Boggs excelled against such odds.
Mere mortals like you and I, however, need to find ways to even the count. One such way is through the use of "spreads" and other combinations of options. The strategies aren't difficult to set up, and they can be enormously profitable.
In the S&A Short Report, we've gone to bat with this strategy nine times so far this year. We've closed out four positions with gains of 58%, 70%, 50%, and 125%. Of the five that remain, two are profitable, one is basically unchanged, and we're behind in the count on the other two.
No matter how you look at it, that's a pretty good batting average... and it's all thanks to conservative options strategies.
On Thursday, I'll show you my second favorite strategy for evening the count on American Airlines calls. S&A Short Report subscribers will learn exactly how to play it this afternoon. If you're interested in learning more, click here.
Have a wonderful Independence Day.
Best regards and good trading,
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