Thursday, April 5, 2012
On Tuesday, we discussed the basics of how to pick the right options trade for you. Today, we'll look at the key concept a successful options trader needs to understand before jumping into the market...
Options traders need to understand probability. What are the odds a stock will move in the direction you expect it to?
A stock can do three things: It can go up... It can go down... Or it can stay the same. So by betting on one of those outcomes, you have a 33% chance of getting it right. In other words, for every three option trades you make, you're going to have one winning trade and two losers.
This seems simplistic. There are strategies traders can use to increase their odds, and there are definitely mistakes we can make that reduce them. But for the most part, a 0.333 batting average is a safe assumption.
So if we're only going to make money on one out of every three trades, we need to make enough on the one winner to counter the two losers. Since the losses can be as much as 100% each, it's important to only consider trades that can produce 200% gains or more. Of course, we're not holding out for gains of 200% on every trade. That's unrealistic. And we won't be suffering 100% losses all of the time, either. But the potential for a 200% gain has to exist for a trade to offer the proper risk/reward setup.
That potential is what I look for most when deciding which strike price to buy on an option.
Let's take another look at our mock options trade from Tuesday: buying the SLV July options. Today, we'll narrow down which strike prices offer the best setup for the trade...
Here's a look at the pricing of some of the July call options with strike prices close to the current price of SLV shares ($31.50)...
Let's set an upside target of $41 per share for SLV stock by option expiration day in July. From here, it's really just a matter of simple mathematics to determine which option would give us the best return based on that target price.
But SLV could run into resistance at $34. It's possible the stock will get pinned at that price and fail to break out to the upside... So we also need to consider how the trade will work if SLV shares get stuck at $34 rather than jumping all the way to $41.
Here's the minimum price for each of those option contracts if SLV hits the target prices of $34 and $41 by option expiration day in July...
In every case, these options offer the potential for at least a 200% return on the trade if SLV rallies to our upside target. So we have a favorable risk/reward setup. The July $30, $31, and $32 call options, however, are profitable at the lower $34 price target.
The July $34 call option offers the highest potential return, given our expectation of SLV rallying to $41 by July. But it also has the most risk if SLV can't get above the initial resistance level of $34.
I prefer to go with the trades that have the highest probability for a profit. At first glance, that would be the SLV July $30 call option. The stock doesn't have to rally much to recoup our initial premium of $2.95 per contract. And it's a profitable trade at both the $34 and the $41 price targets.
Since each option contract covers 100 shares of stock, it would cost $2,950 to purchase 10 SLV July $30 call options ($2.95 premium x 100 shares per option contract x 10 contracts). A trader would have the potential to make $8,053 on this trade if SLV rallies to $41 per share.
In this case, I'd probably set a stop of 50% on the trade to limit my losses. That means if the options lost 50% of their value, I'd admit I'm wrong on the trade and get out of it with a $1,475 loss. So we're risking $1,475 here in an effort to potentially make $8,053. That's five times as much potential reward as risk. That's a good setup.
Of course, this setup requires that you actually stick to your original plan and cut the losses if the option loses half of its value. That seems like an easy enough thing to do. But most people – including experienced traders – have a tough time cutting their losses. It can be emotionally painful. So here's a different tactic...
If you struggle with discipline, you need to find a way to limit the dollar amount of your losses if the option goes to zero. In the previous example, we were willing to risk $1,475. But if the option goes to zero, the loss would be far worse – $2,950.
Instead, we could take an option position where the initial investment is less than $1,475 at the outset. We could buy 10 of the SLV July $34 call options for a total of $1,200 ($1.20 premium x 100 shares per contract x 10 contracts). If we're right and SLV rallies to $41, these call options will be worth at least $7,000. That's a gain of $5,800. Yes, that's less than we'd make with the SLV July 30 calls if we're right on the trade. But the risk is now just $1,200 – even if the option goes to zero.
Figure out how much you're willing to risk on a trade, and then select the option that offers the best risk/reward scenario based on your risk tolerance. Be honest with yourself. If you struggle with cutting your losses – and most traders do at one point or another – set up a trade where a 100% loss is less in dollar terms than the trade with the best setup.
Best regards and good trading,
"There are hundreds of options to choose from," Jeff writes. "Picking the best one can be confusing… And it often makes the difference between a good trade and a bad one." But with Jeff's help, it doesn't have to be an intimidating process… Learn more about becoming a successful options trader here: How to Pick the Right Option Trade.
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