Editor's note: With the market closed for Christmas, we'd normally take the day off. But we want to make sure you get the full benefit of this week's "how to" series from master trader Jeff Clark...
Yesterday, Jeff explained that the strategy he has used successfully for three decades to trade his own money offers higher returns and less risk than the strategies most folks use. Today, and over the rest of the week, he's going to show you exactly how this strategy works... and how to start using it yourself.
Tuesday, December 25, 2012
People tend to think being successful in options is all about swinging for the fences and trying to make a killing on one big trade. As I told you yesterday, I fell victim to that mentality when I was 19 years old... and it cost me my life savings.
From that day forward, I realized that having a long and successful career as an options trader has to do with consistently taking profits as they come and focusing on managing the risk of every trade.
That focus is the basis of the strategy I now use with my own money... And today, I'm going to show you how to begin using it yourself.
The question I always ask myself when I'm looking at an option trade is, "How can I make money on this trade, even if I'm wrong?"
You're going to be wrong a lot of the time when you trade options. A stock can go up, go down, or go nowhere. When you buy an option, you're betting one of those three things will happen. You're going to be wrong and lose money if the other two occur.
So you need to look for ways where you can turn your position into a profit... even if you're wrong. I'm going to show you how this works with a real trade my readers took advantage of back in May...
I'm going to walk you through this trade step-by-step. It might seem complicated at first... But it will definitely be worth the time you take to understand how the numbers work.
The first thing to know is that, at the time, I liked the idea of owning Seabridge Gold (NYSE: SA), a Canadian gold explorer. Seabridge was dirt-cheap, and I thought it would be trading much higher a few months down the road.
So I recommended buying the Seabridge January 15 call options for about $1.65.
That call gave us the right to buy Seabridge at $15 a share. We spent $1.65 on it. So to be profitable on this trade, we needed Seabridge to trade above $16.65 on option expiration day in January 2013. That was 25% above the price at the time.
If Seabridge fell in price, we would have lost money. We would have also lost money if Seabridge went nowhere. The only way we were guaranteed a profit on this trade was if Seabridge rallied more than 25% by January.
That may seem like a tall order. But I was confident the trade would work out and I was comfortable making the recommendation.
However, I still had to ask myself, "How can we make money on this trade even if I'm wrong?"
As long as we were spending money out of our pocket to make this option trade, the odds were against us. But there was a way to put some money back into our pocket... without taking on any extra risk.
The easiest way to do this was to create a "spread trade." Spreads involve buying one option and then selling another.
Since we owned the Seabridge January 15 call options, we had the right to buy the stock at $15. To create a spread, we sold someone else the right to buy Seabridge from us at a higher price.
My initial upside target for Seabridge was around $20 per share. So we sold the Seabridge January 20 call options, which gave someone else the right to buy the stock from us at $20. We collected $0.85 for selling the call. By doing this, we recouped more than half the cost of the January 15 calls.
Here's how that looked, trading one contract at a time. (One option contract covers 100 shares.)
Per contract, we paid $165 for the right to buy Seabridge at $15 per share and received $85 for taking on the obligation to sell Seabridge at $20 per share. We spent $80 for each spread.
We immediately lowered our out-of-pocket cost for this trade from $165 to just $80. Our maximum loss fell more than 50%.
We also reduced our maximum profit. Since we sold someone else the right to buy Seabridge from us at $20, we wouldn't have made any additional profit if Seabridge rallied above that level. But because $20 per share was my initial target anyway, we would have looked to lock in profits on the trade at that price. So we were really just agreeing to do so ahead of time.
Now, think about this...
If Seabridge closed at $20 per share on option expiration day in January, the Seabridge January 15 call options would have been worth $500 per contract. We spent $165 on the original trade. So we would have had a $335 profit, or 203% gains on our initial $165 investment.
But by creating the spread, we reduced the cost of the trade to just $80. And the spread would still have been worth $500. By adding the second leg for the spread trade, we would have had a $420 gain. That's 525% on the original investment.
The spread position lowered the cost of the trade, so it also lowered our risk and increased our potential percentage profit if the stock reached my target price.
This was a BIG improvement over just buying the January 15 call options outright. But there was still a way we could do even better.
Even with this spread trade, we still would only have profited if the stock moved higher. We would have lost money if Seabridge fell or went nowhere. To increase our chances for a profit, there was one more thing we needed to do... And in tomorrow's essay, I'll show you how we made this trade even better.
Best regards and good trading,
"I'm not focused on how much money I can make," Jeff wrote yesterday. "I'm focused on how little I can lose." Read the first essay in the series here: How I Retired at 42.
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