Editor's note: Yesterday, master trader Jeff Clark showed you how to take an ordinary option trade... then take one simple step to reduce your risk and increase your percentage gains. Today, he's going to show you one more simple step that will allow you to make money even if you're completely wrong on the direction of the trade...
Wednesday, December 26, 2012
The "spread trade" strategy I showed you yesterday is a great way to reduce the risk of trading options and increase your chances of making money.
But there's an easy way to make it even better...
In the example I showed you yesterday, my readers bought one call option on Canadian gold explorer Seabridge Gold (NYSE: SA) and sold one call option.
While that was an improvement on simply buying the call by itself, we still were only going to profit if the stock moved higher. We would have lost money if Seabridge fell or went nowhere.
To increase our chances for a profit even more, we needed to add one more leg to this option position...
We sold an uncovered put.
By selling uncovered puts, you get paid to agree to buy a stock at a specified price by some date in the future. It's that simple.
Selling uncovered puts is my favorite options strategy. In my experience, it is the most consistent way to profit in the options market.
Now... it's important to only sell uncovered put options on stocks you want to own anyway... and at prices at which you'd like to own them. In a rapidly falling stock market, you may end up having to buy the stocks on which you've sold puts.
Smart folks who use this strategy use it to generate income on stocks they don't currently own but are willing to buy at the right price.
We used this strategy to pay for our Seabridge call option trades. I'll show you how today.
I'm going to walk you through each step of this trade. I know it may appear complicated and intimidating, but trust me, it's worth the time it'll take to learn how to execute these trades.
If you don't remember the details of the trade I wrote up yesterday, go back and review it here.
For a quick summary: We bought the Seabridge January 15 calls, which gave us the right to buy shares at $15. We sold the January 20 calls, which obligated us to sell Seabridge at $20.
That trade cost $0.80 per share. So we were looking to sell an uncovered put option on Seabridge that would give us the $0.80 back and maybe even put a little extra money in our pocket upfront.
Remember... we only sell puts on stocks we want to own anyway and at prices at which we want to own them. Seabridge was a dirt-cheap gold stock I wouldn't have minded buying right then, when it was trading for $12.50 per share. And I would have been thrilled to get paid for agreeing to buy it even cheaper than it was.
So I recommended selling the Seabridge January 10 put options. That obligated us to buy Seabridge at $10 per share if it closed below that level on option expiration day in January.
At the time, the puts were trading for $1.10. That covered the $0.80 cost of our spread trade and put $0.30 per share more in our pocket.
Here's how that looked, trading one contract at a time. (One option contract covers 100 shares.)
We created a trade that paid us $30 to set it up. That $30 was ours to keep no matter what happened to Seabridge.
This trade could have played out in one of four ways...
1. Seabridge closed below $10 on January expiration day. We would have been obligated to buy Seabridge at $10 per share. Figuring in the $30 we received for setting up the trade, we really agreed to spend $970 on 100 shares, or $9.70 per share. So this trade would have been profitable as long as Seabridge held above $9.70 per share.
2. Seabridge closed between $10 and $15 per share on January expiration day. All the options in the combination would have expired worthless, and we would have kept the $30 per contract.
3. Seabridge closed between $15 and $20 per share. The higher Seabridge traded in that range, the more money we would have made. For every $1 Seabridge rallied, we would have collected another $100 per contract.
4. Seabridge closed above $20 per share. The trade would have been worth $500. So our maximum profit would have been $530 ($500 for the combination plus $30 for the original setup of the trade).
In other words, the only way we could have lost money on this option combination was if Seabridge dropped another 25% from its already-depressed stock price. We were going to make money in every other scenario.
Think about that for a moment. We would have made money if we were right on the trade and Seabridge went higher. But we could have also made money even if we were wrong and the stock dropped. That is the beauty of this type of strategy.
Let's recap what we did here...
Instead of having a position that would lose money if Seabridge went down, stayed the same, or failed to move up 25% over the next eight months... we created a trade that would have been profitable under every scenario where the stock didn't fall by more than 25%.
Three months after my initial recommendation, shares of Seabridge had bounced all over the place, trading between $13 and $17. But because we set up the trade with such a large "margin of error," we didn't need to be overly concerned about the day-to-day fluctuations. We could concentrate on the longer-term objective – a higher share price going into January.
By mid-September, Seabridge traded for about $18. I figured for such a short time frame, that was close enough to my original target. And we were able to close the trade for a $250 net credit per contract. Counting the $30 we received for setting up the trade, we had a total gain of $280 per contract.
The Seabridge "spread" I showed you yesterday was a good trade. But by adding a third leg to it, we created a GREAT trade. And it worked out perfectly.
In tomorrow's essay, I'll walk you through another example of a combination trade that worked out even better... and I'll walk you through the math again.
Best regards and good trading,
"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," Jeff wrote yesterday. Learn how he used these strategies to retire at 42 and a way to make money in the stock market... even when you're wrong.
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