Trading Stock Options For Huge Profits
So you want to start trading stock options, do you? I don’t blame you; a 10% gain in the price of a stock can mean several hundred percentage point gains for the price of an option.
Trading options can be very powerful and give you such a huge leverage in the market that any move can be significant. But if you are going to do it, you should learn to do it right, by following your trading plan and limiting your losses.
Below I am going to show you an example of an option trade I took to make a large return in the market and also how I decided it was a good buy. But first I’m going to get into what options are, for those of you who don’t know.
Those of you who already understand it you can skip this section and move onto the next part.
How do Stock Options Work?
There are two different kind of stock options, call options and put options.
A call option gives the buyer the right to buy the stock at a given strike price on or before a certain expiration date. For example if you buy a $30 call option on stock XYZ for the month of January you will be able to buy the stock at $30 anytime from now until the 3rd Friday in January (the third Friday of the month is usually the expiration date) .
If the stock goes up to $40 you would be able to buy this $40 stock for only $30. If it goes to $50 you could buy this $50 at $30, etc. If you buy a call option you want the stock to go as high as possible.
The Second type of option is called a put option. When you buy a put you buy the right to sell a stock at a given strike price on or before expiration.
If you buy the $30 put you will be able to sell the stock at $30. So if the stock goes down to $20 you can buy it at $20 and sell it for $30. The farther down the stock goes the more money you make when you own a put option.
It is also important to understand that you do not have the obligation to buy or sell the stock at $30 if you own the option on it. You can always let your option expire worthless, in which case you lose the premium you spent on the option.
Trading Stock Options
Trading stock options can be very profitable if you do it right. Below I will show you an example of an actual put option trade. Remember it is not a recommendation of how to trade, but merely an example of how I used an option to profit.
On February 17th I believed the markets where going to pull back so I started looking for possible plays to the downside.
I came across the ETF RUT which was just breaking through a descending triangle pattern, which is a good sign that the stock is likely to make a downward move.
For those of you who don’t know when a stock breaks out of a descending triangle pattern the target is determined by subtracting the highest point of the pattern and the lowest part of the pattern and subtracting that from the bottom.
In this case the highest part of the pattern was $515.6; the lowest part is $430. This gives us a potential move of $85.6, or a target of $344.4.
So the first part is done, finding a stock might make a big move. Next I have to decide which option gets me the best return, and how aggressive I want to be.
Picking The Right Option
It is very important that you trade the right option. It isn’t very fun watching the stock do exactly what you wanted it to do and you still lose money because you bought the wrong option contract.
The first thing you want to do is decide how aggressive you want to be. As a general rule options that have a strike price out of the money (below price of the stock) are more aggressive then options that are in the money (Above the price of the stock). In addition, the more time before an option expires the more likely the option will not expire before you make money.
So, I’m going to look at 2 examples here, an aggressive approach (which is what I did) and a more conservative approach.
In the aggressive example we buy the March $420 put for $21. This is an extremely aggressive approach because not only is the strike price of the option out of the money, but the stock only has a little over a month to make the move we are looking for.
In our more conservative example we are going to buy the April $440 put for $44.50 and place a stop on it to exit the trade if it we lose 50% of our invested capital.
This trade is more conservative because we bought an in the money option and gave it one more month to make its move. We also have a 50% stop on the option which means that the most we can possibly lose it 50% of our invested capital.
So if we are right our reward will be greater, but our risk will be lower if we are wrong.
Risk to Reward Ratio
Before you start trading stock options you need to understand the importance of having a good risk to reward ratio. This means if you are risking $1 on a trade what is the minimum amount you are willing to take as your possible reward, if correct?
I like the standard 2/1 risk reward ratio. If I am risking $1 on a trade I need to be shooting for a profit of at least $2.So let’s look at our options and see if they fit.
Our aggressive approach involves us buying the $420 option for $21. If we lose our max loss is $21. If we are correct and the stock moves to $344.4 our option will be worth at least $420-$344.4 or $75.6, which would give us a profit of $75.6-$21 or $54.6
In other words we are risking $21 to make $54.6. Our risk to reward is $54.6/$21 or 2.6/1. That passes the 2/1 risk to reward requirement.
In our more conservative example we buy the $440 put for $44.5. We also have a 50% stop on it limiting our loss to $22.25. If the stock reaches our target our option would be worth at least $440 - $344.4 or $95.6, this gives us a total potential profit of $95.6-$44.5 or $55.10.
This gives us a risk to reward of $2.45. Which also passes the 2/1 risk to reward requirement.
Anytime I am trading stock options I assume I am going to lose money and position size accordingly. Anytime I risk money in a trade that money is only a small portion of my total account balance, this way if I am wrong it is not the end of the world.
In this example both of the stock options would have been profitable, The more aggressive trade would have given you a profit of 260% and the more conservative approach would have given you a profit of 170%.
Either way it would have greatly beat the return of holding the stock through that period, especially considering the stock went down.
|Sponsored Links Free Trading Videos Watch free trading videos online! Simply watch and learn to be a better trader.|
Other ways to trade stock options
Remember there are many other ways to use stock options to your advantage. Some of these are,
Selling Covered Calls
Selling Naked Puts
You can also use the put to call ratio in order to help predict where the market is going. But if you plan to get into option trading remember, do it with a plan and paper trade until you feel comfortable putting real money in.
Creating An Online Option Trading Plan