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January 26, 2012

Stop Loss or Trailing Stop?

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 11:21 am

Some may hear the terms trailing stop loss and stop loss order and wonder exactly what these are and how a stop loss can enhance a trading strategy. Well, fret no more – that is what we will discuss in this blog entry. Let’s start with the basics, defining a stop loss order. Basically, a trader will tell the broker a certain price on a stock (or option) where the position will be closed; but it’s a little different than a typical closing order. For longs, the closing price is below the current market price and for shorts the stop loss closing order is above the current market. Let’s take a look.

Stop Loss Example
A trader could purchase a stock for $15.00 and set a stop-loss order at $13.50. This means that the position will be closed at the market price once the stock drops below $13.50, simple right? It is called a stop loss order because it rather simply stops the investor from taking any more losses. Many investors have a set percentage of a trade for a stop loss order. If a trader wants to use a stop loss order for an option, the bid and ask prices would be monitored and then the same decisions as were made in the stock example are made.

Trailing Stop Loss Example
A trader  chooses a lower target price to keep losses in check and tells the broker to sell the contract once this price is breached. There is another stop loss strategy, the trailing stop loss. A trailing stop loss is either a fixed percentage or a fixed nominal increment from the current market price. Once the market price moves away from the stop, the stop moves, or trails, the market. It remains in place, though, if the market moves towards it.

Once the trailing stop loss is triggered the stock is sold, just like the regular stop loss. The benefit of the trailing stop loss is that it is flexible. If you purchase an option for $10 and set a trailing stop of 50 cents, the sell target is $9.50. Of course, as the stock increases in value, the 50-cent trailing stop will do follow (the stock trades at $10.50, the trailing stop becomes $10.00).

A trailing stop loss, then, can be used very effectively in profit taking. And it may sometimes require an adjustment. Let’s revisit the $10 stock with a 50-cent stop loss. If the company reports blow-out earnings, driving the price sharply higher, it might be time to adjust the trailing stop loss. In this example, let’s say the stock jumped to $12.00. A nice profit, but there could be some more room to the upside. Maybe the trader will adjust that trailing stop a little tighter to, say, 25 cents. Doing so allows the trader to lock in a profit of at least 1.75 (12 minus 10 = 2, 2 minus 0.25 = 1.75).

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 19, 2012

Bull Call Spread vs. Purchasing a Call

Filed under: Options Education — Tags: , , , , , , , — Dan Passarelli @ 10:38 am

Bull Call Spread vs. Purchasing a Call
Let’s say that you have a moderately bullish bias toward a stock and the overall market is slightly bullish. Is there a way that you can take advantage of this investing scenario while limiting risk? Certainly, there are a few. One that is often superior to the rest is the bull call spread.

Definition
When executing a bull call, you purchase call options at one strike and sell the same number of calls on the same company at a higher strike with the same expiration date. Let’s use Apple Inc. (AAPL) which is currently trading around $430 as an example. In this case you would purchase February calls at the 430 at-the-money strike at the ask price of $14.45. You would then sell the same number of February calls with a higher strike price, in this case 450 at the bid, $6.25.

The Math
Your maximum profit in the bull call spread is limited, you can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that you purchased one February 430 call and sold one February 450 call resulting in a net debit of $8.20 (that’s $14.45 – $6.25). The difference in the strike prices is $20 (450 – 430). You, therefore, subtract 8.20 from 20 to end up with a maximum profit of $11.80 per contract. So, if you traded 10 contracts, you could make $11,800.

Although you limited your upside, you also limited the downside to the net debit of $8.20 per contract. To simply breakeven, the stock would have to trade at $438.20 (the strike price of the purchased call (430) plus net debit ($8.20)).

Advantage versus Purchasing a Call
When trading the long call, your downside is limited to the net premium paid. If you simply purchased the at-the-money February 430 call you would have paid 14.45. The potential loss is, therefore, greater when employing a call-buying strategy. If you move to a call with a longer time frame to expiration, you would pay even more for the option. This would also increase your potential loss per option.

Conclusion
By implementing a bull call spread, you have hedged your bets – limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no fool-proof ways to make money by using options. However, knowing your strategy is a good way to limit losses.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 12, 2012

Buying Call Options Rather Than Stock for AAPL

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 8:44 am

 You have your eye on a stock, a very high-valued stock like Apple (NASDAQ: AAPL ). You believe that this stock, despite its high price, continues to have tremendous upside potential. The problem is that you don’t want to shell out $420 for one share of the search giant. What can you do to maximize your money and cash in on the perceived upside? Easy, buy a call option rather than the stock.

Quick Definition
For the uninitiated, a call option is a bullish strategy wherein a trader purchases the right (but not the obligation) to purchase a stock at a specified price within a specific time period. One advantage to buying a call option rather than purchasing a stock is that you can gain a much larger percentage return on your investment.

The Example
If you want to purchase 100 shares of AAPL stock at $420 it is going to cost you (100 X $420) $42,000.  However, let’s say that you decide to purchase 1 call option on AAPL (each option represents 100 shares) with a strike price of, say, 420 with a February expiration, which carries a price tag of $16.40. Rather than dishing out $42,000 for 100 AAPL stock shares, you instead pay $1,640 for the options – a rather nice difference of $40,360 that you can use for something else or to purchase other options.

The Money
The cost efficiency of purchasing call options can be far greater than simply purchasing shares of a stock, especially when you are dealing with high-priced stocks like AAPL. Remember that one option contract is the right to purchase 100 shares of a stock at that price. So, rather than purchasing 100 AAPL shares at $420 at the massive cost of (100 X $420) $42,000; you have dished out a more reasonable $1,640 for the transaction. Of course, this is the scenario if you want to simply be bullish on AAPL stock.

Conclusion
As you can see, it is possible to lay out far less money to purchase call options on a stock that to by the call itself. In fact, the earlier the expiration you choose, the lower the price you could pay. No matter what math you use, paying $1,640 is far better than paying $42,000 for the same product. What if you want to sell these options to someone who is willing to pay a higher ask price than you paid? That is another subject for another time. Remember, there is no fool-proof way to make money in the market – there is risk involved in any trading strategy. One way to make sure you maximize your cash is to make sure you study your subject, remember that knowledge is power. Please check out our special Online Education deal for Options Blog readers.

Edited by John Kmiecik

Senior Options Instructor

 Market Taker Mentoring

January 5, 2012

The Stock Repair Strategy

Filed under: Options Education — Tags: , , , , , , , , , , — Dan Passarelli @ 11:13 am
Stock Repair Options Strategy

It’s been a rough ride for a lot of investors. Some investors are waiting (patiently) for some of their losers to turn around. Some traders are buying at new, cheaper prices. But as experienced investors know, the market can always go lower, sometimes fast and furiously. There is one more alternative that can make sense in some cases: the stock repair strategy.

Introduction to the Stock Repair Strategy
The stock repair strategy is a strategy involving only calls that can be implemented when an investor thinks a stock will retrace part of a recent drop in share price within a short period of time (usually two to three months).

The stock repair strategy works best after a decline of 20 to 25 percent of the value of an asset. The goal is to “double up” on potential upside gains with little or no cost if the security retraces about half of its loss by the option’s expiration.

Benefits
There are three benefits the stock repair strategy trader hopes to gain. First, little or no additional downside risk is acquired. This is not to say the trader can’t lose money. The original shares are still held. So if the stock continues lower, the trader will increase his loses. This strategy is only practical when traders feel the stock has “bottomed out”.

Second, the projected retracement is around 50 percent of the decline in stock price. A small gain may be marginally helpful. A large increase will help but have limited effect.

Third, the investor is willing to forego further upside appreciation over and above original investment. The goal here is to get back to even and be done with the trade.

Implementing the Stock Repair Strategy
Once a stock in an investor’s portfolio has lost 20 to 25 percent of the original purchase price, and the trader is anticipating a 50 percent retracement, the investor will buy one close-to-the-money call and sells two out-of-the-money calls whose strike price corresponds to the projected price point of the retracement. Both option series are in the same expiration month, which corresponds to the projected time horizon of the expected rally. The “one-by-two” call spread is ideally established “cash-neutral” meaning no debit or credit. (This is not always possible. More on this later). To better understand this strategy, let’s look at an example.

Example
An investor, buys 100 shares of XYZ stock at $80 a share. After a month of falling prices, XYZ trades down to $60 a share. The investor believes the stock will rebound, but not all the way back to his original purchase price of $80. He thinks there is a reasonable chance for the stock to retrace half of its loss (to about $70 a share) over the next two months.

The trader wants to make back his entire loss of $20. Furthermore, he wants to do it without increasing his downside risk by any more than the risk he already has (with the 100 shares already owned). The trader looks at the options with an expiration corresponding to his two-month outlook, in this case the September options

The trader buys 1 September 60 call at 6 and sells 2 September 70 calls at 3. The spread is established cash-neutral.

Bought    1 Sep 60 call at 6
Sold         2 Sep 70 call at 3 (x2)
-0-

By combining these options with the 100 shares already owned, the trader creates a new position that gives double exposure between $60 and $70 to capture gains faster if his forecast is right. FIGURE 1 shows how the position functions if held until expiration.

(See Figure 1 above)

If the stock rises to $70 a share, the trader makes $20, which happens to be what he lost when the stock fell from $80 to $60. The trader would be able to regain the entire loss in a retracement of just half of the decline. With the stock above 60 at expiration, the 60-strike call could be exercised to become a long-stock position of 100 shares. That means, the trader would be long 200 shares when the stock is between $60 and $70 at expiration. Above $70, however, the two short 70-strike calls would be assigned, resulting in the 200 shares owned being sold at $70. Therefore, further upside gains are forfeited above and beyond $20.

But what if the trader is wrong? Instead of rising, say the stock continues lower and is trading below $60 a share at expiration. In this event, all the options in the spread expire and the trader is left with the original 100 shares. The further the stock declines, the more the trader can lose. But the option trade won’t contribute to additional losses. Only the original shares are at risk.

Benefits and Limitations of the Stock Repair Strategy
The stock repair strategy is an option strategy that is very specific in what it can (and can’t) accomplish. The investor considering this option strategy must be expecting a partial retracement and be willing to endure more losses if the underlying security continues to decline. Furthermore, the investor must accept limiting profit potential above the short strike if the stock moves higher than expected.

Some stocks that have experienced recent declines may be excellent candidates for the stock repair. For others, the stock repair strategy might not be appropriate. For stocks that look like they are finished or may even head lower, the Stock Repair Strategy can’t help - just take your lumps! But for those that might slowly climb back, just partially, this can be a powerful option strategy to recoup losses fast.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring