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September 27, 2012

Stop Loss or Trailing Stop?

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. To get more educational ideas like this, sign up for a free two-week trial of Market Taker Mentoring’s options newsletter. 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).

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 20, 2012

Bull Call Spread vs. Purchasing a Call on AAPL

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. To learn to trade more option strategies, please visit our website.

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 $700 as an example. In this case you would purchase October calls at the 700 at-the-money strike at the ask price of $20. You would then sell the same number of October calls with a higher strike price, in this case 720 at the bid, $11.

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 October 700 call and sold one October 720 call resulting in a net debit of $9 (that’s $20 – $11). The difference in the strike prices is $20 (720 – 700). You, therefore, subtract 9 from 20 to end up with a maximum profit of $11 per contract. So, if you traded 10 contracts, you could make $11,000.

Although you limited your upside, you also limited the downside to the net debit of $9 per contract. To simply breakeven, the stock would have to trade at $709 (the strike price of the purchased call (700) plus net debit ($9)).

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 October 700 call you would have paid 20. 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 13, 2012

To Buy Puts or Not to Buy Puts…

Filed under: Uncategorized — Tags: , , , , , — Dan Passarelli @ 10:36 am

A lot of traders especially those who are just learning to trade options are enamored by the all mighty put – especially buying the shortest-term, or front month, put for protection. The problem, however, is that there is a flaw to the reasoning and practice of purchasing front-month puts as protection. Ah, yes; it’s true. Front-month contracts have a higher theta – and relying on front-month puts to protect a straight stock purchase is not, necessarily, the best way to protect an investment. If you were to continually purchase front-month puts as protection, that can end up being a rather expensive way to by insurance.

Although front month options are often cheaper, they are not always your best bet. The reasoning may be sound, the trader purchases a number of shares of the stock and purchases out-of-the-money puts to protect his position; but sound reasoning does not always lead to good practice. Let’s take a look at an example.

We will use a hypothetical trade today. The stock is trading a slightly above 13 and our hypothetical trader wants to own the stock because he/she thinks the stock will report blow-out earnings in each of the next two quarters. This investment will take at least six months, as the trader wants to allow the news events to push the stock higher.

Being a savvy options trader, our stock trader wants some insurance against a potential drop in the stock. The trader decides to buy a slightly out-of-the-money July 13 put, which carries an ask price of $0.50 (rounded for simplicity purposes). That 0.50 premium represents almost 4 percent of the current stock price. In fact, if the investor rolled option month after month, it would put a big dent in the initial investment. To be sure, after about seven months (assuming the stock hangs around $13) the trader would lose more than 25 percent on the $13 investment.

What if the stock drops? That is the ultimate rationale for the strategy in the first place: protection. The put provides a hedge. The value of the option will increase as the stock drops, which counterbalances the loss suffered as the stock drops. Buying the put is a hedge, a veritable insurance policy – though, albeit, an expensive one. Investors can usually find better ways to protect a stock.

Learn a better way to hedge with this FREE options report.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 6, 2012

Butterflies and Weekly Options

The weekly options have been the topic of our blog many times before.  Despite this topic being the trendy subject and in the forefront of many discussions, it is helpful to recognize the functional flexibility this dramatically shortened lifespan brings to a variety of  option strategies. If you need to find out more about weekly options or other option strategies, feel free to visit the options education section on our website.

As an example, consider the case of a frequently traded spread vehicle, the butterfly.  For those first encountering this strategy, it is helpful to consider briefly its components. It is constructed by establishing both a credit and a debit spread sharing a central strike price.  It can be constructed in either all puts or all calls.

Butterflies can be designed to be either a non-directional or directional trade strategy.  Functional characteristics include: negative vega, variable delta and accelerating gamma and theta during its life span. In the case of the long standing monthly duration option cycles which had heretofore been available, these characteristics developed over weeks to months and reached their final expression during the week of option expiration.

These functional characteristics have limited the utility of butterflies over brief duration moves occurring early in the options cycle.  Many butterfly traders have had the experience of correctly predicting price action early in the cycle only to have the butterfly deliver little, if any, profit.

The short nine day duration of the weekly options has dramatically accelerated the pace of butterfly trading as the changes begin to occur literally over the extent of a few hours.  As such, it is possible to gain the advantage of this trade structure over brief directional moves or in the case of non-directional traders to have market exposure for briefer periods of time.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring