One of the basic directional spreads when learning to trade options is that of the vertical spread. It can be extremely versatile and represents a major building block of more complex spreads. With a vertical spread, the various strike prices for an option are arranged vertically and the expirations available to trade are displayed horizontally. This defined risk position consists of both a long and short position at different strike prices within the same expiration. It can be constructed with either puts or calls and the initial cash flow can be either a credit or debit. Strike prices can be selected to produce either aggressive or conservative stances depending on the outlook and the risk/reward that is desired.
As an example, let us consider a vertical spread in Apple (AAPL). The stock has dropped considerably over the last several weeks just like the prospect of Aaron Hernandez’s NFL career, and at the time of this writing is hovering around $400. With AAPL being heavily traded, the option chain show tremendous liquidity, a tight bid ask spread, and moderately elevated implied volatility.
For the trader who has a bullish diagnosis for the price action in AAPL into July expiration, a put credit spread can be established by selling the July 380 put ($4 credit) where it has a pivot low and buying the July 375 put ($3 debit). The total premium received is $1. At the time of this writing there are 23 days to expiration, the maximum potential return is 20% and is achieved as long as AAPL remains above the short put strike of 380. Maximum risk is defined by the long 375 put. The maximum risk is defined by taking the difference in the strikes $5 (380 – 375) minus the premium received ($1) or $4 if AAPL finished below $375 at expiration.
As contrasted to a naked put sale, this position has the following major differences: 1. Risk is crisply defined as opposed to the naked sale maximum risk of the underlying going to zero, and 2. Margin requirements for the position and hence yield are dramatically improved. Understanding the potential risk of each strategy and implementing the one that matches your trading personality can go a long way at making you feel comfortable and successful as a trader.
With several disaster films like World War Z and White House Down scheduled to be released, it’s no wonder traders may be a little nervous. But on a serious note, after this past week’s decline, there’s still a potential for the market to move lower and it’s probably a good time to talk about stop losses. Traders may hear the terms trailing stop loss and stop loss order and wonder exactly what those terms mean and how a stop loss can potentailly enhance a trading strategy. Well, worry no more because that is exactly what we will review 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 which is 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 $20.00 and set a stop-loss order at $18.50. This means that the position will be closed at the market price once the stock drops below $18.50, pretty simple right? It is called a stop loss order because it stops the trader from taking any more losses. Many traders use 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 followed.
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 violated. 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 is a strategy I have used often myself. 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).
We’ve identified a recurring pattern in the market that could end up being one of the best market predictors yet.
Take a look at a daily candle chart of the S&P 500 (or the SPY ETF) for the past 12 months overlaid with the 50-day moving average. As you can see, the index has been in a solid up trend for the past year. There were six pullbacks during just the last six months alone where the SPY pulled back down to the 50-day moving average and bounced higher to continue its assent. It has been a tried and true support line.
But as far as support lines go, moving averages are pretty weak in representing actual trade information—compared to a horizontal support line at a specific price. A horizontal support line shows where the buy orders have been in the past for value investors. For example, if a stock dipped down to $50 a share several times in the past, then rose back up, it shows that that level ($50 a share) is where the demand pressure is—value investors bought the stock at $50 which forced the price back higher.
But, moving average support lines are merely psychological. Because the line is not at a constant price, it doesn’t represent a price where demand occurs. Traders only buy it there because it is a moving average. It’s essentially a self-fulfilling prophecy.
In the case of the market today, one of two things can happen technically over the next few days. 1) Support at the 50-day moving average will hold once again and the SPY will continue higher, or 2) Support at the 50-day moving average will not hold and the SPY will continue lower.
But if the SPY ends up closing below the 50-day moving average, we could see a free fall similar to the eight-percent drop we saw in October of last year when the 50-day moving average did not hold.
This potential drop is compounded by the fact that we’re seeing the implied volatility of the S&P 500, or the VIX, illustrating investors’ jitters. The VIX above 18 says the market is scared. Even the Man of Steel himself (Ben Bernanke of course) won’t be able to keep the market up as he has thus far this year if the levy breaks.
So, we need to sit and wait. I think any move resulting in a close below the 50-day moving average warrants strong selling. But a bounce higher from here probably means more of the same. Up, up and away!
A naked call strategy is defined as an option strategy where a trader sells (writes) call options without owning the underlying stock. Some option traders may refer to this strategy as an “uncovered call” or “short call.”
The goal of the naked call is for the trader to collect premiums if the option expires worthless. A trader could sell an out-of-the-money (OTM) naked call each month and pocket premiums, provided the stock price either stays flat or drops. This process could continue as long as the stock remains below the strike price. For those interested in learning all the ins and outs of naked calls and possibly safer alternatives, please visit the Learn To Trade section of our website.
The maximum gain for selling a naked call is limited to the premium received for the call option. With that being said, the loss potential is unlimited – as the stock can rise indefinitely in theory. If the underlying stock’s price is above the strike price at expiration, it will result in the trader having to sell the stock at the strike price (which will be lower than the market price or current price).
A loss on the trade can occur if the stock price rises. If the price of the underlying stock is greater than the short call’s strike price plus the premium received at expiration, the option should probably be bought back to close the trade. If not, when the option is assigned and a short-stock position is acquired, further losses are possible. On the flip side, the maximum profit is achieved when the underlying stock is less than or equal to the strike price of the sold call at its expiration.
For this specific example, we will take a look at Apple (AAPL) – which is trading right around $440 at the time of this writing. A June 445 call carries a bid price of 7.50. If the stock remains below the strike price (445) by expiration, the call expires worthless and the call seller keeps the $7.50 in premium (less any commissions). The problem is if the stock rallies through the strike price at expiration, the call will be assigned, resulting in a short sale of 100 shares at $445. With the premium the total loss comes to $1,750.
With unlimited loss potential, the naked call is considered one of the riskiest option strategies. A, perhaps, safer way to structure a trade with a similar risk profile is to sell a call credit spread. Selling a call spread will be discussed in future posts.
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Option (ODD) which can be obtained from your broker; by calling (888) OPTIONS; or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606. The content on this site is intended to be educational and/or informative in nature. No statement on this site is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice. Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions.