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September 25, 2013

The Stock Repair Strategy

Stock Repair Options Strategy

It’s been a tough couple of weeks for investors with this recent downturn in the market. 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 especially with this pending debt ceiling crisis right around the corner. 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 all or some of the losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 18, 2013

Fractal Position Management

Option traders have to manage risk. Want a job description? That’s about it. Every trade has a risk and reward associated with it and traders must realize that especially when first learning how to trade. Because options are instruments of leverage, it is very easy to let risk get out of control, if you’re not careful. Traders must manage risk carefully, instituting tight reins on their options, spreads and portfolio. The management technique of each is essentially the same because position management is fractal.

Something that is fractal has a recurring pattern that has continuity within its scale. For example, a tree is fractal. A tree has a trunk with limbs extending from it; limbs with smaller branches extending from it; smaller branches with yet smaller branches; and leaves with veins that branch off within each leaf. The pattern is repetitive within each iteratively smaller extension of the last. This is found in option position management too.

Individual options have risk that must be managed. They have direction, time and volatility risk which are managed by setting thresholds for each of the corresponding greeks which measure them. When individual options are a part of a spread, the resulting spread has these same risks of direction time and volatility. The spread’s risk must consequently be managed likewise. A trader’s complete option portfolio, which may be comprised of many spreads has systematic risk in accordance to the market. These risks are the same as for individual options or individual spreads: direction, time and volatility. Traders should treat their all encompassing portfolio as a single spread and use the portfolio greeks to set parameters to minimize the total risk of the portfolio.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 12, 2013

What Makes a Great Trader Part I

With summer ending and trading volume expected to rise, it might be a good time to give yourself a mental break and reflect on your trading before the fall. Are you the great options trader you thought you would be by now or have you ever wondered what truly makes a great options trader? I mean not a options trader that does pretty well, but one that you envy and want to be? Are great options traders just born that way? Does being smarter necessarily give you an advantage in options trading? Is studying charts until you are bleary-eyed from looking at them the secret; or is it just dumb luck on who succeeds and who fails? How does one learn to trade options?

The qualities that you will need to succeed in my opinion are a commitment to success, having a options trading plan and the most important, mastering your emotions—or the psychology of options trading. I believe that options trading is the hardest job in the world (quite possibly the best, but the hardest). That’s why it will probably take you a lot longer than you think before you really get a solid grip on it.

So let’s first talk about your commitment to success. This essentially sounds like the easiest of the three qualities to master doesn’t it? Why does anyone want to become a options trader in the first place? Probably, because they want to become wealthy and very successful. Who isn’t committed to that, right? All you need is some money, charts, and a platform and you are on your way. Almost everyone says they are committed but most people are not because when they find out options trading is work—and it is. They tend to lose their focus and their original goals when the going gets though.

If you are committed to success then you must be committed to reaching your goals. The most important part of having goals is to write them down. If you never write them down they are simply just dreams. We don’t want to dream we are a great trader we want to realize that we are! Only about 2% of Americans write down their goals. Is it really shocking to know that most people never achieve what they want out of life? As “corny” as it may seem, when you write something down no matter what, your thoughts are transformed from the subconscious to the conscious and are now tangible. Your goals have become something you can see and say out loud. If you never write them down they never exist outside of your thoughts.

Let me leave you with this before I end this introduction on how we are going to build a great options trader out of you. I think everyone can agree whether you are a beginning options trader or a more experienced options trader that there are several key components you will need to do to become a standout. Having said this I also know that most of you will not be committed to do this at first. I know I wasn’t. I thought to myself I am too smart and I know how to options trade. I knew it would not be easy but I was unprepared for the results that followed. I’ll give you a hint, they weren’t good. After I decided to fully commit myself and write down my goals did my results finally change. Let’s face it; options trading is a realm like no other. Options trading looks easy and which in turn makes you lazy to work at it. Be committed to your success and write down your goals right from the start will only help you achieve the success you are after that much quicker.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 5, 2013

Naked on AAPL

The Strategy

If you want to learn to trade here’s a really useful option strategy that all traders should and need to know. Let’s take a look at an option strategy that involves the selling of a put, often referred to as an uncovered put write or simply a naked put. A naked put is when a trader sells a put that is not part of a spread. This strategy is generally considered to be a bullish-to-neutral strategy.

The maximum profit is the premium received for the put. The maximum profit is achieved when the underlying stock is greater than or equal to the strike price of the sold put. Though this allows for a lot of room for error (The stock can be anywhere above the strike at expiration), note that the maximum loss is unlimited and occurs when the price of the underlying stock is less than the strike price of the sold put less the premium received. So, executing this trade in the right situation is essential. To calculate the breakeven point, subtract the premium received from the sold put’s strike price.

The Example

For our example we will use Apple Inc. (AAPL). Apple shares have moved higher since the beginning of July but recently pulled back again. Now the trader thinks after this brief pullback the stock will once again continue to move higher. For this example we will assume the stock is trading around $490 a share at the beginning of September. A trader sells the October 460 put, which carries a bid price of $8.00 (rounded to make the math a bit easier) because there is an area of support at that level that the trader thinks will hold. Should AAPL stock be trading above $460 a share at expiration, the October 460 contract will expire worthless and the trader will keep the premium collected. (Do not forget to take any commissions the trader may pay from the equation.) All is good, right? Well, what if the stock falls below that area of support?

If AAPL falls another $50 to $440 at expiration, the put would expire in-the-money and would have to be purchased back to avoid assignment. This could cost the trader a rather hefty sum. Assigning values, our investor collected $8 in premium. The 460 put expired with $20 in intrinsic value. The trader loses the $20, less the $8 premium collected results in a loss of $12, or $1,200 of actual cash.

Why Sell Naked Puts?

We have already discussed the profit potential of selling naked puts, but there is another reason to do so – owning the stock. Selling naked puts is a good way to purchase at a specific price by choosing a strike near said target price. Should the stock price drop below the put strike and the puts are assigned, the trader buys the stock at the strike price minus the option premium received. Again, should the put not reach the strike price, the premium is pocketed at expiration. Traders should be aware of the risk when selling naked puts and that potential losses can be extreme when compared to other option strategies.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring