Charting Your Best Course Geoffrey Smith
It has been my experience over the past 25 years that most traders like to trade options. I can't blame them, since options are cheap and allow them to control 100 shares of stock, or one futures contract, for very little expense. I'm a commodity trader myself for the most part, but like playing the option market in equities. There are those who like to sell options (write options), and those who like to buy options. I do both, depending on the market conditions. In trending markets, you make more buying options, in chewy, quiet markets, you make more selling premium and avoid the time decay when buying options.
The problem in today's market (don't really know if it a problem) is that just about everything is trading at the all time highs. The markets are on a roar. Because of this, buying call option spreads are a bit risky because you cannot get any premium for the short call in the spread (the stock has never been there so the premium is low). Below is a daily chart of Home Depot (HD). It has an all time high of 166.63 and is trading at 166.10. If you look to buy a 165/170 call spread, the 165 call will cost $2 to $3, but the 170 call is only worth .20¢. That does not help a whole lot. So it may just be better to buy the call outright.
The problem in today's market (don't really know if it a problem) is that just about everything is trading at the all time highs. The markets are on a roar. Because of this, buying call option spreads are a bit risky because you cannot get any premium for the short call in the spread (the stock has never been there so the premium is low). Below is a daily chart of Home Depot (HD). It has an all time high of 166.63 and is trading at 166.10. If you look to buy a 165/170 call spread, the 165 call will cost $2 to $3, but the 170 call is only worth .20¢. That does not help a whole lot. So it may just be better to buy the call outright.
Let's look at another example. Below is a daily chart of Apple (AAPL). Notice it has an all time high at 163.96, and a recent high at 160.90. It also has pulled back and holding support around 155. In this case, AAPL has room to move up and we can look at buying the 155/160 call spread and possibly do a little better. A couple of weeks out, the 155 call is 4.50 and the 160 call 2.02. Since AAPL has been to 160 before in life, the market knows that it can get there, and therefore we can get more for the short call.
There are various ways of trading in the market. Using the same technique, as AAPL is holding support at 155, one could sell the 155 put (naked or write a put). In doing so, you will pull in the premium from the sold put. If the stock goes up, the premium will decrease because it is getting further away from the strike price, and you are taking advantage of time decay. If on expiration AAPL is above 155, you keep all the premium and the trade is done. However, if AAPL is below 155 on expiration, the stock will be put to you. You will then own 100 shares of AAPL at 155. But remember, you brought in premium from the put you sold. You can then sell a 160 covered call, again bringing in premium. If AAPL does not close above 160 on expiration, you keep the premium and are still long AAPL. If it does close above 160 on expiration, you keep the premium and make $500 on the stock.
Let's do the math on both scenarios to help explain. First, the call spread, this is the cheapest way of trading the long side. You buy the 155 call for 4.50 and sell the 160 call for 2.02. Since the bought call cost $450 and the sold call cost $202, your net debit is $248. The difference between the 155 call and 160 call is $5 or $500. So the maximum profit is $500 – $248 = $252. Your maximum risk is $248 (what you paid for the spread).
The second scenario takes more time and money. Assume it is Wednesday and one sells next week's 155 naked put for 1.31. This is a credit of $131. If it is not below 155 on expiration, you keep the $131. If it does close below 155, then you keep the $131, and are long 100 shares AAPL from 155. You will need $15,500 for a cash account or $7,750 for a margin account to buy 100 shares of AAPL (this is also the margin required to sell the naked put). You then go out 2 weeks and sell the 160 covered call against the stock for 2.08 ($208). At this point, you have brought in $131 from the naked put and $208 from the covered call for a total of $339 in premium. If AAPL sells off, you will not lose money until it gets below 151.61 (155 – 3.39 = 151.61).
Notice on the chart above that the next support is around 152, so you have financed the trade below 152 on the stock. If the stock gets below 152 and you exit the stock, you will also need to exit the covered call, or you will then have a naked call (you can keep it if you like and see if it deteriorates to zero and keep all the premium, but if AAPL rallies and closes above 160 on expiration, you could end up short the stock). So if that happens, you will not get all the premium from the 160 covered call that you sold, but most of it, since it has declined in price (further from strike) and have had time decay. So you break even on the trade (very little or no risk).
If AAPL rallies and closes above 160 on expiration, AAPL will be called away from you at 160. You owned it from 155 and sold it at 160 for a profit of $500. But we also brought in $339 of premium for a total of $839 in profit. Risk next to zero to make $839...not bad.
There is another scenario that we need to discuss, what if AAPL is above 155 but below 160 on expiration. This is almost better that making the $839, because we get to keep the 100 shares of AAPL and keep the $339 in premium from the options sold. So sell another 160 covered call for the next week and see what happens. If you look at the low on the AAPL chart above at 149.16, you might be able to bring in enough premium to finance below that. So now you can risk $500 on AAPL and lose nothing, or if they call it away, you can make over $1000 with virtually no risk.
One thing to keep in mind when selling premium, as the stock gets closer to strike the price will increase the option's premium. This will show a loss in your account. This is where most forget about the end game and concentrate on the current market. They begin to panic because they are losing and bail the trade for a loss. Remember, we are trying to acquire the stock, hence we sold a put. On expiration, if the underlying security is below the strike price of the sold put option (in the money), the stock will be put to use and we keep the premium from the sold option and now have the stock that we can sell covered calls against. We want the premium to increase to get the stock. So really, we are not losing money, just getting closer to owning the stock.
The point is to find a stock that has pulled into support, held support, and has room to move from support to resistance. Trying to buy stock at all time highs is hard to swallow, especially for option traders. But now you have a couple of tools to help you navigate the stocks to want to trade and help you minimize risk, and maximize gain.
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Geoffrey Smith is DTI’s Chief Instructor
He teaches Level 1, 2, and 3 Core Curriculum Classes, regular educator and instructor on the 24-hour Educational TradeRoom, GPS Coaching, and one of Tom Busby’s first students.
An active trader and investor for 25+ years, Geof focuses in futures, equities and option trading including trading commodity option futures. Geof took an instrumental role in developing the DTI Method. The Platinum Experience core level classes took first place in SFO Magazine and Trader Planet’s STAR awards in the best trading courses category. Before coming to DTI, Geof was a pipeline engineer working in Oklahoma and Texas.
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