Don’t get me wrong — I LOVE trading stocks. Picking momentum winners has been my bread & butter for years.
But I took my trading game to the next level in 2019. You know how?
Now, I know that options trading seems scary. It did for me too, at first.
But as a former teacher, I’m here to coach you to success.
And I want 2020 to be the year WE win the trading championship.
Our game plan? Tap into the POWER OF LEVERAGE.
But, there is a right and a wrong way to tap into it. How you decide to use it, will dictate your success as an options trader.
Therefore, someone with leverage has the upper hand.
That is also true in the world of options trading. Options allow you to boost your returns without putting a massive amount of capital on the line.
That’s because calls and puts give you control of 100 shares of a stock, without having to buy those shares outright.
Even better — my winning Weekly Windfalls trading strategy offers the added bonus of LIMITED LOSSES.
Let’s look at an example…
The (Very Fake) Stock: QRST Company (QRST)
Let’s say QRST shares recently pulled back to chart support, and are now trading around $47.
Previous retreats to support — say, the 200-day moving average — have acted as “buy” signals in the past.
Plus, QRST Company is set to report earnings in a few weeks, and preliminary data suggests the next release could be a bullish catalyst for the shares.
Player 1: Tommy
Tommy has been stalking QRST shares for some time, just waiting for the right moment to pounce.
He thinks the recent dip presents a buying opportunity, especially ahead of earnings.
Tommy decides to buy 100 shares of QRST for $47 a pop, or $4,700.
Player 2: Timmy
Timmy is also bullish on QRST.
However, he decides to buy a call option instead of purchasing the shares outright.
When you purchase a call, you’re essentially betting the shares will move above the strike price by the time the options expire.
So, by buying a 47-strike call with a month to expiration, Timmy expects QRST to move north of $47 in that time frame.
A 47-strike call option on QRST expiring in a month is asked at $2.16, and since one option controls 100 shares, Timmy pays $216 ($2.16 x 100).
Player 3: Tammy
Tammy also likes QRST at $47, but isn’t so firm in her conviction of a big pop higher. After all, there’s always a chance that earnings could disappoint.
She decides to initiate a bull put spread on the stock.
She sells a 47-strike put expiring in one month for $2.23, or $223 total ($2.23 x 100 shares).
By selling the put, Tammy expects QRST to remain above $47 through the option’s lifetime.
What’s more, the ODDS ARE IN HER FAVOR — because option sellers win 70% of the time, so it’s like being “the house” at a casino.
Tammy then buys a leg of options “insurance” on her position, in case she’s wrong, purchasing a 44.50-strike put for $1.23, or $123 total ($1.23 x 100 shares).
By pairing the sold put with the bought put, she’s protecting herself in case of a sharp move to the downside by QRST.
Since Tammy received more premium for the sold put than she paid for the bought put, the trade was established for a net CREDIT.
Specifically, the spread was established for a net credit of $1.00 per pair of options, or $100 total ([$2.23 – $1.23] x 100 shares).
Now, let’s huddle up and look at a few situations…
Situation A: QRST Stock Skyrockets
QRST Company reports blowout earnings, sending the stock to $50.
TOMMY, our stock buyer, would now be holding 100 shares at $50 apiece, so his investment would be worth $5,000. That’s a $300 profit.
TIMMY, our call buyer, would be holding an option with $3 of intrinsic value ($50 stock price – 47 strike). Minus the $2.16 paid to purchase the call, he’s up $0.84, or $84 total (since remember — one option controls 100 shares).
TAMMY, our spread trader, would be holding puts set to expire worthless — that’s GOOD NEWS for her. That means she can KEEP the entire $100 received at the initiation of the spread.
So, it looks like TIMMY won here, right?
While he made more than his counterparts in absolute dollars, look at the return on investment.
A $300 gain on a $4,700 investment is just a return of 6.4%.
TIMMY’s $2.16 call purchase netted a return of about 39%.
TAMMY got to keep 100% of the money she made at the start of her spread.
Situation B: QRST Hovers Just Above $47
In this case, TOMMY is no worse for wear. His $4,700 QRST holding is worth the same as it was when he bought the shares.
In the case of TIMMY, time decay has eroded the value of his call to just a penny, since there’s really no time left for QRST shares to make a big move in the right direction. Essentially, Timmy lost nearly 100% of his investment.
However, TAMMY once again is ahead, still set to pocket the entire $100 she received to initiate the put spread.
Because as long as QRST shares stayed above her sold put strike of 47, she was golden.
Situation C: QRST Drops to $44
Now, let’s say QRST Company issued an ugly sales forecast, sending the shares to $44.
TOMMY’s stock investment is down $300 ($4,700 – $4,400).
TIMMY’s call option is worthless — another 100% loss of $216.
Because TAMMY hedged her sold put with a bought 44.50-strike put, her risk was capped at $1.50 per spread (calculated by the difference between strikes minus the net credit).
So, 2.50 – $1.00 — or $150 total, accounting for the 100 shares — no matter how far below $44.50 (the strike of the bought put) the stock sank.
While that’s also a 100% loss, it’s still a much lower dollar amount than her cohorts.
A Review of Leverage
So, team — what did we learn?
- Options give you the power to speculate on a stock’s direction, just like people who buy or sell short a stock, BUT they require a much lower investment out of the gate.
- Option traders often see a greater return on investment compared to stock buyers, thanks to LEVERAGE.
- And finally, vertical option spreads — what I trade in Weekly Windfalls, and the strategy that’s set to help me have my best trading year EVER — also offer the benefit of MINIMAL RISK.