How to Trade Stocks and Options

In a previous post to this website, we referred to and explained an extension of a basic trading options strategy but did not provide an example. So we are providing one now and the following example uses the real prices of a stock entry based on recommendations published in an advisory service I subscribe to, it is a while ago so don’t recall all the details but our records show:

The date is March 30, 2010 and we have been watching the stock OII (Oceaneering International, Inc., traded on the New York Stock Exchange), then trading at around $62 and decide to buy 1 call option, in keeping with our Four Rules for Trading Options, it has to be in the money, expire several months out, and with a delta of about 60.

The choice is obvious, there is a July 60 call available with delta 63 at $6.65. One contract controls 100 shares and the call contract costs $665, ignoring the commissions for now.

Over the next 4 weeks the stock rises, falls back and then rises again to about $68, it then again falls back and when the price goes down to $66 we close out the trade on April 29, selling the call option at  $8.90 for a gain of $8.90 – 6.65 = $2.25 per share, 100 shares times $2.25 = $225, that’s a 34 percent gain. A good example of how an option can provide an excellent gain with a maximum risk limited to the possibility of losing only a modest amount.

How the extended stock option strategy can provide added gains

Below is the stock chart showing the action that took place for the period of interest, the period covered by the option, March 30 to its expiry on July 17, 2010. From this we can consider what could have happened if we had followed the Stock Option extension method described in the post titled “Trading Options, an Extension of the Basic Strategy”  in which we would hold the option and sell short the shares of OII, the underlying stock.

So instead of closing the long call option position with the stock at $66 let us assume we held the option and, in another account, we sold short 100 shares of the underlying stock, OII, at $65 and stayed with both positions while the stock dropped in price, something we could not be sure would happen when we entered the trade, but we followed the guidelines of the strategy that in this case works out exceptionally well, and it should be emphasized that other “hold the option, short the stock” plays do not always produce such profitable results as can be seen possible on the above stock chart.

To review the possibilities, three things can happen with the price of the stock at this point, it can stay at the same price for a while, it can continue on its new downward path, or it can reverse and go back up.

If the stock had not continued to fall but again reversed and went back up, as it started to do on May 09, we still had the call option with a July expiry date that would capture the continuing upward move, although in that event losing on the short position, but the losses and gains on the two positions cancel each other out.

As it turned out, the upswing that did occur from $55 was short-lived and after reaching $60 the stock again reversed and continued lower. On May 19, with the stock down to $55, a 10-point gain on the stock short from $65, the stock option is now far out of the money and worth much less but probably with some value left because it is still far away to expiry.

So the option can be sold at this stage, but does not have to be, as the stock declines further in price the option will become almost worthless.

But if it was sold at this point, let’s be conservative and say the option can be sold for only $100.00 net, giving a loss of  $665 – $100 = minus $565. However, the gain on the short is $1000 meaning a $435 gain if both positions are then closed out ($1000 – $565 re the option loss = $435) That is a very good result compared with the $225 gain on the basic option play.

What happened next if the positions are not closed out?
The stock, as shown on the chart, appeared to have no support and seemed likely to continue on down at this point, although at that time we cannot be sure of that, we have no way of knowing what did actually occur after that date, we can only see it now after everything has been recorded.

If the short position was not already closed, there would an element of increased risk in holding the short position in case of another turn around so the stock needs a lot of watching and with the trailing stop loss in place until the trader is ready to exit and secure a profit. That might be at any time from that moment on. The chart shows that the stock actually dropped to $42 as mentioned above. If the short position was held until then and sold after a $5 rise from the low it had reached, it would have produced a very good profit indeed, much more than is usually the case. You may wish to make the calculations to determine the amazing gain that would have been made.

Conditions required for success with this strategy
The success of this strategy depends on owning a long call on a stock that, after rising in price to provide a profit for the option holder, faces a likelihood of falling much lower in price, perhaps because of negative news or some other unforeseen events.

The stock option extension strategy requires that, with a winning call option trade in hand and when the underlying stock begins to fall back in price,

1. Don’t close out the option trade but continue to hold the long call, that’s a must.
2. Sell short 100 shares of the underlying stock, the number of shares controlled by the call option. The brokerage account has to be a margin account to allow stocks to be sold short.
3. At an appropriate time in the future, sell the long call option and  cover the short position not necessarily simultaneously. Only then can you count the profit from this strategy for trading options.

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A key element in choosing a stock option to trade is that the amount of financial risk is limited and known at the beginning, the most that can be lost is the cost of taking the position. If a trader picks a high priced expensive option and cannot afford to lose that much then the trade should not be opened – and there are always option trades on other less expensive stocks that are less costly, although never compromise by taking an at the money or out of the money option because it is less costly. Stay within the established rules, noted in the link reference below.

Following up a recent post on trading stock options by using the simple and less risky approach in doing so, as outlined in Four Rules – A Guide for Trading Options,  there is a further twist we can add to that strategy.

We can take the strategy a step further and describe an extension of the basic play. It works well with stocks that tend to rise periodically to a peak, perhaps to the extent of being overbought, and then falling back to a much lower price after reaching the higher price.

If the option was purchased early in its ascent then the option trade would have been profitable and the usual pattern is to capture that profit by selling the option at the new higher price – remembering it is not a profit until it is sold.

“The best, most conservative strategy ever invented to profit from the stock market.” Jim Cramer, from his book “Getting Back to Even”.

But in an extension of the basic play, and for the purposes of description, let us consider the option is a long call, the option is held and not sold until later because a new and additional position is first taken by selling short the actual underlying stock of the option. The short sell involves the same number of shares as that controlled by the original option. A single call option controls 100 shares of the underlying stock, so therefore, for every option contract, 100 shares of the underlying stock will be sold short at or near a recent peak of the stock’s price.

The short trade
The trader borrows the underlying shares and sells them at the current price while having an option that gives the trader the right to buy the same amount of shares at the price established by the option strike price.

I hope that does not sound confusing, but the object is to gain from any substantial fall back in the price from the stock’s high and to do so without any risk involved because the call option already gives the right to buy those shares back, as the short position requires, at the lower strike price of the option.

The big advantage is that there is no risk because the option provides a safety  net.

The anticipated outcome of the strategy is that the fall in stock price will enable a greater profit to be captured that the one-way call option strategy provides.

Perhaps it is best explained with reference to an an example that can be found here.

I would also like to mention that the well known trading pundit by the name of Jim Cramer, known to almost everyone in the stock market, has outlined this same strategy in his book “Getting Back to Even” published in 2009 by Simon & Schuster.

For the record, although being known for his somewhat wild antics and clowning around on his nightly TV show Mad Money, Jim Cramer has achieved great success and financial independence as a trader, making money in markets where others failed. He credits the strategy described here in which, in his words, he goes “long-call, short-common”, as having made millions of dollars for his hedge fund and for himself in his own trading. Cramer, in his usual enthusiastic fashion, describes this method as “the best, most conservative strategy ever invented to profit from the stock market.” I would say that it’s worth the price of the book just to read the two chapters, “Using Options to Replace Stocks” and Taking Options to the Next Level”.

I echo his advice, for this and for all other stock trading strategies, to first practice and learn how to trade stocks by paper trading [http://howtotradestocksguide.info/explanation/learn-how-to-trade-stocks-by-paper-trading/] before putting up real dollars, and when it seems appropriate to start trading for real, start cautiously. After the first ten or so trades are made it will probably show there have been winning trades and losing trades, just like there are for the pros,

Obviously, the objective is to make more wins than losses but it is also important to know how to minimize losses through good trading practices, using stop losses or setting automatic price levels at which a losing stock must be sold and not held onto because of thinking “it may come back if held a little longer”. See: The Stop Loss and Exit Price when Selling a Stock.

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