Trading Options, an Extension of the Basic Strategy
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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