The Art of War Part 3: Strike Like a Thunderbolt
Part 1 of this guide taught you how to use your weapon of knowledge.
Part 2 taught you how to win a battle with it.
Now you’re ready for the third and final part of this report series – which teaches you how to win a war.
The strategies and principles outlined here are more advanced, but they’re still something a beginning options investor can use to great effect. Once mastered, these strategies will serve you well in the markets.
So, if you’re ready, then it’s time to fight – and it’s time to win. These are the strategies and principles that will allow you to win the options trading war!
Strategy No. 1: LEAPS
Thanks to a unique, simple strategy, you can take more than 85% of the risk off the table and still not give up an ounce of upside. Think about that. You can pull 85% of your cash out of the market but still retain the same exposure you had before.
With a class of options called LEAPS, or Long-Term Equity Anticipation Securities, you can mitigate substantial amounts of risk while still enjoying unlimited upside.
LEAPS are options you can buy in any account, including your retirement account. They allow you to control the underlying shares for periods of up to three years.
When you consider that most investors today don’t hold stocks for more than a few months, three years is like an eternity.
These LEAPS are usually available on most established midcap to large cap stocks on the Nasdaq and the New York Stock Exchange. You will find them on companies like Apple (Nasdaq: AAPL), NVIDIA (Nasdaq: NVDA), Merck (NYSE: MRK), Barrick Gold (NYSE: GOLD) and the like. You won’t find them on small cap tech or biotech stocks.
Let’s say you own 1,000 shares of Apple, for example. You are at risk $152,000 in the market for your position. You think Apple is going to $220 in the next two years. That would be a fat return. But your 25% downside stop means you are willing to give up more than $38,000 if you’re wrong.
Let’s look at how a LEAPS option would work in this situation. You can buy a LEAPS option that expires in 840 days (more than two years), which allows you to own Apple at $155. That option would cost you about $23 per contract. For a 10-contract trade (100 shares per contract), which allows you to control 1,000 shares, your cost would be $23,000.
So right off the bat, you stand to lose less than your 25% stop loss. In fact, the MOST you can lose on this trade is what you invested. Twenty-three-thousand dollars is 14.9% of the $154,000 you would have at risk owning the Apple shares outright. So you have just yanked 85% of your cash and risk off the table.
If Apple hits your $220 target, you would be up $66,000, or 42%. Your LEAPS option would be worth $65 ($220 minus the $155 strike). You must subtract another $23 for your cost, so your net would be $42,000 ($65,000 minus $23,000). That is almost double what you invested! Sure, your actual dollar return is less, but you have 85% less at risk!
At the time of writing, with volatility so low, you can control 1,000 shares of a gold stock like Barrick Gold for less than $3 per contract, or $3,000 to control 1,000 shares. This is the right time to use LEAPS, as the market is in nosebleed territory and low volatility allows you to buy call options cheaply.
The great thing about LEAPS is that even if the market corrects, you will still have time on your side. Two years is more than enough time for the market to correct and then resume its upward trend. If it doesn’t rebound, your risk is still limited to what you paid for the option. If it screams higher, you know that you won’t miss out on that move. What you also know is that you have the bulk of your cash squirreled away as well. That makes for a very good night’s sleep!
By using LEAPS, we can reduce the amount of money we have at risk by up to 90% of what we would ordinarily invest in a play. Apples to apples, we are risking only 10% of our capital, and that’s a far cry from a 25% stop loss or worse.
Second, we will reduce our risk further and potentially enhance our returns by using a spread play. A spread play is quite simple. It means that your gains are limited to the amount between two price points – the spread. For this limited return, your gains are also limited.
Let’s use an example to illustrate.
You think that asset X is going higher. It’s currently at $20. You think it could be at $30 by the end of 2012, where it was at the beginning of 2010. You look at the $20 LEAPS call options, and they are trading at $4, about 20% of the underlying price.
Volatility has made them more expensive. How can you reduce that cost and the dollars you have at risk?
The answer is selling a LEAPS option against the one you just bought.
Let’s use the target price of $30 as the strike price of the LEAPS we are going to sell. The $30 LEAPS option is trading for $2. We buy the $20 LEAPS option for $4, and we sell the $30 LEAPS option for $2. Our net cost is now $2 per contract, about 10% of the underlying price. The most we can make from this trade is now $10 minus the cost of $2 or $8. That’s a 4-to-1 return.
On a 10-contract trade, 1,000 shares would be an $8,000 profit with $2,000 at risk. The same stock trade would cost you $20,000 to make $10,000… just $2,000 more in profit for $18,000 more in risk.
What have you given up? Well, if the shares move higher than $30, you get no more on your options trade since you sold the right to buy the shares at $30 to someone else for that $2 in premium you received. The holder of the stock has unlimited upside.
Strategy No. 2: Covered Call Writing
Sometimes the market trades in quite a narrow range, showing no signs of breaking out or breaking down. It’s a wicked environment for investors looking for momentum. What you get one day you give up the next. Your portfolio, while not crashing, is not exactly soaring either.
If you’re like 99% of investors out there, you would do nothing but watch the paint dry. If you’re the other 1%, you’re reading this.
There are some assumptions we need to make first. The biggest one is that you OWN stocks that you plan on keeping for a while in your portfolio, unless, of course, there are extenuating circumstances. In other words, you have stocks that you will hold on to regardless of whether the market goes higher or lower.
If this applies to your whole portfolio or just a portion of it, then you need to listen up because you’re leaving money on the table. You really need to learn how to write call options on your stocks, a strategy also referred to as covered call writing.
It’s technical, but really, really easy. When you sell a call option against your shares, you are getting paid to sell your stock at a higher price. Your stock gets sold at a higher price if and only if the shares close at or above that higher price when the options expire. Think of it as collecting rent from your portfolio. Who wouldn’t like that?
Here’s how it’s done – let’s assume that you own Merck at $34.
- You set a target price where you would sell Merck.
- You find the option with the strike price closest to your target price.
- The option will have a price, a bid and an ask, just like stocks.
- You enter into a trade, called an opening trade, where you SELL TO OPEN “x” number of contracts against your Merck position.
- When you do this, you receive money immediately in your account – money that is yours, period.
You own 1,000 shares of Merck. Let’s say you use $40 as your target price. In this scenario, the Merck January $40 option is selling for $2. You can sell up to 10 contracts (each option contract is equivalent to 100 shares) against your position.
So multiply 10 by 100 by $2, and you get $2,000. That means you would get an extra $2,000 in your pocket by selling an option to sell your shares at a price $6 higher than it is now. Conversely, you have just reduced your cost in Merck to $34.
The only way the shares will be sold out of your account is if Merck closes at $40 or above at expiration, or if someone is willing to pay you $40 for your Merck stock at any time prior to expiration. Either way, you know you’re either going to get $40 for your Merck shares or you’re going to keep your shares. The $2,000 is yours to keep regardless.
Strategy No. 3: Volatility, Your New Best Friend
On February 5, 2018, volatility – as measured by the VIX – surged by 116%. That is the biggest daily percentage move since 1990 when the VIX first launched. The biggest daily move before last year was in February 2007, when the VIX jumped 64% in one day.
What does this mean to us? Don’t buy long stocks in February!
Jokes aside, volatility is a serious threat to your portfolio. And we’re going to show you how to turn that threat into a benefit by making volatility your best friend.
Volatility is a measure of velocity when it comes to investing. It’s a measure of how large of a move you can expect in the price of a stock and the direction. While it’s not a leading indicator, it can be used to establish a trend.
It’s critical to understand that massive moves in volatility up or down are very short term in nature.
High volatility will likely last only for a matter of days or weeks. This is when you need to be ready to make money – probably the easiest money you’ll ever make.
But without a strategy in place, you’ll just be sitting around and worried about your portfolio like most people. Don’t be like them.
You have two choices when it comes to investing using volatility: establish long-term positions or set up short-term trades.
As a rule of thumb, the VIX has specific ranges that you should be aware of before any investing takes place.
The VIX measures the number of put and call options being bought and sold on S&P 500 shares. If people are buying a lot of puts, they think the market is going lower and the VIX will move higher. If they are buying a lot of calls, they think the market is going higher and the VIX will decrease in price.
Here’s the key: When the VIX is between eight and 15, the market is at the lowest levels of volatility and investors are complacent. This can last a long time. When it’s between 15 and 25, the market is trading in a normal range and you can expect moderate up days and moderate down days. When it is trading between 25 and 35, you can expect significant action to the tune of 1% to 2% moves in a day. Between 40 and 50, you are in a full-scale correction. Above 50, and you are likely in the midst of a crash with 80 to 90 being the high-water mark.
When volatility climbs, consider a long-term trade. For those of you seeking income, the time to lock in some huge future payouts is when the VIX is high. Preferred stocks, real estate investment trusts, utilities and other income vehicles will fall hard when the VIX is above 40. Investors don’t discriminate in a panic. During the crash of 2008 and 2009, you could pick up preferred stocks of companies like Bank of America (NYSE: BAC) that would pay you more than 15%.
When the VIX is above 40, you should also take positions in fundamentally sound, long-term plays. A company like Berkshire Hathaway (NYSE: BRK-B) comes to mind. You can usually buy these kinds of companies at multiyear lows and well below their historical price-to-book and P/E ratios. Companies like Amazon (Nasdaq: AMZN), Google’s parent company Alphabet (Nasdaq: GOOG) and other high-growth companies will fall the hardest and usually make for the best bargains of the bunch.
Buying call options on high-growth stocks or market indexes is also a great idea when the VIX is above 40. Panic doesn’t last, and the snapback can make you a ton of money in a very short period of time if you are willing to take the risk.
With options, your risk is much lower in terms of the dollar outlay than it is with stocks. You will pay a higher-than-normal price when you buy options because of the increased volatility, but you will also see quicker returns when volatility normalizes.
If the market is complacent, start thinking about going short or betting the market will fall. However, shorting stocks is a dangerous game, and the market can be complacent for a long time.
When the market is complacent, it’s the perfect time to use LEAPS options. LEAPS allow you to bet on the direction of the market for up to three years while being at risk for only the amount you spent on the option. Unlike shorting, which results in unlimited upside and downside, a long-term option can give you a bigger bang for less risk. The downside is that options do expire and, if the market or stocks don’t move in your direction, you will take a 100% loss.
As mentioned above, increased volatility will result in more expensive options prices. That makes periods of increased volatility the best times to be a put option seller. When you sell put options, you are agreeing to buy a stock at specific price on a specific date. In return, you receive a nice payment in cash that is yours to keep regardless of the outcome. If the shares fall below the price at which you agreed to buy them, you must buy those shares at the agreed-upon price.
Since increased volatility is associated with downward moves in stock prices, you get twice the bang for your buck when selling puts. You pick up more cash and potentially get to buy stocks at even lower prices. For a long-term investor, it is the best of all worlds!
Volatility is scary, but it’s also misunderstood. If you are prepared for all types of volatility (and even the lack thereof), you can put yourself way ahead of the crowd and prepare for major gains.
Strategy No. 4: Strangles and Straddles
Strangles and straddles are two option strategies that capture gains from a sharp move in a stock, either up or down. They’re best applied in situations when the underlying shares are volatile and prone to oversized moves.
To place either trade, you must buy both a put option and a call option. A put option is a bet that the shares are going lower, and a call option is a bet that they will head higher. In order to profit from the trade, the shares need to exceed the strike price at which you sold the option by enough to cover the loss from the other option, which will likely lose value.
Strangles and straddles are both options strategies that allow an investor to gain from significant moves, either up or down, in a stock’s price. Both strategies consist of buying an equal number of call and put options with the same expiration date. The difference between the two is that the strangle has two different strike prices, while the straddle has a common strike price.
To place a strangle trade, you must use two different strike prices on the same option. For example, if you think Stock A, which is currently at $15, could go to either $5 or $25, you would buy put options at below $15 and call options above $15.
Let’s say you choose the $10 strike for the put and the $20 strike for the call. Each option costs you $1. You will need the shares to move to $8 or $22 to break even. However, any move above $22 or below $8 will make you a profit. So if the shares moved to $5, you would make $5 minus the $2 you paid for both the put and the call, for a net return of $3, or 150% on the entire trade.
A strangle is often confused with a straddle. A straddle is similar in that you take a put and a call position; however, it differs in that the strike prices you use for the option on a straddle are identical.
Strategy No. 5: Spreads
Everyone has a favorite type of trade. Some people focus on technicals, others on fundamentals. Some trade only bonds or cryptocurrencies. We trade them all. But we like using strategies that involve fewer dollars at risk.
Don’t get us wrong. We have a healthy stock portfolio chock-full of dividend-paying stocks and the like. But if you’re like us, you like to spice things up as well. We’re not ashamed to admit it… We like to swing for the fences.
The best way to do this is by buying a put or call option that bets on the direction of a stock. You have unlimited upside when buying a call option (betting a stock will go up) and huge upside when buying a put option (betting a stock will go down). And your risk is limited to the amount you pay for your option. In other words, you have defined risk.
That’s fine, but we have an even better strategy that we employ when trading options. It’s one that we can do in our retirement account. We can also bet long or short, and have defined risk. But it also costs us less money than buying a put or a call straight up. For that “discount,” we give up some upside. In return, we generate income while reducing our cost.
We employ this strategy only on companies that are not highfliers. There’s no point in limiting our upside on a speculation! That would defeat the whole purpose.
No, this strategy is for the steady growers, the blue chips and some midcaps too. It works perfectly in both the tech sector and biotech sector. Now, we would not use it for a stock like NVIDIA, since that has the potential to soar as well as crash. But we would certainly use it for companies like Cisco Systems (Nasdaq: CSCO) or Intel (Nasdaq: INTC) where we could see 20% to 30% upside.
The trade is called a “spread.” And you can do it in any type of account as long as you get approved by your broker. So yes, it does require an extra step from your broker, but it’s well worth it.
For a spread trade, follow these steps. You buy an option and sell an option at the same time. This way, the proceeds of the option you sold reduce your overall cost on the trade and increase your upside. It’s almost like a covered call in stock trading but without owning the stock. Let me show you using an example stock.
Stock XYZ is currently trading for $47.50. Its 52-week high is $57.60. Let’s assume for the sake of this example that you think XYZ will hit $60 by the end of next year.
You can buy 1,000 shares of XYZ and spend $47,500. Or you can buy 10 contracts of the XYZ call option that expires in January 2020 with a $47 strike price (that means you have the option of buying XYZ at $47). It will cost you $6, or $6,000 for 10 contracts.
If Stock XYZ were to go to $60, you would make $12,500 on your stock position, or 26% plus a couple percent for the dividend. Let’s call it 30%.
The price of the option at expiration would be $13 ($60 minus $47). Your profit would be $7, or $7,000, once you subtract what you paid for the option. Your gain is 116%.
Now, let’s see what would happen with a spread trade. You buy the $47 option and pay $6. Against this, you sell the $60 option with the same expiration date. That option is currently selling for $1.80. Your cost for the trade is now $6 minus $1.80, or $4.20. Your upside is capped at $60, so any move above $60 will not make you any extra money.
Your profit if the shares go to $60 or above is $13 ($60 strike minus $47 strike). Subtract from that your $4.20 cost, and you are left with a net profit of $8.80. Your percentage return with this trade is 209%.
Using a spread will reduce your cost in a trade dramatically. In this case, your spread required 30% less cash upfront than the straight option buy. Your profit was higher too – almost twice as much as the regular option trade and seven times more than the stock trade.
The downside is that if XYZ moved substantially higher than $60, your uncovered option trade would return more. As for the downside, in terms of dollars at risk, the spread trade would have lost you less money if XYZ closed below $47. And your total risk versus buying the shares outright would have been less than 10%, which is below the 25% stop loss we normally follow when recommending stocks.
“The Greatest Victory Is That Which Requires No Battle”
This report is your guide to options investing. It has all the information – from fundamentals to more advanced trading – you’ll need to get started with options investing. Once you’ve taken the information in this report to heart, you’ll be able to start making money trading options like an expert.
As you take your first steps onto the battlefield, you will not be alone. We will provide the advice and guidance you’ll need to win the war, which means making successful trades and significant profits before you know it!