Yesterday, I showed you how options can reduce your risk in the market.
Today, I’m going to walk you through a real-world example of how to start buying options to reduce your risk AND increase your potential returns.
If you’re new to trading, this is a MUST READ. If you’re an experienced trader, you might be tempted to skip over this essay. Don’t do it. There’s a good chance you’ve never seen the technique I’m about to show you. And it will significantly increase your success as a trader…
[ad#Google Adsense 336×280-IA]Let’s go back in time a few months, to mid-July 2014.
Diamond Offshore (DO), a deep-sea oil and gas drilling-services company, was trading for about $50 per share.
The stock looked cheap.
It traded at just six times cash flow, and it paid a 7% dividend.
So you want to add the stock to your portfolio to profit if it goes up.
You could buy 100 shares at $50 each – a $5,000 investment.
Like every good investor, you would also set a downside stop on your position – a point where you’ll admit you’re wrong on the trade, get out of the position, and save the rest of your capital for another trade. For this example, let’s say you would set a 20% stop loss.
So in this case, you would buy 100 shares of DO at $50 for a $5,000 total investment. And you’re willing to risk it falling to $40 – a possible $1,000 loss – for the potential to profit if the stock moves higher.
Now, keep in mind that even though you set a stop loss to limit your potential loss, the entire $5,000 investment in the stock is technically at risk. There’s no guarantee you’ll be able to sell your shares at $40.
You don’t want to risk $5,000, so you take this idea over to the options market.
Rather than putting $5,000 into the stock, you’re going to deal only with the $1,000 you’re willing to lose if you’re wrong. The other $4,000 will be tucked away safely in a money market fund or Treasury bill for the duration of the DO investment. You absolutely will not lose more than $1,000 on this investment.
But let’s say you want to limit your risk even more. So you only take half the $1,000 you were willing to risk on the stock over to the options market.
Back in July, when DO was trading near $50 per share, the DO October $50 call options were trading for about $2.50.
So rather than buy the actual stock at $50 per share, you can simply buy the call option that gives you the right to buy the stock at $50 by option-expiration day in October. Since each call option covers 100 shares, you can buy two call options for $500 and have the same exposure to the upside of the stock. And your maximum loss is now only $500.
Think about this for a minute… You can put up – and risk – $5,000 to buy 100 shares of DO… Or you can buy two call options that give you the same exposure to the upside but limit your risk to just $500. Obviously, buying the call option is a much lower-risk trade.
But we don’t just use options to lower risk. We use them to increase returns as well…
Let’s say the stock rallies to $60 by the October expiration date. If you bought 100 shares of the stock at $50, you’d have a $1,000 profit. That’s a 20% gain on the investment.
You’d do much better with the call options though.
At $60 per share for DO, each DO October $50 call option will be worth at least $10 per share ($1,000 per option). You own two call options. You can sell them, collect $2,000, and realize a $1,500 profit. That’s a 200% gain on the trade.
By using the options, you put up $500 – much less than the $5,000 to buy the stock. And you made $1,500 – much more than the $1,000 gain on the stock.
That’s what would have happened if the stock had moved higher. But that’s not what happened in real life…
DO nosedived and closed at $37 per share on option-expiration day in October.
If you had bought the stock, you would have stopped out of the trade at $40 and lost $1,000. That’s a 20% loss on your $5,000 investment.
The DO October $50 call options expired worthless. So if you had purchased the options, you would have lost 100% of your $500 investment.
But here’s the important point – a point that often gets distorted by folks who think option trading is risky – it is FAR better to lose 100% of a $500 trade than to lose 20% of $5,000.
You lost money either way. But by using options, you cut your risk on this trade in half. And as I explained earlier, if DO had moved higher, you would have made more on the smaller investment in options than you would have made in the stock.
Either way, at this point, you’re out of the trade with a loss and it’s time to move on.
But wait…
If you bought the call options, you would still have $500 in your back pocket. This was money you were willing to lose on DO. But there was no need to put it at risk since buying two call options gave you more than enough exposure to increase your potential reward on the trade.
Now, with DO trading at a lower price, it is an even better investment. If you had owned the stock at $50, you would have already lost the most you were willing to risk on DO. There’d be nothing left to buy it with here.
But if you bought the DO call options instead, you would still have $500 in your back pocket that you can put into a new DO call-option trade.
Right now, the DO January $40 call options are trading for $2. You could buy two of those call options for $400, and tuck the remaining $100 away in the money-market fund with the other $4,000 of investment capital.
Now, no matter what happens to DO, you will still have $4,100 tucked away safely. That’s better than the $4,000 you’d be left with if you had bought the stock at $50 and got stopped out at $40. And you would have the right to buy 200 shares of DO at $40 by option-expiration day in January. So you would still have a chance to profit on the trade.
If DO bounces back to $50 per share by option-expiration day in January, you would be able to sell the DO January $40 call options for $10. You’d collect $2,000 – which more than doubles the $900 total investment from both DO option trades.
On the other hand, if DO continues to fall, the options will expire worthless again. You would lose 100% of the money you put into this trade, too. But you would still have the $4,100 tucked away in the money-market fund. Your $900 total loss would still be better than the $1,000 loss suffered by buying the stock.
Novice investors think buying options is risky because they look at the track records of option trades like this and they see two losses of 100% each, or a total return of -200%. They look at the track records of the stock purchase and see one 20% loss. So they conclude that it’s safer to buy the stock and it’s risky to trade options.
That’s not the case at all.
Traders who use options the right way – in a way that reduces the risk and increases the potential reward – can always construct a trade that works out better than buying the stock itself.
Even in this example with DO, the option trader’s maximum loss is $900. The stock investors lost $1,000.
This is the right way to trade options. By using this technique, you will ALWAYS be able to reduce your risk and increase your potential returns. And that is, after all, what options were created for in the first place.
Best regards and good trading,
Jeff Clark
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Source: Growth Stock Wire