Post edited 9:55 pm – June 24, 2009 by spreadtrader

Let’s say you want to buy a stock like CEO but you don’t want to lay out the capital that it takes to hold it long term, exposing you to significant market risk. You could buy its call options, but you’d find that they are pretty high priced too, relative to the fact that they may very well expire worthless. How can you make efficient use of your capital, reduce your market exposure and still have a dog in the fight?

Suppose you have a $100,000 account and you want no more than 15% risk exposure to any one stock at one time (this may be a bit high for your personal risk tolerance, but we’ll go with this for the sake of discussion). You could only buy roughly 100 shares of CEO to stay within that parameter at the present price of $122.80. How about if at the same time you bought 1 CEO December 130 call at about 12.50 ($1,250) based upon today’s close? Now you’re controlling 200 shares of CEO stock, but you’re laying out about $13,500 to do it. At some point you’d like to have that capital free to be able to invest it in the next great thing that comes along, yes?

So how about if you were to sell 1 CEO July 130 call option for 3.00? You’d put $300 into your account, effectively reducing the cost of the December 130 call option to $950. Suppose the stock gets called away because the price of CEO goes up to 134.00 by July option expiration (less than 30 days from now). Not only do you put the $300 premium into your account, the stock is called away at a 7.20 profit (130.00 – 122.80). You apply this additional profit to the cost of the (now) $950 December 130 call option further reducing its cost to $230. You can repeat this process by buying an additional 100 shares of CEO in late July and selling another near-the-money August call option. This transaction should likely reduce your cost in the December 130 call to zero, perhaps even put additional profit in your pocket.

Meanwhile, as CEO continues to go up the December 130 call increases in value as it is in-the-money. If the CEO stock is called away in August, your profit is similar to the profit you made in July. Now, within 2 months you have absolutely no market risk exposure in CEO. That is true of BOTH the stock and the option. Why? Because one, you no longer own the stock….it was called away twice at a profit. Two, the profit on that part of the trade more than paid for the cost of the remaining December 130 call, which you continue to hold. If the price of CEO is at 170.00 just before Christmas your profit on the call alone is 40.00, or $4,000; and your capital was at risk in the market for only 60 days. Believe me, minimizing the time and risk of your capital in the market is what every professional trader seeks to achieve. If you have no risk when the market crashes, what do you care? Think about it.

You can do this with any stock that trades options. Of course, I have described the best case scenario; and there are certainly risks associated with a trade like this. But ask questions. Try a trade like this on paper. It’s just one more way that options can be used to improve the efficient deployment of capital, reduce and control risk and maximize profit potential.

As for CEO’s chart its price hovers just above its 8 year 50% Fibonacci retracement line (about 118.00). The stock is in an up trend, in a favored sector (oil service) with good room to move up based upon positive monthly momentum. We’re one box from a relative strength buy signal. The stock is volatile as is the price of oil; and therefore, it is suggested for larger accounts……….DDD.

Well, nobody seemed much interested in this trade, but if'n you did it you'd be holding a CEO December 130 call worth $1,500. Not only did it cost you nothing, but every penny left on it at expiration is all profit and you no longer have any money at risk in the market.

………………….pretty slick, eh?

spreadtrader said:

Post edited 9:55 pm – June 24, 2009 by spreadtrader

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Let’s say you want to buy a stock like CEO but you don’t want to lay out the capital that it takes to hold it long term, exposing you to significant market risk. You could buy its call options, but you’d find that they are pretty high priced too, relative to the fact that they may very well expire worthless. How can you make efficient use of your capital, reduce your market exposure and still have a dog in the fight?

Suppose you have a $100,000 account and you want no more than 15% risk exposure to any one stock at one time (this may be a bit high for your personal risk tolerance, but we’ll go with this for the sake of discussion). You could only buy roughly 100 shares of CEO to stay within that parameter at the present price of $122.80. How about if at the same time you bought 1 CEO December 130 call at about 12.50 ($1,250) based upon today’s close? Now you’re controlling 200 shares of CEO stock, but you’re laying out about $13,500 to do it. At some point you’d like to have that capital free to be able to invest it in the next great thing that comes along, yes?

So how about if you were to sell 1 CEO July 130 call option for 3.00? You’d put $300 into your account, effectively reducing the cost of the December 130 call option to $950. Suppose the stock gets called away because the price of CEO goes up to 134.00 by July option expiration (less than 30 days from now). Not only do you put the $300 premium into your account, the stock is called away at a 7.20 profit (130.00 – 122.80). You apply this additional profit to the cost of the (now) $950 December 130 call option further reducing its cost to $230. You can repeat this process by buying an additional 100 shares of CEO in late July and selling another near-the-money August call option. This transaction should likely reduce your cost in the December 130 call to zero, perhaps even put additional profit in your pocket.

Meanwhile, as CEO continues to go up the December 130 call increases in value as it is in-the-money. If the CEO stock is called away in August, your profit is similar to the profit you made in July. Now, within 2 months you have absolutely no market risk exposure in CEO. That is true of BOTH the stock and the option. Why? Because one, you no longer own the stock….it was called away twice at a profit. Two, the profit on that part of the trade more than paid for the cost of the remaining December 130 call, which you continue to hold. If the price of CEO is at 170.00 just before Christmas your profit on the call alone is 40.00, or $4,000; and your capital was at risk in the market for only 60 days. Believe me, minimizing the time and risk of your capital in the market is what every professional trader seeks to achieve. If you have no risk when the market crashes, what do you care? Think about it.

You can do this with any stock that trades options. Of course, I have described the best case scenario; and there are certainly risks associated with a trade like this. But ask questions. Try a trade like this on paper. It’s just one more way that options can be used to improve the efficient deployment of capital, reduce and control risk and maximize profit potential.

As for CEO’s chart its price hovers just above its 8 year 50% Fibonacci retracement line (about 118.00). The stock is in an up trend, in a favored sector (oil service) with good room to move up based upon positive monthly momentum. We’re one box from a relative strength buy signal. The stock is volatile as is the price of oil; and therefore, it is suggested for larger accounts……….DDD.

ST:

This is great. I do have a question. When the stock price of CEO is $134 at the end of July and your $130 call option that you sold resulted in your CEO shares being called away at $130, shouldn't you also consider the $4 difference as a loss ($134 minus $130)?

Will

Will said:

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ST:

This is great. I do have a question. When the stock price of CEO is $134 at the end of July and your $130 call option that you sold resulted in your CEO shares being called away at $130, shouldn't you also consider the $4 difference as a loss ($134 minus $130)?

Will

Hey Will,

First off, the stock could not have been called away in July because the option expired on the 7/17/09 close with the stock price at 127.81. Second, I posted on 7/14/09 (see post #2 above) that you should buy the July 130 call back at .20 – .30 cents and then sell the August 130 call for 3.50. So the August call is the one that caused the stock to be called away.

Finally, when that happens there is no "loss'. You have merely elected to limit your profit on the stock (130.00 – 122.80 = 7.20 profit) and "sell" it in return for holding a longer term call that is now in the money and that cost you nothing.

Of course, to reduce your basis (not tax basis) in the long term call trade, you apply the profit from the stock and short term call option sales to zero out your cost. It looks like this:

Profit from stock getting called away = 7.20; profit from July 130 call = 2.70 (3.00 – .30); profit from August 130 call = 3.50. So 7.20 + 2.70 + 3.50 = 13.40 gross profit. The cost of the December 130 call was 12.50. So 13.40 – 12.50 = .90 net profit.

Your capital is no longer at risk in the market and you're holding a call that is worth more than 15.00 today.

That's profit, not loss…….hope that's clear as mud.  

Will,

You ask some interesting questions because they deal with issues that are not apparent on the surface, yet they definitely impact one's potential to succeed at trading.

Let's say you buy a stock at 10.00 and it goes to 15.00. You decide that you don't want to give up all of your profit but you want to protect yourself against a catastrophic market event. That's prudent, yes? You place a trailing stop in the market at 13.00. The next day the stock rallies to 16.00 but the market fades in the afternoon and some bad economic data comes out and all stocks tumble. Your stock closes at 12.50. Your stop is hit and you exit at 13.00 (luckily there was no slippage).

Is the glass half empty…..or half full? Did you make 3.00 a share (13.00 – 10.00)? Or did you lose 3.00 a share (16.00 – 13.00)?

Now, the next day the stock tumbles to 8.00. Are you glad that you had that stop in place?

No wait….I mistakenly left off a digit. The stock actually rallies the next day to 18.00. Now how do you feel about that stop?

Think about this………..until you are psychologically and emotionally OK with either outcome……..you will not be a successful trader.

To answer your question directly, it is absolutely NOT lost profit.

Post edited 8:43 am – August 29, 2009 by spreadtrader

Good question. The only reason that I want to do that in this case is because I know that in order to fully pay for the long calls I need to do another transaction. At the point I posted, the conditions that set up the call buy back and August call sale were very favorable. The alternative was to run the RISK that the stock would jump up, get called away and leave me having to buy the stock again (at perhaps a higher price) and HOPE that I could sell another call (at perhaps a higher strike) with as much premium as I received when I decided to jump. It's all about assessing the risk of the unknown; and a lot of this is judgment and experience.

But your point is well taken and that's part of the beauty of the trade…….flexibility. You could have let the stock be called away (which in pont of fact, in July it wasn't). My sense was I 'd rather give up .20 or .30 cents of premium and deal with the devil I know………instead of waiting another week for the devil I didn't know. The major risk with this trade was always that the price of CEO may tumble. Having bought it at 122 and change gives much greater comfort once it is at 130.00 that you won't be dealing with the risk of loss on the stock. If you have to buy it back again at 130.00 the risk of loss on the stock trade s increased to that extent.

Post edited 12:50 am – December 7, 2009 by BillyBob

spreadtrader said:

if you want to learn more about how to use options as a tool in trading, let me know. If used properly, they add a new dimension and flexibility to your trading. But it's far from "genius". As with most things, keeping it simple helps; and those are the techniques that I find most valuable.

i COULD USE THE HELP AS JUST GETTING TO THE MONEY MANAGEMENT AS SEEMS i HAVE A PRETTY GOOD HANDLE ON WHAT MOVES ALOT AND USUALLY PRETTY GOOD AT THE DIRECTION AS WELL.. oops caps on… I'm not a typer just hunt and peck… I'd love to learn anything you'ld like to teach and seems the search all your posts doesnt work or I havent found it or…

Thanks, BillyBob 

ST, you're great. I hope utube comes to do a video on you sometime.