SAY YOU HAVE A SYSTEM FOR FINDING AND
executing stock trades. And maybe that
system is working. But if you could make it
better, would you?
Making it better might mean reducing
trade risk, adding theta so the position could
decay as time passes if the stock’s price
doesn’t move, and maybe increasing the
probability of making a profit. Sounds a little
like the intro to the TV show The Six Million
Dollar Man. But you don’t need to crash and
burn before you try these techniques.
HUMAN POWERS, ONLY
It’s not that you have to change how you
determine trading decisions. You can keep
doing what you do. But you may consider
an alternative strategy for those decisions.
Every trading choice has trade-offs, whether
decreased profit potential or increased commissions. That’s why you should consider all
aspects of a strategy. Let’s see how options
combine risk, positive theta, and potential
increased profit in three scenarios.
BULLISH—Long Shares vs. Short Put
Yup, a traditional strategy. If you’re
bullish on a stock, you buy its shares.
If the stock price goes up, you make money,
and if it goes down, you lose. Now, you know
that if you buy stock, the max you can lose
is the price you pay for it. And while stock
prices can go to zero, they don’t usually.
However, a stock’s price doesn’t have to go
to zero to be considered a crash; even a 20%
drop could do it. Consider a 20% drop in a
$20 stock. That’s $4 and, if you owned 100
shares, the loss is $400. The long 100 shares
can also make $400 if the stock price rises
$4. So the p/l for a certain
percentage price change up
or down in the stock’s price
is the same.
As an alternative to long
stock, let’s look at a short put
(Figure 1). A naked short
put is a bullish trade. You sell an out-of-the-
money (OTM) put and take in a credit. Sure,
a naked short option sounds risky, and it is,
but a short put’s maximum risk isn’t great-
er than owning the stock. In other words,
the max risk on a naked short put is the
strike price minus the credit received, and
its breakeven point is the strike minus the
credit, plus commissions.
For example, if you sell the 18 strike put
on a $20 stock and receive a $0.40 credit, it
would have a breakeven point of $17.60 with
a max possible loss of $1,760 if the stock goes
to zero, not including commissions. The long
100 shares you bought for $20 would lose
$2,000, not including commissions.
If the stock price drops 20% and closes
at $16 at the option’s expiration, then the
short 18 put would have a $160 loss. The
18 put would have an intrinsic value of $2,
but you took in a $0.40 credit. The loss is
$2.00 – $0.40 = $1.60, or $160 not including
commissions. That’s less than the $400 loss
on 100 shares.
If the stock stays above $18 through expiration, the short put would still make its max
profit of $40, not including commissions.
That means the stock can drop from $20 to
$18, and the short 18 put can theoretically
still profit. Even if the stock stays at $20,
all things being equal, the put’s price will
erode because of time decay, and you get to
keep your proceeds. There’s a wider range
of stock prices for the short put to be profitable ($18 and higher) than there is for the
long stock ($20 and higher). And that wider
range increases the short put’s chance of
FIGURE 1: Shorting a put. It’s a bullish strategy
where a naked put is sold for a credit. The max risk
is the strike price minus the credit. You might short
a put when you believe the stock could move up or
sideways prior to expiration. For illustrative purposes only.
SHOR T PU T
FIGURE 2: Short call vertical. It’s a defined-risk
strategy where potential losses are limited. Your
trade will stop losing money when the stock’s price
rises above the long strike, but potential profits are
also limited. For illustrative purposes only.
SHOR T CALL VER TICAL
FIGURE 3: Iron Condor. If you think a stock or index
may move within a narrow range, you could consider
an iron condor. Its potential profit and losses are
limited. For illustrative purposes only.