No doubt the stock market has been erratic of late.
Last December saw a dramatic sell-off that had everyone thinking this is the big one, and that we're about to embark on Recession 2.0.
And then out of the blue on December 26, the market staged an incredible "v-shaped" four month recovery that brought it to all-time new highs on May 1.
Also since early May, we saw another mini sell-off, mostly due to the recent U.S.- China trade stand-off.
And guess what?
We've undergone another v-shaped recovery that's pushing back to all time highs.
How is one to cope with such movements?
Well, we should leave that to the short-term traders, who live and die by the market's every move.
For most of the rest of us, we shouldn't be so worried about all those micro moves. We should think long-term, and understand that over time, the market finds its way higher.
Decades of market action prove it. Time and time again, after conflicts, wars, terror attacks, trade disputes, etc, the market rallies to new highs. And of course, it will do so again.
So, if you have a few stocks on your radar that you're interested in picking up on the next (inevitable) pull-back, here's an ingenious way to play for free.
Hop The "Fence", And Get In For Free
I've been at this a long time, and have employed just about every option strategy during my 27 years of trading experience.
One of the most creative ways to use options contracts to mimic a bullish position in a stock , is to employ a strategy called a "fence".
Options contracts are there to be used as a substitute for stocks, and the best thing about that is you can create endless possibilities based on your level of conviction, time frame, and the amount of money you want to spend.
If you are bullish, let me show you the fence trade and how to create a position for zero cost.
A bullish fence is created by using two different option strategies in one:
1. Selling an out-of-the-money (OTM) put option.
2. Buying an out-of-the-money (OTM) call option.
If you've been reading my blog, you should be completely familiar with selling put options, as I've posted numerous articles about it.
By selling an OTM put option, you will receive the upfront cash premium from the put-option buyer. In exchange for receiving that cash, you are promising to purchase the stock at the agreed upon level (the strike price) at some point in the future, if, and only if, the stock falls below the strike price.
For the second part of the fence, you will purchase an OTM call option at a strike price level in which you feel the stock can surpass by the end of the expiration date.
Both trades will be for the same expiration date.
But the most important detail about getting into the trade for free is that the sale price of the put option must exceed the cost of the call option.
Let's look at an example that existed a few weeks ago (example only!)
At the time, Apple traded near $179 per share.
If you were interested in a bullish trade and felt the stock could rally back to at least its last recent high of $215 per share, but also wanted some downside protection in case it drops a bit more, initiating a fence could be the perfect trade.
By setting a floor purchase price of $145 per share (Apple's last recent low point), one could've sold a put option with a $145 strike price. And with your target price of $215 per share, one could've purchased a $215 strike price call option.
Let's see how the option prices looked:
Giving time for the trade to develop, we looked at the option chain above which represented the January 2020 expiration date.
By selling the $145 put option for a fair value of $4.47 per contract and buying the $215 call option for a fair value of $4.28 per contract, the trade yielded a credit of $.19 per fence.
Meaning, for every fence traded, the investor's account would've received $19.
One of the best ways to visually see how an option position can develop over time is by using an option strategy graph.
This is a great one from optioncreator.com
You will notice two different colored lines on the graph. The orange line yields the profit/loss results on expiration day, and the blue line represents the results as of time of trade.
Because many stocks can end up meandering in a range for a period of time, the fence is also great for this type of activity, as long as the trade is initiated for a credit (which this one was).
You will also notice that if Apple stock closes anywhere between $145 to $215 at January 2020 expiration (orange line), no profit or loss will result, except for the small $19 credit received at the onset of the trade.
Considering that with Apple at $179 per share at time of trade, it's nice to know that it can drop $34 in price and there would be no loss. On the flip side, if Apple rallies $36 in price, there would be no gain either at expiration. That is part of the safety trade-off.
Options trading can yield very different profit and loss profiles, which are highly dependent on how and when the stock moves within the expiration cycle.
One common mistake I see amateur option traders make is that they don't take profits along the way.
If you look at the blue line of the graph, you will see how the profits can add up rather quickly if Apple rallies right off the bat. If that happens, it's in the trader's best interest to lock in at least partial gains. This would require having multiple contracts of the fence.
If you only have one fence spread, then you only can take profits on one occasion. If you trade multiple contracts, you can stagger the profit-taking.
Either way, the upside profitability is unlimited.
Word of caution: remember, selling a put option obligates the trader to buy the stock at the strike price if called upon to do so. If Apple falls below $145 per share at expiration, make sure you still have the desire and the funds to pay for the stock in full at $145 per share.
If the stock ends up being purchased, the downside potential now becomes unlimited - just like any other stock.
Remember my motto: only sell put options on stocks that you have a genuine interest in owning.
If the outlook for Apple ever changes, and the investor wants out of the trade, it can always be unwound at any time. That's the beauty of trading options. And depending on where Apple might be trading at that time, a profit or loss can result.
Bottom-line of the fence trade is that if the stock makes the bullish move that's expected, the upside profit can be unlimited, all while getting into the trade for no cost.
Next time you're looking to buy a stock, check the option prices on a fence trade. You might be pleasantly surprised.
Who says you can't get anything for free?
Until next time...