Seriously, you can make a profit if your directional call is wrong?
You sure can!
How is that possible?
By using a very popular options trading strategy that not only has a built-in limited-risk loss feature, but also an extremely high probability of profit.
And this probability of profit can sometimes run as high as 95%.
What's it all about?
When Being Wrong Turns Out To Be Right
At the beginning of anyone's journey in the investing world, we're usually taught that in order to make a profit, we need to figure out directionally where the stock (or any investment vehicle) is going to go.
If investing in the stock market, the most likely scenario would be to buy a stock and hope it goes up.
History shows that over time, the stock market goes higher, so if you hold on long enough, you should make a profit.
But many times, the stock ends up going down, and we get stopped out of the trade, yielding a loss.
It's always smart to have a stop-loss in place though as it can keep a small loss from turning into a big loss. But many times, once we've been stopped out, the stock starts to move higher again, usually without our participation. I know, I've been there. It stings!
Being a professional options trader for the last 30 years, I've seen my fair share of strategies that work, and ones that don't.
But the overarching theme to my time as a trader is that I've learned that option-selling strategies can offer some of the highest probabilities of profit, huge amounts of peace of mind, and most importantly, it doesn't rely on picking the correct direction as the deciding factor to whether you're profitable.
If you can open your mind to the thought process of targeting where the stock won't go (instead of where it will go), then you'll open yourself up to new and exciting profit-making opportunities.
And once you've taken hold of that mind-set, you can use a multitude of option-selling strategies to your advantage.
Enter The All-Star Strategy
In my book, Get Rich With Options - I discuss the four best option trading strategies for the everyday investor. Three of those strategies are option-selling based, while the fourth is the only option-buying strategy I recommend.
If you want a quick and concise breakdown of those four strategies, just click here.
For today though, we're going to concentrate on the All-Star strategy, specifically one subset of it.
For any of you who read this blog consistently, you know how much I love selling put options. It's my bread-and-butter, and favorite option trading strategy.
But some of my readers will tell me that their brokers won't allow them to sell single put option contracts due to the perceived risk in the trade. Has this happened to you?
The broker's rationale always irks me because I don't believe they understand the true risk of put-selling as compared to someone who outright buys stocks.
You see, when a put option is sold, the option seller is obligated to buy that particular stock if it falls to a certain price (the strike price) by a certain date (expiration date).
If the stock is at $100 for example, and an investor sells a $70 put option, they are obligating themselves to buy 100 shares of that stock at $70 a share if that stock falls to $70 (from $100) by the expiration date.
If the stock does fall to $70, then the option seller must follow through and buy the 100 shares at $70 a piece. That would represent a 30% discount from its original $100 price tag.
Now, there's nothing stopping the stock from falling further. Heck, it could drop another 30%.
That's the risk a put-option seller takes - that the stock can fall further.
That also sounds very familiar to the risk that a regular stock buyer has, yes? If an investor bought those same shares at $100 (or even $70), they would have the same risk - that the
stock could keep falling.
But for some reason, the brokerage industry sees put-option selling as a much riskier strategy, and they will restrict certain investors from using it.
To this day, I'm still not sure why.
To combat the reluctance of the brokers to allow certain investors from selling individual put options, a specific option "spread" strategy can be deployed to alleviate the fears.
Enter, The Credit Spread
One of the best ways to overcome the downside risk of selling individual put options is to purchase another put option, which creates an option spread - called a "bull put spread".
The sold put option is at a higher strike price and is more expensive than the purchased put option, thus, creating a credit into the investor's account.
One of the biggest features of selling put option credit spreads is that although it's a neutral-to-bullish strategy, it's not necessary for the stock to go up in order for it to be profitable.
That's the beauty of selling individual put options and selling put option credit spreads - in that having to predict the stock's correct direction is not paramount to making a profit.
Do you know how much a relief that is, and how much pressure can be taken off the investor if they don't have to predict where the stock is going? Until you've used these option-selling strategies, you'll never know that feeling.
Let's look at a real-life option credit spread example that we recently implemented in our Vertical Spread Trader newsletter.
We recently sold an out-of-the-money (OTM) option credit spread on the Healthcare Select ETF (XLV).
This entailed selling an $87.33 strike put option contract while simultaneously buying an $82.33 strike put option contract. These two transactions formed the spread and an initial credit of $.25 per spread was received.
The premium that was received for selling the $87.33 put option was $.25 per contract more expensive than the premium that was paid out to buy the $82.33 put option. Thus, a credit of $.25 ($25 actual dollars) was received for each spread sold.
At the time of execution, XLV was trading for roughly $101 per share. By using $87.33 as the short strike of the spread, we gained almost $14 per share (13.5%) of downside cushion in which XLV could fluctuate (as seen in the chart above).
This meant that as long as XLV moved higher, remained flat, or even dropped some, we could walk away winners in this trade.
How Does The Risk/Reward Play Out?
You see, when selling single put options or put option spreads, profitability occurs as long as the stock remains above the sold strike.
It doesn't matter if the stock is $1 above or $30 above the sold strike. As long as it's somewhere above it, the trade will win.
With XLV at $101 at the time of the trade, it didn't matter if it continued to move higher, remained range-bound, or even fell a bit (which it did at the end of January). The credit spread will still move into profitability.
But how does an option spread make money?
All option contracts have a cost, and the buyers of those options have to pay it. It's called the "premium" (just like insurance).
If the stock doesn't move to its intended target by expiration, that option contract will wither away and die. Meaning, its value will slowly erode towards $0 and will expire worthless, handing the option buyer a 100% loss on their investment.
As the seller of those option contracts, the premium is received upfront. In the XLV trade, we received $25 for each spread sold on January 3, 2020.
The person that bought the spread from us needs XLV to drop below $87.33 before expiration in April. As each day passes and XLV doesn't move anywhere, the option spread loses value.
As of yesterday's close (2/14/20), the option spread was worth $.09 per spread.
This means that we have $.16 of profit built up already. If we wanted to, we could purchase the spread back at the $.09 premium and close the trade. This would lock in the $.16 ($16) per spread profit.
For now, we plan to hold a bit longer until the spread price gets down to under $.05 per spread, or we might hold until expiration and realize the full profit of $.25 per.
Selling put options and put option credit spreads are definitely a neutral-to-bullish strategy, but obviously you can see that the stock doesn't necessarily need to go up or remain flat in order to make the profit. XLV has even fallen some since we entered the trade, and yet the spread is still profitable so far.
Not having to pick the right direction of the stock is a HUGE bonus when using option-selling techniques.
When we consider trades like this, even though we may be neutral-to-bullish, we're not trying to guess how high XLV may travel. We're more concerned where XLV won't travel. In this case, we don't want it to travel below $87.33.
Now, What's The Risk/Reward In This Case?
Well, when selling any option or option spread, the maximum reward is what is received at the outset of the trade. In this case, our maximum reward can be no greater than $.25 per spread. That equates to an actual dollar amount of $25 per spread using the 100 option multiplier (each option contract = 100 shares of stock).
To find the risk, the width of the spread needs to be calculated.
$87.33 - $82.33 = $5 wide.
$5 x 100 option multiplier = $500 maximum risk.
If the strikes are $2.50 wide, then the risk would be $250 per spread. If the strikes are $10 wide, the risk would be $1,000.
In our XLV trade, the strikes are $5 wide, so the maximum risk is $500. But since $25 was collected upfront, the overall risk is $475. Yes, we're risking $475 to make $25.
Now before you roll your eyes at that risk/reward profile, have a look at the probability of the trade being successful.
Having a high probability of profit is critical for any trading strategy. On day 1 of the XLV trade, there was a 96.46% chance that XLV would not fall to $87.33 by expiration in April. As of yesterday (2/14/20), that probability moved up to 99%.
So the chances look good that we could walk away with full profitability (if we even wait that long).
In our newsletter, we like to close trades well before expiration if enough profit is built up.
That's another thing about trading options - you don't have to wait until expiration to make a move.
As far as the percentage returns on trades like this?
Well, since the maximum risk in the trade is $475 and the maximum gain is $25, the return would yield 5.26% ($25/$475) for 105-day hold period (if held that long). If annualizing the numbers, the yield could be roughly 18.3%. Pretty good.
What Happens If The Stock Keeps Dropping?
No trade is risk-free, but knowing that there's limited risk when using spreads, can keep you sleeping soundly at night.
In the XLV case, the risk can never move above $475. Even if XLV drops to zero, the risk would still only be $475.
But does that mean we have to accept the full loss if XLV ends up crapping out? Of course not!
Creating a risk management plan is paramount in the trading game. This helps keep your account in the green.
If you are a stock trader, you most likely have stop-loss levels in place once the trade is executed. Some use a 10% stop-loss, some use 25%. It's up to you.
The same goes for options trading. A stop-loss can be used if you don't want to accept the maximum risk.
It can be based on the stock's movement, or it can be based on the option price's movement.
With Vertical Spread Trader, we consider a 2:1 or 3:1 risk-to-reward ratio on the option prices in addition to our assessment of the stock's current condition.
For instance, since the XLV spread was sold for $.25 credit, we would look to stop out of the trade and take a loss if the spread widened out to $.75 or $1.00 per spread.
If we had to buy the spread back for $.75, that would create a loss of $.50 per spread ($.75 - $.25). That would entail a 2:1 risk-to-reward scenario.
If we had to buy the spread back for $1.00, that would create a loss of $.75 per spread ($1.00 - $.25). That would entail a 3:1 risk-to-reward scenario.
Deciding on a 2:1 ratio or 3:1 ratio would also be dependent on where the stock was trading at the time. If I felt XLV was breaching major support areas and looking to move even lower, the trade would be closed out closer to the 2:1 level.
We never like to extend the trade to where the maximum risk ($475) would be realized. But once again, based on the probabilities shown above, that scenario is extremely unlikely.
In the end, the biggest appeal and advantage for using option-selling techniques is the fact that picking a correct direction is not the only determinant of a profitable outcome.
The stock could move in multiple directions and still yield a winner.
We like to concentrate on where the stock won't go versus where we think it will go. That makes a big difference in a trade's probability and profitability.
And as shown in the XLV example, even if the stock moves against us, we can still walk away winners.
I hope this post was enlightening and educational.
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Until next time...