Oh, you didn't see that Microsoft (MSFT) finally broke out of its trading range (channel)?
Take a look at the chart below:
The "channel" is a classic chart pattern.
Once the stock breaks out of the channel, it tends to keep moving in the same direction.
And with the market entering the most bullish seasonal time of the year (November - May), I can only see MSFT continue to move up.
So How Am I Playing It?
There are a multitude of ways to play a breakout:
1. Buy the stock
2. Buy call options.
3. Buy call option debit spreads.
4. Sell put options.
5. Sell put option credit spreads.
One of my biggest fears is that if I buy a stock, it will immediately drop and I'll lose money.
I think maybe we all have that fear because I'm sure it's happened to all of us! Right?
So, when I enter into a bullish play, I always want to give myself some room for directional error. I call it downside cushion.
Selling either single put options or put option credit spreads can offer that downside cushion while being bullish.
One thing we know when selling out-of-the-money (OTM) put options, is that although it offers a downside buffer, the stock can continue to move lower, potentially leaving the door open for unlimited downside risk.
When selling put option spreads, you engage two put options - one a sale and one a buy. This creates a limited maximum risk and a limited maximum reward profile. There's no need to worry about unlimited risk.
Both put options are of the same expiration date, and the one that is sold is more expensive than the one that is bought, so it creates a "credit" into your trading account.
And since selling put option credit spreads is a bullish strategy, it can be a great way to capitalize on a stock breakout while still gaining room for directional error.
Here's What I Did
Since I am bullish on MSFT, I decided to sell the January 17, 2020 $130 strike put option for $1.26 per contract and bought the $125 strike put option contract for $.76 per contract (different than what you see above).
This is called a "vertical credit spread", or a "bull put spread".
It is executed as a single trade even though two different option contracts are involved. I didn't need to sell the $130 put option by itself and then turn around and buy the $125 put option as two different transactions. I was able to trade both simultaneously in a single spread trade. All brokers offer this capability.
By selling the spread, I received a $.50 per contract credit ($1.26 - $.76) into my trading account.
Since each option contract represents 100 shares of stock, the $.50 credit is multiplied by 100 to reveal the actual dollar amount received: $50. If ten spreads are sold, $500 would be received.
What's the Profit/Loss Profile?
Graphing an option position is a very easy thing to do, as seen in the picture above. Optioncreator.com is what I use to make these option strategy charts.
What you'll see from the chart is the profit/loss profile of the MSFT option vertical spread.
On the upside, the maximum gain that can be made is $50, which is the premium received from selling the spread. While on the downside, the maximum loss can be $450.
Yes, you're risking $450 to make $50. But, the odds are skewed to my side.
You see, in this trade, I wouldn't start to lose money until/unless MSFT stock starts dropping below $129.50.
In order to find that breakeven point, you must subtract the premium received from the sold option strike ($130 - $.50 =$129.50).
Since MSFT stock is currently at $143.72, I have a decent $14.22 of downside cushion in case my directional assessment is off. In other words, I'm giving myself $14.22 of buffer for MSFT to move around.
In order to win on this trade, I would need MSFT stock to finish anywhere above $129.50 between now and January 2020 expiration. For maximum gain, I would need MSFT to finish above $130.
In this trade, I'm already starting at a huge advantage because MSFT is at $143.72, well above my breakeven price of $129.50.
MSFT stock could move higher, stay the same, or even move lower, and I would win in all three scenarios. I just would need it to stay above $129.50.
As far as my odds of that happening, look at the chart below:
The probability calculator you see above is telling me that there's an 80% chance that MSFT will stay above $130 by expiration in 78 days. Those are pretty good odds.
How often are you given the chance to win if a stock moves in three different directions? Not often I bet. Option spreads can give that opportunity.
Now, the higher odds you have, the smaller the payoff might be - $50 in this case.
There's always a trade-off. Do you want a higher chance of winning? If so, the payoff will be smaller. If you want a higher payoff, the odds will be lower.
I'd rather have smaller wins with higher chances of winning. That's just me.
And don't snub your nose at a $50 payoff. This can done with multiple contracts, using multiple stocks, during multiple times throughout the year. The money can really add up.
The best thing about trading option credit spreads is the comfort it can give knowing that your potential losses are always capped and known ahead of time. You can sleep soundly at night with that.
Trading option spreads is something that is offered at every broker so it can be easily set up for your account.
I like to use option spreads when I have an idea about future direction, but also want to have a buffer and a safety net in case I'm wrong.
What Happens At Expiration?
As can be seen in the option P/L graph above, varying amounts of profit or loss will occur at varying prices of MSFT at expiration.
If MSFT finishes anywhere above $129.50, profits will occur, with the maximum being the $50 received at the outset of the trade. To reap the maximum gain, MSFT would need to be above $130.
On the downside, losses will occur once MSFT moves below $129.50. The loss will be capped at a maximum of $450 no matter how low MSFT trades. The maximum loss occurs when MSFT moves below $125.
Risks & Contingency Plans
As I've been saying, the risks with option spreads are capped and known ahead of time.
But how do you calculate what the maximum risk can be?
It's very simple. The distance between the strike prices multiplied by 100 is the maximum risk.
In this case the distance between the strikes is $5 ($130 - $125 = $5). Multiply that by 100 and you get $500 per spread. You cannot lose more than that. Period.
The maximum gain of course is the $50 that was collected at the beginning of the trade.
If you've collected $50 out of the possible $500, then with the MSFT trade, the maximum loss would be $450.
Now, for those of you "Expected Value" fans, who like to calculate the odds of winning compared to the possible payoff, I can see that you might have questions about the numbers in this specific trade.
If we have an 80% chance of winning and the maximum profit is $50, that equates to an expected value of +$40 ($50 x .80 = $40) on the upside.
While 20% x -$450 = -$90 for expected value on the downside. To be a profitable long-term trader, it makes sense to have trades with a positive expected value.
To combat this scenario, the key is to have a stop-loss point on the trade, just as you would with any other investment.
Just because the risk is capped, doesn't mean that you have to accept the maximum loss. Option trades can be offset or closed out at anytime before expiration.
The smart thing to do is to concentrate on the stock's movement and base your option trade decisions on that.
For instance, if you look back at the stock chart of MSFT, there's really good support near $132 per share. I know that if MSFT starts to breakdown and fall through that level, it most likely means it's going to keep moving lower. In that case, I would close out the trade at that time, which would most likely be for lots less than the maximum loss.
Option spread trades move very slowly, and they don't reach their full value until very near to expiration. So if MSFT fell long before expiration, the spread would not be too harmful in terms of a loss.
At Vertical Spread Trader, we institute a 1:3 ratio of reward-to-risk, meaning, once the spread reaches three times the amount we collected, we will close the trade for a loss.
In the MSFT example, we would look to close the whole spread if it expanded to $2.00 per spread.
That would yield a $150 loss on the trade. On an expected value basis, it would be -$150 x 20% = -$30 on the downside, whereas we'd realize a +$40 expected value on the upside (+$50 x 80%).
Having a stop-loss is critical to longevity in this game.
Yes, risks are capped with option spreads, but there's no need to let it run to the maximum.
And the returns? Well, if the trade expires worthless, the profit would be $50. Your risk, or "investment" in the trade is $500. That ends up being a 10% return ($50/$500). Some may argue it's $50/$450 = 11%. For a two and half month trade, that annualizes out to roughly 50%. Not too bad.
In the end, trading stocks and individual options can lead to bigger profits, but they can also lead to bigger losses. Option spreads offer a happy medium.
Have a look at Vertical Spread Trader if something like this interests you. Just click the link!
Until next time...