Welcome to 2020!
I'm so excited for what lies ahead, but my goal is still the same - to make these blog posts the best education you'll find on the subject of option trading.
If you've been reading any of my work, you know I'm a huge proponent of option selling (versus option buying).
That's because it offers an incredible cushion for directional error (which we all have!) and incredibly high odds of profitability.
If there's one phrase I'd like to burn into your brain, it's this:
"make your trade based on where the stock won't go, versus where it will go"
A majority of investors and traders focus on one thing - trying to guess where a stock will move to.
If you've ever bought a stock, your first instinct is to dream about how high it might go and how much money you might make.
But did you also know that you can make money by guessing where the stock won't go?
It's true. And it's the way I trade in the market 99% of the time with my own investments.
1) If you have an idea of where the stock might go, then you should have an even better idea of where it won't go. This can allow for very high probability option trades.
2) As an option buyer, you can only win in one scenario - the stock absolutely must move in your desired direction within the time limit (expiration date). This is why option buyers fail upwards of 95% of the time. Too hard to predict a stock's where and when.
3) By selling an option, you can win whether the stock moves in your direction or not. And if you sell an option based on where you think the stock won't go, the odds move in your favor even more.
Here's What I'm Doing
I'm a huge fan of Paypal (PYPL).
It's the king of online payment processing and it's starting to break out from a narrow trading range.
Here's the current daily chart.
Although I am bullish and expect it to go higher, I am structuring my trade based on the fact that I believe it won't fall below a certain level, versus picking a number somewhere higher than its current price.
With it near $110.77 as I type, I'm targeting the $80 level as an area it won't fall to. That level will form the basis of my trade.
And if it falls to $80, then I can put forth Part II of my trading plan.
By selling 5 contracts of the May 15, 2020 $80 put options (not a public recommendation!), I will collect at a minimum $250.
The option chain above shows the May 15, 2020 $80 puts with a bid/ask market of $.50 bid/$.53 offer.
Each option contract consists of 100 shares of stock, so by selling five of them, I'm handling 500 potential shares.
And by selling each contract at $.50 per, I will collect $250 total for the five contracts.
$.50 x 100 shares x 5 contracts = $250.
Selling put options is my absolute favorite trading strategy.
The moment I sell those five contracts, I receive $250 in my trading account.
What do I need to give in return?
I must purchase 500 shares at $80 per share if PYPL drops to $80 between now and May 15, 2020.
By selling a put option, an investor is obligating themselves to purchase the chosen stock at a specified price (the strike price) within a specified period of time (expiration date).
In exchange for that obligation, the put-option seller will receive an immediate upfront payment (the premium).
For my PYPL trade, I'm obligating myself to purchase 500 shares at $80, under any circumstance, between now and May 15, 2020. In return, I receive $250.
Now, obviously with PYPL stock currently near $110.77, I won't be able to purchase the 500 shares at $80, as no one would sell them to me at that price. But if PYPL drops below $80 over the ensuing months, I may be called upon to honor the agreement.
Since PYPL is currently at $110.77 (as of 01/02/2020), I have a fat cushion of $30.77 in which PYPL can meander. That's a solid 27.8% buffer.
If PYPL remains above $80 until May, the put option contracts will expire and I'll walk away with the $250. In this case, PYPL could move higher, remain flat, or even drop $30 per share, and I could still win - meaning I keep the $250.
If PYPL falls below $80, I'll gladly buy the shares, as that is a level I deem acceptable to me to create a bullish position. Plus, I'll still get to keep the $250.
But I won't know whether that will happen until May 2020.
What Are The Odds Of That Happening?
Using our trusty probability calculator below, we can see the chances of PYPL dropping to $80 (and staying below) is a scant 3.62%. Said another way, it has a 96.38% chance of staying above $80 by May 2020.
Why are the probabilities important?
Because it gives an idea of how probable it is for a stock to move a certain distance within a certain timeframe. This can help formulate a high probability trade.
If PYPL stays above $80 by May 2020, I win. I get to keep the $250.
If an option buyer was making a bet that PYPL would fall to $80, they would only have a 3.6% chance of being right. Or said another way, they'd have a 96.4% chance of losing. Not great odds.
Sure, I could make a trade that might yield a bigger profit, but it would have to be the type of me guessing how high PYPL might go, and by when.
That's too hard to do.
By selling put options, I can take my bullish slant and gain lots of cushion in case I'm wrong.
PYPL could fall $30 per share and I'd still win.
What's Part II?
I mentioned at the beginning of the post that if PYPL fell to $80, I could put Part II of my plan into action.
What would that be?
Well, if I'm lucky enough to buy the 500 shares at $80 per, I can then hold indefinitely to ride them higher for price appreciation.
But the best part is that I can then use another great option-selling technique - selling covered calls!
This strategy will add another layer of income generation for potentially months on end (if not years). That's good!
Don't let your current long shares go to waste. If you have at least 100 shares of stock in your account, you can sell covered calls.
In the end, my strategy is to pick a stock's direction, and then craft an option trade based on where the stock most likely won't go.
Let me know your thoughts, especially if this how you trade too.
Until next time...