Stock Option Profit Strategies With Little Risk
To get started, let me ask a question to get you thinking. If there were stock option strategies that could improve your odds of making a profit and at the same time limit the amount of dollars that you could lose, would that be a strategy you would be interested in? What’s that? Did I just hear you say “Ok show me?” You did? All right then. That is exactly what I will do. Read on.
The way to accomplish better odds of making profit and limit risk is by trading specific combinations of options. For example, the market, at the time of this writing, is in a severe down momentum. And with all the bad worldwide economic news hitting us every day, it does not look like things are going to get better anytime soon. So in order to trade in this kind of down trend, let’s look at an option combination strategy that a trader could profit from. Oh, but you say the market is really wild and while it is mostly down, sometimes there are huge up days! So how do we protect against that? Well, don’t be so impatient. The less you interrupt the faster I can get to the point.
Actually, there are many combination option strategies that can be created and used for various situations. The following example is just one way to carry out our goal of making profit on a down market. Since the market is so very volatile as you pointed out, the strategy needs to give protection in case the market suddenly changes directions. How do we do that? One way is to enter into a Debit Put Spread. In the following example, I will use the SPY options since the SPY is an ETF, based on the S&P Index and the expectation is that the S&P will continue dropping.
The SPY, at the time of this writing, is trading at about 113.65. But the actual price the SPY is at is not important. What is important is the market is in a down trend and you want to take advantage. I’m just using this price to set up an example. To make a straight down play, we might buy to open the monthly September 113 Strike Put. The September expiration is about a month away. But to protect ourselves from the wild swings we need to add another option (leg) to our trade. To add protection against an unexpected change in the market momentum, would selling to open the 111 Put. Now let’s put this combination together and see what we get. So at the time of this writing, the September 113 Put was trading at about $4.35 per share ($435 per contract) but selling the September 111 Put would create a credit of $3.45 ($345 per contract). This credit is distributed to your account that same day. That leaves you with a total debit of $.90. (-$4.35 +$3.45 = $.90). That means $.90 a share, or $90 per contract, is the most you can lose – the amount of your debit.
Now what are the possible outcomes? If you are correct and the SPY keeps dropping, you stand to gain a maximum profit of $1.10 (the difference in the strikes which is $2) minus your cost of $.90. The maximum profit would occur if the SPY drops to 111 or lower by expiration date. That’s a pretty good profit on a $.90 investment. Remember, the SPY in this example is at $113.65, so it only has to drop $2.65 more by expiration date to give you the maximum profit. Why does this work? It works because, if the SPY drops to or below 111, the 113 strike Put will be worth at least $2. For example, if the SPY dropped to exactly 111 on expiration date, the 113 Put would be worth $2 of intrinsic value alone because it is in-the-money by $2. And the 111 strike Put would be even with the SPY, meaning the value of the option would be zero on expiration date. So you would sell the 113 Put and collect $2.00 and let the 111 Put expire worthless. You initially invested $.90 so you subtract that cost from the $2.00 you collected for the 113 Put, leaving you with a $1.10 profit.
Let’s take one more example. If the SPY drops to say 110, you will still make the $1.10 profit but not more. The reason is the 113 strike Put would be worth $3.00 on expiration date because it is $3 in-the-money. But the 111 strike Put would now be worth $1 because it would be $1 in-the-money. You would then sell the 113 Put and collect $3, but have to buy back to close the 111 Put which then gives you a net of $2.00. (Sell long 113 Put for $3 and buy back to close the 111 short Put for $1 leaves $2). Then subtract the $.90 investment and that still produces $1.10 overall profit. Put another way, on 10 contracts, that is $1,100 profit. Not bad for little work. If you are wrong and the SPY goes up instead and stays above 113, both options would expire worthless on expiration date and that would leave you with your maximum loss of $.90 or $90.00 per contract that you invested.
There can be a third outcome and that is if the SPY winds up in-between the 113 and 111 strikes. For example, what would happen if it ended at 112 on expiration date? The 113 strike would be $1 in-the-money so you could sell it for $1. But the 111 strike would be worthless on expiration date because it is still out-of-the-money. That would produce a $.10 profit as follows: Sell the 113 strike for $1.00 and subtract the $.90 initial investment leaving $.10 ($1.00-$.90 = $.10). That is just above break-even, but you can hopefully see that the odds of at least breaking even or better in this strategy are more than a single option trade.
There is one other thing to discuss with the Debit Put Spread. At any time the trade is open, if it is showing a profit, there is no reason you cannot close the trade out by selling the 113 Put and buying back to close the 111 Put. Let say it is only one week into the trade and it already has a $.75 profit a share ($75 a contract). That is a pretty good profit for a short time and you may not want to risk losing it so closing the trade out might be a smart thing to do. These decisions are up to the individual trader, but all such trades should be monitored daily.
Please note, while this play can be profitable, you should not attempt to make such a trade unless you have a full understanding of the type of option play you are making and understand well the possible outcomes and risks involved. If you are newer to option trading, consult your broker or financial adviser before making such a trade. And always paper trade a new strategy several times before making an actual trade.
Did you enjoy the article and understand the benefits? You did?? Great! Well, Tony Ponzo has a lot more of these types of ideas. Check out his newly published ebook, Never Let Wall Street Steal Your Money Again! The book is packed full of step by step instructions on the fundamentals of stock and option trading and has tons of option strategy ideas for every market condition. Get a Free Preview. Also, send us your questions and comments to contact@splitMaster.com