Archive for October, 2009
The Riskiest Option Trading Strategy Known To Man.
Today, I wanted to discuss the riskiest Option Trading Strategy known to man. I am going to go through the strategy and then I am going to give you the names of two other strategies that you will want to stay away from because each one of them is using the risky trade within the strategy. So, let’s get started.
The Option Trading Strategy with the highest risk to an investor is known as selling naked calls or short a call. How this strategy works is as follows:
1. You find a stock you think will not have much upside nor volatility, aka SPECULATING. This should be your first indication that this strategy should not be used.
2. You sell a call naked (this means you do not own the stock, but, you are obligating yourself to selling this specific stock sometime in the future at a predetermined price.)
3. You receive a premium (meaning someone is paying you to have the right to buy the underlying stock, that you do not presently own, from you sometime in the future.)
4. Now, this is where this strategy can get UGLY!! READ BELOW
Selling naked calls (short a call) is gambling. You receive a premium from an investor that gives him the right to buy either from the market or from you, whomever is cheaper. Consider the example below.
You sell one (1) naked call on ABC stock at a strike price of $20. The buyer of your naked call pays you $3. (Alright, you just made $3 per contract, or $300.00)*
The current market price of the stock is $15.
Sounds good so far huh? You have $300 and the stock would have to move from $15 to above $23 ($20 strike price plus the $3 premium) before the person holding the call option would come to you and have you buy the stock at the market price and sell it to him for $20. Well, just to let you know, because there is no ceiling on how high the price of the stock can climb, your risk is UNLIMITED!!
Let say you wake up one morning three weeks into the future and find out the stock that was trading at $15 back when you sold the naked call just spiked up $50 per share. Well, guess what, the person that bought the call from you is doing? He is outside banging down your door to get you to sell him the stock at $20, so he can sell it in the market at $65. What an ugly predicament you are in now. You have to buy the stock at $65 and turn around and relinquish it at $20 leaving you with a loss of $42. (Your cost of $65 minus what you sold it for $20 equals $45. But remember, you were already paid $3, so your loss is $43 per share or $4300.00) OUCH!!
Now granted, this is an extreme example, but it is better to just stay away from selling naked calls so you don’t end up on the wrong side of a run away stock while you were sleeping. Get my drift.
Well, hopefully you understand the risk involved in selling naked calls now, here are two other option trading strategies to avoid like the plague:
short straddle: short a call and short a put
short combination: short a call and short a put (combination will have different strike prices, i.e. sell a 20 call and sell a 30 put)
* One (1) contract equals 100 shares of stock, therefore if you receive $3 per contract, you will receive as a premium $300.00.
To Your Successful Trading,
p.s. Here are some additional articles you may be interested in
- Stock Option Trading Millionaire Principles – Jason Ng explains some critical elements that will guide you to consistent profitability in options trading. stocks options option trading Stock trading options trading
- Options Warrants Futures Derivatives Headquarters – Articles about option trading strategies, option pricing, Black Scholes, Spread betting and … or just give a thumbs up? Be the first to submit a blurb! …
- Option Trading Explained – in layman terms – Explaining Options Trading In Layman Terms. Possibly the only writing in existence that tells you both the good and bad effects of option trading. options option …
Over the last few weeks we discussed either buying or selling calls or buying or selling puts in our option trading strategies. We determined, that if the stock we are interested in is a good company, meaning, that it has strong fundamentals like good management, good product, increasing revenues or increasing earnings, we would purchase a call option in anticipation of the stock value increasing. On the flip side, if we noticed a company that was showing a poor performance or if we determined that the overall market is bearish on the stock (that is the market thinks the value of the company is overpriced), then we would buy a put option in anticipation of the stock decreasing in value.
But, what if we are uncertain about the direction of the stock? For instance, what if the company showed good earnings, but the market was bearish on the stock of the company. What do we do? Well, I was explaining to a close friend of mine the other day that when we are uncertain about a stock but anticipate some volatility (volatility is large swings in price, either upward or downward), we can either disregard the stock and move on to more certain investment strategies or we can take advantage of the volatility in the stock. But, how exactly would we do this, you ask? Great question and below we are going to walk you through how we would use this option trading strategy.
So, we have decided to pursue a company that has a lot of volatility, but are uncertain about the direction of the stock, so here is what we would do to take advantage of a great opportunity. We are going to purchase a call and a put. That’s right! we are going to purchase a call based on the fact that under the above scenario, the company has good fundamentals (earnings, revenues, management, product, etc), so we buy the call in anticipation of the stock increasing. But wait, didn’t we say that we are uncertain about the movement of the stock. Absolutely! So in addition to buying a call, we are also going to buy a put. Holy cow batman, we are hedging our position on this stock! That is exactly correct. We are buying a put in addition to buying the call, because, we recognize that the company has good fundamentals, but the market (the investors buying or selling the stock) are showing signs of fear in the future fundamentals of the company (this is called speculating, because investors can never really know whether or not the future of the company is in peril until it is too late). By buying a put option with our call option, our option trading strategy now will have the opportunity to make a return on the stock as long as the stock has the volatility that we are anticipating.
So what are the costs? Typically, we will pay a small premium for each option we buy. For instance we will pay one price for the call option and we will pay another price for our put option. The great thing about investing in this option trading strategy is we are only risking our premiums. However, if the stock does have the volatility we anticipate, we can close out one of our option positions as the stock moves favorably towards the other option position. This will limit our loss, but give us unlimited gains.
The downside of this strategy is if the stock has no volatility and stays in a low volatile trading range for the life of our option trading contracts. If this happens, we will lose our premiums. But, in my opinion, it is better to take a small premium loss versus buying into a stock (meaning investing a higher amount of capital) that is not going to move at all or buying the stock and it plummets and takes your capital with it.
this strategy is called a Straddle. It is highly recommended for stocks with high volatility but with the uncertainty of the stock’s direction.
Here’s a couple related articles that might be of interest:
- Options Trading Strategies You Can Use to Profit – Options Trading Strategies You Can Use to Profit. Caterina Christakos is an article writer and reviewer. Read her latest reviews here: http://espressocoffeemakersale.com/commercial-espresso-machines/. Over 50% of individual traders fail …
- Option Trading Research Options Trading Options Trading Strategies … – Internet Marketing Articles by Moe Tamani the SEO Services Consultant.Main feature of day trading lies in its daily evaluations and prediction for the moves of the market, the other day At the time this options position was purchased, …