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 …
You pick up the phone and call your stockbroker to see how your portfolio is doing. He quickly tells you about a great stock that is showing some significant improvement in the market and he suggests you buy some of this amazing company that is trading around its 52 week low. He continues by stating how spectacular the profile of the company is. “Oh, you are not going to believe how strong the balance sheet is of this company” and “This Company is sitting on a huge amount of capital that will allow them to expand by acquiring other companies in their sector.”
Well, if this stock is ripe for the taking, why risk a large amount of money purchasing the stock. You see, there are many strategies you could be using as opposed to buying stock and letting it sit in your portfolio until you make a 10% or 15% return. Why not use option trading strategies to increase your cash on cash return?
One fundamental option trading strategy that can be used based on your stockbroker’s analysis of a great stock is purchasing calls. Purchasing calls is a way to really increase your cash on cash return. For example, you can buy ABC stock at a price of $30.00 in anticipation of making a 15% return over the next couple of quarters. Sure, it is possible for ABC stock, which is near its 52 week low, has a strong balance sheet and is sitting on a large amount of capital to increase from $30.00 to $34.50 ( $30 x 1.15 = $34.50), but why risk $30,000.00 on purchasing 1000 shares at $30.00 for a return of $4500, when you can buy 10 call option (for every 1 option contract, you will control 100 shares of stock) and control 1000 shares of ABC for a buy-in of between $1000.00 to $5000.00.
Now consider this, for every point ABC stock moves up, your call options will increase dollar for dollar. So if you purchased 10 calls options at $5.00 each and ABC stock moves from $30 to $31, your option will move from $5 to $6.
So let’s compare the return on a one point upward move in ABC stock:
- Purchase 1000 shares of ABC stock at $30: Your risk is $30,000.00
- Purchase 10 ABC call options at $5: Your risk is $5000.00
- ABC stock moves from $30 to $31: Your increase in cash for the stock purchase is $1000 and your % return on your stock purchase is 3%.
- Now compare the purchase of 10 ABC call options:
- ABC stock moves from $30 to $31: Your increase in cash for the 10 call option purchase is $1000 and your % return on your 10 call option purchase is 20%
As you can see, your cash on cash return is extremely higher by purchasing an option over purchasing the stock.
Before I end this article on the value of option trading strategies and the value of purchasing call option versus purchasing stock, let me be very clear… anytime you buy options, there is a time value or an expiration date on the call option contract or any option for that matter, whether you are buying or selling options. So understand, an option will expire worthless, so always give your self ample time to earn a return on the purchase of your call option.
Further, in regards to the information scenario above, we only discussed the upside and the return when the stock increases in value. You should also be aware that for every point movement downward, your call option contract will lose point for point with the stock, so make sure your decision to purchase call options is prudent with the understanding that the most you can lose in your trade is the price you pay for the call options.
Lastly, this strategy is best used for a volatile stock that has an obvious trading range. Our example above was based on a hypothetical company that was trading near its 52 week low.
Here’s a few links of interest:
- Stock Replacement Strategy – Introduction – Over on TheStreet.com, Jim Cramer and his partner James Altucher have created a couple of video segments regarding options and a strategy Cramer calls stock replacement. I’ve searched the internet for what stock replacement is and how …
- the best five option trading strategies – these are (in my opinion) the absolute best options trading strategies that minimise risk and give very respectable profits: selling credit spreads – with almost no work, and about 30 minutes a week, it is possible to grow your …
- Trading: Options Trading Strategies For Consistent Approach to … – Options Trading Strategies For Consistent Approach to Leveraged Trading. Options abound methods for the options trader. Options are very flexible trading instruments and are suitable for a variety of viable strategies. …