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Trading Options That Beat the Buzzer

I spent Sunday afternoon on the edge of my seat at a high school basketball game. The spread of the teams’ scores rarely varied more than five points for the entire game. In the last minute, the other team committed a foul and we were up by one with a successful free throw. Then with less than 20 seconds left the other team charged down the court and scored a three-pointer leaving us down two at the buzzer.

I’ve been thinking a lot about the buzzer when recommending option trades for Profit Catalyst Alert subscribers. Just as in that basketball game, if the score isn’t leaning in your direction when an option expires, you’ve lost your money. The flip side for an option trader is that you can close out a winning position mid-game, before expiration. It’s the equivalent of ending a basketball game when your team is ahead.

The expiration feature of options makes them one of the more exciting and frustrating trading vehicles for investors when making money comes down to the buzzer.

Options are sold with various expiration dates and strike prices. Investing Daily offers a clear and concise handbook on option trading, but they can be complicated and risky. In a nutshell, buying a put or a call option on a stock requires estimating the price the stock will be at a particular point in the future. Option expirations can be as soon as one week out or as far as two years away.

As with any forecasting, it’s always easier to predict a stock’s movement the longer the time horizon. Ask any analyst if he’d rather estimate what the price of corn or the S&P will be in one year or in two weeks. He’d likely choose the longer time frame, which allows prices to smooth out from any unexpected short term gyrations.

But time is expensive. The further out in the future that the option expires, the higher the price of the option. You can buy options on most stocks that go out at least a year. Some option series go out as much as two years. These longer-term options are called LEAPS and will put a dent in your wallet.

At Profit Catalyst Alert I usually construct my option recommendations tied to specific events. It might be an earnings report, a company meeting or even an earnings report of a customer or a competitor. If I have a firm date in hand and conviction of how a stock will move based on that event, it gives me a framework from which to choose an expiration date and strike price.

Despite the best analysis, an option trade can still go awry. Buy an option that expires too far out in the future and the stock might move too far in the future and the stock can get caught up in the tide of a fast-moving market before the event occurs. Buy an option with a near expiration and the stock just might not move in time. Option traders are constantly tiptoeing on the tightrope of price and expiration.

This earnings season has been a busy one for Profit Catalyst Alert with option recommendations.

Although not every option recommendation has been immediately profitable, I’m taking my cue from prior seasons and being patient. Last year, the majority of the option trades that I closed out were profitable despite many of them being under water at some point. Being patient was handsomely rewarded with those profitable trades gaining more than 100%.

While my team might be down a few points, I’ll be watching every pass and dribble and enjoy having some more time on the clock until those options expire.


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Stock Talk

Richard Hill

Richard Hill

I have been reluctant to invest in Options for Income because if I get assigned early on a put that I have sold, the cost of the assigned stock purchase would far exceed my folio amount. I recall hearing you say that being exercised was an inconvenience only. I would like to know exactly what happens when early assignment occurs.

Thank you,

Richard Hill

Jim Fink

Jim Fink

The cheapest way to trade options is through spreads, where you buy one strike and sell another strike to help finance the purchase.

I recommend option spreads every week in Options for Income and Velocity Trader.

http://www.investingdaily.com/options-for-income/

http://www.investingdaily.com/velocity-trader/

If early assignment of a short put does occur, it is a minor inconvenience that is easily rectified by simply selling the 100 shares of stock per contract that has been assigned and simultaneously selling the remaining lower-strike put you are long (as part of the original spread) since you no longer need it for insurance.

You don’t need the cash to purchase the 100 shares per contract of assigned stock if you sell the assigned stock on the same day you are notified of the early assignment. There is no margin call on an early assignment because your broker knows that your risk is limited to the spread width, so even if you don’t have the money in your account to purchase the 100 shares per contract of assigned stock, your broker will purchase the 100 shares per contract of stock for you and simply require that you sell the stock immediately. This one-day waiver of margin requirements is called “same day substitution

http://www.investopedia.com/terms/s/samedaysubstitution.asp

Your maximum loss is limited to the spread width minus the initial credit received. For example, if you initially sell a 100/95 put spread for $1.00 per share ($100 per contract) and the stock falls to 40, the 100 put you are short would be exercised against you and you would be required to buy the stock at 100. You could either: (1) sell the stock at the current market price and simultaneously sell the 95 put you are long; or (2) exercise the 95 put and sell the stock at the 95 strike price. Maximum loss would be the spread width of $500 per contract [(100-95)* 100 shares per contract] minus the $100 credit per contract received up front when the spread trade was initiated.

This maximum loss of $400 per contract does not change – regardless of the actual price of the stock. The stock could drop to 40, 20, or even zero – it doesn’t matter how low – your loss remains limited to $400 per contract.

Richard Manns

Richard Manns

I don’t understand options even though I read about them. You say you give 2 sentences instructions. What happens after that? I would need someone to ” hold my hand” through the process. Do you follow up with instructions if something else has to be done to maintain or achieve the maximum profit? Does one have to own the stock prior to acting as you advise or what? I have only bought one stock since I got the ok through my financial advisors company and that’s about the only experience I have. Can you give me an example of what you might say in your 2 sentence instructions. Perhaps something from an earlier option.

Rex Finley

Rex Finley

I head a little time before getting into options, but I will.

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