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Save Yourself From a Sharp Correction

By Chris Rowe May 23, 2007 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

First, I'd like to briefly acknowledge that in last Thursday's article titled "The Invaluable Understanding of Delta III" there were a few errors. 

And, of course, this was one of those articles that could actually impact your net worth, BIG TIME.

How the mistakes were made is a long story.  But since having a basic understanding of options and some of their characteristics can seriously save you a few years of life due to reduced blood pressure, ulcers etc., I would strongly recommend that you read the corrected version by clicking here.  If you use the tools that I've been giving you, then you will make more and lose less - period.

Would you like to know what on earth I'm talking about without having to do much work or much studying? 

Fine.  Today, I'll give you the quickest and dirtiest of quick and dirty on simple options trading.

This will be a nice complement to the three-part series on "delta," but like I said, this is the quick and dirty, so you don't even really have to know about delta if you don't have the desire to.  If you just take my word for it, this approach will likely make you more money, with less risk.

Here We Go ...

(PLEASE REMEMBER: The following is a WAY oversimplified way of doing this.  If you understand the mechanics of options,  the calculations, the effect of implied volatility, and the impact that dividends, interest rates, etc. have on options, you will be able to take advantage of options with a higher degree of accuracy.  But these are a few steps that you can follow to get started if you don't want to learn more than what's here.  And again, this approach is still a better approach than outright stock ownership (unless you are looking at a time frame that the options don't provide.)

The following are the 6 steps that you'll want to take to reduce risk and increase your return.  I'll go over them in detail below:

STEP 1: Find the stock, ETF, or Index that you like.

STEP 2: Find call options that expire at least three months after your anticipated holding period.

STEP 3: Find call option that has low extrinsic value (up to 18% of the option's value or less.  This will vary due to volatility of the option.  If the option has higher volatility, the extrinsic may be more.)

STEP 4: Buy one call for every 100 shares that you believe to be the right sized position.  This is personal.  Consider commission costs and bid-ask spreads.

STEP 5: Put the excess cash in a stable, interest-bearing security of your choice.

STEP 6: Sell out of the call option earlier than three months before the expiration day.

NOTE: Most options are very cheap now as reflected in the level of the VIX, down in the low teens.  The VIX only reflects the price of S&P500 options, but it's usually a good indicator of option prices in general.

WARNING: Don't get caught in the leverage trap.  If you get greedy and use options only for leverage instead of in place of stock, then you are not reducing your risk; you're doing the opposite.

Details:

STEP 1: Find a stock, ETF, or Index that you like.

Let's say that you loved Suncor Energy (Symbol: SU) and you thought it was going to trade much much higher over the next three months.

You could buy the stock, of course, but instead, you want to take a position with much less downside.  What do you do?

STEP 2: Find call options that expire at least three months after your anticipated holding period.

Since you know that you want to hold it for three months, you should look for an option that expires in at least six months.  (Remember:  You want to use the option that expires at least three months after your estimated holding period.)

Since we are in May, we count six months out to November.  Since there are no existing November options yet, we go to the December call options.

Assuming Suncor is at $86.71

STEP 3: Find call option that has low extrinsic value (up to 18% of the option's value or less.  This will vary due to volatility of the option.  If the option has higher volatility, the extrinsic may be more.)

We know that Suncor trades at $86.71.  So we immediately look at the call options that give us the right to buy Suncor at a much cheaper price.  These call options are "in-the-money."

We want options with little extrinsic value (up to 18% of option's total value.)  To refresh, the extrinsic value is the price of the option minus the in-the-money amount.  We want low extrinsic value since extrinsic value is the only part of the option's price that erodes due to time passing.

So we look at the December 70 calls which are at $20.10.  To calculate the extrinsic value we first calculate the "intrinsic value", aka "in-the-money" amount, this way:

Stock price $86.71 - Strike price 70 (Dec 70 call) = $16.71 intrinsic value

Then we use that to figure out the "extrinsic value" which is only the remaining value in the option's price:

Option's price $20.10 - $16.71 intrinsic value = $3.39 extrinsic value (the only part of the option that's impacted by time decay.

What percentage of the option's price of $20.10 is extrinsic value of $3.39?

$3.39 / $20.10 = 0.1686 (or 16.86%) 

You can even enter the order as a limit order at a price which is less than the asking price of $20.10 so that the extrinsic portion is even less than that. 

NOTE: You will understand the effect that the movement in Suncor's stock will have on this call option's price if you look at the article "The Invaluable Understanding of Delta III" and check out the first table that I created which shows the options on Cisco Systems.  Look at what happens to the January 20 call when Cisco moves up or down.

STEP 4: Buy one call for every 100 shares that you believe to be the right sized position.  This is personal.  Consider commission costs and bid-ask spreads.

Look at the overall size of your stock portfolio.  How much Suncor would you have bought if you were to buy the stock itself?  Remember, each option contract represents 100 shares, so for every 100 shares of stock that you would have bought, you would purchase one call option.  If you would normally buy 400 shares of stock, you should buy four December 70 call options.

STEP 5:
Put the excess cash in a stable, interest-bearing security of your choice.

Now, 400 shares of Suncor would have cost you $34,684.00.  But four December 70 call options would cost you $8,040.00 (plus trading fees.)  So, now that you have a position in Suncor, you should take the remaining $26,644.00 and stick it in an interest bearing account or security.

STEP 6: Be sure to sell out of the call option earlier than three months before the expiration day.

That's it!

Following Step 6 gives you less risk exposure.  If you want to know why this gives you less risk exposure, you can look at the corrected version of "The Invaluable Understanding of Delta Part III" (by clicking on it.)

IMPORTANT NOTE/REITERATION: This is just a way to reduce risk.  If the stock moves lower, the call option would move down less than the stock would.  But one of the other ways that it reduces risk is that you can only lose what you've committed to the option.  Therefore, if Suncor drops by 40 points, for example, your call can only lose the $20.10 that you put up.  But...  A great way to lose all of your money is by using all of the money that you have committed to your long stock positions to buy call options.

That would be crazy because the market can tank at any time.  Don't get all crazy when you discover the power of leverage, because, just as it can make you more money, it can destroy your portfolio just as fast, if not faster.  It's always smart to keep some money on the side, in cash, or in stable interest-bearing securities, in case of a steep market decline. 

It's also smart, if the market is trending higher, to take mostly bullish positions, but to also take some bearish positions (like put options) in stocks that are in weak sectors showing little strength relative to the market.  This will help if the market drops.  The opposite is true if the market is tanking (take more bearish positions, but keep some bullish positions in stocks that are in sectors that are strong.)

I hope this helps!  Now, go reduce your risk!

If this helps you, then let me know by clicking the link below.

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