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Read This, and Never Trade Stocks/ETFs Again! (Delta, Part 5)

By Chris Rowe August 17, 2009 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

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Dear Mr. Rowe,

"Just like your other reader, you saved my financial life -- free of charge.  And I have the last guy beat because I have 8 offspring!  Thanks for making me understand delta (which you did from 2006-'07).  My account is quite a bit smaller than the last guy, as I've been investing in stocks for only 4 years.  But I will say that, from 2006, I increased my account to over $120,000 from $30,000."

Dala W.
Portsmouth, Minn.

Happy Tuesday, Tycoons!

If you want to see results like Dala (above), without taking a huge risk to see those results, then you've got to take some time to read this.  IT'S MORE THAN WORTH IT!

After our readers realize that they would almost be foolish if they ever traded stocks/Exchange-Traded Funds again (instead of positioning themselves CORRECTLY in the right option, using the right amount of money), the most commonly asked question is:

"Out of the numerous options contracts listed on any given stock/ETF, how do we know which is the right one to buy?"

Answer:  There is a quick answer, but there are caveats that go with the answer, and I plan on explaining them all over time. 

Why do I harp on this topic?

When I read e-mails like the one above, it strengthens my drive to try to get all Tycoon readers in that same boat (minus the eight kids -- ha ha, just kidding).  But to make your life very easy, and much more profitable (always a wonderful combination), I am in the process of building a tool that I will soon offer you -- FOR FREE -- that will make in incredibly easy to find the right option to use in place of stocks/ETFs. 

You won't even have to understand options pricing to participate.  It should be available within the next few weeks, so keep on reading Tuesday's Tycoon Report.

In the meantime...

How Can Delta Make You Millions?

Why am I sharing my favorite way to trade? Because there is more than enough room in the options markets for everyone to profit.

You would probably find out about delta another way; I want to make sure you have a thorough understanding of the power you have to take charge of your portfolio and preserve the wealth you have, and make much more, the right way.

My Promise:  Studying my series on delta (be sure to review Part 1, Part 2, Part 3 and Part 4), and following the simple steps I describe will...
1.  Change your investment life dramatically where you know how to position yourself to lose MUCH less when you're wrong and make much more when you're right

2.  Give you an edge over more than 90% of individual investors.

3.  Make you feel like thanking me over and over again for harping on the importance of the understanding of delta

4.  Make you understand why you should be trading options much more than stocks/ETFs, if not exclusively.

The Goal of Today's Article:
  Show you how to lock in the profits that you make, when the stock/ETF moves in the right direction, without exiting the position!

Let the Games Begin!

During the last several weeks, I have been showing readers of The Tycoon Report why it typically doesn't make sense to trade any stock or ETF if they can trade the stock option or ETF option instead.  Using options, you can take just a fraction of the risk while being in the position to make the same (or much larger) reward.  

Without knowing much about options, you can still position yourself so you'll MAKE MORE when your stock/ETF moves in the right direction by 10 points (etc.) THAN YOU WOULD LOSE if the stock/ETF moves in the wrong direction by 10 points (etc.).  

You are taking unnecessary risk with stocks/ETFs because, with a 10-point move on 1,000 shares (for example), you'd make $10,000 when you're right, and lose $10,000 when you're wrong. 

But if you trade the way I always suggest, you'd make more like $11,500-$12,000 when you're right, and lose more like $8,500-$9,000 when wrong.

The key that unlocks the door to positioning yourself with the risk/reward ratio that you once thought only institutional traders are offered can be found in the Options Pricing Model, which has several variables called "the Greeks."  And the first place to start, in understanding how options pricing works, is with the options' "delta."

Just to refresh, delta is the ratio comparing the change in the price of the underlying asset (such as a stock or ETF) to the corresponding change in the price of an option contract. For example, an option contract that has a delta of 0.65 should (theoretically) advance or decline by 65 cents if the stock moved up or down by 1 point.

We have been talking about it, not so much as a tool or a calculation, but more as a concept.  We don't have to get into a deep discussion about the actual deltas of the options that I use as examples because the goal is for you to have a clear understanding of the reasons option prices change the way that they do

Besides, pretty soon I'm going to just give you the tool that automatically tells you which option gives you that kind of advantage -- all you'll have to do is punch in the stock symbols.  

We're going to keep this very simple today.

Making Profits Starts With Keeping the Money You Already Have

Today you'll learn how to LOCK IN the profits that you'll have on the table when you find yourself in a winning trade that you're not ready to exit ... and I'll show you how that relates to the option's delta.

It's simple, really.  If you own an in-the-money call option (which is a bullish stock-replacement strategy) and the stock advances, then your call option should advance. 

When that happens, you can lock in the profits you have on the table (because the price of the call option increased) by exiting the call option that you own and buying a different call option, on the same stock, but with a higher strike price. 

Here's the Basic Idea...

With Apple (AAPL) trading at $161, let me take you through the process of vetting its options as potential trades based on their delta. (Note that this is for example purposes only.)

The Jan 140 Call (which is 21 points in-the-money and has a delta of 0.75) is trading at $28.  That means that this $28 call option has 21 points of intrinsic value, and 7 points of extrinsic value ($21 plus $7 = $28). 

Since it's trading at $28, you know $28 is the absolute most that you can lose -- even if Apple declines by $100.  So basically, the most we can lose is 17.4% of the entire value of Apple's stock. (17.4% of $161 is $28.)

If Apple advances 18.6% from $161 to $191 within a month, the call option will probably advance from $28 to $53.  That means the call option that was 21 points in-the-money is now 50 points in-the money. And when an option moves deeper in-the-money, as it did in this example, the delta increases.  The delta in this case would increase from 0.75 to about 0.95.

Since our Jan 140 Call would be trading at $53 after Apple's advance, you know $53 is then the absolute most that you can lose -- even if Apple declines by $191. 

But why risk the entire $53?  I would rather only have only $28 at risk, as we originally did.       

The stock may possibly decline, causing your $53 call to trade down to $40, giving back about HALF of the profit you had at $53.  The stock could decline even more, sending the call option to $27 -- giving back ALL of your profit plus a point. Or even worse, the stock could decline even more, causing you to see a large LOSS on the call option!

So Here's What You Should Do Instead...

Again, originally, before the stock advanced, the call option you bought was only 21 points in-the-money (with a delta of 0.75).  Now it's up, and 51 points in-the-money (with a delta of 0.95).

You should then sell out of your Jan 140 Calls at $53, and then buy the same number of option contracts of either the January or February calls that are about 21 points in-the-money.

I say "or February" because we are assuming 30 days have passed and, therefore, you would start out with the same amount of time till expiration you originally had if you buy February calls.  Since February calls don't currently exist yet for AAPL, we will use the Jan 170 Calls as our example, but you get the point.

After Apple trades up to $191, causing your call to trade from $28 to $53, you would exit (sell to close) your call option (locking in the profit you have) and then buy the same number of option contracts in options that have a higher strike price -- the Jan 170 Calls, which are, once again, 21 points in-the-money and which would be trading at about $28.  

So, what we did here was we sold out of something for $53, and bought something for $28, thus locking in our profit of $25! 

We can put that $25 per option contract and leave it sitting in cash.  If we are trading 10 call options, that's $25,000 that nobody can ever take away from us

We're also repeating the process, (hopefully) allowing us to stay in the game for another advance, and also taking some money off of the table!

Remember, we originally bought the Jan 140 Call options that were 21 points in-the-money. But after the stock moved from $161 to $191, the options became 51 points in-the-money (51 points above our $140 strike price).

Originally, the option chain looked something like this:

With Apple @ $161 TODAY...

January 140 Calls:  $28 (Delta is 0.75)
January 150 Calls:  $21.50 (Delta is 0.66)
January 160 Calls:  $16.30 (Delta is 0.56)
January 170 Calls:  $12.20 (Delta is 0.46)

Now the option chain looks like this:

With Apple @ $191, 30 days later...

January 140 Calls:  $53 (Delta is 0.95)
January 150 Calls:  $43.10 (Delta is 0.90)
January 160 Calls:  $34.90 (Delta is 0.84)
January 170 Calls:  $28 (Delta is 0.75)

If the stock advances, that would cause the call option to go deeper and deeper in-the-money.  And, as we discussed in earlier parts to this series on delta, the deeper in-the-money an option is, the higher the delta will be.  

We don't have to know what the delta actually is yet.  Remember, I am creating a tool, free to Tycoon readers, that will show you exactly which options you should consider trading.  Let's just say, for the sake of this article, that you want to be sure the extrinsic value is between 10% and 20% of the entire value of the option when you buy it.  

Using Delta Shouldn't be 'Option'al

If you read this and you still aren't convinced that it's absolutely insane in almost all cases to own stocks or ETFs when you can just trade the options instead, you haven't really grasped this yet.

If you are convinced, then you are on the road to making profits in the stock market that you once thought were unheard-of.

Either way, you're in luck because there's more to come.  You WILL grasp this, you WILL increase your profit potential and, if you want to, you WILL use your knowledge of delta as the foundation of your understanding of options pricing -- thus, you can learn more-advanced strategies. 

It's OK to be a beginner.  It's not OK to be ignorant.  This is your hard-earned money we are talking about.

One Last Note on Our AAPL Example...

You may have noticed that when the stock traded up 30 points, the call only traded up by $25.  So, if you bought 10 call options to replace 1,000 shares of stock, then you would make $25,000 instead of $30,000 on that move. 

If you guessed that I have even more to cover on this topic, you're right!

Tune in this coming Tuesday, and I will show you how to position yourself to make MORE than the stock/ETF trader or lose LESS than the stock or ETF trader.