Doc Maher continues his series with a put trade.
You see a short term set-up in a high-priced stock where you have identified a trend. You want to capture the movement of the stock, but its price is more than you want to spend on one trade. You can still capitalize on this opportunity by swing trading with options. Options provide leverage, which is a way to use a smaller amount of money to control a much more expensive asset. In the following post, I will show how to leverage OTM puts to control a very expensive stock - Google.
THE PLAY - Long Put
TRADE FORMATION
On July 9, the following scenario occurred in GOOG stock:
Open: $550.76
High: $555.68
Low: $540.73
Close: $541.55
Most recent swing high: $555.19 (July 8)
Most recent swing low: $515.09 (June 27)
Pertinent information: Earnings after market close (July 17)
ACTION POINTS
Strike A: Buy to open 10 GOOG August 520 puts at $17.50
Stock at potential entry: GOOG near $540
Day to enter: July 10th if below July 9th low
Profit point using option price: $35.00 (double cost)
Profit point using stock price: $515.09 (recent swing low)
Stop-loss using option price: $12.50 bid
Stop-loss using stock price: $556 or higher
Stop using time: July 17 before market close
Time duration of trade: Up to 7 days
REWARD-TO-RISK RATIOS
Target gain using option price: $35.00 - $17.50 = $17.50 per contract
Loss limit using option price: $17.50 - $12.50 = $5.00 per contract
Reward-to-risk ratio on option price: $17.50 / $5 = 3.5
Stock movement target: $540 - $515 = $25
Stock movement stop: $556 - $540 = $16
Reward-to-risk ratio on stock movement: $25 / $16 = 1.5
Maximum gain: $502.50 per contract per share (Strike A - debit)
Maximum loss: debit paid of $17.50 per contract per share
Break-even point at expiration: GOOG = $502.50 (Strike A - debit)
Click here for a larger GOOG chart.
ALL-STAR COMMENTARY
Above is a chart of Google on July 9, 2008. As we can see there is a downtrend in place and a bear-rally. For more on bear-rallies, please read Frustrated by Getting Stopped Out. In this post I will be using the same techniques described in Swing Trading with Stocks. These guidelines would have me enter only if GOOG breaks below the July 9th candle, around $540. I would then set my stop at the swing high ($556) and use the last swing low ($515) as my target. These stock points give me a reward-to-risk ratio of 1.5 (see Trade Formation). This is not the 2:1 ratio that I like to have for stock trades; however it should serve as a good example anyway.
When it comes to swing trading with options there are additional choices to make. Do I buy shorter or longer term? Do I buy in-the-money (ITM) or out-of-the-money (OTM)? The answers depend on how much leverage I want to employ and how much risk I want to take. In general if there is more leverage, there is more risk. I think an example will help illustrate.
All long options (options you own) provide leverage because they allow you to use a small amount of money to control a stock which is typically much more expensive. Deeper ITM options provide less of this leverage; further OTM options provide more. Today I'm going to look at the higher-leverage, higher-risk approach - an OTM option. I am going to select the 520 strike put. At the end of the day on July 9 the bid-ask was $18.75-$19.50. (The delta was probably around 0.30Δ.)
As noted in my earlier posts, a swing trade generally last two to six days, however it may last longer. If I focus on the six day idea it is clear that a six month option provides too much time. In this particular case GOOG announced its earnings on July 17 after the bell. Since I wouldn't want to hold this position through earnings, I would treat July 17 as a hard time-stop. If things go as planned I would enter on July 10 and the trade would last a maximum of seven days. July options will expire on July 18, but this term is too short a time frame even for me. So I'm going to look at August expiration options.
I intend to buy this August 520 put on July 10 if GOOG falls below $540. If I am watching the stock this is not going to be a problem, however I may want to go do something else, like go to work. To accomplish this without being in front of my screen all day I need to use an advanced order called a "contingent order". Contingent orders are found under the "Advanced Orders" pull down menu on the TradeKing trading pages. This allows me to place an order "contingent" on the price of the stock. Below is what it would look like if I were placing this order today.
Click here for a larger order entry screen.
The top part is the order to buy the put (GOP TV) and the bottom part is where I enter the contingent parameters. In this case I have used a market order. If I used a limit order, I may not have gotten filled. Before I place this order, I need a plan for this trade so I'll know how to manage it.
Plan for GOOG Swing Trade:
Entry Buy 10 GOOG August 520 puts at market if stock goes below $540.
Expected cost approximately $19.80 per contract per share.
Exit for profit
Option target: If the option price doubles I'll sell half of the position.
Stock target: If GOOG goes below $515 I'll sell half of the option position.
Note: I usually place a limit order for the option price only. At the end of the day if I see that my stock target has been hit and the option target hasn't, I will manually enter an order to sell half of the contracts the next morning.
Exit for loss
Option stop: If the option price drops by $5.00 I will exit the trade.
Stock stop: If GOOG stock goes higher than $556 I will exit the trade.
Time stop: I must be out of this trade before the market closes on July 17.
Note: I usually place a stop order for the option price only. I will manage the stock price stop manually. You may also combine the option limit order and the option stop order by using an advanced order - One Cancels Other (OCO).
Click here for a larger image for trade entry.
Now that I have my plan in place, above is a chart of what happened the next day. GOOG went below $540 around 14:15. According to the bid-ask prices, my market order would have been executed at $17.50. By the end of the day the bid-ask was $18.30-$18.90. The high market for the day was $21.30-$21.75. My plan is to move the stops as GOOG drops, probably just keeping the $5 loss as a trailing stop. I will also place a limit order to sell five of the puts if the put price reaches $35.00, because this would be double my cost.
Click here for a larger image.
Above is a chart of GOOG on July 15. On this day the bid-ask went as high as $38.50-$39.25. Five of my puts would have been sold at $35.00 due to my limit order. By the end of the day, the bid-ask was $30.00-$30.50. The stock target was also hit, but since I already sold half using my option order I will ignore it. I would now move my option price stop from $12.50 to $25.00.
Click here for a larger image of trade exit.
On July 16 (above) I would have been stopped out and sold my remaining five puts for $25.00. To calculate potential return on investment (ROI): I hypothetically bought ten contracts for $17.50. I would have sold five at $35.00, and another five at $25.00. My average selling price would be $30.00, resulting in a profit of $12.50 per contract per share. Profit divided by cost gives me 71% ROI in four days before commissions. If I had selected an ITM put, the total dollar profit would have been higher but the ROI would have been lower.
I know this looks very good but in this case everything cooperated and I had a very short time horizon. Buying short term OTM options is risky because the chance of losing one's total investment is high. Buying more ITM and longer term options reduces this risk. So don't think I'm advocating that everyone go out and start buying short term OTM options. As they say "your mileage may vary."
I say that this was higher-risk trade because I had an original stop at $5, which was 28% of the initial cost. If GOOG had gapped up I might have lost even more. The only thing that made this worth while was that I had a plan and I knew where my exits were.
If I get the opportunity I'll show you an ITM option case.
"Income Trader"
Did you enjoy this blog? If YES, please click "GOOD POST" at the top of the page.
Doc's previous posts: Trader or Investor and Throwing Good Money After Bad
For a list of previous All-Star Trades, please click here.
Nicole Wachs contributed to this post.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.The theoretical return for this trade is not actual and does not guarantee future results.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
