Monthly Archives: November 2013

Vertical Spreads – Options Trading Video 5 part 1

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In the last video, I showed you what happens when you buy an in the money call. In our case, we’re buying the July $48 strike price calls. On June 16, we bought the Julys that had 29 days left in its expiration. We had a profit of $509, as you can see down here, in the right-hand corner.

Now, what I want to do is look at the example of taking an at the money option, and see what the difference in both the percentage gain, and the dollar gain that we would experience, as the market rose. Remember, we were looking at the QQQs. We were looking specifically at a range of prices that we saw, that the market was ready to turn around.

There’s a little rally here, that the QQQs experienced. If we go back, we want to take a look at the at the money options and see how they differ, when you purchase an at the money option rather than an in the money option. When we were doing the in the money option, we wanted a Delta of at least 88 to 90. 91 or 92, at the most. That’s where I like to stay. Number one is that you don’t want to pay for more Delta, when you’re very close to one anyway. If you get an 88, or a 91, it’s very close to the 100 Delta. You don’t want to pay more than you have to, in order to get that type of Delta.

Now, we’re going to be looking at the at the money option, which is the 55. It has a Delta of 38. That means, for every dollar that the QQQs rise, this option will gain 38 cents. Since each option represents the right to buy 100 shares of the stock, the underlying ETF, it would rise $38, for every dollar that the QQQs rise. That’s how you would calculate. You calculate the 38 times one times 100. The one is the number of option contracts that you have, and the 100 is the number of shares that you can actually purchase with each contract.

We’re going to go ahead and purchase that. It gives us the price here. We’re using the Think Back section of the Think or Swim platform. What it allows you to do is go by date, whatever date you put into it, to determine how well your strategy would have worked in the past.

That’s exactly what we’re doing. Now we know that, in the chart, we had a low here, on June 16. Then, we rallied. With great hindsight, we are trying to profit from that. We have a price of 77 cents, which is the split between the bid and the ask. The bid is 75. The ask is 79 cents. Instead of going through every single day, we’re going to go straight through to our ending trade date, which is July 7, and see how well we did.

We know that July 7 was a temporary halt to that rally that we noticed. We have a profit of $357. It’s not as good, in total dollar terms, as the $509 profit that we had when we purchased the in the money call. However, on a percentage basis, since our original price was only 77 cents, that represents a much higher percentage gain, than the one that we purchased in the money. In fact, it’s over a 500-point percentage gain, on that particular option.

It was just over a 250% gain, on the option that we bought, that was in the money. It only cost us $77, and it returned a profit of $357. It’s a fairly good trade. However, there’s one thing that we had in our favor, and that was hindsight. We knew that the market was going to rally strongly and very sharply. That’s the only time that an at the money option would actually profit, if there’s a very strong move coming.

If we didn’t have a very strong move, and we just moved sideways, or we moved down a little bit, that option would have expired nearly worthless. It would have eroded over time, losing money on a daily basis. Keep that in mind. Whereas the in the money option eventually would have lost less value, if the market just went sideways, or up slightly.

In fact, if it just went up a little bit at a time, rather than a roaring rally, you would have maintained its value, and maybe even made a small profit on it.

Let’s look at purchasing an in the money put. Let’s see what would happen if, in fact, you purchased a put, thinking wrongly that the market was going to go down, instead of up. Let’s see how much money we would have lost.

I like to purchase in the money options with a Delta between 85 to 92. In this case, we’re probably looking at a purchase of the $58 puts. We’ll go ahead and purchase one of those. It split the bid and ask again. Many times, you can get the split in the bid and ask. If it’s bidding $4.05, and it’s asking $4.17, sometimes you can put it right in the middle.

The Think or Swim platform, with this Think Back facility, automatically splits the bid for you. Sometimes, in a fast-moving market, it’s almost impossible to get that split. You can try it. You might even go after the bid, actually, when you first start to put in your bids. We’ll talk more about trading strategies, and exactly how to enter orders, in a later video.

Now, we bought the put. We know that there’s a strong rally. We bought it at the same time. We thought the market was going to continue lower. Instead, it roared higher. Let’s see what happens. We’re going to go straight to our termination date, on our trade. You can see that we lost $393.53.

Being in the money, we definitely lost money, about $400. We were wrong. The market roared higher. That’s pretty much our maximum loss. We would have had to sit through this entire rally, all the way up to July 7, which is this minor top here. If you were losing money on this trade, you probably would have set a stop loss someplace around here. This would be June 27.

Remember, in a good trading strategy, the number one rule is preservation of capital. If the market starts to prove that you’re wrong, it’s a good idea to set a stop loss someplace, to get out. In this case, we probably would have set the stop loss on June 27, when it rose above that minor high. If we go to June 27, a more realistic loss point is $132.50, for an in the money option.

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