What Is Option Trading – Option Trading Strategies Video 29 part 3

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I don’t pay attention to fundamentals, as much as I do the charts. I just want a stock that’s going to move. Generally, what they do with the Investors’ Business Daily is, they rate the stocks, 1-100, on the IBD 100, and 1-20 on the IBD Big Cap 20.

When you pick up a copy of the Investors’ Business Daily, you’ll see exactly what I mean. On Tuesday, they come out with their IBD Big Cap 20. For the issue that I have in front of me, Research and Motion, RMM, is the top stock right now, in the IBD 20.

RMM has a tremendous number of options. They’re highly liquid. They do have wider bid-ask spreads, but that has more to do with the volatility of the stock than anything. The volatility is pretty big on RMM. You can see the July options have an average implied volatility of 58.24%. If we take a look at their chart, you can see that this stock has quite a bit of volatility. It does move around quite a bit, which is something that we’re looking for in a stock.

However, it’s also pretty expensive. It’s $132. If I were looking for a stock to invest in at the beginning, I would take a look through the list. Let’s say I wanted to have a little bit of a lower opportunity, and a lower risk. I might look at something – the #8 stock on the IBD list that I’m looking at is NXY, Nexen. Generally, the stock has a nice uptrend to it. It’s paused a little bit up here. But if it’s still on the IBD 20, it could have some upside potential to it.

That might be a good candidate. If we take a look, we want to make sure that they have some options on it – the average daily volume on this is approximately 1.9 million shares, so that’s pretty good. The problem here is the bid-ask spread on the 40s. Let’s say we wanted to purchase this stock with a covered position. We buy the stock, and we buy the $40 puts. We’re talking about close to a 30-cent spread on these puts.

With a 48% volatility, it’s a little bit more expensive. Let’s say we wanted to buy 100 shares. Let’s go ahead and analyze that. We have a maximum of risk of $226 on that. It’s not too bad. Of course, we have the unlimited upside potential, which is nice.

However, you can do it a different way. Let’s say you find a stock in the IBD 100, and in some cases, they don’t have options. Or, the bid-ask spread on the options is too large for your comfort. In other words, you’re paying a 30-cent spread here. It’s not too much of a problem if you’re going to hold the trade for quite a while – if you’re going to hold it until at least July expiration, which is fine.

In some cases, you might find a stock that is traded, that either doesn’t have options on it, or has too large of a bid-ask spread. What do you do? Are you locked out of those kinds of trades?

Not necessarily. We’re taking a look at Investors’ Business Daily. I’ve gone through the IBD 100. I’ve gone through the IBD 20. I haven’t really found anything. Investors’ Business Daily also has a couple of sections in their newspaper, which can give you some ideas for stocks that you might like to purchase. That is the NYS, Stocks in the News, and the NASDAQ’s Stocks in the News.

I look at both of those as well. They highlight stocks that are up and coming. There are plenty of ideas in the Investors’ Business Daily. You don’t have to use the IBD 100, or the IBD 20. The NASDAQ’s Stocks in the News has some really interesting charts for some stocks there, that may do very well.

I pull up one of the stocks that I’m interested in, and it’s Almost Family Inc, which is AFAM. As you can tell, there are no options for this stock. Are we stuck? That’s the question.

Let’s say you wanted to buy some shares of AFAM. You really think this stock has absolutely wonderful potential over the long term. It’s coming up against the resistance point here, which it’s going to bump up against, a couple of times. You feel like it’s going to break out to the upside. You would really like to buy some of these shares.

I wouldn’t recommend it, because the average daily volume on this stock is pretty low. It’s less than 20,000 shares – maybe 60,000 shares a day. That may eliminate this kind stock. What you’re really looking for is a stock like… Another one that looks like it has a little bit better daily volume is called Psychiatric Solutions, PSYS.

It doesn’t meet my criteria of a million shares a day, but it has had a couple of days in which it got over a million shares. If we take a little closer look at this, it’s only trading 147,000 shares today. It’s been up around anywhere between 700,000 and 500,000 shares. There were a couple of days where it hit a million. It’s starting to grow in popularity, and you want to get in early on this.

The problem, of course, is that the options are probably extremely thinly traded. Let’s take a quick look at that. Yeah. They’re pretty thin. There are only three strike prices, and they’re $5 apart. You have 20 cent bid-ask spreads. If I took a look at the volume in open interest, they have 39 on the July options. There are only 39. That’s the total open interest for these options.

The puts only have an open interest of 15 contracts. That’s pretty thin. Even though you like the stock, the number of shares being traded every single day isn’t huge. You feel that it has some potential. I’ve drawn a little flag pattern here, so it looks like it’s a continuation pattern that may actually move the stock up a little bit higher.

You really want to get into this stock. What do you do? How do you protect yourself? What you can do is go ahead and click on the “Buy.” Let’s say you only wanted to buy 100 shares to open, just to get your feet wet in this stock, and begin to have some sort of potential for the stock itself to determine whether or not it’s going to move. How do you protect yourself in this stock?

Let’s say we have 100 shares. Let’s just say, for example, that we want to buy 100 shares. The options are not particularly attractive, because they’re really not very active. The open interest is only $15 on these $35 put contracts. There are only 2 contracts outstanding open interest on these July 40s. Also, they’re pretty expensive, and the bid-ask spread is pretty wide. What would we do here?

Let’s take this over to our Analyze tab. Here we are with 100 shares of our stock, at $36.81. How do we protect our downside, if the options are not particularly attractive on the stock, but we do want to own the stock? We’re going to take a look at our Delta. Our Delta is actually 100, because on a stock, a stock will move point-for-point, up or down, with price changes in the stocks. Our Delta is always 100 on stocks.

What we can do is go up here. What we’re going to do is switch from a single symbol to a “Portfolio, beta-weighted.” Remember this from our previous lessons, of trying to determine the true Delta of our portfolio, based on the beta-weighted positions of our portfolio? We’re going to do the same thing for this type of trade.

What we would like to do is say, “Hey, I have 100 shares of the stock. I would like to be able to protect it from any downside risk. In order to do that, I need to get Delta-neutral, or as close to Delta-neutral as I possibly can.” In order to do that, what I would like to do is pick an index that we can use in order to hedge this stock position.

When we pick an index, we obviously want the most liquid index that we can possibly find. Preferably, we would like to find an index that has penny-wide spreads, and also maybe $1 strikes between them.

That’s why I like the QQQs.

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