Options Implied Volatility – Option Trading Strategies Video 31 part 1

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Hello, tradeologists. I want to welcome you to this really special video that I’m doing. I think you’re going to be super excited about this, because it’s a way that you can set and forget your trades. It’s really interesting. There is some tweaking to do as things progress in the trade, but still, these are the kind of trades that you can put on and forget about, until something triggers.

I think you’re really going to be excited about this. What this does – and the main objective of this kind of trade – is to totally limit your risk. I mean, really limit your risk. I’m not talking about limiting your risk to losing maybe a few hundred dollars. I’m talking about limiting your risk to maybe $10 or $20, $40 or $50 at the most, and then having totally clear upside potential. It could be into the thousands of dollars.

There’s absolutely no limit to the upside potential of these kind of trades. When you start to put together a portfolio of these kind of trades, you’re going to see a really dynamic and interesting effect on your portfolio. That’s what we’re going to take a look at today. This is a trade that doesn’t seem particularly intuitive. It’s not something that you just think about and say, “Oh, this sounds like a good trade.”

It does help mitigate your risk. The downside risk is almost minimal. In fact, you could even make money on the downside. In some cases, if you scour through enough stocks, you can put these on so that you make money whether the stock goes up or down. Our primary goal is to have an unlimited upside potential on these kinds of trades. This means that you can make anywhere from $20 to $100, $500, $1000, $4000, $10,000. The upside limit is unlimited.

On the downside, if you happen to get it wrong, the risk is minimal. In fact, you could even make money if it goes down. This is a very simple trade to put on. It’s very quick to get filled on these. You don’t have to mess around with mid-prices. Generally, you’re just putting in market orders – limit orders, basically.

I’m going to show you how I do it, because I’m actually going to put a trade on live, right now. This works best with stocks that are in the news all the time. I’ve been looking at Yahoo, and we’ll talk a little bit about Yahoo. If you watch CNBC, or you watch some of the other financial news channels, one or two stocks generally are highlighted in a particular day for some kind of news, like a takeover, a buyout, or something. There’s something in the news about these particular stocks.

You know what? A lot of times, the stock won’t move right away. You’ll feel like the news is starting to build up. Maybe you’ll start to hear about it every single day, or maybe a couple of times a week for a couple of weeks. You’ll feel like, “I wish there was a way to play that kind of stock, and really have the unlimited upside potential of that stock, but not get hurt if it goes the wrong way, or if the deal doesn’t go through?”

This is a way to play these. I wouldn’t suggest using this, necessarily, on just any stock that you want. As you see, I’m building a portfolio of these kinds of trades. The risk is really quite minimal on them, but there are a couple of risks specifically to this type of trade, that we’re going to talk about as we go along here.

As I mentioned, I’m looking at Yahoo stock. There’s lots of trades that you can make, obviously. You can go ahead, if you think the stock is going to be a takeover target, and you think someone is going to buy Yahoo – basically, what happened in February of this year – and you can see that Yahoo is trading down here at around the $19 level.

I’ll just put a little oval around this. It’s trading down here around $19. News came out that Microsoft was interested in buying Yahoo. What happened to the stock? It went from $19 up to $28.50, the very next day. We had this huge move up.

But you know what? In the news, there was actually quite a bit of information about a potential takeover target, Yahoo as a particular takeover target… They weren’t quite sure. They didn’t have a vision. They didn’t have a business model. They had revenue, they had cash, but the CEO of Yahoo wasn’t taking it in the right direction. There was no clear vision for the company.

There were rumors of a potential takeover of Yahoo, so you could have played that alone, and just got into some position. But what do you do? When you get a news story like that, or a rumor like that, sometimes they pan out, and sometimes they don’t pan out.

In this case, Yahoo was trading at about $19. In the very next day, when Microsoft came out with the news that they were interested in purchasing Yahoo, it jumped up to $28. It traded as high as a little bit over $30 here, and then, as negotiations continued and continued. Finally, there was quite a bit of disappointment when Microsoft started backing out of the deal, and saying that maybe they were not that interested in Yahoo after all.

The stock just tanked. Now we’re back down to about $21.50. This is July 2nd of 2008. The Wall Street Journal’s headline news was that Yahoo could be taken over by a number of different players. There’s more takeover news, related information about Yahoo, and you feel like, “Something could happen here. What if they get a takeout offer of around $32, $33, or $34, which is close to the high of October of last year? That’s a $13 to $14 move. How can I play that?”

This type of trade that I’m going to show you really helps to answer that question for you. The goal, of course, is to limit your risk. If the trade doesn’t work out… A lot of times, when investors are disappointed in the fact that nothing is going to work out, and nobody is going to take over Yahoo, they’re going to sell the stock off. The stock is going to be in the dump.

You have to think about, “How do I have unlimited upside potential, but at the same time, limit my downside risk?” That’s the key.

Let’s take a look at what a traditional strategy might be. Number one, obviously, is to buy the stock. Well, to buy the stock right now at $21.53, you have unlimited upside potential, to be sure, but you also have some downside risk here. It’s not unlimited downside risk, because obviously, Yahoo can’t go below 0, but it could go to 0, and you would lose your entire investment.

There are ways in which you can limit your risk. Let’s take a look at this, just for a second. Let’s take a look at Yahoo. We’ll go ahead and open up – we’re going to click on the asking price, here. I’m in my Think or Swim trading platform. I have my limit set up to $500 per shares of anything that I purchase.

You can set it, of course. You can by 50 shares, 100 shares, 5000 shares, it doesn’t matter. Let’s go ahead and analyze exactly what our risk is here. We’ll go over to our Analyze tab.

I only want 500 shares. 500 shares of Yahoo stock right now, at $21.47, gives you unlimited upside potential. If the stock does go up to $30, which a lot of people are saying is probably the takeout price, if somebody did come in and offer shares for Yahoo, and make a good offer on Yahoo stock. Your upside potential is about $4200 for 500 shares.

Let’s say we don’t want to go that high. We only want to buy 100 shares. 30 will give you about $900 in profit, if it gets taken over at $30 a share. The problem, of course, is that if the stock goes down, you could easily lose 900,000 – in fact, your entire investment, if it goes down to 0, or $1795.

Obviously, you have unlimited upside potential. The problem is that you have nearly unlimited downside risk of your entire investment.

Let’s go back to the Trade tab here.

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