Option Spreads – Option Trading Strategies Video 31 part 3

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Let’s go back to our Trade tab. We’ve gone through a couple of different scenarios. What I want to do now is just set this trade up for you, and then talk about the entrance and other kinds of criteria.

Basically, what you do is you start with the front month option. In this case, we’re in July. I want to make it clear too that this is an option strategy. It could turn into a stock strategy, but right now, it starts out as an options strategy. You have to be comfortable with options, to begin with.

If you’re watching this video, I’m guessing that you’re probably already somewhat familiar with options. If you’re not, there are plenty of good resources out there to help you get familiar with what options are.

Basically, options are simply financial instruments that you can buy or sell, around a particular issue of stock. It helps you manage risk. Some people use them for speculation purposes. If they think a stock is going to go up a lot, they will buy a cheap call. They’ll buy some puts, if they think it’s going down.

They are basically hedging and risk management financial tools. What we would like to do – and it’s very simple to get this thing started – I’m in my Think or Swim platform. What I do is I set up my advanced order, way down here at the bottom, to “First triggers sequence.”

What I want to do is be able to go out into a far month, generally a time period in which I think news is going to break on the particular stock that I’m targeting. In the case of Yahoo, if you take a look at the time period between February and July, February was the month in which the news came out. Now we’re in July, and some more news has come out about that. It’s about five months, because we’re still in the beginning of July, here.

If I can go out another five months, that will probably give me the time that I need in order to determine whether or not this is going to be a viable strategy, and whether Yahoo will get an offer for their stock. If I go out July, August, September, October, November would be ideal. But we don’t have November. We have October, and then we have January.

I’m not so sure I would like to go out as far as January. I’m going to start with October. What I want to do is a basic strategy of buying some calls that straddle the current price, just a little above the current price. The current price is $21.89. I’m going to go ahead…

Let’s say I want to buy the $25 calls, which is just a little bit above. I could have gone with the $22.50s, but I’m a cheapskate, so I want to buy a little bit less expensive calls. I’m going to go with the $25, which is just about $4 above the current price.

I think that $30 or higher is probably going to be the offer that is made on Yahoo, if somebody makes an offer. This is not a recommendation to buy Yahoo stock, or to do anything with Yahoo whatsoever. This is only for illustration purposes.

There are lots of stocks out there that are in the news. Lots of talk, lots of rumors. This is the kind of thing that you can put on any of those kinds of stocks, if you can find the favorable conditions. This is what we’re going to talk about right now.

I have the October 25 call here. Because it is a back ratio spread – technically, you can say it’s a back ratio spread. I tweak it a little bit, and you’ll see how I do that, in just a few minutes. I like to buy a longer-dated option. In October, in this case, we’re going to go a little bit above the price of the stock, about $25. We’re going to start out with at least 3 of these, right now.

Then what I like to do is go back and do something that’s counterintuitive. That is to sell an in the money call. I know what you’re thinking – you’re probably thinking, “Wow, you’re going to sell an in the money call.” If you know anything about options at all, it means that when you buy a call, you have the right, but not the obligation, to purchase the stock at the strike price that you have purchased.

In other words, if you buy a call at the July $17.50 strike price, that means it gives you the right, in the future, to purchase shares of Yahoo stock at $17.50. You are not obligated to do that, but you can do that. It gives you the right to do that.

What we’re doing is, we’re not buying them. We’re actually going to be selling one of these. We’re going to set that up. We’re going to sell one of the $17.50 July in the money calls.

This is part of the risk of this trade, although it’s fairly minimal. We are going to be putting on both of these trades at the exact same time. The three October Yahoo calls at $25, and we’re going to sell one of the Yahoo July 8 $17.50 calls. We’re putting them on at the exact same time.

For those of you who know options, you understand that if you sell an in the money call, the potential is there to have the stock assigned to you. What that means is, if you sell one of these contracts, the person who bought the call – the person who you sold it to, or maybe somebody else – anybody who’s long that call, can exercise their option. Randomly, you can be picked to have that stock sold to you.

You would automatically have a short position at the stock at 17.50. However, you’re going to have these three calls at the October $25 strike price, as protection against the short stock that you might be assigned. That doesn’t happen too often, but it is a risk.

It’s not a risk in a bad way. As you’ll see when we go ahead and do our analysis of this trade, the risk is really minimal.

Let’s go ahead and go back to our Analysis tab. I’m going to go ahead and analyze this first, just the three October 25 calls that we’re purchasing. Look what happens. We have a very similar risk/reward, profit and loss graph, as we did when we purchased an outright call on the stock itself.

In other words, we have a maximum loss of $411, which you can see is the green line, which is our expiration line for this particular option. It expires in October, and we also have the white line. Our white line is our current profit and loss graph. If we were to purchase the October 25 call right now, for $1.37, if the stock moves up, we follow this white line. We would actually profit from that. If it moves down, we are going to meet our maximum loss, which is $411 on this trade.

Like I said, not a bad scenario. But, like I said, if you do these more than two or three times a month, I don’t want to lose $300-$400 on every trade that I do.

Let’s go back to our Trade tab. Now we’re going to bring over the one call that we sold in the $17.50 strike, in the near month, which is July. All of a sudden, our graph looks extremely different.

Let me take that out for you, to show you the difference. That’s with selling one of the July $17.50 calls, and that’s without selling the July $17.50 call. That’s a maximum loss of $411. Yes, we have unlimited upside potential.

Now, look what happens when we sell that one in the money July 17.50 call. All of a sudden, we have a scenario in which our maximum loss, if we take a look right here in the center – our green line is our expiration – of $50. That’s it. That’s our maximum downside risk, if nothing happens in this stock. In fact, if the stock trades down a little bit…

Let’s say the deal doesn’t go through, and the stock gets sold off as a result. We can actually make $60-$70, if the stock trades down. What happens if it just falls apart completely, and goes all the way to $5? At the most, we can lose only $11. That’s it. That’s our maximum loss, unless we stay right around this level here and nothing happens. Then we lose $50.

However, the important thing to consider is the fact that we have unlimited upside potential on this particular trade. This is what separates this kind of trade from any other trade that I’ve ever seen. You’re not going to get the total profit potential – if you had just those calls out there, you would maybe make $1000 at expiration on these. But when you sell these at $30, you’re only going to make $634.

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