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Remember those two rules. Prices will fluctuate, and options expire. Let’s say that we wanted to capture 82 cents. There’s this May 74. We wanted to sell this option for 78 cents. If we wanted to collect as much premium as possible, what could we do to protect ourselves?
If we thought that there was some danger that the Russell 2000 index, which we can also take a look at a graph of… The Russell 2000 index, now, has been trading downward. However, now, it looks like it might be turning around.
If we think it’s going to remain in some sort of trading range, all we have to do is sell this contract and collect 78 cents. But if we want to protect ourselves so that we don’t get hurt if it does go up dramatically, then we can also buy a contract, just slightly above our 74 strike price.
Now what we have is a spread. In other words, if the Russell 2000 index does not go above 74, we get to collect and keep that entire 78 cents that we just sold that contract for. But we had to pay for protection, and that protection cost us 50 cents. The difference between the 78 cents and the 50 cents is 28 cents, which we get to keep. That’s how much we will get to keep.
Now, you say, “Why would you buy protection?” Well, because, like I said, even with an index, the price can fluctuate dramatically. If it goes up to 79 or 80, and all of a sudden – the contract that we sold at 74, if it goes up to 80, is worth $6. If it’s worth $6, we’ve lost $5.22. We would have to pay out $5.22, which is not a pleasant thing to do.
However, if we protected ourselves, while buying the $74 contract, that $75 contract is also worth $5. So, the maximum that we could lose on this contract, is the difference between the 74 and the 75, which is only $1. The maximum loss is not $6.22. But because we’ve protected our short position with a long position, now, the maximum loss is only the difference between these two strike prices, which is $1.
I can show you exactly how this works. Normally, what we do when we go to enter orders like this, is we would go, and right click on these, in the TOS platform. What we’re doing is we’re selling a vertical spread. This is called a vertical spread. The same month, same index, and same underlying.
As you can see, we’re getting the difference between the 78 cents and the 50 cents. The natural price is 28 cents credit, but we can also try to get a little bit better. If we wanted a little bit more credit, we could try to get the mid-price. The natural price, the difference between these two options, is 28 cents. We would get to keep that 28 cents.
We’re going to keep this at one contract for now, just to show you what we’re going to be doing here. If we were to simply enter this, we would receive a credit of $22.10. We can also take a look at a graph. If we go to anywhere within this little red area here, right click on that, and go to “Analyze Duplicate Trade,” we could actually take a look at a graph at what the profit of this would look like.
We want to take a look at how profitable it will be at expiration. As you can see, we collected $22 after commissions. You can tell that the price is right here, and as long as the price does not exceed $74, which is the exact strike price of our short option – the option that we’re selling. As long as it does not go above that, and the stock remains lower than that, we make the full profit amount.
It doesn’t matter how low the stock goes. We collect the entire premium. It’s only if it goes above the price at which we sold it, that we begin to look at a potential loss situation. We can graph all of our positions in the TOS platform.
Normally, what we’d like to do, is not do one-sided trades like this. Because what will happen if, for example, we sold the May 74 option, and we bought the May 75 option as protection, like we’re doing here? This little plus symbol in front of the number of contracts means that we’re buying it, which it says here: “Buy.”
We’re selling one of the May 74 calls, for a 28 cent credit. We get to keep that credit. But we normally don’t do anything one-dimensional like that. We also like to take a look at the put side, because – and this is one of the tenets of our system. We do not know where price is going.
We just don’t know. We may have some ideas. If we take a look at this graph, going back about a year, we can tell that the Russell 2000 index is going down, but lately, it’s been going up. We don’t really know what’s going to happen to the price.
This is really critical to understand, as far as this system goes. We do not try to predict price. Price fluctuates. That is the only rule. No matter what you say about any particular stock, or any particular index, there’s only one rule in the financial markets. Prices will fluctuate.
It doesn’t matter how long you go back. You can go back five years. You can go back ten years. Prices go up, and they go down. You might be able to determine certain types of trends. Like, from 2000 to 2003, the trend was down. From 2003 up to the middle of 2007, the trend was up. From mid-2007 to the present, the trend, again, is down.