No doubt the stock market has been erratic of late.
Last December saw a dramatic sell-off that had everyone thinking, “this is the big one, and that we’re about to embark on Recession 2.0.”
Then, out of the blue on December 26, the market staged an incredible “v-shaped” four-month recovery that brought it to all-time new highs on May 1.
But now, once again, we’re seeing a little mini sell-off, mostly due to the recent U.S.-China trade stand-off.
How is one to cope with such movements?
Well, that’s the thinking of extreme short-term traders, who live and die by the market’s every move. For a majority of the rest of us, we shouldn’t be so worried about all those micro moves. We should think long-term, and understand that over time, the market finds its way higher.
Decades of market action prove it.
Time and time again, after conflicts, wars, terror attacks, trade disputes, etc., the market rallies to new highs. And of course, it will do so again.
So, if you have a few stocks on your radar that you’re interested in picking up on this current pull-back, here’s an ingenious way to play for free.
Hop the “Fence” and Get in For Free
Being one of the options experts at Dent Research, I have employed just about every option strategy during my 27 years of trading experience.
One of the most creative ways to use options contracts to mimic a bullish position in a stock is to employ a strategy called a “fence.”
Options contracts are there for us to use as a substitute for stocks, and the best thing about that is you can create endless possibilities based on your level of conviction, time frame, and the amount of money you want to spend.
If you’re bullish, let me show you the fence trade and how to create a position for zero cost.
A bullish fence is created by using two different option strategies in one:
- Selling an out-of-the-money (OTM) put option.
- Buying an out-of-the-money (OTM) call option.
By selling an OTM put option, you will receive the upfront cash premium from the put-option buyer. In exchange for receiving that cash, you’re promising to purchase the stock at the agreed upon level (the strike price) at some point in the future, if, and only if, the stock falls below the strike price.
For the second part of the fence, you will purchase an OTM call option at a strike price level in which you feel the stock can surpass by the end of the expiration date.
Both trades will be for the same expiration date.
But the most important detail about getting into the trade for free is that the sale price of the put option must exceed the cost of the call option.
Let’s look at an example…
Apple currently trades near $179 per share.
You’re interested in a bullish trade and feel the stock can rally back to at least its last recent high of $215 per share, but you also want some downside protection in case it drops a bit more.
Initiating a fence could be the perfect trade.
By setting a floor purchase price of $145 per share (Apple’s last recent low point), you can sell a put option with a $145 strike price. And with your target price of $215 per share, you can purchase a $215 strike price call option.
Let’s see how the option prices look:
Since we want to have some time for the trade to develop, we’ll look at the option chain above, which represents the January 2020 expiration date.
By selling the $145 put option for a fair value of $4.47 per contract and buying the $215 call option for a fair value of $4.28 per contract, the trade will yield a credit of $0.19 per fence. Meaning, for every fence traded, your account will receive $19.
One of the best ways to visually see how an option position can develop over time is by using an option strategy graph.
This is a great one from optioncreator.com
You will notice two different colored lines on the graph. The orange line yields the profit/loss results if the trade is held to expiration, and the blue line represents the results as of today.
Because many stocks can end up meandering in a range for a period of time, the fence is great for this type of activity, as long as the trade is initiated for a credit (which this one is).
You will notice that if Apple stock closes anywhere between $145 to $215 at January 2020 expiration (orange line), no profit or loss will result, except for the small $19 credit.
Considering that, with Apple at $179 per share today, it’s nice to know that it can drop $34 in price and there will be no loss on your part. On the flip side, if Apple rallies $36 in price, there will be no gain either at expiration. This is part of the safety trade-off.
But, options trading can have very different profit and loss profiles, which are highly dependent on the time of occurrence before the expiration date.
A Mistake to Avoid
One common mistake I see amateur option traders make is that they don’t take profits along the way.
If you look at the blue line of the graph, you will see how the profits can add up rather quickly if Apple stock rallies in price right off the bat. If that happens, it’s in the trader’s best interest to lock in at least partial gains. This would require having multiple contracts of the fence. If you only have one fence spread, then you only can take profits on one occasion. If you trade multiple contracts, you can stagger the profit-taking.
Word of caution: Remember, selling a put option obligates the trader to buy the stock at the strike price if called upon to do so. If Apple falls below $145 per share at expiration, make sure you still have the desire and the funds to pay for the stock in full.
If the stock ends up being purchased, the downside potential now becomes unlimited (just like any other stock).
Remember my motto: only sell put options on stocks that you have a genuine interest in owning.
If your outlook for Apple ever changes, and you want out of the trade, you can always unwind it at any time. That’s the beauty of trading options. And depending on where Apple might be trading at that time, a profit or loss can result.
Consider the fence spread for your next no-cost bullish opportunity.
Until next time…
P.S. This example of a fence spread is that only: an example. But if you want to make real trades, consider joining me in my Instant Income Alert service.