Welcome to the second installment of the best option trading strategies for 2019.
On Wednesday, we discussed how to make stocks you already own work for you, by using them to produce income, with an additional bonus of being able to set your own profit point.
We do this using covered call selling.
Today, we’ll explore how to take a directional opinion and use a limited risk/limited reward “option spread” to reap high probability wins.
Let’s look at an example with the current market environment in mind.
Playing the Downside with High Probability
Let’s say you’re convinced that the bear market is here to stay and that stocks won’t re-visit their recent highs anytime soon.
Your target is the retail sector and believe brick and mortar stores won’t have a strong holiday season. You key in on one of the biggest retailers of all time – Walmart (NYSE: WMT).
Look at this weekly chart of Walmart. It was trading at $87.28 per share at time of writing.
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It’s in a solid downtrend, which you believe will continue for the foreseeable future. Revisiting its highs above $105 are not in the cards.
How can you take advantage of that directional assessment with a high probability of success?
For starters, you can take the route that I’ve been espousing in recent Rich Investor emails – that instead of trying to figure out where the stock will go, you take the route of predicting where the stock won’t go.
If you’re pretty sure it will go down (because you’ve done all your research), then you’re probably really sure that it won’t go up beyond $105 per share.
Choosing an area on the chart where the stock won’t go is actually an easier way to make a profit than trying to figure out where it will go.
Let’s see how that works.
The Limited Risk/Limited Reward Option Spread
To play your assessment with high probability, you can engage in one of my favorite types of trades – the option credit spread. You can use this trade to create a current income stream (like covered calls) while gaining a large cushion against directional error.
Below is a sampling of Walmart call options that expire in June 2019.
I’ve circled the $105 and $110 call options as the strike prices we’ll examine for the trade.
We’d execute the trade by selling out-of-the-money (OTM) call option spreads, also known as the “bear call-option credit spread.” It’s a way to speculate on a bearish prediction while maintaining a limited-risk profile.
By selling the lower strike $105 call option for a $0.96 credit (splitting the bid/ask market) and buying the $110 call option for a $0.53 debit (splitting the bid/ask market), you produce an overall $0.43 per spread credit.
Since each option contract equates to 100 shares of stock, you multiply the $0.43 credit by 100 to reveal your upfront collection of $43 per spread. Selling 10 spreads brings in $430, and so on. But realize, even though you collect more money when selling more spreads, the dollars at risk go up as well.
Even though you’re engaging two individual trades within the spread itself, the end game is to produce an overall credit into your account, which is the $43 in this case.
Risks and Rewards
Considering that WMT stock is currently at $87.28 per share, as long as it doesn’t move back above $105 in the next six months (June 2019 expiration), the trade will be a winner.
The goal is to have the stock not move above the sold strike of the spread ($105). As long as it stays below $105, you’ll realize the maximum reward of $43.
Whenever a single option or option spread is sold, the maximum reward in the trade is always capped at what the initial credit is. In this case, that’s $43 per spread.
As far as the risk – we calculated that by taking the width between the strikes, subtracting out the initial credit, and multiplying by 100.
In our example, that looks like this…
(($110 – $105) – $0.43) X 100 = $457.
Now I know what you’re thinking: you’re going to risk $457 to make $43?
The reason why the risk/reward seems so unbalanced is due to the large directional cushion the spread has and the high probability that WMT won’t move back above $105.
Can we calculate the chances of that happening?
The graphic below shows that the chances of WMT staying below $105 per share is 85%.
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Said another way, the chances of WMT moving above $105 is only 15%.
That’s an extremely high probability to win on a trade. And when probabilities to win are high, the payoff ends up being lower.
Look at it from the spread buyer’s view – the only way they could win is if WMT moves above $105 by expiration. There’s no other scenario that can give them a win. WMT absolutely must move above $105. No ifs, ands, or buts.
But in the spread seller’s case, they could still attain a full win in three different directions. WMT could continue to move lower, it could meander sideways, and it could even move higher (but not breaching $105). That’s a 3:1 directional advantage over the spread buyer.
When you have that much probability to win on a trade, you can see how the risk/reward can feel lopsided.
I’ve had a long successful career using option credit spreads. I devoted a whole chapter to it in my book.
Some Final Points
1. You must have a clear directional conviction before making the trade. And then employ option spreads using the “where the stock won’t go mentality.”
We’ve used a bearish case in this article, but if you’re bullish on a stock, then you could employ put-option credit spreads, a.k.a., “the bull put-option credit spread.”
2. You can unwind the spread at any time if you’re not comfortable with your directional opinion anymore.
Just buy back the whole spread, which will incur a debit on your part. Where the stock is trading at that time, and how much time is left before expiration, will determine whether it turns out to be a profit or loss.
See you next time when I’ll discuss option strategy #3 – the only option-buying trade you’ll ever need!