Top trader: The ultimate options-buying strategy
From Jeff Clark, Editor, The Delta Report:
Yesterday, I explained how most folks use options the wrong way. In short, they INCREASE their risk with options contracts.
Today, I’m going to show you the RIGHT way to buy options…
If you’re new to trading, this is a MUST READ. If you’re an experienced trader, you might be tempted to skip over this essay. Don’t do it. There’s a good chance you’ve never seen the technique I’m about to show you. And it will significantly increase your success as a trader…
Let’s go back in time to mid-July 2016. Bristol Myers Squibb Co. (BMY), one of the world’s largest pharmaceutical firms, was trading for about $75 per share. The stock looked good. It was a high-quality blue-chip company with a healthy dividend and a solid pipeline of new drugs. It was a Wall-Street darling. And, you want to buy the stock and profit if it goes up.
You could buy 100 shares at $75 each – a $7,500 investment. Like every good investor, you would also set a downside stop on your position – a point where you’ll admit you’re wrong on the trade, get out of the position, and save the rest of your capital for another trade. For this example, let’s say that downside protection is a 20% stop loss.
So in this case, you would buy 100 shares of BMY at $75 for a $7,500 total investment. And you’re willing to risk it falling to $60 – a possible $1,500 loss – for the potential to profit if the stock moves higher.
Now, keep in mind that even though you set a stop loss to limit your potential loss, the entire $7,500 investment in the stock is technically at risk. There’s no guarantee you’ll be able to sell your shares at $60.
You don’t want to risk $7,500, so you take this idea over to the options market…
Rather than putting $7,500 into the stock, you’re going to deal only with the $1,500 you’re willing to lose if you’re wrong. The other $6,000 will be safely tucked away in a money-market fund or Treasury bill for the duration of the BMY investment. You absolutely will not lose more than $1,500 on this investment.
But let’s say you want to limit your risk even more. So you only take part of the $1,500 you were willing to risk on the stock over to the options market.
Back in July 2016, when BMY was trading near $75 per share, the October $75 call options were trading for about $3.00.
So rather than buy the actual stock at $75 per share, you can simply buy the call option that gives you the right to buy the stock at $75 by option-expiration day in October. Since each call option covers 100 shares, you can buy two call options for $600 and have almost twice the exposure to the upside of the stock. And your maximum loss is now only $600.
Think about this for a minute… You can put up – and risk – $7,500 to buy 100 shares of BMY… Or you can buy two call options that give you even more exposure to the upside but limit your risk to just $600. Obviously, buying the call option is a much lower-risk trade.
But we don’t just use options to lower risk. We use them to increase returns as well…
Let’s say the stock rallies to $90 by the October expiration date. If you bought 100 shares of the stock at $75, you’d have a $1,500 profit. That’s a 20% gain on the investment.
You’d do much better with the call options, though.
At $90 per share for BMY, each BMY October $75 call option will be worth at least $15 per share ($1,500 per option). You own two call options. You can sell them, collect $3,000, and realize a $2,400 profit. That’s a 400% gain on the trade.
By using the options, you put up $600 – much less than the $7,500 to buy the stock. And you made $2,400 – much more than the $1,500 gain on the stock.
That’s what would have happened if the stock had moved higher. But that’s not what happened in real life…
BMY nosedived and closed at $49 per share on option-expiration day in October 2016.
If you had bought the stock, you would have stopped out of the trade at $60 and lost $1,500. That’s a 20% loss on your $7,500 investment.
The BMY October $75 call options expired worthless. So if you had purchased the options, you would have lost 100% of your $600 investment.
But here’s the important point – a point that often gets distorted by folks who think options trading is risky – it is FAR better to lose 100% of a $600 trade than to lose 20% of $7,500.
You lost money either way. But by using options, you cut your risk on this trade by more than half. And as I explained earlier, if BMY had moved higher, you would have made more on the smaller investment in options than you would have made in the stock.
Either way, you’d be out of the trade with a loss and it would be time to move on.
But wait… there’s more…
You were willing to risk a $1,500 loss on BMY stock. But, instead, you bought the call options for a total of $600. So, you still have $900 in your back pocket from the money you were willing to lose on BMY. But there was no need to put it at risk since buying two call options gave you more than enough exposure to increase your potential reward on the trade.
Now, though, with BMY trading at a lower price, it may be an even better investment. If you had owned the stock at $75, you would have already lost the most money you were willing to risk on BMY. There’d be nothing left to buy it with here.
But if you had bought the BMY call options instead, you would still have the $900 in your back pocket that you can put into a new BMY call-option trade.
On option expiration day in October, 2016, the BMY December $50 call options were trading for about $2. You could have bought two of those call options for $400 and tucked the remaining $500 away in the money-market fund with the other $6,000 of investment capital.
Now, no matter what happens to BMY, you would still have $6,500 tucked away safely. That’s better than the $6,000 you’d be left with if you had bought the stock at $75 and got stopped out at $60. And you have the right to buy 200 shares of BMY at $50 by option-expiration day in December, 2016.
So you still have a chance to profit on the trade.
As it turned out… BMY bounced back to $58 per share by December expiration day. You would have been able to sell your BMY December $50 call options for $800 each. That’s a total of $1,600 for the two option contracts, and it works out to a gain of $1,200 on this trade.
That’s enough to offset the loss on the first BMY option trade and still leave you with a $600 profit overall.
This is a HUGE deal…
BMY shares fell from $75 to $58 between August and December, 2016. If you had bought the stock you would have stopped out of the position at $60, and lost $1,500 on the trade.
By using options instead, you put less money at risk, increased your potential profit, and ultimately exited the trade with a $600 gain.
Novice investors think buying options is risky because they look at the track records of options trades and see strings of 100% losses. They look at the track records of the stock purchase and see losses of just 20%. So they conclude that it’s safer to buy the stock and it’s riskier to trade options.
That’s not the case at all.
Traders who use options the right way – in a way that reduces the risk and increases the potential reward – can always construct a trade that works out better than buying the stock itself.
Even in this example with BMY, the option trader’s maximum loss for the two trades was 1,000. The stock investor lost $1,500.
This is the right way to trade options. By using this technique, you will ALWAYS be able to reduce your risk and increase your potential returns. And that is, after all, what options were created for in the first place.
Crux note: Jeff’s trusted technical indicators have signaled a big correction in the coming months. That’s why he’s hosting an emergency briefing on Wednesday, February 15 at 8 p.m. E.T. In this FREE webinar, Jeff will show you his trusted indicators… and how to position yourself to profit with low-risk options trades like he describes above. Sign up right here.