People tend to think being successful in options is all about swinging for the fences and trying to make a killing on one big trade.
I fell victim to that mentality when I was 19 years old… and it cost me my life savings.
From that day forward, I realized that having a long and successful career as an options trader requires focusing on risk management and consistently taking profits – even if they’re small.
Quite frankly, you’re going to be wrong a lot of the time when you trade options.
A stock can go up, go down, or go nowhere.
So, you need to look for ways to turn your position into a profit… even if you’re wrong.
That focus is the basis of the strategy I use with my own money… And today, I’m going to show you how to begin using it yourself.
Always Start With This Question
I’m going to show you how this works with a real trade my readers took advantage of…
At the time, I liked the idea of owning Seabridge Gold (SA), a Canadian gold explorer. SA was dirt cheap, and I thought it would be trading much higher a few months down the road.
So, I recommended buying the Seabridge January 31 $15 call options for about $1.65. That call gave us the right to buy SA at $15 a share. We spent $1.65 on it.
To be profitable on this trade, we needed SA to trade above $16.65 on option expiration day on January 31. That was 25% above the price at the time.
If SA fell in price, we would have lost money.
We would have also lost money if SA went nowhere. The only way we were guaranteed a profit on this trade was if the stock rallied more than 25% by January 31.
That may seem like a tall order. But I was confident the trade would work out and I was comfortable making the recommendation.
However, I still had to ask myself, “How can we make money on this trade, even if I’m wrong?”
That’s where this next strategy comes in…
How to Place a “Spread Trade”
As long as we were spending money out of our pocket to make this option trade, the odds were against us.
But there was a way to put some money back into our pocket… without taking on any extra risk.
The easiest way to do this was to create a “spread trade.” Spreads involve buying one option and then selling another.
Since we owned the Seabridge January 31 $15 call options, we had the right to buy the stock at $15. To create a spread, we sold someone else the right to buy Seabridge from us at a higher price.
My initial upside target for this stock was around $20 per share. So, we sold the Seabridge January 31 $20 call options, which gave someone else the right to buy the stock from us at $20.
We collected $0.85 for selling the call. By doing this, we recouped more than half the cost of the January $15 calls.
Here’s how that looked, trading one contract at a time. (One option contract covers 100 shares.)
Per contract, we paid $165 for the right to buy SA at $15 per share. And we received $85 for taking on the obligation to sell SA at $20 per share. We spent $80 for each spread.
That means we immediately lowered our out-of-pocket cost for this trade from $165 to just $80. Our maximum loss fell more than 50%.
We also reduced our maximum profit. Since we sold someone else the right to buy SA from us at $20, we wouldn’t have made any additional profit if the stock rallied above that level.
But because $20 per share was my initial target for this trade, we would have locked in profits at that price anyway. We were just agreeing to do so ahead of time.
Reducing Cost Is the First Step
Now, think about this…
If SA closed at $20 per share on option expiration day, the Seabridge January $15 call options would have been worth $500 per contract.
We spent $165 on the original trade. So we would’ve had a $335 profit, or 203% gains on our initial $165 investment.
But by creating the spread, we reduced the cost of the trade to just $80. And the spread would still have been worth $500.
By adding the second leg for the spread trade, we would have had a $420 gain. That’s 525% on the original investment.
The spread position lowered the cost of the trade, so it also lowered our risk and increased our potential percentage profit if the stock reached my target price.
This was a BIG improvement over just buying the January $15 call options outright.
But even with this spread trade, we still would’ve only profited if the stock moved higher. We would have lost money if SA fell or went nowhere.
To increase our chances for a profit, there was one more thing we needed to do…
How to Make a “Good” Trade Great
There was an easy way to make this trade even better. We needed to add one more leg to this option position…
We sold an uncovered put.
By selling uncovered puts, you get paid to agree to buy a stock at a specified price by some date in the future. It’s that simple.
Selling uncovered puts is my favorite options strategy. In my experience, it’s the most consistent way to profit in the options market.
Now, it’s important to only sell uncovered put options on stocks you want to own anyway… and at prices at which you’d like to own them. In a rapidly falling stock market, you may end up having to buy the stocks on which you’ve sold puts.
But SA was a dirt-cheap gold stock I wouldn’t have minded buying back then… when it was trading for $12.50 per share.
So, I recommended selling the Seabridge January 31 $10 put options. That obligated us to buy SA at $10 per share if it closed below that level on option expiration day January 31.
At the time, the puts were trading for $1.10. That covered the $0.80 cost of our spread trade and put an extra $0.30 per share in our pocket.
Here’s how that looked, trading one contract at a time. (One option contract covers 100 shares.)
We created a trade that paid us $30 to set it up. That $30 was ours to keep no matter what happened to SA.
This trade could have played out in one of four ways…
- Seabridge closed below $10 on January expiration day. We would’ve been obligated to buy SA at $10 per share. Counting the $30 we received for setting up the trade, we agreed to spend $970 on 100 shares, or $9.70 per share. So, this trade would have been profitable as long as SA held above $9.70 per share.
- Seabridge closed between $10 and $15 per share on January expiration day. All the options in the combination would’ve expired worthless, and we would have kept the $30 per contract.
- Seabridge closed between $15 and $20 per share. The higher SA traded in that range, the more money we would’ve made. For every $1 SA rallied, we would’ve collected another $100 per contract.
- Seabridge closed above $20 per share. The trade would have been worth $500. So, our maximum profit would’ve been $530 ($500 for the combination, plus $30 for the original setup of the trade).
In other words, the only way we could have lost money on this option combination was if Seabridge dropped another 25% from its already-depressed stock price.
We were going to make money in every other scenario.
The Strategic “Third Leg”
After my initial recommendation, SA shares had bounced all over the place, trading between $13 and $17.
But because we set up such a large “margin of error,” we didn’t need to worry about the day-to-day fluctuations. We could concentrate on the longer-term objective – a higher share price going into January.
Only a few months after my recommendation, SA traded for about $18. I figured for such a short time frame, that was close enough to my original target.
So, we closed the trade for a $250 net credit per contract. Counting the $30 we received for setting up the trade, we had a total gain of $280 per contract.
The “spread” I showed you earlier was a good trade.
But by adding a third leg to it, we created a GREAT trade. And it worked out perfectly.
Best regards and good trading,
Jeff Clark
Source: Jeff Clark Trader