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Risking $20 to Make $730
Is Investing Risky
Many people are scared to jump into the markets and trade. Why is this? If we really want to know why people get scared it typically boils down to a lack of knowledge. This reminds of a recent commercial that has been on television. I don't even remember what the commercial was for, but I remember the commercial itself.
A man is on the phone with a knife in his hand. He has his doctor on the other end of the phone telling him where to cut himself open. The man's response was, "Shouldn't you be doing this?"
Put the knife in the doctors hand and he could successfully cut a person open, fix something, and then sew them back up again. Put a knife in my hand and I could do some real damage to a person. In fact, because I don't know what I am doing my hand would be shaking profusely as I even tried to cut a person open. What is the difference? Knowledge!
The markets are only as risky as a persons lack of knowledge. I am going to show you a strategy using what is called a Bear Credit Call Spread. Now, don't let the name scare you. As we walk through this strategy you are going to find out how you can structure a trade while only having $20.00 at risk. In addition, the maximum profit that you can make would be $730.00. I don't know about you, but that seems to be a pretty good risk to reward ration.
What is a Bear Credit Call Spread? First of all by the term "bear" we know that we are expecting the particular stock that we are looking at to go down. A bear market goes down while a bull market goes up. These terms came from the individual animals method of fighting. A bear will typically come "down" on it's prey while a bull will lower his head and come "up" against it's opponent.
The next word in the name is "credit." This means that when we initiate the trade that we will end up with a credit in our account. In other words this trade will create money (the maximum profit) and immediately be deposited into our account. A debit would be an expenditure that takes money out of our account.
The next word is "call" which refers to the type of options we will be purchasing. A call option makes money while the market is going up. But remember we are anticipating this particular stock to drop. Therefore, our profit will be derived from the deterioration of the value of the options.
The final word is "spread." This means we are going to use more than one option and spread ourselves out in this trade. It will make sense as we lay out this trade. The stock that I have chosen is one that looks like it will likely drop in price. Therefore, the numbers that I am using are actual numbers based on the closing price of today's market.
Please note that I am not recommending anyone trade this stock, but illustrating this for educational purposes!
The closing price of the stock symbol MTN was $34.50 today. As I stated earlier we are anticipating that this stock will lose value. Why do we believe that? Looking at a few indicators we see the following:
- Looking at a daily chart a pivot is being formed that would indicate that a top has been reached
- The MACD has crossed over indicating that a change in the direction of the stock is taking place
- Looking at the Stochastic we find another crossover indicating that there may be a change in the direction of the stock
- The volume has shifted and the pressure is on the selling of the stock and not the buying
- The Chaikin Money Flow indicates that money is flowing out of the stock at this point
- The next earnings date is December 9th so there shouldn't be any unexpected surprises resulting from this
Since there are some good indications that this stock looks like it is ripe for a correction we, for this example, have decided that a downward move in the stock looks very probable and therefore have decided to trade it using the Bear Credit Call Spread.
In a Bear Credit Call Spread we are going to do the following:
- Sell a Call. This means that we will collect the premium and will obligate us to sell the underlying stock should the option be exercised. I have chose an in-the-money Oct 09 Option with a strike price of $22.50. (If you don't understand a call option read the following link). At the close of today's market the bid/ask on this option was $11.70/$12.20
- Now we will buy a call option at a higher strike price. This will give us safety allowing us to limit our risk to $20.00. The option I chose was an Oct 09 Call with a strike price of $30.00. At today's close the bid/ask price on this option was $4.50/$4.80.
The margin requirement for this trade will be the difference between the strike prices, which is $750.00. As you can see you don't need a HUGE account to make a decent trade.
Let's do some simple math. We can purchase these two options at a price that is somewhere between the bid/ask spread. If you make a "market" order you would "sell" the first call at $11.70 and you would buy the second call at $4.80, resulting in a net premium of $6.90 per share for a total of $690. However, we don't make "market" orders, but because we know that we can shave some of the spread down. Therefore, we will make a "limit" order for $7.30 (theoretically selling our option for $11.90 and buying our option for $4.60).
Being filled on this order results in a net credit of $730.00 (excluding commissions). In other words we sold an option for $730 more than we bought another option. This $730.00, being a credit, is placed in our account immediately. It is our money! It is also the maximum amount that we can make on this trade.
Now let's calculate our maximum risk. Our maximum risk is determined by the difference between the two strike prices ($7.50) less the premium we collected. Our strike prices are 30.00-22.50 = 7.50 less the premium of $7.30 that we collected. Our maximum risk no matter what the market does is $20 plus commission paid. Tell me that you wouldn't be able to sleep easy no matter what the market conditions were?
When do we make money? The credit premium has been placed into our account when we made the trade, but now we want to keep the money. Our anticipation is that this stock is going to go down therefore our break-even point is determined by taking the lower strike price ($22.50 in our case) and adding the premium we collected to it. Since the lower strike price is $22.50 and we collected $7.30 the break even price would be $29.80. Once the price of the stock falls below $29.80 we will start making money. If the stock does not fall below this price then when it is all said and down we will have lost $20.00.
Maximum profit is realized when the stock price falls below the lower strike price. If the stock price fell to $21.00 per share you would keep the full $7.30 ($730). If the stock price only fell to $25.00 then you would keep $4.80 ($4.80). The math is pretty simple. The break-even is $29.80 - 25.00 = 4.80. Therefore, a profit is realized at any stock price between the break-even point and the net credit.
What's my point? There are ways to invest that you are not putting yourself at great risk. The problem for most people is that they won't take the time to learn how to be successful. I've always remember a saying that I heard years ago, "Success is not a reward, it's a result."
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