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Something From Nothing - - An Options Trade

Updated on January 14, 2013

The Right Set Up

There are many components in Options trading that one needs to consider such as the strike price, days to expiration, delta (and/or other Greeks), underlying stock and so forth. But that's not all. Volatility as a lot to do with options pricing.

Right now, as I right this HUB volatility is very low, which means that it is a great time to buy options, especially if you can get them for free. In this HUB I will show you a great trading strategy for times when the volatility is low, which can be monitored by the VIX (Volatility Index). Here is a recent trade that I put on.

A Recent Trade

I am going to give you the parameters for a trade I recently made. I am not going to give the symbol as I don't want this to be misconstrued as a position one should take.

As stated above volatility has been very low therefore I am looking to buy an option. In this particular setup, I had been watching a stock that I felt was VERY overvalued. I really expect this to come crashing down at some point as it really isn't a good company and it's price is extremely high.

We had a very strong down and everything and it's brother seemed to be up, except this stock that I had been watching. It was also trading very close to it's all time high. When I saw that it couldn't break through on such a strong day I knew it was poised to drop. However, nothing is guaranteed.

Stocks can do only three things. They go up, they go down, or they are flat and trade in a sideways range. This particular stock looked like it would either be flat or go down and the likelihood of it going up was minimal.

When I constructed the trade this particular stock was trading in the $170 area. I first constructed what is called a Bear Call Spread. In other words, I was able to sell a $180 Call and simultaneously buy $185 Call. This was a way from this companies all time high and I felt that it would really struggle getting over this amount.

However, this is where my risk is. If the stock price rises above $180 I would start losing money on this position, but limiting my risk in theory to $500 (I'm not going into the actual calculations). For taking on this risk I received a premium because the 180 Call I sold had a higher value then the 185 Call I bought, thus giving me a net credit.

Because I felt that this stock would drop in price I wanted to profit from the fall therefore I bought an out of the money Put (same expiration month). I usually buy in the money or at the money options, but in this case I am wanting to profit from either an increase in volatility or the actual movement of the stock. Therefore, I found an option whose price could be paid for from the premium I collected from the Bear Call Spread I created. I was able to do this with a $155 Put.

In the construction of this spread, after commissions, I had a net credit of $15.00. As long as the price did not exceed $180 I would either profit greatly or net $15 at expiration. The only way to loose money is for the stock to rise above the $180.

Next I will tell you what happened.

What Happened

First off, before I tell you what happened, remember that this trade paid me a small amount to put it on while also covering all my commissions.

I was right on the weakness of this stock. Within just a few days (less than 10) I had over a 50% return on the long Put that I owned. Because of the nature of how this stock trades I felt that it would try to bounce again and so I took my profits on the long Put leaving me with only the Bear Call Spread (I still didn't think it would increase past $180).

I ended up getting out of my long Put two days early, but I was happy with my returns. Then I just sat on my spread which netted me another 30% upon expiration.

The good news is that there are a bunch of deals out there at the time of this writing where being net long has a lot of potential. I presently, at this writing, have three such positions as I have described and as of now all three look like they will end up being profitable.

Happy Trading!

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