Before getting into this week’s investing topic, I want to tell you about a special free event this Thursday. I’m holding a live options webinar on March 19, and I would like to give you first dibs to sign up. We have a limited number of seats available for this webinar, and as a valued reader, I want you to be able to take part.
During this live event, I’ll discuss two basic strategies for producing income in all market environments, and how to protect your hard-earned investments using options. I’ll also go over a few real-time trades, including another Apple trade and a weekly trade among others. And best of all, I’ll field questions from attendees.
If you’ve ever had any questions about option strategies, or would like to talk with me personally, next week is your best opportunity.
OK, on to the topic of today’s issue.
What would you buy now?
It’s a question that we, as self-directed investors, should have to answer. Yet the question is asked every day in almost every financial media outlet. And most of the answers lack depth and sound reasoning.
Moreover, the probability of choosing a successful stock is always 50-50. Why do you think monkeys throwing darts at The Wall Street Journal stock section performed as well as the professionals?
This concept underlines the success of my conservative investing approach. Most of the time, we probably shouldn’t be buying or selling anything. As investors, most of the time, the odds are stacked against us. That’s why we have to be patient and wait for the times when the odds are stacked in our favor.
That’s my strategy.
Does that mean we won’t have losing trades? Of course not. There is no holy grail when it comes to investing. It’s proper position-sizing that leads to long-term profits, but I will save that for the webinar as well.
As an example of how I use this strategy in actual practice, let’s look at a type of credit spread I use known as a bear call spread.
A bear call spread is a credit spread composed of a short call at a lower strike and a long call at a higher strike. In essence, it is a way to protect your portfolio from any near-term decline in the market.
The nature of call pricing structure tells us that the higher strike call we are buying will cost less than the money collected from the sale of a lower strike call. It is for this reason that this spread involves a cash inflow or credit to the trader.
The ideal condition is for the spread to expire worthless, thus allowing you to keep the premium collected at the time of the sale of the spread. In order for this to happen, the underlying stock will have to close below the lower strike call option that you are short.
In essence, a bear call spread is an options strategy that lets me choose my own probability of success based on my risk tolerance. Yes, that’s right. I can choose my own probability of success.
Let me explain, using options on the S&P 500 (NYSE: SPY). The table below is a partial listing of some SPY call options that expire in April (32 days).
With SPY trading at roughly $208, I want to choose a strike that meets my risk/return objectives.
I prefer to put a little more on the table to gain a higher probability of success, because ultimately I want a winning trade. Yes, I could bring more money in by selling a strike that is closer to the current price of SPY. But this lowers my probability of success.
Don’t forget, the ultimate goal is to increase your probability of success while at the same time taking on risk that allows for a return that is suitable for your income goals.
Again, this is the foundation of how I trade in the Options Advantage portfolio.
For my trading with this strategy, I prefer a win rate/probability of success in the 70%-90% range. As such, I like the SPY 213/215 bear call spread or the 214/216 bear call spread.
Both have a high probability of success. As you can see in the Prob.OTM column above, the SPY 213/215 has a probability of success of 79.08%, whereas the SPY 214/216 bear call spread has a probability of success of 83.68%.
I like to give myself a decent margin for error, which obviously increases my probability of success. For example, the 213 strike allows for a 2.4% cushion to the upside, whereas the 216 short strike offers a slightly higher margin of error at 2.8%.
Let’s compare the returns of both strikes:
SPY 213/215 Bear Call Spread SPY 214/216 Bear Call Spread
Return $0.80 – $0.41 = $0.39 $0.57 – $0.29 = $0.28
$0.39/(2 – $0.39) = 24.2% $0.28/(2 – $0.28) = 16.2%
- The “2” in the formula above comes from the use of a spread that is two strikes wide – in our case 213/215 and 214/216.
So depending on which spread you choose, SPY would have to move above either 213 or 214 for the trade to start losing value. As long as SPY stays below one of these strikes through April options expiration the trade is successful.
Ultimately, you have to make the decision of what best fits your risk/reward profile.
So basically, you can be wrong in your directional assumption and still have a winning trade.
Credit spreads are my favorite way to trade options – particularly selling vertical spreads. It’s an extremely simple strategy to learn and arguably the most powerful strategy in the professional options trader’s tool belt.
Click here to get signed up for my webinar event, and you can ask me your questions on Thursday.
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