Hello fellow community members,

First of all, thank you for being active and response to our survey. The stock winner is Amazon.com (US:AMZN) and we have started to work on its profile. We are shooting for the early November, so stay tuned.

Also we have received a lot of interest from our community about options and have decided to provide more information about options and going forward we will be providing one basic and one advanced option strategy to our S2O Reports. For more information on equity options we have an S2O exclusive article "Are Options Risky?" by veteran options trader Juan Sarmiento.

Are Options Risky?

by Juan Sarmiento

This is like saying that chain saws are dangerous. If you are an experienced and/or well trained lumberjack, you would think that this is a mislabel. There is no question that a chainsaw is the proper tool for many situations, but if you are not properly trained, it can be very dangerous indeed. Similarly, options can be quite dangerous, if you try trading them without a forecast. In my opinion, however, stocks can be just as dangerous. In fact, I have not owned stocks for any more than a few days since 2003. Here is why:

Any stock can go from your purchase price to zero, so your entire capital in a stock position is at risk. The rewards, however, are potentially unlimited. With options, we can construct trades that have unlimited potential, but also have a limited risk. My favorite feature of options that is not present in stocks is leverage. With a relatively small amount of capital at risk, you could get the potential profit of 100 shares of stock by buying a simple call contract. Time is of the essence, however, which means we have to be really smart to estimate a price target and a time by which to reach it. Then the selection of options become easy. I started trading options because I found that I could accurately predict market direction in timing, using my own brand of Elliott Wave analysis. So I just needed the best leverage tool. Then I found that options can be a risk management tool as well.

Unfortunately, people use options as an accompaniment to their stock strategies, and I think that this is misguided. Take, for example, the covered call strategy: you limit your upside potential, which is a good thing for stock holders, while only partially limiting the risk to the downside. If you think of your investment as a risk/reward ratio, you just increased that ratio unfavorably. What is worse, those people willing to do covered calls as a strategy are not savvy enough to time the markets properly, because if they were, they would be using other strategies with a lot less risk, and a lot more reward, such as iron condors, butterflies and calendar spreads.

Another strategy commonly used by beginners is the married puts. Again, this comes from a stock holder's point of view. Now suddenly you are bearish, but instead of liquidating your stock position, you “buy insurance.” Again, this is another bad strategy from the risk/reward perspective, as you are increasing your cost, and reducing your potential gain on a percent basis. If you are really good enough to figure out when to be bearish and when to be bullish, buying a put to protect your stock shares make little sense. It would make more sense to sell your stock and then to enter the best possible bearish option strategy for the time you believe the stock will go down.

Once you admit to yourself that holding stocks is probably not the best approach for someone with forecasting abilities, then you can start thinking of more cost-effective ways to take advantage of those abilities, and begin to think of ways to limit your risk and leverage your reward potential. I have made a career of studying different option strategies. If, on the other hand, your forecasting abilities are more limited, you are not alone, but you can still make a very good return using options. I have created a system of trading based on the PCCRC (the put-call calendar ratio combination) which relies on observation, rather than forecasting, that is more reactive than proactive, and thus is well suited for the beginner who wants to get out of the trap that is stock holding. I trade this strategy only once a week in front of an audience on my Thursday webinars and keep a paper money account that has grown from $100,000 to $274,000 since June 2007.

Options, in my opinion, are like chainsaws, they are powerful and the right tool for the job in the hands of the experienced and/or well trained user.

Advanced Option Technique for GOOG

GOOG is one of the most popular stocks these days, despite the large price per share. There was a time when investors bought shares in 100 increments, but buying 100 shares of GOOG is not for individuals with relatively small portfolios. Even buying 100 shares in a margin account is prohibitive.

Options represent a more cost-effective alternative, depending on your time frame and expectation. Let’s say that you are bullish for GOOG, and that you expect a move up in the stock between now and December expiration. You could consider buying a option call with December expiration. The problem with this trade is that in order for the option to become profitable, GOOG would have to move up and exceed $567, even if the option you buy has a strike price of $525. In this case $567 is the break-even point. If, however, you buy 2 of these option calls and sell one October call at the same strike price, your break-even point falls to $514, which is below current market price. What I am saying is that even if GOOG does not move significantly higher before October expiration, you could still have a small profit. This trade is called CRC (Call ratio Calendar). You can roll over your October short to November (buy back the October call and sell a November call). This action will give you a small credit, without fundamentally changing the trade.

This is an advanced technique, to be sure, but it is very effective in that your potential gain is unlimited and that the effect of decay of the option is minimal. I explain this technique routinely in my Tuesday webinar for members of OptionsVet.com. Incidentally, the CRC has a cousin called PRC (put ratio calendar) which is similar except, that is used for bearish situations. They offer great results, provided that your forecast is correct!

Author

Juan Sarmiento is a veterinary pathologist (DVM, PhD), who began trading stocks in 1991. In 1995 he became a full-time option trader using the Elliott wave (EW) theory. In 2005 he created a unique Options system based on the PCCRC (put-call calendar ratio combination. He has published over 450 articles in his blog and founded and now maintains the website OptionsVet.com where participants exchange ideas, link to Juan’s two live weekly webinars, and dozens of video archived tutorials with detailed explanations about his profitable trading strategies, technical analysis and EW forecasting.

Yours Truly,
Stock2own.com Team