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Most traders have heard about options, but many don’t fully appreciate the wide variety of strategies we can employ when trading options. For example, we can use options to generate extra monthly income, protect our share portfolio, or enter into a new share trade with limited risk.
In this article, I will look at using Put options as a limited risk way of opening a new position on a share that you believe is going up. With this strategy you can either make a profit from the option trade or end up with shares you wanted to buy anyway and still have insurance on them. Let me explain how this works.
There are several spread type strategies that I can use in this situation, but the one that I’ll focus on is the Put, Diagonal, Calendar Spread. I’m using this strategy because my view is that the market is likely to track sideways for a while.
The mechanics of the trade are simple; we sell an ATM or slightly ITM Put option for November and then buy a December Put option one strike price lower. This type of trade can normally be done for about even money. The maximum risk is limited to the width of the spread and should the share fall and I am assigned shares from my short Put, then I will have the long Put as insurance until the 18th December.
Ideally, this is how the trade works. The share does track sideways and at November expiry I can buy back my short Put very cheaply and then sell my long December Put, make a profit on the trade and do it all again for the next month. The profit from this trade is actually lowering my eventual cost price of the shares, as I do ultimately want to purchase them.
The company I have chosen to do this trade on is the Commonwealth Bank (CBA). In Chart 1 below from Profitsource, we can see the Elliott Wave is showing an ABC formation, indicating that the stock is trading in a channel, roughly between $40 and $45 since July.
click to enlarge
The actual trade, based on prices on the 24th of October, is to sell one November $41 strike Put for $2.60 ($2600 per contract) and buy one December $40 strike Put for $2.75 ($2750 per contract) for a debit of $150 and a maximum risk of $1150. What this means is if the November $41 expires worthless then I only have to sell the December $40 Put for more than 15 cents to make a profit.
If however, CBA did drop in price and I was assigned shares on the short November $41 Put then I would still have the long December $40 Put as an insurance policy and would then decide what to do with the shares. Ideally I would be able to do a covered call and sell the December $42 Call option at a reasonable price to cover my present $1150 risk on the trade.
Chart 2 below shows an Optiongear Risk Graph, which details the expected Profit and Loss on the trade at expiry, depending on the share price.
click to enlarge
Using options gives you the ability to adjust a trade, whilst limiting your risk. The Australian Options Course is a great way to get you started on learning to trade options. For more information, please visit www.optionscourse.com.au
Remember, you always have options,
Ken Paddison
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