Tactics For The Small Investor: Swing The Premiums

|
Includes: AA, AAPL, QCOM
by: Green Dot Investor

Summary

Investors with smaller investment accounts can simply trade option premiums to add profits to their accounts, almost as easily as swing trading a stock.

Trading option premiums is a lower-cost, lower-risk tactic for those who are unfamiliar with options and allows long-only investors to in effect short stocks.

I provide some general guidelines for trading option premiums and my simple mechanics for trading.  Stocks that have strong price reversal patterns are the focus.

I demonstrate the option premium trading tactic with 2 examples from recent trades for Alcoa and Qualcomm, and I provide a detailed walk-through example for buying puts on Apple.

I get email ads all the time proclaiming how someone turned a $5,000 trading account into $100,000 in 2 years, or something similar. I have no doubt that it can be done, using advanced options strategies. I've also read that perhaps 2/3 of investors have never traded options, which therefore seems to forever exclude most of them from growing a smaller account significantly using only dividend and buy-and-hold tactics. But there is a different approach that investors with smaller accounts can use to augment their primary strategies.

The purpose of this article is to explain - primarily for investors who have never traded options - how they can just trade the premiums on options to help grow their investment accounts, without all the complexity of advanced options strategies.

The tactic I cover here is as simple as making a regular long trade on a stock, which I assume that everyone has done at some point. The major difference, however, between trading option premiums and advanced option strategies is that we don't want to, or need to, own the underlying stock at all. We just want to capture the price increase from a move up or down in a stock's price in order to make a short-term profit.

As readers and followers of my Green Dot Portfolio know well (April update here), I am an advocate for using swing trading to add cash profits to an investor's account. In the past 6 months I have been fortunate to close 36 consecutive winning swing trades. These small trades (average cost of $936) have returned an average gain of +7.6% for an average of 35 trading days, or +54.57% annualized (including dividends and after commissions).

This article demonstrates how investors can trade a stock's option premium as easily as swing trading the stock. Trading option premiums means we don't have to learn or understand all the complex concepts of advanced options (not that understanding "the Greeks" is bad if you can master that). Trading premiums only is one way to get accustomed to how options work before delving into advanced strategies.

Why Small Investors Don't Trade Options

Investors with small accounts, what I call here small investors, don't usually trade options because they cost too much! Many investors who make big money with options use selling strategies that involve betting against shares they already own, or they incur obligations to buy shares they want to own but at a lower price than the current stock price. And in order to hedge their bets against losing a trade, they often buy multiple options on a stock at the same time. But these options can become prohibitively expensive for the smaller investor because each option is a contract against 100 shares of the stock. Selling covered calls on Facebook, for example, to generate income means that you have to already own 100 shares for each contract, at about $187 per share at current price.

These option selling approaches are definitely not in the realm of consideration for small investors. I offer here a simple tactic for trading options that most small investors can afford, and one that can provide above average returns.

2 Examples of My Option Premium Tactic

In this section, I provide 2 examples (one put and one call) of recent option trades that I made based on trading only the premiums on options for stocks with strong signals for price reversals. Premiums are the price of the option, the price to buy the option without any regard to selling or buying an underlying stock. There is no stock ownership, and so no dividends are collected. My total investment for these 2 trades was only $733.65, and I was fortunate to realize a total profit of $491.67 (+67.02%). Even at 30% profits for short-term trades, swing-trading option premiums is worthy of consideration.

Alcoa (AA)

  • On 4/20 (Friday) I "bought to open" 3 put contracts on Alcoa at $1.25 per contract (AA Jul20 2018 50 Put). On 4/23 (Monday), I "sold to close" my 3 puts at $2.35 for a gain of +90.94% for 2 days in the trade.

This option trade was based on the chart of AA below, which shows how extended the price of Alcoa was, with a clear topping tail on Thursday, 4/19 (the red reversal candle on the day with the high tag at $62.35). Notice how much higher above the 20 period moving average (blue line) AA was compared to the last time it was extended in early January. The chart said that AA was ready to "revert to the mean." On Monday the stock dropped >13%.

(Source: Chart created by author from TD Ameritrade 'thinkorswim' platform.)

Here's my trade log:

Qualcomm (QCOM)

  • On 4/23 I "bought to open" 6 call contracts for Qualcomm at $0.60 per contract (QCOM Jul20 2018 60 Call). On 5/10 I "sold to close" my 6 calls at $0.89 for +43.20% for 14 days in the trade.

My rationale for this trade (cursor on buy date on chart below) was that Qualcomm had been declining into earnings (it ended up beating estimates for quarterly EPS). QCOM was simply over-sold and I expected it to reverse to the upside. After several days into the bounce, I sold the position because the 50 day moving average was overhead (green line) and the stock had gapped back into the congestion zone between $54-56 that held from about 3/23 to 4/18. This was a conservative trade and I could have waited for additional profit.

Here's my trade log:

Guidelines for Selecting Stocks for Option Premium Trading

My tactic for trading just the premiums on stock options includes the following:

  1. Trade only stocks that are well known and that are generally large cap or larger companies. This assures that there are a lot of traders for the underlying stocks as well as enough options being traded on those stocks.
  2. Trade only stocks that have strong technical set-ups for a reversal in the price trend. Think of this the same way as making a decision to go long or short on a stock for a swing trade. Is the stock showing a clear short-term bottoming or topping pattern? Is the stock into major support or resistance? Is the stock exhibiting maximum extension above major moving averages?

Mechanics of Making an Option Premium Trade

My tactic for the small investor also involves a set of trading mechanics:

  1. Generally limit the total investment to between $300 and $500. This assures that you will not potentially lose a lot of money on any individual option premium trade. With my strategy you can only lose the initial trade amount and will never be obligated to buy a stock.
  2. Always "buy to open" the trade for both calls and puts. And always "sell to close" the trade for both calls and puts. You do not want to be obligated to buy or sell any underlying stocks.
  3. Select an expiration date that is the closest but at least 3 months beyond the date of purchase (less than a week short of 3 months is OK). So if you buy an option premium in May, select an expiration date in August or September. This assures that there is plenty of time for the underlying stock to make the expected reversal in price. There are other longer-term option strategies, but these are not the focus of my short-term premium tactic. The 3 month expiration also easily accounts for the time decay of the option that occurs during the last month before expiration. With my approach to options, the bottom line is that you are out of the trade at expiration, win or lose, which can reduce the propensity of many traders to hang onto losing positions.
  4. Select a strike price that is generally within 3 to 6 strikes "out of the money." I illustrate this with the example below, but the decision on strike price should be strongly influenced by the expected price movement from a technical point of view.

Walking Through the Trade

I'll walk through the mechanics of an option premium trade, step by step.

Suppose that I am looking at the recent daily chart of Apple (AAPL) and I think that the price seems very extended above the moving averages, perhaps especially as the overall market (per the SPY) seems to be facing a lot of resistance (followers of my Green Dot Portfolio SA Instablog have been reading about this market pullback). As the chart below shows, the price of AAPL was $157.51 on 2/12, and it shot up +20.86% in just about 3 months to $190.37 on 5/10. Here is that chart for AAPL:

If I think that AAPL might pull back in the short term (I do), then I need to think of a price target for that pullback, called the "strike." There are several pivots, gaps, and even Fibonacci levels that I might consider based on the past 3 months of trading, but I conclude that it's not improbable that over the next 3 months AAPL might go down to as low as $150. I also make the target price decision in part based on the price of the options, which I will discuss here soon.

The following example of the trade mechanics for the AAPL option premium trade uses my TD Ameritrade platform. Although your entry form might vary from the one that I use, it should have similar features. Charts here were created from my TD Ameritrade 'thinkorswim' platform.

First, on my trading platform tabs, I select "Trade" and then the "Single Order" under "Options." I do not want covered calls, vertical or calendar spreads, or straddle-strangles. I type in the stock symbol, AAPL. At this point my order screen looks like this:

Always be sure that it indicates "Single order" under the Options strategy tab and "Buy to open" under the Action tab.

Next, I click on the Options chain tab, and I drag it to the right a bit. On the Options chain box, I select "All" under Strikes. Then I click to expand the dates available under the Expiration tab. Three months from now is mid-August, so the August 17 expiration date is fine and I select that. The order screen now looks like this:

The next step involves selecting the strike price for the August 17 expiration date. Because I'm expecting a pullback in the price of AAPL, that means I'm am buying a put option. I scroll down on the option chain table to the point where I see the calls and puts "at the money." As the tiny box at the bottom of the option chain box indicates, the darker blue-highlighted strike prices are shown at the points where the options are "in the money." Notice that the calls and puts are opposite in that regard, with the middle ("at the money") between $185 and $190. That is because the last closing price of AAPL on 5/12 was $188.55.

I see that at the $170 strike price, buyers are offering $2.24 for each option (the "bid" price), with sellers of these options wanting $2.30 (the "ask" price). At any point in time, the option trades somewhere between this bid/ask spread, but those prices change continuously over the day based on the price movement of AAPL. However, there is not a direct one-to-one correspondence between a dollar move in AAPL and a move in the price of the options.

If I stay within my overall general price guideline of $300-500 per trade, I can buy no more than 2 options for AAPL at the $170 strike, realizing that each option in effect represent 100 shares of the underlying stock. So my option cost is 100 times the price. If my bid triggered at $2.25, 2 options cost $450 plus any commission. If I think that AAPL might go lower than $170, I see from the option chain table that each put option bid is $1.54 at a strike price of $165, and is $1.07 at a strike of $160. I could buy 3 options at the $165 strike (100*$1.54*3 = $462) or even 5 options at the $160 strike (100*1.07 *5 = $535, not far over $500, assuming the bid price triggers).

Let's assume that I decide to place a bid for 4 contracts for $1.07 at the $160 strike price. I fill in all the required boxes on my order entry and it looks like this, with a total cost of $428 plus commissions if it triggers.

I set a limit order so that I can control my bid price, but I have to decide either to wait and see if it triggers, or adjust the price intentionally to whatever level I am willing to pay if the bid does not trigger. Often a trade will trigger somewhere in the middle of the bid/ask spread.

For this example, let's assume my bid triggers at $1.10. I am in the trade and now need to wait for a profit.

If I am comfortable with a 30% profit, for example, I can set a sell limit order immediately after buying and just "set it and forget it." That would be 30% times the $1.10 put price, or $1.43 (0.3 * 1.10 = .33 + 1.10 = 1.43). If AAPL starts to drop rapidly, I might adjust my limit for a 40% profit, and so on. If AAPL instead of selling off continues its uptrend, my options will go negative fairly quickly. But I have 3 months for the price to reverse. At no point can I lose more than my total investment of $428 plus commissions. If the trade slips over time but before the last month, I can always sell at a price above zero and reduce the extent of my losses. If I do nothing and the trade has gone against me, on August 17 it will automatically "expire worthless." Many brokers will not charge a commission for an expired trade (your consolation prize).

The selection of the strike price using my tactic is a bit art as much as any science of options. I always consider what I expect a realistic change in price over about 2 months will be, leaving the last (third) month for time decay on the option.

Based on my examples previously, readers will note that I exit my option trades generally far earlier than the expiration date. Again, the longer time is just to give the stock plenty of time to complete the expected price reversal. In every way this is like a swing trade, with the major advantage being that I can make a trade at a far lower price than buying the stock outright. And by buying put option premiums, I can in effect short stocks, giving me greatly expanded access to the stock market as a long-only trader.

Final Thoughts

As an investor, my long-term goal is to grow my investment account. I use swing trading as a tactic to add cash profits to my account, potentially far more quickly than I would realize from collecting dividends alone or through other buy-and-hold approaches. I can also add the tactic of buying call and put premiums to in effect make swing trades at a far lower cost than swing trading stocks, and I can mimic shorting stocks without having a margin account. Option premiums control my trading costs.

Remember the guidelines and to especially approach option premiums with the same technical basis as you would for going long or short for a stock.

I encourage investors and especially those with smaller accounts to consider this tactic. Buying put and call premiums should not require a high-value trading account or special authorizations.

Start slowly, and limit option trades to a small percentage of your total investment account (perhaps 10-15%) until you have achieved consistent returns.

Best to your investing and trading!

=Green Dot Investor=

Disclosure: I am/we are short AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I recently bought AAPL Aug17 2018 Puts.