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The Art Of Profitably Trading Stock Options

|Includes: iShares China Large-Cap ETF (FXI)

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Options Trade of the Week - FXI By NetPicks

As a full time trader and NetPicks coach, one of the comments that I dislike hearing the most is "trading options is too complex".

So many traders are looking for the easy fix to their trading, that they often overlook the area that can give them the best odds of success.

Sure it's easy to trade futures or Forex because the only two options available to you are to buy or sell a contract.

Traders shy away from trading options because they get intimidated when they start hearing terms like;

Short Vertical Spread

Iron Condor

Broken Wing Butterfly

In reality, when you start learning how to trade these strategies you will see how simple they can be. Not only are they simple to use, they also give you tremendous flexibility to react to the different market conditions that we all face these days.

My Favorite Feature Of Options Trading

My favorite feature of trading options is the way we can use certain trade types to give us multiple ways of being successful. When you buy a futures contract you have to see the market go up or you will lose money.

The same is true when you buy an options contract.

The minute you buy that contract the time decay starts to kick in. You need to see that move in your direction immediately or you will start losing money.

So what else can we do?

We can still make a directional bet but we can do so by giving ourselves some wiggle room if we are wrong on direction or the exact timing of the trade.

Options Trade Of The Week

Let's take a look at our trade of the week to show some of the different things you can do with your options trading.

Over the past few months we have seen many markets reach both bullish and bearish extremes. When markets get to these extremes it can lead to really nice retracement opportunities.

One of the areas that we felt got oversold into the middle of September was in the global ETF's. We decided to take a look at FXI which is an ETF that tracks the Chinese Large-Cap stocks.

Chinese markets took a big hit going back into the summer months. While the media was busy talking about a big market collapse coming, we looked at FXI as a big opportunity to play a bounce higher.

When just getting started with options trading, you learn that one way to play a move higher is to buy a call option. This can lead to large profits as long as the stock moves in your direction fast enough.

The problem with this trade is that you are battling that time decay and also a potential drop in volatility. So essentially you need everything to go in your favor for that trade to make money.

Instead of buying a call option, we looked at the FXI options and saw that the Implied Volatility was extremely high.

In fact, the levels of Implied Volatility on FXI options were near 52 week highs.

This meant the options were very expensive at the time. We went into our options playbook to see which other strategies would allow us to play a move higher without getting hurt by that time decay or decrease in volatility.

We settled in on a short put spread.

FXI Short Put Spread

We decided to sell to open the FXI October 36/35 put spread.

I know when you hear about put options you immediately think about playing a move to the downside. However, since we were looking at selling a put spread to open the trade it was actually a bullish trade.

Our trade was placed by selling the October 36 put and at the same time we bought the 35 put to make it a risk defined position.

You don't have to be intimidated by selling premium in this case because we know what our maximum profit and loss could be before even getting into the trade.

We sold the 36/35 put spread and collected .38 or $38 per spread. As a result of collecting premium when putting this trade on, the $38 became our maximum profit potential. The hope was to eventually close the trade by buying it back for a cheaper price which would allow us to keep the difference.

Our maximum risk was limited to .62 or $62 per spread. This was calculated by taking the $1 difference between the strikes (36-35) and subtracting the .38 credit we received for putting the trade on. The $62 was also the amount of capital that was tied up to put the trade on.

So we we are risking $62 to make $38?

That doesn't sound like a smart move…or is it?

Let's dig in to the details of this trade.

Options Trading Success

When placing this trade, our short put strike was 36. This meant we wanted FXI to close above the 36 level by October expiration.

It actuality was a little better than that because we collected .38 to put the trade on, so our break even point on the trade was 35.62 (36 strike minus the .38 premium collected). Originally, we mentioned that we wanted a trade that would profit from a move higher in FXI.

The short put spread gave us the potential to do just that, but now all we needed to do was get FXI to close above 35.62.

If FXI went higher, sideways, or slightly lower we could still have made money as long as it closed above 35.62. So instead of needing a big move higher to make money with a long call, we were giving ourselves some wiggle room just in case we were wrong about direction.

Options Trading Success

So we can make money in all 3 potential market moves.

Oh it get's even better…

We Profit From Cheaper Options

When we buy a long call to profit from a move higher, we mentioned that we would need that move to happen right away or we would start to get hurt by time decay. This is true whenever you buy an option.

However, in our case we sold the put spread to open the trade. We were collecting premium up front. This meant we actually put time decay in our favor because we want the options to get cheaper.

Every day that we held the trade, we made money from the time decay adding up. So we could have made money from all 3 potential stock moves (up, down, sideways) and also from the time decay.

Can you already start to see why trading options gives us tremendous flexibility? It keeps getting better though.

Lower Implied Volatility Equals More Profit

The final way we can make money is by seeing the Implied Volatility contract. Remember back at the start I mentioned that the Implied Volatility on the FXI options was near 52 week highs?

Well we know that over time volatility levels don't like to stay at extremes. If the Implied Volatility levels drop off the 52 week highs, then that would hurt a long call position even if FXI moved higher.

In our case since we sold the put spread to play a move higher in the stock price, then a drop in Implied Volatility would actually help our position. It would lead to the options getting cheaper, which is what we wanted to happen since we needed to buy the spread back to close it.

Just look at all the different ways we can be profitable on this trade:

We make money from FXI moving up.

We make money from FXI moving lower.

We make money from FXI moving sideways (as long as it stayed above 35.62).

We make money from time decay adding up.

We make money from volatility contracting.

That's 5 different ways we can make money on the trade!

Earlier, we mentioned we were risking $62 to make $38 on the trade which isn't a great risk to reward ratio. However, the tradeoff here is that we have so many ways of making money. That's why I loved this trade when we put it on.

How Our Options Trade Ended Up

The trade ended up working out for us and FXI did in fact move higher. We ended up buying the spread back for .05 or $5 per spread. That gave us a $33 profit per spread. While that doesn't sound like a lot of profit, remember it only cost us $62 per spread to put the trade on.

You could have put it on 10 times and still had only $620 of risk on the trade.

That was a long winded explanation of how the trade played out, but I wanted to show how easy these trades are to take and how flexible they can be.

We had 5 different ways to make money on this options trade.

This is how professional traders make money long term.

They put the odds in their favor.

Our full strategy playbook gives us the opportunity to take what the market is giving us at the current time.

No longer are we only focused on buying long calls and puts and hoping for the best. We can use strategies like a short put spread to really increase our odds of success.

If you are struggling with your trading and have never looked at trading options before then I think you are missing out. We see these trades all the time.

Expand your trading toolbox and you are setting yourself up for better profits.

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