New Option Trader

Taking classes on options trading and reading books on option trading are both definitely the best way to learn at an in depth level.  But, that can get expensive and it does take a while to really feel comfortable with what you’re learning.  So, I recommend supplementing these paid educational classes with the multitude of free training that’s available on the web.  Personally, I don’t believe the following resources are enough on their own but they are a great supplement.

I have alot of resources to post so won’t do it all in one post. So, here are three places where you can go to view free trading videos:

Free Trading Videos
Informed Trades
You Tube

I can hear it now.. naked puts are risky and dangerous — never use naked puts! Ever! That’s what we’re told when we’re first learning how to trade options, right? I know I’ve heard it more than once.

Well, there is a place for naked puts and it’s a good place — in an IRA. But, as long as you understand why you’re
buying them and what you’re trying to accomplish. Naked puts are a great way to acquire stock — stock that you want to buy, you’re GOING to buy anyway — at a lower price and a ultimately a higher ROI on the trade.

Normally, I’m not that into stock; too expensive. But, IRAs are a good place for stock and it’s still just as important to get the best return possible. You might hold a stock trade a little longer, but the purpose is still the same — to make a profit. So, getting the stock when it pulls back is a good thing because it increases your total return.

Key Points:

• If you’re going to use this strategy, you must want the stock — just at the cheaper price.
• You must have the cash in your account to buy the stock in case you get it at the cheaper price.
• This is a bullish stock acquisition strategy and not a bad way to to continually acquire stock that you intend to hold for a while.
• If you’re wrong about the direction of the stock, this trade can go against you because now you’ll be buying a falling stock on it’s way down. The goal is to buy a rising stock on a pullback but that is still in an uptrend.
• Your ROI will be higher due to two factors:
  1. The premium you receive from the naked put offsets the price of the stock
  2. Plus, you’re getting the stock when it pulls back, so it’s cheaper

How to Sell Naked Puts to Establish Long Stock Positions

1. Find a stock you like.  Use all your technical analysis skills and understanding of the company to determine to if it’s a good stock to own
2. Find the nearest available expiration date that has at least 23 calendar days to go. That may be the front month or it may be the next month.
3. Find the put option one strike OTM with a delta of 30-40
4. Sell that put short using a limit order. Selling this put short will give you the quickest rate of decay (in this case a good thing) relative to the highest probability of success.

By the way, I got this info from taking a free Options Planet class called, Options in Your IRA.  Options Planet is run by Think or Swim and they give these free classes because  they believe that an educated option trader is a successful option trader — what a concept!

One last thing… if your broker won’t let you do this, find another broker.  Think or Swim has no problem with it because they know this strategy is using cash secured puts and is just a more cost effective way of buying stock.

The chat is about to begin, I’ll post my notes but these things move pretty fast so I’m not always able to get everything. I’m also just posting things that I think are significant, so I recommend if you want more detail listen/watch it on the chat archive at the Think or Swim site.  They now are archiving the video as well!  So, though it’s not live it’s still incredibly valuable as a recording.

These notes may be Think or Swim specific in some areas but hopefully are standard enough to be available at most brokers.

Today’s chat was basically about how to trade in market like this one (volatile, unpredictable, holiday weekend.. yada, yada, yada..) And, what they we’re saying is that this not a bad time for covered calls and naked puts (naked puts — only if you want the stock anyway.  I have a post coming up about naked puts).

Covered Calls

1. Show Covered Return column on Trade Tab.  “Covered Return” is the return you would get if you sold that covered call every month (annualized) — not the return for this particular month
2. Find a stock that’s been under a lot of selling pressure or reached a level of support.  Also, look for a reasonable level of volatility.
3. Buy the nearest OTM call in the nearest month with at least 20 days to expiration

Naked Puts

1. Same criteria for covered calls above but check the “covered return” for selling naked puts instead.  It may be significantly higher and/or the trade may end up costing you less since you’re not buying the stock but tying up capital in case you’re assigned.
2. If you’re not assigned you get to keep the premium — love that!
3. If you are assigned then you got the stock at cheapo price and the premium you received pays for part of the stock — not a bad deal if you ask me..

A few things to remember when doing Bull Spreads. This helped me a lot in keeping straight what this type of trade is doing and why…

The leg to focus on is the position with the more valuable leg. The short position is in effect a hedge!  Having this hedge reduces the cost and risk of the trade. Isolate the more valuable option — that’s what is driving the trade.

So, how do you decide which bullish option strategy to use?  Run the numbers…  The trade with the higher potential return and the lower potential loss is the winner.  Both are bullish option strategies but one uses calls and other puts.  And, one generates a credit to your account; the other a debit from your account.

Bull Call Spread Calculations (Debit Spread)

Max Profit =  Difference in strikes -  the premium
Max Loss =   The premium
Breakeven =  The long leg + premium (remember the short leg is basically a hedge)

Bull Put Spread Calculations (Credit spread)

Max Profit =  The premium (credit you received)
Max Loss =   Difference between the strikes – the premium received
Breakeven =  Strike price of the short put – premium received

This isn’t ALL there is to evaluating which vertical spread is right for a particular trade. But, it will get you most of the way there and is often enough on it’s own.

Hedge
Reducing the risk of loss by taking a position through options or
futures opposite to the current position they hold in the market.