By Greg Jensen
CEO and Founder, OptionsANIMAL
For most investors, the adage “buy low, sell high” is a familiar one; however, my guess is that most view the statement as a moving target for an often squirrely goal.
On paper it sounds easy. But, if you have worked hard to save, for example, $10,000 to buy 200 shares of a $50 per share stock, only to watch that stock drop from $50 to $35 after an earnings warning, then you know first-hand that it isn’t easy.
That nagging investor paranoia of “what if the stock drops” invades our thoughts almost immediately upon placing the trade.
Those of us who have traded stocks for a long time started this same way, hoping the stock would go up, but left frustrated when Murphy’s Law kicked in and the stock began to fall immediately.
So, what can we do instead?
Protect your positions with a system.
When I started trading, I learned quickly to protect the value of my stocks with long put options and, in doing so, control my fear. Controlling emotions is something we emphasize heavily at OptionsANIMAL because being subject to those emotions means trading without a system.
Every successful investor I know has some form of systematic approach to the market. You will find that trading with a system is much less stressful and far more lucrative than trading without one. The biggest benefit is that you can repeat what works, drop what doesn't, and work on projecting your profits. Just like running any successful business.
A System Means Survival – A Plan for Recovery
If we return to our stock example and consider what prompted us to buy, it was a belief the stock was at a “low” point and would soon be going up. We would sell it then at a higher level. As we know from our example and real life, that does not always happen. We can get taken out of that trade.
What can we do to protect ourselves?
One strategy is a short put option.
The Short Put
The short put can be thought of in the following context. Let’s assume you conduct your due diligence and determine that a stock is trading at below fair market value and so you believe it is “on sale.”
Instead of buying the stock, you enter a short put, which essentially means you enter a contract with the following terms: “You get paid a certain amount to agree to buy a stock at a certain point.”
In our example, if the stock is trading at $50, you could enter a strike 47.50 put option for a credit of $1.00. This means that you get paid $1.00 ($100 per contract) for agreeing to buy the stock if it goes below $47.50. What a deal! If you believe the stock is a bargain at $50, then you will definitely view the stock as being on sale when it is a few dollars lower. And if the stock doesn’t go lower you keep the $1 and move onto the next trade.
A real world analogy might be to consider walking into a car dealership and finding a $25,000 car that you really like. You approach the dealer with a proposal that states, “I really like your car, but I am not ready to buy it at this price. However, if you pay me $1,000 I will come back in a month’s time and buy it from you for $22,000. How does that sound?”
Obviously your car dealer will think you are crazy and turn on his heels!
But in the stock market that deal is out there every day of the week. In fact, a similar deal is out there at an even lower risk then what is outlined in our example, when employing an option spread like a bull put instead of a short put alone.
The Short Call
Similarly, the short call offers traders the ability to get paid to agree to sell their stock positions at prices higher than where the stock is currently trading. This short call should always covered by stock and/or another long call option to control risk.
So, if you are always getting paid to agree to buy stocks lower than where they are currently trading and getting paid to sell stocks higher than where they are currently trading, how can you lose?
Okay, even I can come up with a few scenarios, but the question sounded nice right?
The next step is learning trade adjustments. Combining our adjustment strategies and exit points, you will find that “missing link” of a successful trading method that can generate attractive stock market returns and at the same time structure trades in a way that controls risk.