How do single-day stock gains of 40%, 50%, 75%, even a 100% or more sound? If you're anything like me they sound pretty darn great.
Those kinds of gains happen almost every day, but the mainstream financial media would much rather focus on recent stories such as: FB jumps 14% on increased mobile revenue, GOOG rockets ahead 13% on higher top line, or TSLA up 8% on higher than expected sales of the Model S.
Don't get me wrong; those are great single-day gains for large-cap companies - but the real single-day home runs usually come from micro-cap and small-cap companies - especially micro-cap and small-cap biotech companies that have just announced exciting news.
The news can include positive trials results, a partnership with a major pharma company, earnings that surprised the Street... basically almost anything that catches traders by surprise.
When these kinds of announcements occur, it's not uncommon to see shares gap up 50%, 75%, 100% or more, overnight. Those are the kinds of gains that create unimaginable wealth, and very quickly, too.
But, as you can imagine, this story of riches can just as easily become a nightmare if the company releases unfavorable trials results.
When that happens, shares can easily drop 50%, 75%, or more in after-hours trading. Even prudent investors using protective stops will feel the sting because they won't be able to exit the trade until the market opens, after the damage is already done.
What if I told you there was a simple way to target these 100% gains while at the same time guaranteeing that you avoid any catastrophic losses?
In this case, though, it actually is true...
Protect Your Profits with These Simple Steps
All you need to do is purchase one accompanying "put option" for every 100 shares of the stock you own, which essentially guarantees your exit price - no matter what price the stock is trading.
Professional traders refer to this as "marrying" the put option to the stock. I just refer to it as "buying insurance."
Let's take a moment to look under the hood of this strategy - in five quick and easy steps.
Step 1: Let's assume we've identified a company that is scheduled (on a specific date) to make an important announcement. My favorite announcement is the release of data from a clinical trials program.
Once we have the potential company we're interested in, it's time to buy some insurance.
Step 2: We're going to focus on put options with the nearest expiration date "after" the scheduled date for the upcoming announcement.
For instance, if company XYZ plans to release clinical trials results on March 10, 2014, then we'll want to investigate put options with the first expiration after March 10, 2014.
Just a quick side note: Typically, options expire on the third Friday of the month, but there is an increasing amount of companies that have "weekly" options. Just make sure to target an expiration that occurs "after" the planned date of the announcement. Remember, the put option is insurance... it won't do us any good (as insurance) if it expires before the company announcement.
Step 3: After we've identified the appropriate expiration date, we'll need to target the "strike" price.
This is a matter of personal preference - and availability - so we're going to want to investigate a strike that represents a price we would be comfortable selling XYZ in the event the announcement disappoints the market.
Personally, I like to limit this trade to stocks that have options with strikes very near the current price. For instance, let's say XYZ is trading at $5.20. I'll consider buying the $5.00 put option. If XYZ is trading at $7.25, I'll consider the $7.00 strike. If XYZ is trading at $10.35, I'll consider the $10 strike. You get the picture.
The main thing we're looking for is a strike price that is very near the current price.
Another quick note: Not every stock is going to have a strike that is close enough for my personal risk tolerance. When that's the case, I just avoid the trade altogether. There's always another opportunity just around the corner.
For the purposes of this explanation, let's assume XYZ is trading at $5.20 and we've targeted the "XYZ March 2014 $5 Put" option.
Step 4: Once we've identified the potential stock, the expiration, and the strike price, we want to spend a couple of minutes to investigate the "premium" (which is the price).
Just like car insurance, we have to pay for our insurance (put option), so we want to make sure it's not too expensive.
What constitutes too expensive? That's also a personal preference, but generally I want to buy insurance that doesn't exceed 5% of the strike price. In this example we would proceed with the trade if we could buy the put option for $0.25 or less (or $25, because options are priced in multiples of 100... unless they're minis).
In this example, the $0.25 price (per share) we pay for the put option will be added to our overall cost, which means our total cost to enter the trade is $5.45 ($5.20 for the stock + $0.25 for the put option) per share - or $545 per 100 shares.
Just to reiterate: We'll be purchasing one "XYZ March 2014 $5 Put" for every 100 shares of XYZ that we intend to own (as each single put option represents 100 shares... unless they're minis).
Step 5: This is the easiest step of all - just sit back and wait for the upcoming announcement.
If XYZ reports great results, the stock could be off to the races and we'll be darn happy we were smart enough to buy shares "ahead" of the announcement. At this point, we can just let the put option expire worthless - similar to your car insurance at the end of the month.
On the other hand, if the results fall short, XYZ shares could gap down 40%, 50%, or more in the afterhours - but we'll get to sell our shares for $5.00, no matter what, because we purchased XYZ March 2014 $5 Put.
In this example, our loss would be capped at -8.25% or $0.45 a share, while other investors would be staring a huge loss in the face.
The Best Insurance to Buy...
Especially When You Don't Use It
If you're new to options and would like the opportunity to cash in on the tremendous upside that options offer, while "insuring" against a large downside, I recommend reading Money Map Press' The Power of Options to Slash Your Risk and Make You Money. If you're not a Money Map Report subscriber, you can click here to learn more.
Some investors will be put off (no pun intended) by the additional cost associated with buying the put option insurance, but they shouldn't be.
After all, just like car insurance, no one throws up their hands in exasperation at the end of the month because they didn't get in a car wreck in order to justify paying for car insurance.