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This might sound hard to believe, considering how intimidated investors can be by options, but they were actually created to minimize risk.
That's one of my favorite features of these tools: You can use options to participate in pending price moves, up or down, in some seriously expensive stocks without having to pony up piles of your hard-earned cash. The price you pay for one contract, controlling 100 shares, is much less than what you'd pay to buy a share of the stock.
So, to this day, plenty of traders still use options to manage their risk, but more and more, savvy traders are buying options with the intent to profit – to buy low and sell high.
Today, we're going to get an object lesson in both of those cool features. We're going to go after one of the biggest, most liquid, and expensive stocks on the market, but we're going to do it for a fraction of what it might cost to buy outright, just $500.
And even better, we're likely to double our money on this…
Selling Will Dominate a Down Market This Month. Perfect…
I recently showed you that my proprietary tool, the Money Calendar, indicates the bears will lead the bulls most often in May.
That's just fine for us. The idea of making money in a bearish market could make some new traders uncomfortable, especially when the stock and the options seem so expensive, but let me show you how this trade works…
Now, we talked a bit about the put debit spread earlier this year (a.k.a. the bear put spread and the reverse "loophole" trade). But what I want to look at today is how you can use the bear put spread to make money on an expensive stock like The Priceline Group Inc. (Nasdaq: PCLN) while minimizing your total risk… and for no more than $500 of your hard-earned money.
We've talked before about risk management and why you should never risk more than 2% of your account on any one trade. Now you, your broker, chief financial planner, or financial advisor can decide the amount or percentage that you should risk…As of the time I'm writing this, Priceline stock is trading at $1,354 per share. The $1,350 put options on the stock, which are considered at-the-money for the month of May this year, are trading for $51.90. This means that for one contract, you'd have to spend $5,190 ($51.90 x 100 shares).
…But buying a put option for $5,190 is a lot of a money to spend on one trade. Even if you're saving yourself a ton of money by buying this put option over buying 100 shares of the stock – which would cost you $135,000 ($1,350 x 100 shares) – you're still spending over ten times the maximum capital risk of 2%. And that could be pretty costly to you if the stock doesn't move in your favor.
So here's what you can do…
This Is a Really Easy Trade
Instead of spending that much money on one put option, you can simply sell another put option – with the same expiration with a lower strike price – at the same time.
This creates a put debit spread (or bear put spread). A put debit spread is created from buying-to-open one put option and selling-to-open another put option with the same month's expiration. You would need to buy and sell the same number of contracts, and I recommend looking for a spread between the strike prices of about $5 to $10, depending on the stock and anticipated move. This means that you would want to sell the put option at a strike price that is between $5 to $10 more than the strike price at which you bought the put option.
Buying-to-open the put option will cost you money (creating a debit in your account) while selling-to-open the put option with the lower strike price bring you money to offset the cost of the put you bought. The put option you bought is more expensive than the put option you sold, so you are still creating a debit to your account up front.
Keep in mind that you're hedging your risk by creating a put debit spread. And the more you reduce your risk, the more you reduce your reward. But when you're faced with the opportunity to double your money on an expensive stock like Priceline's without spending $5,190 on one put option, this strategy can't be beat.
Let's take a look at how a put debit spread will make you money – while saving you money at the same time…
In this example, we bought-to-open the PCLN May 20, 2016, $1,350 put option while simultaneously selling-to-open the PCLN May 20, 2016, $1,340 put option, creating a put debit spread. The difference in strike prices creates a $10-wide spread. Notice that both put options have the same expiration of May 20, 2016.
Now remember, the cost of buying one May 2016 $1,350 put option at $51.90 is $5,190… but by creating a put debit spread, you are only spending a total of $465. This is because you spent $51.90 on one put option while selling the other put option simultaneously for $47.25, giving you a difference of $4.65. One contract of 100 shares x the difference of $4.65 gives you your total cost of $465.
I'd much rather spend $465 for a put debit spread on a $1,352 stock than $5,190 for one put option or $135,200 for 100 shares of the stock… and I have a strong feeling you would, too.
Now the most you can lose on this trade is your total cost of $465. So no matter how far up the stock goes, you cannot lose more than that $465. You can consider closing the spread at expiration to be sure it all ends up as you like.
Some Things to Remember About Your Potential Profits
As I mentioned earlier, the smaller the risk, the smaller the reward. And the trade-off for your maximum risk of $465 is that your maximum profit potential is capped, too.
In the put debit spread we looked at above, the most you can make is $535, which is realized if and when the stock trades under the short leg of the spread – the $1,340 put option.
If Priceline is trading under $1,340, you'd get the chance to exercise your right to sell the stock at $1,350 while buying the stock at $1,350 – resulting in that $10 hitting your account. That $10 credit to your account is offset by your original cost of $46, leaving you with a profit of $535. (Keep in mind that there may be commissions and fees, which could bring this number slightly lower.)
Even though you could potentially make more going long a put, you would need to spend that $5,190 to do so – and the stock would need to move in your favor to avoid losing all of that money. In this situation, your maximum profits are capped at $535, but you only spent $465 on the trade and still earned a healthy 115% ($535/$465).
One last thing…
Before placing any spread trades, it's very important that you check with your brokerage firm and make it clear that you want to trade spreads – both put and call spreads. You'll need to have the right clearance to place spread trades as well as the right trading platform. OptionsXpress, TD Ameritrade's "Think or Swim" platform, and Interactive Brokers are good places to look.
About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.