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I've been teaching people the best way to trade for 30 years. My mission is to show average investors just how easy it is to crush the markets and double your money.
In fact, I've taught more than 300,000 subscribers the secret to doubling their money week after week. And I share weekly options trading strategies in my free Power Profit Trades service.
Today, I'd like to tell you about a number of ways to lower your risk by using options.
With these strategies, you can potentially spend less money upfront, make more on the return, and profit no matter which way a stock moves.
Let me show you…
Profit Whether a Stock Goes Up or Down with Straddles and Strangles
As you know, you can realize profits many times greater than your initial investment with options. Plus, options let you profit from decreasing stock prices just as much as increasing ones.
Those two facts together mean that you can bet on and against a stock at the same time, and if the stock moves far enough in either direction, you can still pocket a handsome profit.
This strategy is perfect when market volatility is high, or during earnings season when stock prices can move dramatically in a matter of minutes.
Here's how it works…
In a straddle, you buy one call and one put option on the same stock, both with the same strike price and same expiration date.
This increases your cost to open the trade, requiring a greater move in the stock price for you to realize a profit. But the benefit is that you profit if the stock moves up or down.
Let's see how this pays off with a real world example…
On July 2, 2019, Exxon Mobil Corp. (NYSE: XOM) was a month away from its next earnings report release.
At the time, XOM stock was trading for $75 a share.
Now, nobody can know for sure what a stock will do after earnings. And even if you correctly predict if a company will beat or miss expectations, stocks often fall despite an earnings beat or rise despite an earnings miss. Exxon stock was likely to move, so there was an opportunity to set up for profits, but it meant playing both directions.
That profit strategy involved two purchases: buying one at-the-money call option and one at-the-money put option, both expiring Aug. 16 at roughly $3.70 per share.
By Aug. 5, Exxon shares had dropped 7% to $70 per share – despite beating earnings. So while the call had moved far out of the money, the put was now trading for $5.79 – a 56% gain over the total original investment in just over a month.
For a more speculative play, you could also use a strangle…
A strangle works the same way as a straddle, except both your calls and puts will be out of the money. That means the strike price of the call will be higher than the strike price of the put.
The cost of this trade is lower than a straddle, but it comes with greater risk.
Here's another example…
On July 18, 2019, another opportunity arose for earnings-based profits in Ralph Lauren Corp. (NYSE: RL), which was trading at $110 and would report earnings at the end of the month.
Another big move was predicted for RL stock. To play both directions again, for only $530, you could buy RL calls with a strike price of $113 and RL puts with a strike price of $107.
When earnings came around, Ralph Lauren beat expectations but not by enough to move the stock higher.
Shares tumbled over 15% to $95 by Aug. 5. While the call option expired worthless, the put option grew to $1,007 in value, nearly doubling the initial investment.
Lower Your Cost with Debit Spreads
As we frequently say at Money Morning, you should never risk more than 2% of your account on any one trade.
That means that for an account with, say, $25,000, you should never risk more than $500 on any one trade. On occasion, though, you may spot a trade that you believe in your heart can make you big money.
The only problem is… it costs more than $500 for a single contract.
So can you still make a profit without completely ignoring your risk management? The answer is yes!
You can "sell to open" an option against the one you "buy to open" to reduce the cost of your trade. The number of contracts, the expiration date, and the type (call or put) of the option you're selling should be the same as the one you're buying. The only thing that changes is the strike price. If you buy to open a call option, the corresponding call option you sell to open should have a higher strike price. If you buy to open a put option, the put option you sell to open should have a lower strike price.
By selling to open this other option, you bring some money back to your account.
Now, this is all part of the same trade. These two options are to be opened at the same time on the same order ticket. I recommend consulting your broker to find out if they charge an extra commission for this type of trade.
You generally want to close these two options at the same time. To do this, you simply reverse your orders: sell to close the option you bought to open, and buy to close the option you sold to open. Again, you'll want to enter these orders simultaneously on the same ticket.
I've nicknamed the two versions of this strategy – the debit call spread and the debit put spread – the "loophole" and "reverse loophole" trade, respectively. "Loophole" in this context means you offset your cost by looping some money back to your account through selling to open an option against the one you bought to open.
Now, let's take a look at some examples…
The Debit Call (or Bull Call) Spread
Here's an old example of a debit call spread (which I also call a "loophole trade") on LinkedIn Corp. (NYSE: LNKD) from 2016. I'm going to use the LNKD June 17, 2016, $125/130 calls. This $500-wide spread ($5-wide spread) trade example is below…
On this order, you buy to open the $125 calls while simultaneously selling to open the $130 calls. This creates a vertical spread with a limit price of $2.75 (or $275), which results in a debit to your account of $275.
Here's how it works: If LNKD moves above $130, the market has the right to buy LNKD away from you for $130 because that's the option you sold. But you have the right to buy an equal number of shares of LNKD for $125 because that's the option you bought. Your broker should know this to make sure it actually happens.
The difference in the strike prices of $130 and $125 ($5) is your profit, offset by the cost of the trade ($2.75) shares, giving you a maximum profit of $2.25 ($225 per contract).
If LNKD falls below $125, however, both options expire worthless, and your risk is capped at the cost of the trade, or $275.
The Debit Put (or Bear Put) Spread
Now, let's look at an old example of a put debit spread – or reverse loophole trade – on Tesla Inc. (NASDAQ: TSLA).
I used the June 17, 2016 $205/$215 puts. This $1000-wide spread ($10-wide spread) trade example is below:
On this order, you buy to open the $215 puts while simultaneously selling to open the $205 puts. This creates a vertical put spread with a limit price of $5.17 (or $517), which results in a debit to your account of $517.
As mentioned, this is a $10-wide spread. I tend to look for a wider spread of 10 points on stocks that are in the upper $100 to $200 price range – usually closer to $200 is more likely.
The reason I recommend looking for this type of spread is that stocks in the $200 price range easily move five points or more – so you're able to find trades with an increased probability of making you money.
The stock has to be at least $0.01 below the strike price of the option you sold in order for you to realize your maximum profit. The market has the right to put the stock to you (or sell you the stock) at $205, whereas you have the right to sell the stock for $215 (and your broker should know this and make sure it actually happens). This $10 difference in strike prices is offset by the $5.17 cost, leaving you with a maximum profit of $4.83 ($483 per contract).
Your maximum risk, on the other hand, is the total cost of the trade, which is $517. No matter how much higher TSLA goes in price above $215, you can't lose more than the original $517 you spent to get in the trade.
Profit from Small Market Moves with Credit Spreads
You can also offset the costs of your options trades with a credit spread. Credit spreads work precisely the same way as debit spreads, except that the option you buy has a lower value than the one you sell, resulting in a net credit to your account.
Now, that credit isn't yours until the trade has been completely closed. And this trade doesn't completely absolve you from risk, but it's a perfect strategy to hedge your risk when you expect a stock to make a more moderate move.
Let's take a look at how it works…
The Credit Put (or Bull Put) Spread
A bull put spread is a "credit put spread" where you set the trade up for a credit to your account. And if all goes well, you keep the credit upon expiration when the options expire worthless.
In a bull put spread, you would typically buy a put option and then sell the next higher strike price option. Below is an example of buying a $40 put option and selling a $45 put option at the same month's expiration. To highlight what we're looking at in the images below, we've numbered them as follows:
- The purchase at the lower strike price and the sale at the higher strike price at the same time and as one order.
- The resulting credit amount on a per-contract basis as a result.
- The maximum profit and risk potential on the trade.
There is much more profit potential on a long call, but that would incur a cost, whereas the bull put spread generates a credit to the account. As long as the stock gets above (and stays above) $45, maximum profitability would be achieved.
And even though you might miss out on the possibility of unlimited reward for a long call, the probability of the stock reaching that maximum profitability point is higher in a bull put spread option.
In this scenario, the stock only needs to get above $45 for this option trade to pay the maximum reward of $2.50. The reason being… if the stock is greater than $45 at expiration, would anyone in the markets sell it to you for LESS than the current market price of over $45?
The answer is likely no.
And in that case, would you have the necessity to force someone to buy the stock at $40?
In this case, both options expire worthless, and no transaction takes place. So there are no transaction costs or fees, and you get to keep the full credit of $2.50, or $250 per contract.
Your risk is also capped at $250 for this trade.
If the stock falls below $40, the market has the right to put the stock to you at the $45 strike price, which you cover by putting the stock to the market at the $40 strike price.
The $5 difference in strike price is offset by the $2.50 credit you got when you opened the trade, resulting in a maximum loss of $2.50 ($250 per contract).
The Credit Call (or Bear Call) Spread
A bear call spread is a "credit call spread" where you sell a call at a certain strike price and buy another call at a higher strike price. The number of contracts for each and the expiration month should be the same for this type of spread.
Rather than using a bearish loophole strategy, the bear call spread will pay out its maximum reward at expiration without a transaction cost – as long as the stock ends up where it should.
Below is an example of selling a $97 call and buying a $100 call, creating a $3 credit call spread. To highlight what we are looking at in the images below, I've numbered them as follows:
- The sale of the lower strike call and the purchase of the next higher strike call at the same time and as one order.
- The credit amount on a per-contract basis as a result.
- The maximum profit and risk potential on the trade.
A long put option may pay out more because the stock has the opportunity to drop all the way down to zero. But by minimizing the risk of buying options and creating a spread, you still – as you can see in this case – have the chance for a healthy return on investment percentage.
You face your maximum risk if the transaction gets executed when the stock is anywhere above $100 at expiration.
If the stock gets called from you at the strike price of $97, and you have to exercise your option to buy it at $100, the difference in the strike prices ($3) is your loss. You offset that $3 loss with the credit of $2.09 that's generated to open the position. Therefore, your maximum risk amount is $91 (on a per-contract basis).
Anywhere below $97 at expiration gives you the maximum reward of $209 because if the stock is below $97, who would want to exercise the right to buy it from you at the higher price of $97?
Likely no one.
Therefore, you do not have to exercise your right to buy the stock at $100 in order to replace it at $97. Both options expire, and you keep the premium you sold to open the trade.
There are many similarities between the bull put spread and its mirror image, the bear call spread. In either strategy, you need the stock to be trading out of the money at expiration to maximize your reward potential.
But while the bull put spread needs prices to move slightly higher, the bear call spread only needs prices to slightly drop.
One Final Note on the Probability of Spread Trades
As you know, stocks can move in three directions only: up, down, or sideways. With a long call or long put, the stock HAS to move in the anticipated direction (up for calls and down for puts) for you to make money. This gives you basically a one-in-three chance for profitability.
But when it comes to a call or put spread, the stock can move in the direction you need it to or stay right where it is… and profitability can be achieved.
Remember, the more risk, the more reward. Just as the less risk, the less reward. A call or put spread is a way to minimize your risk, which decreases your profit potential.
However, a higher probability of success might be worth this trade-off to you – especially on an expensive option.
- What it is: buying an at-the-money call and put with the same strike prices and expiration dates.
- When to use it: during high market volatility and earnings season.
- Maximum risk: the premiums of both the call and put options.
- Maximum reward: unlimited.
- What it is: buying an out-of-the-money call and put with the same expiration dates (the strike price of the put will be lower than that of the call).
- When to use it: during high market volatility and earnings season.
- Maximum risk: the premiums of both the call and put options (lower than a straddle).
- Maximum reward: unlimited.
Debit Spread (Loophole and Reverse Loophole)
- What it is: simultaneously buying and selling two calls or two puts with the same expiration date but different strike prices. The call or put you're buying is more expensive than the one you're selling.
- When to use it: for options with premiums outside your risk tolerance.
- Maximum risk: the premium of the option you bought minus the premium of the option you sold.
- Maximum reward: the difference in the strike prices of the two options, minus the cost to open the trade.
- What it is: simultaneously buying and selling two calls or two puts with the same expiration date but different strike prices. The call or put you're buying is less expensive than the one you're selling.
- When to use it: when you expect a small move in the stock.
- Maximum risk: the difference in the strike prices of the two options, minus the credit you received when you opened the trade.
- Maximum reward: the premium of the option you sold minus the premium of the option you bought.
Put These Strategies to Work
Now, you've read all about different trading strategies you can use to lower your risk when trading options. But what if you could see my strategies in action? Well, now you can.
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The best part is this options trading strategy is super easy to understand and even easier to put into action.
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About the Author
Tom Gentile is widely known as America's #1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Now, he's diving into the biggest market in the world - one that almost no one has heard of before.