How to Hedge This Market with Options Trading

If you think that trading options is not for you, think again.

Set aside all the stories you may have heard about high rollers and market gamblers who bet the farm on whatever the next big thing might be.

The truth is that options can be part of a conservative investment strategy.

That's right - conservative.

You can use options to hedge your portfolio against losses or you can take advantage of a market pullback without having to sell your stocks and incur possible tax consequences.

You can even use options to generate a steady stream of income with low risk and for low cost. You may have even read about "selling covered calls."

So, let's talk more about profiting from a market decline, because stocks have been on shaky ground since peaking earlier this month...

Many of those high-flying technology stocks are now taking it on the chin, and it's no wonder.

The Nasdaq Composite Index was up a whopping 76% from its March low through Sept. 2.

How many stories did you read saying how overvalued they were? Well, the piper is now being paid as these stocks pull back even harder than the broad market.

You can be conservative and buy some put options as an insurance policy against losses in your portfolio. Or, you can make some real money trading options to take advantage of the correction itself.

And what a correction it could be with all the unknowns out there...

Will there be a second wave of infections? Will there be a safe vaccine that can be mass-distributed soon? And what about the ripple effect from all the jobs that have been lost and may never come back?

Of course, we have not even mentioned the division over the pending presidential election...

That is a lot to worry about, and if there is one thing the stock market hates, it is uncertainty.

Money Morning's own options trading specialist, Tom Gentile, thinks there are more declines ahead. And he thinks protecting your portfolio with options is the way to do it.

Tom Gentile's Best Options Trade Today

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Tom is more excited now to be in the market, but just not in the way most people think. He recently said, "I'm anticipating nothing but profits" as this correction progresses.

For Tom, it's all about volatility. And markets are historically the most volatile in bear markets...

Just look back to March of this year. The S&P 500 lost one-third of its value in less than five weeks. And the VIX spiked over 500% from February to March.

Options traders particularly love volatility because it means that bigger sums of money can be made in less time when prices move fast.

A 10% move in the underlying stock could mean 1,000% returns on the right options trade.

But how do we walk the line between too much risk and not risking enough?

After all, we have to risk something to make something. For that, Tom recommends a strategy called a credit spread, also called a bearish call spread.

With this strategy, you make money when the underlying stock goes lower. But rather than exposing yourself to excessive risk should market volatility send your stock higher, this strategy protects you.

Here's how it works.

You sell a call option with a strike price at or just below the current price of the stock. At the same time, you buy a cheaper call option with a strike price above the first option. Because the cost of the second call is lower than the money you receive for the first, you get a net credit in your account. That's how it got its name.

You make money when the stock falls below the strike price of the first option. As long as the stock closes below the lower option strike, you keep the entire credit in your account.

Here's the best part...

If the market surprises you and pops up in a big way, the lower strike option you sold has theoretically unlimited risk. If the stock goes up 100 points, you could be on the hook for that amount of money.

However, since you own the second call, that option will make lots of money on that big stock gain. Your loss is limited to the difference between the two strike prices less the credit you received.

Let's say the difference in strikes is $5 and you received a credit of $1 at the start of the trade. Your net loss would be 5 - 1 = $4. And it does not matter how high the stock goes - your loss is the same limited amount.

Tom recommends that the two options strikes be between $1 and $10 apart and the expiration date for both is anywhere from two weeks to one month away.

Here is just one trade you can do on the SPDR S&P 500 ETF Trust (NYSEARCA: SPY) today...

Tom's trigger to begin this trade is the SPY falling below $330 per share on strong volume. This is an important technical level on the charts.

Sell the Oct. 12 2020 $330 SPY calls. And use that premium to buy Oct. 12 2020 $335 SPY calls.

If this trade is successful and the SPY keeps falling, do it again with a lower set of strike prices.

Remember, if the market does break down like this, a bearish trend could last for many weeks.

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