Editor's Note: Options aren't as dangerous as Wall Street would have you believe. In fact, they can actually minimize risk. Take this options strategy Tom shared back in 2016, which can help you secure big double-digit gains while capping any potential losses. Here's Tom…
In the past 10 years, I've taught well over 300,000 traders about many different moneymaking strategies.
Whenever we talk about a new options trading strategy, the first thing I always say is, "practice before you spend any real cash on a live trade."
And the second thing I always say is, "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.
So can you still make a profit without completely ignoring your risk management?
The answer is yes!
Create a Call or Put Debit Spread to Hedge Your Risk on a Higher-Priced Option
We've talked before about risk graphs and how you can use them to "see the future" of two straight directional options trading strategies, long calls and long puts.
Today, I want to use a risk graph to show you the risk and profit potential on two of the debit spreads I often like to use during volatile times – the debit call spread (or bull call spread) and the debit put spread (or bear put spread).
Remember, a risk graph will show you the theoretical profit potential you have when trading long calls and long puts. Keep in mind that your profit potential is unlimited when buying calls, but your maximum profit potential when buying puts is limited since the stock can only drop as low as zero. The most you can risk (or lose) on a long call is the amount of money you spent getting into the trade. The most you can risk on a long put is the same – the amount of money you spent on the trade.
With a debit call or debit put spread, what you're really doing is "selling-to-open" an option against the one you "bought-to-open" to hedge the risk of your trade. This means that you're simultaneously buying and selling either calls or puts (on the same order ticket) to offset the cost of the calls or puts you bought.
Now, as I mentioned above, the best way to manage your risk is by making sure that you never risk any more than 2% of your account on any one trade. That's a maximum risk of $500 per a $25,000 account.
But if you want to make money off an option that costs more than $500, the best way to do it is by creating a debit call spread or debit put spread.
Well, you can buy-to-open that option priced higher than $500 ($5.00) and sell-to-open the same number of contracts for another option that has a different strike price but the same expiration month as the option you bought-to-open.
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 the commissions 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 these two trading strategies – debit call spread and debit put spread – the "loophole" and "reverse loophole" trade. 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.
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.