An Advanced Options Trade

| March 2, 2010 | 0 Comments

Many of our readers focus on trading stocks and ETFs in the market.  While you could spend a lifetime learning about and perfecting trading strategies on these securities, others expand their horizons.  There are a number of other trading opportunities available for investors willing to put in the work and learn about new strategies.

Take commodities for example.

For years, experienced traders stayed away from the commodity markets because of their complexity and risk.  Trading futures with huge levels of leverage was risky… you could lose more money than you invested.  The phrase “losing your shirt” takes on a whole new meaning.

Today, trading commodities is a whole lot easier… new commodity ETFs mirror fluctuations in commodity prices.

It’s the same with currency trading.

An entire market, once off limits to ordinary investors, is now available to everyone.  You don’t have to be super wealthy!  Anyone can trade currencies… right in their regular stock trading account.  Once again, the magic of ETFs make it possible.

Now, there is one area of opportunity for huge gains… but the trading strategies can be a bit more complex.

I’m talking about trading options.

My first trade in the stock market (way back when) was actually an options trade.  I didn’t have enough money to buy 100 share blocks of stock… so I started trading options.

Now, options aren’t for the faint of heart.

If the stock trades above the strike price before the expiration date, your call option becomes very valuable… and if it doesn’t… well, the option could become worthless.

So why take on the risk?

For the potential rewards… I’ve seen options skyrocket in value… returning 200%, 300%, or even more within a few short weeks.

In my Currency Options Insider service, I recommended buying put options on the British Pound.  Less than two months later, the option had increased in value by 1,027%… just thinking about it makes me smile.

Can you imagine turning every $1,000 invested into $10,000?

Obviously, every trade doesn’t work out like that… but you only need a few big winners to make some serious money.  Option trading can get a lot more complex.  Here’s an advanced strategy for those of you who have traded options before.

It’s simply called a spread trade.

When you buy an option (a call or put), you’re banking on the stock moving one direction or the other.  However, buying the option can get expensive.  You need to come up with the cash to purchase the option.

Instead of fronting all the cash, you can sell a similar type option and uses the proceeds to offset some of the costs.

Some advanced traders (like hedge funds) use spread trades to lower their cost of trading options.

Here’s a real life example…

Right now you can buy Citigroup (C) call options with a $3 strike price and a September expiration for $0.64.  To reduce your cost, you can sell the same number of call options with a $4 strike price and a September expiration for $0.21.

You simply buy one set of call options and sell another set.

Why would you do this?

The proceeds from the sale of the call options help reduce your overall cost by over 32%.  When all is said and done, you’ll pay something close to $0.43 instead of $0.64.  Remember, the price of the option is multiplied by 100 to get the total cost of one option contract… In this case, you’ll pay $43 for each contract.

How do you make money?

Your break-even on the trade is $3.43.  (Simply add the cost of the option to your strike price.)  As soon as Citigroup trades above $3.43, you’re making money.  Remember, you’ll have until September for this to happen.

Your maximum profit is when Citigroup hits $4.00… so you’ll make $57 per contract.  It doesn’t sound like much, but you could buy 100, or even 1,000 contracts.

If Citigroup trades above $4.00, your profit is capped.  Remember, you sold the $4 option to somebody else… so while you can use your call options to buy Citigroup at $3, you’ve agreed to sell it to somebody else at $4.

This strategy caps your total return.  But, you were able to reduce your overall cost of doing the trade.

I’ve just scratched the surface of advanced trades here.  You can create spread trades in a number of ways including calendar spreads, diagonal spread, vertical spreads, horizontal spreads… the list goes on and on.

Once you understand how the trade works, it can be a very powerful strategy.

Remember, this is an advanced strategy.  You might need additional permissions in your trading account.  Most importantly, if you’re confused at all, consult your broker – that’s what they’re there for!

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Category: Options Trading

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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