Financial Literacy

How Using Options Predicts Profits – Part 2

In yesterday’s Trade of the Day, we focused on how to calculate the move expected in a stock after its company releases earnings.

Here’s a refresher:

Take a look at the stock price and choose the options that have the closest expiration and the closest strike price to where the stock is trading. Do that for both put and call options.

Then add up the price of the put and the call, and divide that number by the current share price. That gives you a percentage approximating the move expected by the market.

As an example, take stock “X”…

Assume the shares for stock X are trading at $20. You look up the options chain and see that there are weekly options. The $20 call option is trading for $1.20, and the $20 put options are trading for $1. That is $2.20 in total. Divide $2.20 by $20, and you get 11%.

That is the expected move for the shares. It’s that simple.

Now, that 11% doesn’t give you the direction of the shares. It just gives you the expected move.

Today, we’ll focus on how to play this move…

There are two ways to do that.

The first is making a directional bet by buying a put or a call. A put is a bet that the shares will move lower, and a call is a bet they’ll move higher. If you do this, you can win only if the shares move in the direction you choose.

Taking the example of stock X from yesterday, if the shares move higher by the expected amount of $2.20, the price would be $22.40. If you bought the call for $1.20, the call would be worth $2.40 and you would double your money. That is a directional bet.

The second bet is a strangle. Knowing that the probable move is $2.20, you can play both sides of the trade. An upside move could bring stock X to $22.20, and a downside move could put it at $17.80 (you get this by adding $2.20 to $20 or subtracting $2.20 from $20).

A strangle trade lets you “safely” bet by covering both directions a stock could move. However, the move of the stock’s share price must be great enough to cover the combined cost of this trade, or else you’ll end up losing money.

To perform a strangle on stock X, you would pick the $19 put option and the $21 call option. The price on each would be around $0.50. If the shares went to your upside target of $22.20, that option would be worth at least $1.20. Your cost is $1, so you would make $0.20 or 20%. If the shares moved to $17.80, the same would be true on the downside.

In the case where the shares don’t react strongly in either direction, you would lose your $1 investment.

The minimum goal is to at least cover your cost. However, it really gets to be fun when the numbers are a blowout one way or another. When they are, one part of the trade, whether it’s the put option or the call, will expire worthless – but that doesn’t matter.

If the shares moved by 20% or $4, you would be looking at triple-digit gains, easily!


About

With more than 20 years of experience, Karim has mastered the subtle art of options trading. What we admire about him is his ability to score huge gains while minimizing the massive amount of risk that often comes with options. Beyond his expertise in options trading, he is also the author of the best-selling book Where in the World Should I Invest? He publishes weekly about smart speculation in his latest free e-letter, Trade of the Day.

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