With markets at extended levels, but prices seemingly with no cap in sight, it becomes a challenge to put new capital at risk.
We often fear that we will be the last ones in and will be left holding the bag. Of course, that could happen. But if you are a good risk manager, you will read the technical signs and proceed with caution and may come out safe. But how does one take a stab at this market when it seems everything is so expensive?
Options are a perfect vehicle for trading, if you trade them for a living, like I do. These are cash-only instruments and define your risk to the amount of premium paid. So, you can only lose what you put in. Options are a great leverage vehicle, offering either to eight to 12 times leverage on the stock if you get the direction and the timing correct.
Options traders are not looking to get married to a stock and are not purchasing the shares. Rather, we are looking for a sharp move up or down. Buying a call would mean we are looking for a higher pop in the stock.
When the market takes a dip in the middle of a run, you have to look at it strategically and see if this is just a small dip to be bought or something more serious. This past week was filled with opportunity, if you had your attention there.
Recently we had a call play on Apple ( AAPL) : We bought a January $265 strike for $5.50 per contract after the stock took a big dip following the Thanksgiving holiday. The stock was selling at $258 a share at the time we bought our call. Apple closed on its highs that day and our call was positive right out of the gate.
A couple more positive sessions and gaps higher into last Friday put more momentum into Apple and our calls, and by Friday the stock bolted over $270 and our calls were worth $11.30. That is more than a 100% gain in our option, as the stock moved up an impressive 4.6%.
But do you see the leverage of options?
In just four days, we have a 20-to-one leverage ratio on the stock. Further, our losses were capped at $5.50 per contract if the trade did not work out in our favor. Tell me what you would rather have made, a 100% gain in four days or a 4.6% gain? I think I know your answer.
Like anything, the timing and execution doesn't always work out this well. Next week I'll show you a play that didn't work out, and what we did with it.
Either the name is going to rally or the dividend is going to get dropped.
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