Straight option plays have a very high rate of risk. Very few people make consistent money at straight option plays---as compared to writing covered calls. Lately though, I've seen a number of students do really well. Some are several trades profitable without hardly a losing trade. I've been trying to analyze this and have come up with a few observations. I will make a list, but that is a strange way to explain this. Let me explain why the explanation is difficult. I think successful option trading is more of an art than a science. Yes, you gather all the information, but much of it comes down to gut feelings. So, even though I'll make the list to keep things organized, please feel free to think outside of the box.
These trades stretch back to last summer. Primarily they have been on the LULU stock split, then on the DIA (trading the movement of the whole market), and now on Ross Stores (ROST). They have been inordinately successful, generating a lot of cash flow. You can read all of these trades in previous blogs.
Here are the three things that need explaining: (1) KNOW YOUR EXIT; (2) THE FORKLIFT; and (3) USE A SPECIFIC FORMULA. These three are the perfect storm of a cash flow system.
(1) EXIT POINTS: From my earliest days teaching real estate and stock market seminars I've opinionated how important it is to know your exit before you go in the entrance. In fact one should never go in the entrance without knowing the exit. So let me explain this in everyday working knowledge that Molly, Fiona, and Fred have used.
- They used either a set point on the option to exit the trade, or a price of the stock. For example, Molly just traded the Jan $50 calls on a deep dip on LULU. It backed off $6, almost $7 on their earnings announcement. I've taught, "Don't just read the headlines." The news writers always go for the shock treatment. Read the details. Lululemon Athletica sells high-end yoga wear for women. They're now also selling young girls dance wear. The whole article said that their main problem is they can't supply their stores well enough. What a great problem to have. Sales would be up if their stores had more inventory. Molly jumped in on the slam, and bought the Jan $50 calls for $1.28 (ten contracts), for $1,280 and sold them the next day for $3.40, or $3,400, netting $2,120. Do you see the specific reason she got in? Now, by looking at the chart, she realized the stock may go up to $55 or so, which seems to be the resistance level as of late. So, she didn't get greedy and took her profits off the table. The forklift did its job. There will be another trade on another day.
- The same has been happening with trading the Dow---or the ETF, ticker symbol DIA. Look at the charts, and you'll see a definite trading range. In fact, I think the Dow is stuck in a trading range---11,600 on the support (though it did break below that for a day or so), and 12,200 (maybe up to 12,600) on the resistance. Write it down. Buy calls when low, sell them on the rise and buy puts on the downturn. This is an easy strategy to paper-trade, or simulation trade. Learn and Earn.
- Next, don't exceed expectations. Choose the right strike price. I firmly believe you should enter straight option trades with a chance at a triple, or 300%. Rarely do we ever achieve this level of profit, but we enter the trade with that possibility---meaning that the stock/option has a chance to make it and the time to make it to the point you desire. Within this scenario, the time speaks for itself. It's the "chance" that is the hard part. How good is the news? Where does it stand on the chart? What direction is it heading (check the stochastics)? What is the whole market doing?
- Check the Delta, the relationship of the Stock movement to the Option movement. Now, I would like to introduce you to a new topic. I've covered it before but not in these blogs. It's called the Percent to Double. It's often the heading of a column that many brokers have to help them and you make better decisions. It's listed as %Dbl. What this means is the percentage the stock has to move for you to double your money on your options. Example: Let's say you're trading the Dow, as in the DIA. It's at 119 (meaning the Dow is at 11,900) and the $120 calls are going for $2.20. The Dow would have to move up about 3% or about 400 points for your option to double to $4.40. Can it do so? Of course, if the timing is right. What if it's been struggling with 11,900, or 12,000? What if the news about housing, unemployment or the Euro is all bad? Yes it's possible, but improbable. Nevertheless, it doesn't have to move that much for you to be profitable. Point: You don't have to get a double to be profitable. Remember your expectations, your exit point. I still think the Dow movement of 100 points means about a .50 cent move in the options. Is a $500 profit good on $2,200 (ten contracts at $2.20 each) for a day of two, or even an hour or two? I say, "YEP!!!" The Dow has to only move up 100 points.
2) EVENTS: Do you have a specific event you're using to move your stock? Call it a "Compelling Reason," or an "Other Motivating Factor," or a "Forklift"---it is the cause behind the movement. Now check your event against all that I wrote in #1 above and question it thoroughly. Time to work? Strong enough to be real? Clear and workable strike price?
- The event has to be specific. It has to be important---and important to others, not just you. For example: Great earnings. A Dividend increase. Expansion. The ending of a lawsuit. Is the company big enough to be followed by many analysts? If not, is it a falling tree in the forest?
- Is there more than one event to make it move up or hold it up. For example, Ross stores right now has great earnings (14 quarters of profits); a two for one stock split; Christmas and the upcoming Santa Clause rally (almost every year); and a dividend on Dec. 29th. That's a lot to go on. Watch this one. Analyze the trades and rationale here. You'll see a lot of these.
- The longer I live and trade the more convinced I am that the greatest discovery I've ever made has been the "Red-Light, Green-Light" phenomonon. I feel bad someone has taken my RL-GL title and now sell a course by that name. It has nothing to do with me. My strategies are in a book of the same title, and will soon become part of a new Home Study Course. My point here is that everyone knows how important earnings season is to stock movements, but no one relates it to options. And no one ever says: "Hey everyone, we're leaving earnings season. Get your money out of harms way." You need to use this RL-GL knowledge as the back-drop, the canvas of every trade.
- I call it "Passion, Precision, Persistence and Profits"---as in after the first three comes the profits. If you do not have the passion, a strong desire, you'll never stick with it long enough to gain the knowledge of the details---the precision---to be profitable. This is part of the "ART" that I so frequently speak about. Note also, that two people, with similar backgrounds and training can look at the same facts and make completely different trades. Why? It comes down to acting on your feelings, after you gather the facts.
- You need to put market forces to work for you. Time to options is usually the enemy. Sell covered calls. Only do trades with enough time on your side. If you do straight option trades, remember you have a 2 1/2 chance out of 3 of being wrong. It takes a lot of thought to come out on the right side. I studied hundred million dollar option traders who continually got 20% annual returns. I learned some valuable lessons. My attempt is to make 20% a month, so I need to pay close attention to these strategies.
- Always do a trade with a chance to get a 300% return. A triple. You may not get it, but enter it with that opportunity.
- Cut your losses at 50%. If you have $1,200 in the trade, get out when it goes down to $600. Weed the garden better. Let the winners work, cut the losers.
- Do even dollar trades. If you have $10,000 to trade, then do five $2,000 trades, or ten $1,000 trades (or as close as you can).
- Wishful thinking is not an investment strategy. Don't guess, don't hope. Don't make predictions, make projections. Calculate the exit from the entrance and enter when the stars have aligned.
Speaking of the STARs, let me share the system we use to explain a trade. Let it be known that we can't get the info on all of our student trades in time to share all of it before the trade is entered. However there should be enough information to help you make similar trades. We use the STAR as an acronym. Read the summary at the end of this.
S. The Scenario in the market. What's the storyline? What's going on with a particular stock
and what's going on in the sector, the whole market, and even the economy. Why do this
trade now?
T. The Technique to be used. Is it a covered call; A Bull Put Spread; A straight option, a stock
split, or a spin-off?
A. The Actual trade. What we paid for the option or the stock, then what did we take in for
selling the option if it is a covered call trade.
R. The Results. Either the expected results---and this may change as the trade matures---and/or
the actual results achieved---win or lose. And if appropriate the lessons learned---good or bad.
SUMMARY
I suggest that if you use this S.T.A.R. system in your own trades---after watching us use it for educational purposes---that your trades will go better. In fact, by thinking it through---especially the exit point, or expected profits---it will cause you to rethink many trades and not enter trades that will do harm with little upside potential. All of the above is designed to help you think more clearly, taking into account numerous points, and help you connect the dots better.
Let's return to the first part of this article, we've come full-circle. If I could make a 3 or 4 point list and say if you just do these things in order, all well go well, I would do so. But it doesn't exist. If it did, everyone would follow it and get rich. Many people think that some black box exists. A little inside secret or methodology that works everytime. Sorry. It comes down to the art of the deal. "The Art of the Deal" is a book by Donald Trump. I haven't read it but I know exactly what he is talking about. Sad, but most people will never get it. It comes down to using all the science you can gather, then turning it into an art. And you'll never be a great painter or artist or cash flow expert without starting and learning and growing as you go.
"LEARN TO MAKE CORRECTABLE DECISIONS, NOT JUST CORRECT DECISIONS."
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