Everyone loves to smack one out of the park. There is nothing quite as exhilarating as buying cheap out of the money calls on a stock just before it is bought out, or buying a currency option just before central bank intervention.
Happy as those blockbuster trades are, though, the truth is that smaller, consistent profitable trades are way easier to find. Plus, what happens when you DO find that gangbuster megatrade and you are sitting on 100% profit, when do you get out? How many times have you thought, "I will try to get another dollar out of this," only to have the trade turn around and wind up with a loser?
That is why I LOVE option spreads. They set up small guaranteed wins, with the potential for bigger wins.
Using today's price actions, lets look at a trade we did. I knew the market was going to gap down and thought it would probably swing way down, but was unable to track early activity due to other responsibilities. By the time I got online, the dow was down over 200 points and trending lower. I grabbed a quick look at the chart to see, and yes, it was still falling off a cliff. I turned around and placed an order to buy three August DIA (Dow Jones index ETFs often called "diamonds") 111 puts. These were already 200 points "in the money" but they were selling for 4 even. I put in a limit order, got em for 4 and was out $1210, counting commissions. I had 600 dollars of "intrinsic" value in the options, and 600 of speculative premium. With only 9 days to expiration, THIS IS A STUPID TRADE, unless I planned to do something right away, which I did. I bought in the midst of a fast moving market, or I would have gone out to at least the October expirations. Anyway, I immediately put in an order to sell three more puts at 109 strike, for 4.25 apiece. The market bumped down close to my order, but never hit it. It then rallied a bit, and I considered selling the calls I had bought, as they were at about 3.90, but I thought, "no, markets that open down like this and rally often really tank in the final thirty minutes of trading." So I cancelled the 109 put order, and replaced it with an order to sell the August 110 puts for 4.25. This got filled at about 3;30.
So where am I now? Well, I entered the trade AT A CREDIT. That means I got more for the puts I sold than the ones I bought, so the trade already makes money. Only about 50 dollars after commissions, but hey, 50 dollars a trading day is 11,000 dollars a year. I'll take it. However, the potential for even better things is also there. The "spread" between the two strikes, if the dow closes less than 10,900 in 9 days will be 100 per trade. That is the difference between 1100 and 10900, since I own the 1100 puts and sold the 10900 puts. So the maximum profit I can enjoy is 300, or 3x100 per trade. Add the 50 dollars I netted on "legging" into this spread (opening one position at a time), and subtract the 20 dollars commission I will pay to "exercise" the options,, and I wind up netting 330 dollars.... and I have NO RISK TO ME.
Over the next several months, I look for the dow to drop at least to 8,000, and maybe down to 6,000 as it did in 2008. If so, I plan to do this same trade over and over. Next time, we will do it in the "out" months of October or November, and we will discuss how to "pick up and drop a leg" to take advantage of option premium decay (the most exciting thing about options!!!) to put money money in our pockets.