In last Friday’s Market Minute, I put out a call to you for help…
I wanted you to give me your best stock ideas… so I could prove to all the skeptics that options are better and less risky than buying stocks… if you know what you’re doing.
So thank you to all those who wrote in – I’ll be providing trading examples in the days and weeks ahead with your suggestions.
First up, Microsoft (MSFT)…
The Power of Options
Lots of folks like the idea of buying “Mr. Softy” into its recent weakness. One reader, Julio, thinks it could be a $550 stock in two months, and he’s willing to risk a potential downside move of 10% to bet on that outcome.
If Julio buys 100 shares of MSFT at the current price of $425 per share, he’ll invest $42,500. If he’s wrong and the stock declines, Julio will stop out on a 10% move. So, he’s willing to risk $4,250.
And, if he’s right and the stock rallies to $550 he’ll make $12,500 on his 100 shares.
That’s nearly a 3:1 reward-to-risk ratio. It justifies taking a bullish position on the stock.
Here’s How We Can Do Better Than
In fact, there are several option strategies that offer traders more reward and less risk than owning the stock. We’ll look at the simplest of those strategies today – buying a speculative call option.
(If you don’t know what a call option is… I have three free training videos right here under the Free Resources tab on the Market Minute website. Check out the first video “Understanding Options and Buying Calls.”
When you buy a call option, you pay a premium and you have the right to buy the stock at the strike price of the option by the expiration date.
Before we figure out which option to buy, let’s work out how much we’re willing to put into the trade.
Keep in mind, whenever you buy an option you are risking 100% of the premium you pay. You can lose everything you put into the trade. So, it’s important to only risk funds you are willing to lose.
In this case, Julio is willing to risk $4,250 if he’s wrong and MSFT declines 10%.
So, the most we should put into an option trade is $4,250. That will limit his risk in the option to exactly what he is willing to risk in the stock.
Many beginning traders make a mistake here. They think, “I can buy 100 shares of stock for $42,500, or I can put the whole amount into call options and really clean up when the stock rallies.”
The problem, of course, is when the stock doesn’t rally, the option expires worthless, and 100% of the money is lost.
That’s why so many folks think options are risky.
It’s Not the Option That’s Risky… It’s the Strategy
Rather than reducing risk, by putting the entire $42,500 into call options, a trader is buying far more exposure to the stock. He’s focusing only on the “reward” side of the equation. And, he’s dramatically increasing the risk of the trade.
If we limit the size of the option trade to just the $4,250 we’re willing to risk on the stock, then we can increase our exposure to the stock – thereby increasing our potential reward – without increasing our risk.
But, we can do even better. Let’s cut our risk in half by limiting the maximum we’ll put into a MSFT option trade to $2,125. By doing this, we’ll limit our maximum loss to $2,125 and we’ll do what options were designed to do in the first place… reduce risk.
Julio is looking for MSFT to rally as high as $550 over the next two months. So, we need to buy an option with an April 17 expiration date.
MSFT closed Monday at about $425 per share. At that price the MSFT April 17 $450 call options were priced at $9.50.
In other words, we can buy the right to buy 100 shares of MSFT at $450 per share anytime up until April 17 for $950.
Since we’re planning to put up to $2,125 into this trade, we can afford to buy two of these options for a total investment of $1,900.
That’s the most we’ll ever lose on this trade. If we’re completely wrong on MSFT and the stock craters, our risk is limited to just the $1,900 we spent on the two options.
Julio was willing to risk $4,250 on the stock. By buying two call options instead, he’ll risk less than half that amount.
Now, let’s see what happens if Julio is right and MSFT rallies to $550 within the next two months…
The 100 shares of MSFT bought for $425 per share are now worth $550 per share. That’s a gain of $12,500 on 100 shares.
The gain on the option trade, though, is even better…
At $550 per share on MSFT, the April 17 $450 call will be worth at least $100 – or $10,000 per contract. We bought two contracts. So, that’s a total value of $20,000 versus our purchase price of $1,900. That’s a gain of $18,100 – nearly 45% more than the profit on owning the stock itself.
By buying shares of MSFT, Julio was willing to risk $4,250 to make $12,500. If he buys the call options instead, he cuts his risk to $1,900 and increases the potential reward to $18,100.
On Friday, I’ll Show You How I Would Trade MSFT
This is an excellent example of how options can be used to reduce risk and increase the return on a trade. Of course, this example is based on the parameters that Julio provided. If we had different expectations for MSFT – like a lower price target or a longer holding period – we would structure the trade differently.
No matter the expectations, though, I’m confident we could use options to set up a trade that performs better than buying the stock itself.
In Friday’s Market Minute essay, I’ll show you how I personally would trade MSFT based on how I interpret the technical setup.
The strategy will expand on how we use options to reduce risk and increase reward.
Best regards and good trading,
Jeff Clark
Editor, Market Minute
P.S. Tell me if you’re liking this series so far at [email protected].
And, if you want me to craft an options strategy for a stock you want to own or short, write me the stock, what your price target is, how much you’re willing to risk, and the timeframe you expect to own the stock.