Dear Reader,
I’ve got another video edition of Market Minute for you…
Because there’s a lot of really crazy things happening in the market right now… and I just wanted to take the time to remind you of a few things…
Like the fact that we don’t gamble here. So many people think using options is the equivalent to gambling, but that couldn’t be further from the truth – if you use them correctly.
It’s my mission to make sure you don’t make the same mistakes I made when I started with options… like blowing up my account because I got cocky… and teach you to slant the odds of winning in your favor, time and time again.
Check out my video, or scroll down to read the transcript.
Transcript
Good morning. I’m Jeff Clark. Welcome back to another video version of Market Minute. And today what I’d like to do is talk a little bit about gambling in the options market. Now, if you follow my work for any length of time, you know, I’m not a proponent of gambling. I like to use options as a way to reduce risk.
And in fact, that’s what options were originally created for. Was to reduce your risk. But I’m also very aware that the psychology of the average human being is that we use options for gambling, or a lot of folks do use options for gambling. So if you’re going to insist on doing that, I think it’s important that you actually set up a situation where you can be successful gambling with options.
Again, I’m not a proponent of that. In the future videos, I’ll show you how you can get away from the gambling side of things. You can use options. But I think it’s the right way. But if you’re going to use options as a mechanism to get more bang for your buck, to leverage positions or to swing for the fences, then I want to show you a little bit today about how to do that.
And understanding the nature of gambling is sort of prevalent behind that theory. When you’re gambling, you’re basically taking a situation where the odds are against you. Most of the time if you go to Vegas, you go to Reno, whatever table games you play, or even at the slot machines. Obviously, the odds of winning are less than the odds of losing.
And when you win and when you lose, it’s basically the same thing. So if you bet a box, you can win a box. If you bet a buck, you can lose a buck. But the odds are tilted much more in favor of you losing a bar in the options market. You can bet a buck lose a buck, but you can better buck, and you can make a lot more than a buck.
So what I want to talk about today is how to create a situation where the risk reward is slanted in favor of reward rather than risk.
And that’s where you can play the odds, even if the odds of a trade are against you, the reward of that justifies taking the trade. So here’s what I mean. When you buy an option, either buy a call option or you’re betting on the upside of the stock, or do you buy a put option, and you’re getting on the downside of a stock.
And the stock can only do three things. It can go up. It can go down or stay the same. And when you buy an option you’re betting on one direction. So if you buy a call option but the stock is higher, you’re going to lose money. If the stock stays the same or goes down. So you can lose money two out of three times buying a call option.
If you buy a put option, you’re going to make money if the stock goes down. But you can lose money, if the stock stays the same or goes up. So you’re going to lose money two out of three times. So when you bet a dollar two out of three times, you’re going to lose that dollar. So what you have to do is when you bet a dollar, you have to have a situation where you can make twice as much as what you can possibly lose to bet a dollar, lose a dollar, or you bet at all, or win $2.
That puts the risk reward basically back in balance. And if you do better than winning $2, then that puts the risk reward in your favor. So I want to show you a setup that I recommended to my Jeff Clark Trader subscribers last week. A trade setup that I like the risk reward on it. And we trade in an option.
I know, again, I don’t trade options with the idea of gambling, but if you’re going to get away, if you’re going to gamble with an option, this is the sort of setup that I like to use. So let me share with you my screen here and we’ll go from there. Okay. So this is NOV, an oil and gas drilling, production company.
Basically they help build drills, for oil and gas wells. So you can see in the very far right of the screen, or on the chart, you can see how we bottomed in early November, and then you see that big spike.
Well, that was a reaction to President Trump’s victory. And of course, those stocks had a big spike in reaction to President Trump’s victory.
So this created a situation where we went from an oversold condition to the beginning, I think of a new rally phase. So we didn’t buy on that particular spike. It was a little bit too late to do that. I don’t want to buy into a spike run up, but you can see this as the enthusiasm behind the victory faded a little bit.
The stock came all the way back down and it’s sitting right on this little coil of moving averages right around $16 a share.
Now I like that position. If you believe that the stock is transitioning from a bear market into an early bull market, then buying it on this type of a pullback makes a whole lot of sense.
Those moving averages that are all coiled around the $16 level are called the support. So I like this setup to buy. And so I like the idea of buying a call option on it. Now for the stock itself. If I’m wrong when this trade and the stock breaks below all of this support, this is down at $16. If it breaks below all of this support, then the odds are it probably comes down and makes a new low down to about say, $15 a share.
You can see the previous low in early November was $15.20. So I’m risking $0.80 or maybe a dollar per share to buy the stock at $16. If I’m wrong, it drops to $15. I’ll say, okay, I’m wrong, I’m out and I’ll take my hit of a dollar a share. If I’m right, however, the stock rallies from here, I have three targets.
On the upside, the first target is this little consolidation period in August, which is right around $18 a share. That looks like an easy chip shot. More likely, I think there’s enough potential for the stock to get up to 19. And then if things really get tricky, we could see, you know, back up to the April high around 20, 20.5 or so.
But really my target on this is around the $19 level. So if I’m buying the stock here at $16, I’m risking $0.80 to a dollar on the downside. And I have the potential to make, say, $3 a share on the upside.
So I like that from a risk/reward perspective, because I’m risking $0.80 for a buck and I can make three bucks.
So that’s a really good setup from a risk/reward situation. So when I took this position over to the option market, I wanted to buy a call option on NOV. And I priced at the time this was last week at priced at the time the December 20th expiration. The 16 calls were trading for about a buck.
So I can buy those call options for a dollar. So in that situation, the worst you can ever do when you buy an option is you can lose 100% of the premium that you bought. So if I’m risking a dollar, the most I can ever lose is that dollar. So I’m willing to risk that dollar. Now on the reward side, if I’m risking a dollar.
Remember I said the odds are 2 to 1 against you making money on an option, we buy it. I got to be able to make at least two. Well, this situation provides that for me because the stock is at 16, I am buying the right to buy it at 16. These are runs to 18. That right to buy it at 16 is going to be worth two if it runs to 19, which is my target, that right to buy it is going to be worth three.
So I paid a buck for it. Make two bucks. That’s 2 to 1 risk/reward ratio reward or risk reverse that so I can make two bucks or I can lose a buck. I like that particular setup. So I made this recommendation. We bought the December 20th 16 call options. And we bought it right here sitting on the coil and the stock, you know we were fortunate. It’s had a nice little bounce. I think the options are now trading for about $1.30. So well we paid a dollar for last week. It’s up to $1.30. We’re up 30% on the trade. That’s a nice situation to be. So now, if I want to use this to lessen my risk a little bit, I can move my stop up on the option to say, breakeven.
So if the stock if the option stock starts to fall and the option comes down to trade to about a buck I’ll get out of it, I will take a loss on the trade. Or better yet, if I’ve leveraged a larger position than I normally would, let’s say I’m gambling and I’ve leveraged a larger position than I normally would take.
Now it’s at $1.30. I can trim a little bit of that off so I can take out some of the risk, take a little bit of profit off the table and hedge my downside with that.
So this is what I’m talking about. If you’re going to use options for gambling, you want to have the type of setup that I’m showing here where you have, at least twice as much upside as potential downside in the stock in the option trade that you take gives you at least twice as much upside as potential downside.
And the more you can do that, the higher the potential upside and the more likely of seeing that potential upside. The more you put the odds in your favor of being able to, being able to take a profit on the trade. And that sets up a, like I said, a pretty good risk reward situation.
Again, I’m not advocating in favor of gambling, but if you’re going insist on gambling, a lot of people do, and a lot of people are successful at it, but you’re only successful at it if the reward compensates you for the risk.
Now, as I mentioned in a future video, I’ll talk about how to use options the right way, which is as a way of reducing risk. And we’ll probably use the same situation we have here, where I can show you how I would trade this particular situation myself. So we’ll do that next time. So for now, let’s take it on that.
Good luck with trading and we’ll talk to you, next time. Take care. Bye bye.
Jeff Clark
Editor, Market Minute