Bracket Trading Techniques

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Long Puts
For aggressive investors who have a strong feeling that a particular stock is about to move lower, long puts are an excellent low risk, high reward strategy.



Example Increase in Volatility Time Erosion
buy put helps position hurts position

Making money as prices fall

Now let's imagine that you have a strong feeling a particular stock is about to move lower. Before puts came into existence, your only alternative was to sell the stock short. Short selling stock is a risky strategy. Should the stock move higher, your loss would be theoretically unlimited. Rather than opening yourself to this risk, you could buy puts (the right to "put" (sell) the stock). Lets suppose XYZ stock is trading @ $90. The 90 puts might be trading for $5. For $500 you could buy one 90 put (100 shares x $5).

Since each contract controls 100 shares, you now have the right to sell 100 shares at $90 per share. If the stock stays at or above $90 before the options expire, the most you could lose is your initial investment of $500. On the other hand, if the stock falls to $60 at expiration, the 90 put will be worth $30 (strike price: $90 - current stock price: $60). At this point, the puts are worth $3,000 ($30 x 100 shares). Before commissions, this represents a 500% gain on your investment. To achieve the same percentage gain on a typical stock trade, a $100 stock would have to increase in value to $600. Needless to say, that doesn't happen every day.

To better see the leverage of options, let's look again at the returns on a percentage basis.

? Opening Trade Closing Trade Profit (Loss) % Gain (Loss)
Stock Price $90 $60 $30 33%
Short 100 shares of stock $9,000 ($6,000) $3,000 33%
Long one 90 put ($500) $3,000 $2,500 $500%


Now, let's see what happens when the stock rises.

? Opening Trade Closing Trade Profit (Loss) % Gain (Loss)
Stock Price $90 $120 ($30) (33%)
Short 100 shares of stock $9,000 ($12,000) ($3,000) (33%)
Long one 90 put ($500) $0 ($500) ($100%)

If you sold the stock short at $90 thinking it would go down and it rose quickly to $120, you would be forced to buy the stock and limit your losses. In this case, you would lose $3,000 (100 shares x $30 share). It's also easy to see that this could get worse. The stock could continue climbing indefinitely. Had you purchased the puts rather than sold the stock short, your loss would be limited to the price of the puts-in this case $500.

Risks

With both puts and calls, the risks fall into the same categories, time and market direction. To make a profit, the buyer of these options has to be right about the price movement of the stock and the time frame in which it will occur. If the stock doesn't make its move before the options expire, they will expire worthless. While a stockholder is concerned with market direction, the timeframe isn't as critical because stock doesn't have an expiration date. You can hold a stock for decades. You can't do the same with options. With the exception of LEAPS (longer-term option contracts), most options expire in a matter of months.
Long Puts
For aggressive investors who have a strong feeling that a particular stock is about to move lower, long puts are an excellent low risk, high reward strategy.



Example Increase in Volatility Time Erosion
buy put helps position hurts position

Making money as prices fall

Now let's imagine that you have a strong feeling a particular stock is about to move lower. Before puts came into existence, your only alternative was to sell the stock short. Short selling stock is a risky strategy. Should the stock move higher, your loss would be theoretically unlimited. Rather than opening yourself to this risk, you could buy puts (the right to "put" (sell) the stock). Lets suppose XYZ stock is trading @ $90. The 90 puts might be trading for $5. For $500 you could buy one 90 put (100 shares x $5).

Since each contract controls 100 shares, you now have the right to sell 100 shares at $90 per share. If the stock stays at or above $90 before the options expire, the most you could lose is your initial investment of $500. On the other hand, if the stock falls to $60 at expiration, the 90 put will be worth $30 (strike price: $90 - current stock price: $60). At this point, the puts are worth $3,000 ($30 x 100 shares). Before commissions, this represents a 500% gain on your investment. To achieve the same percentage gain on a typical stock trade, a $100 stock would have to increase in value to $600. Needless to say, that doesn't happen every day.

To better see the leverage of options, let's look again at the returns on a percentage basis.

Opening Trade Closing Trade Profit (Loss) % Gain (Loss)
Stock Price $90 $60 $30 33%
Short 100 shares of stock $9,000 ($6,000) $3,000 33%
Long one 90 put ($500) $3,000 $2,500 $500%


Now, let's see what happens when the stock rises.

Opening Trade Closing Trade Profit (Loss) % Gain (Loss)
Stock Price $90 $120 ($30) (33%)
Short 100 shares of stock $9,000 ($12,000) ($3,000) (33%)
Long one 90 put ($500) $0 ($500) ($100%)

If you sold the stock short at $90 thinking it would go down and it rose quickly to $120, you would be forced to buy the stock and limit your losses. In this case, you would lose $3,000 (100 shares x $30 share). It's also easy to see that this could get worse. The stock could continue climbing indefinitely. Had you purchased the puts rather than sold the stock short, your loss would be limited to the price of the puts-in this case $500.

Risks

With both puts and calls, the risks fall into the same categories, time and market direction. To make a profit, the buyer of these options has to be right about the price movement of the stock and the time frame in which it will occur. If the stock doesn't make its move before the options expire, they will expire worthless. While a stockholder is concerned with market direction, the timeframe isn't as critical because stock doesn't have an expiration date. You can hold a stock for decades. You can't do the same with options. With the exception of LEAPS (longer-term option contracts), most options expire in a matter of months.
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