October 2012
 

"Pro Trader" Secrets

By Jeff Clark

I was only 19 years old when I made my first options trade.

I had a gut feeling the market was going to go higher... so I bought four S&P 100 call options at $1.50 – a total investment of $600. A few hours later, the options were trading at $4.50. I sold and took the $1,200 profit – a 200% gain. And I was hooked on options forever.

My next trade was in IBM. I bought 10 calls for $1. This time, it took a couple days to double my money. Next, I bought Digital Equipment put options... which nearly tripled in just a few days.

I made 17 trades during my first six weeks as a trader. Every single one was a winner.

Going 17 for 17 was a remarkable feat for a rookie trader – especially since I wasn't using any sort of fundamental or technical analysis. I was just going with my gut. But I was careful not to put more than $1,000 or $2,000 into any single trade. And I still managed to turn my $5,000 brokerage account into $50,000 in just six weeks.

Then I decided it was time to get serious. No more tiny trades. I was too good for the small stuff. For whatever reason, I had figured out a way to beat the market. Heck, I had just rattled off 17 straight triple-digit winners. So I decided to take the $50,000 in my account, add to it my $25,000 in savings, and put it into a handful of option trades.

You can probably guess what happened next.

One by one, each position blew up on me. It was too painful to watch. I kept the television off and avoided reading the newspaper for fear I'd see something bad about the stock market and my positions. When I finally got up enough courage to call the branch manager and check on the status of my account, I learned all the gains I had built up over the previous six weeks were gone.

"Just sell everything," I said.

That was an expensive lesson to learn. But it's one every options trader learns at some point. I was just fortunate it happened to me early in my career.

You see, that experience changed how I looked at trading. Instead of using options as vehicles for speculation – a way to juice my returns and get more bang for my buck – I started using them the way they were intended to be used: as a way to reduce risk.

Today, I still do my fair share of speculating. But I'm not focused on how much money I can make. I'm focused on how little I can lose.

That's a huge difference. And it has allowed me to trade options successfully for nearly three decades.

Every week, I comb through more than 1,200 charts to find the best setups and patterns that I then use to make my S&A Pro Trader recommendations. If you'd like to see some of my favorite chart patterns, be sure to read my Advanced Chart Reading Course.

You see, most folks lose money in the options market – which makes perfect sense if you understand probability. Think about it... A stock can do one of three things. It can go up. It can go down. Or it can stay the same. When you buy an option, you are betting on one of those three outcomes. You have, generally speaking, a 33% chance of being right and a 67% chance of being wrong on the trade.

We've done considerably better than that in my other newsletter, the S&A Short Report. Over the past several years, nearly 60% of our trades have been winners. That's an outstanding track record. And we've accomplished it because we look for trading setups that increase the probability of a profitable trade.

But there's a way we can do even better. We can push that win rate up to 70%... or even 80%... by taking each option trade and adding another element designed to further reduce our risk. It's what we'll be doing in the S&A Pro Trader.

By using the S&A Pro Trader strategy, you'll reduce your risk, increase your returns, and dramatically improve your chances of profiting on any option trade.

In this special report, I'll walk you through the strategy we'll be using... explain how we can make money even if we're wrong... and show you why you don't need to sit in front of a computer all day to make these trades.

How to Make Money... Even If We're Wrong

You're going to be wrong a lot of the time when you trade options because a stock can go up, go down, or go nowhere. When you buy an option, you're betting one of those three things will happen. You're going to be wrong and lose money if the other two occur.

So you need to look for ways where you can turn your position into a profit... even if you're wrong.

Let me walk you through how we did this in the S&A Short Report with Seabridge Gold (SA) back in May...

I'm going to show you this trade step-by-step. It might seem complicated at first... But it will definitely be worth the time you take to understand how the numbers work.

First, I liked the idea of owning Seabridge Gold. This gold stock was dirt-cheap, and I thought it would be trading much higher a few months down the road. So I recommended buying the SA January 15 call options for about $1.65.

We would have been profitable on this trade as long as SA closed above $16.65 (the strike price of the option plus the premium paid for the calls) on option expiration day in January 2013. If SA fell in price, we would have lost money. We would have also lost money if SA went nowhere.

The only way we were guaranteed a profit on this trade was if SA rallied more than 25% by January.

That may seem like a tall order. But I was confident the trade would work out, and I was comfortable making the recommendation.

However, I still had to ask myself, "How can we make money on this trade, even if I'm wrong?"

We had spent around $1.65 to buy the SA January 15 call options. As long as we were spending money out of our pocket to make this option trade, the odds were against us. But there was a way to put some money back into our pocket... without taking on any extra risk.

The easiest way to do this was to create a spread trade.

Spreads involve buying one series of options and then selling another.

Since we owned the SA January 15 call options, we had the right to buy the stock at $15. To create a spread, we sold someone else the right to buy SA from us at a higher price.
My initial upside target for SA was around $20 per share. So we sold the SA January 20 call options – giving someone else the right to buy the stock from us at $20 – for $0.85. By doing this, we recouped more than half the cost of the January 15 calls.

Here's how that looked, trading one contract at a time. (Remember: a contract covers 100 shares.)

Action
Option
Ticker
Definition
Total
Buy
SA Jan 15 calls
SA130119C00015000
Right to buy SA at $15
Spend $165
Sell, to open
SA Jan 20 calls
SA130119C00020000
Obligation to sell SA at $20
Collect $85
Total net cost: $80
Please note: each contract covers 100 shares

We paid $165 for the right to buy SA at $15 per share and received $85 for taking on the obligation to sell SA at $20 per share. We spent $80 for each spread. That's just $0.80 per share.

We immediately lowered our out-of-pocket cost for this trade from $165 to just $80. Our maximum potential loss fell more than 50%.

Our maximum potential profit was also reduced. Since we sold someone else the right to buy SA from us at $20, we wouldn't have made any additional profit if SA rallied above that level. But because $20 per share was my initial target anyway, we would have looked to lock in profits on the trade at that price. So we were really just agreeing to do so ahead of time.

Now, think about this...

If SA had closed at $20 per share on option expiration day in January, the SA January 15 call options would have been worth $500 per contract. We spent $165 on the original trade. So we would have had a $335 profit, or 203% gains on our initial $165 investment.

But by creating the spread, we reduced the cost of the trade to just $80. And the spread would still have been worth $500. By adding the "second leg" for the spread trade, we would have had a $420 gain. That's 525% on the original investment.

The spread position lowered our cost of the trade, so it also lowered our risk and increased our potential profit if the stock reached my target price.

This is a BIG improvement over just buying the January 15 call options outright. But there's a way we can do even better.

How to Make a Good Trade Great

Like I said, we still would only have profited off the Seabridge trade if the stock had moved higher. We would have lost money if Seabridge fell or went nowhere. So to increase our chances for a profit even more, we needed to add one more leg to this option position...

We sold a put.

Selling uncovered puts is my favorite option strategy. In my experience, it is the most consistent way to profit in the options market. By selling uncovered puts, you get paid to agree to buy a stock at a specified price by some date in the future. It's that simple.

It is important to only sell uncovered put options on stocks you want to own anyway... and at prices you'd like to own them. In a rapidly falling stock market – which occurs about once per year – you may end up having to buy the stocks on which you've sold puts.

Smart folks who use this strategy use it to generate income on stocks they don't currently own but are willing to buy at the right price.

We're going to use this strategy to pay for our call option trades.

Like I said, I'm going to walk you through each step of this trade. It may appear complicated and even a little intimidating at first, but trust me, it's worth the time it'll take to learn how to execute these trades.

The "two-legged" Seabridge trade cost $80 per contract. So we were looking to sell an uncovered put option on SA that would give us the $80 back and maybe even put a little extra money in our pocket upfront.

Remember... we only sell puts on stocks we want to own anyway and at prices at which we want to own them. SA was a dirt-cheap gold stock I wouldn't have minded buying in May at $12.50 per share. And I would have been thrilled to get paid for agreeing to buy it even cheaper than it was.

So I recommended selling the SA January 10 put options. At the time, the puts were trading for $1.10. That's $110 per option contract. By selling this put, we collected $110 – which covered the cost of our spread trade and put $30 more in our pocket. We were also obligated to buy SA at $10 per share if it closed below that level on option expiration day in January.

Here's how the entire SA option combination trade looked... (Remember: a contract covers 100 shares.)

Action
Option
Ticker
Definition
Total
Buy
SA Jan 15 calls
SA130119C00015000
Right to buy SA at $15
Spend $165
Sell, to open
SA Jan 20 calls
SA130119C00020000
Obligation to sell SA at $20
Collect $85
Sell, to open
SA Jan 10 puts
SA130119P00010000
Obligation to buy SA at $10
Collect $110
Total net credit: $30
Please note: each contract covers 100 shares

We created a trade that paid us $30 to set it up. That $30 was ours to keep no matter what happened to SA.

This trade could have played out in one of four ways...

1. SA closed below $10 on January expiration day. We would have been obligated to buy 100 shares of SA at $10 per share. If we figure in the $30 we received for setting up the trade, we really agreed to buy the stock at $9.70. So this trade would have been profitable as long as SA held above $9.70 per share.

2. SA closed between $10 and $15 per share on January expiration day. All the options in the combination would have expired worthless, and we would have kept the $30 per contract.

3. SA closed between $15 and $20 per share. The higher SA traded in that range, the more money we would have made.

4. SA closed above $20 per share. The spread would have been worth $500. So our maximum profit would have been $530 ($500 from the spread and $30 for the original setup of the trade).

In other words, the only way we could have lost money on this option combination is if SA dropped another 25% from its already-depressed stock price. We were going to make money in every other scenario.

Think about that for a moment. We would have made money if we were right on the trade and Seabridge went higher. But we would have also made money even if we were wrong and the stock dropped. That is the beauty of this type of strategy.

Let's recap what we did here…

We took the original call option position – which cost $165 and would have created a $335 profit if SA had rallied to $20 per share – and turned it into a trade that put $30 in our pocket right away and could have returned another $500 if the stock rallied.

Instead of having a position that would lose money if SA went down, stayed the same, or failed to move up 25% over the next eight months... we created a trade that would have been profitable under every scenario where the stock didn't fall by more than 25%.

How the Trade Played Out

Three months after my initial recommendation, shares of SA bounced all over the place, trading between $13 and $17. But because we set up the trade with such a large "margin of error," we didn't need to be overly concerned about the day-to-day fluctuations. We could concentrate on the longer-term objective – a higher share price going into January.

By mid-September, SA traded for about $18. Here's what the option prices looked like...

Option
Ref. Price
Current Price
Bought SA January 15 calls
$1.65
$3.80
Sold SA January 20 calls
$0.85
$1.20
Sold SA January 10 puts
$1.10
$0.10

Remember, we originally set this trade up for a net credit of $0.30. (We earned $0.85 for selling the January 20 calls and $1.10 for selling the January 10 puts, for a total of $1.95. And we spent $1.65 to buy the January 15 calls.)

Because each option contract covered 100 shares, we would have pocketed $30 for each combination contract. If we were to close it out with these prices – by selling to close the January 15 calls, buying to close the January 20 calls, and buying to close the January 10 puts – we'd receive another $250. That's a total gain of $280 per contract (the initial $30 credit we received in May, plus another $250 to close it out).

We calculate our percentage gain based on the margin requirement for the trade. That was 20% of the purchase obligation for the January 10 puts. Remember... each contract covers 100 shares. So our total obligation was 100 times $10 per share, or $1,000. The margin requirement was just 20% of that, or $200.

So we were up $280 after putting up $200. Our low-risk trade was up 140% in just three months. And I recommended closing out of the position and locking in our gains.

As you can see, adding a "third leg" to an options trade can really juice your returns. In my experience, the more examples you see of this strategy in action, the more your mind begins to recognize and process it automatically.

So next, I'm going to walk you through another combination trade I recommended back in late 2008 that was low-risk and worked out perfectly...

A 280% Gain in Just Two Months

Back in December 2008, I told readers about a fantastic trading setup in silver.

The metal was trading for $9.38 an ounce, and I had predicted a quick breakout up to $10.50 (and ultimately as high as $19). You could have bought silver outright, but my favorite way to take advantage of the coming rally in silver was through silver royalty company Silver Wheaton (SLW), which was trading around $3.10 a share the day before my recommendation.

Again, I'm going to walk you through each step of the Silver Wheaton trade, like I did with the Seabridge trade. It might seem complicated at first. But as soon as you understand these concepts, you'll be way ahead of 99% of options traders.

Here's the trade we set up at the time. (Remember: a contract covers 100 shares.)

Action
Option
Definition
Total
Buy
SLW March $5 calls
Right to buy SLW at $5
Spend $75
Sell
SLW March $7.50 calls
Obligation to sell SLW at $7.50
Collect $55
Sell
SLW March $2.50 puts
Obligation to buy SLW at $2.50
Collect $60
Total net credit: $40
Please note: each contract covers 100 shares

We had created a trade that paid us $40 to set it up. That $40 was ours to keep no matter what happened to Silver Wheaton. And we would be profitable as long as SLW was above $2.10 per share by March expiration – that's 32% below its price when we entered the trade.

This trade could have played out in one of four ways...

1. SLW closed below $2.50 on March expiration day. We would have been obligated to buy 100 shares of SLW at $2.50 per share. Figuring in the $40 we received for setting up the trade, we really agreed to buy the stock at $2.10. So this trade would have been profitable as long as SLW held above $2.10 per share.

2. SLW closed between $2.50 and $5 per share on March expiration day. All the options in the combination would have expired worthless, and we would have kept the $40 per contract.

3. SLW closed between $5 and $7.50 per share. The higher SLW traded in that range, the more money we would have made.

4. SLW closed above $7.50 per share. The spread would have been worth $250. So our maximum profit was $290 ($250 from the spread and $40 for the original setup of the trade).

In other words, the only way we could have lost money on this option combination is if SLW dropped more than 30% from where we bought it. We were going to make money in every other scenario.

Now... think about what we did here...

We took a simple call option position – which cost $75 and would have created a $175 profit if SLW had rallied to $7.50 per share – and turned it into a trade that put $40 in our pocket right away and could have returned another $250 if the stock rallied.

Instead of having a position that would have lost money if SLW went down, stayed the same, or failed to move up enough over the next few months... we created a trade that was going to be profitable under every scenario where the stock didn't fall by more than 30%.

How the Trade Played Out

By February 2009, shares of Silver Wheaton had soared to $6.70. Folks who owned shares outright were sitting on gains of more than 115%. But we were doing even better...

We closed out of the trade at the end of February. Here's what the prices looked like...

Option
Ref. Price
Current Price
Bought SLW March $5 calls
$0.75
$2.30
Sold SLW March $7.50 calls
$0.55
$0.70
Sold SLW March $2.50 puts
$0.60
$0.10

How to Make These Trades

To execute trades like this, there are a couple things you have to do with your broker first. You may already have some experience trading options. If so, you may have already received approval for this type of trading. If not, you may want to read how to get approval in a special report I've put together, titled "How to Open an Options Account."

The short version is that you'll need to get approval for spread trading and for selling uncovered put options. In most cases, as long as you already have an options account, you'll just need to update your option account form and submit it to your broker for approval. Some brokerages require a minimum amount of option trading experience (usually three years or more) and a minimum account size (around $25,000).

Once you have your account approved for spread trading, you'll be able to make these trades. And the best part is, it's easy to enter these trades with your broker. You simply enter one ticket to buy the calls, enter another to sell the calls... and to create the third leg of the trade, enter a ticket to sell the puts.

The broker I use to trade with (Interactive Brokers) groups these trades together as a single position. Most trading platforms don't consider these trades a single position, but will still list the trades together (like Fidelity and OptionsXpress, for instance). But keep in mind... we may not execute all three positions at once. Some of the best trades occur by legging into the separate positions at different times.

Remember, we originally set this trade up for a net credit of $0.40. (We earned $0.60 for selling the March $2.50 puts and $0.55 for selling the March $7.50 calls, for a total of $1.15. And we spent $0.75 to buy the March $5 calls.)

Because each option contract covers 100 shares, we would have pocketed $40 for each combination contract. If we were to close it out with these prices – by selling to close the March $5 calls, buying to close the March $7.50 calls, and buying to close the March $2.50 puts – we received another $150. That's a total gain of $190 per contract (the initial $40 credit we received in December, plus another $150 to close it out).

We calculate our percentage gain based on the margin requirement for the trade. That was 20% of the purchase obligation for the March $2.50 puts. Remember... each contract covers 100 shares. So our total obligation was 100 times $2.50 per share, or $250. The margin requirement was just 20% of that, or $50.

So we were up $190 after putting up $50. Our low-risk trade was up 280% in just two months.

I know there are a lot of steps to this type of trading, and it may seem a bit complex at first. But the financial payoff is well-worth the effort to learn this strategy.

Lower-Risk, Higher-Reward Trades... Without Staring at a Computer All Day

The two examples above – Seabridge and Silver Wheaton – show exactly why the S&A Pro Trader strategy is a great way to lower your risk and boost your potential returns.

But before you get started with it, you need to understand… it works even better with intermediate- and long-term trade ideas.

Sure, it can be used to reduce risk and increase profit potential on short-term trades, too... But the strategy is best-suited for long-term, high-conviction ideas.

For example, maybe you're convinced gold will be trading much higher a year from now, but you're not as confident about what'll happen over the next month... Perhaps you think interest rates will rise over the next several months... Or maybe you believe semiconductor stocks are dirt-cheap at today's levels but you aren't sure when the market will recognize it.

These types of ideas are excellent candidates for the S&A Pro Trader strategy.

You see, longer-term ideas allow traders a chance to set up what I call "Rip Van Winkle trades." These are trades you can put together and go take a nap. You don't have to worry about the market's day-to-day movements. You've set up a trade that gives you a wide margin for error. And because it's based on a long-term idea, you don't have to watch it every second... or every day... or even every week for fear of missing a big move.

People come up to me all the time and tell me they'd love to trade and do what I do all day, but they can't... They tell me they have a job... or kids... or they're simply too busy. They can't spend the whole day staring at the computer screen and being prepared to trade on a moment's notice.

That's one of the biggest benefits of the S&A Pro Trader strategy. You can make these trades without worrying about constantly monitoring the position. Don't get me wrong: You can spend time staring at the computer screen if you want to... But you don't have to.

The S&A Pro Trader strategy offers lower-risk, higher-reward setups... without taking up all your free time. Sure, it's not a simple strategy, and it takes a little more time and effort to understand how the trades work. So it's OK if you don't process everything on the first read. In fact, most people get the greatest benefit from reading it four or five times. Repetition is how we learn these types of advanced concepts. And once you get the hang of the S&A Pro Trader strategy, it's easy to see why this is how I trade with my own money.

 
 
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