WHAT TO DO WHEN YOUR TRADE GOES AGAINST YOU

As an active trader you can expect that about one out of every four to five trades will have the stock price go in the opposite direction that you expected.

On credit spreads we are challenged if:
a) Bull Pit Spreads
-The price of the stock falls below the strike price of the option you sold.
b) Bear Call Spreads
-The price of the stock rises above the strike price of the option you sold.

When a) or b) occur, the option that you own will also increase in value.

There are two strategies that are available when the price of stock touches the price of the option that was sold. These strategies are as follows:

Do nothing and take a loss. This should only be done if the time remaining on the option you bought is 1-2 days before expiration.
If the time remaining before expiration is 4-7 days or more than, do the following.
a) Buy back the option you sold when setting up the credit spread and take the temporary loss.
b) Hold on the option you bought when setting up the credit spread as price continues to move in the direction of the option you bought.

The following recent examples illustrate that this strategy can be successful!

1. On 4.24.18 the following trade was placed:
Sell JNJ 5.15.18 – 124 puts@ 1.06
Buy JNJ 5.18.18 – 123 puts@ .87

On 5.3.18 the stock market that is, The Dow Jones Industrial Average moved 346 points as an intraday swing. The result was that the price of JNJ dropped below 124. During the day on 5.3.18 I bought back the 124 puts I had sold and then waited. During the next hour the price dropped to 121 and the value of my 123 put increased substantially. Despite the loss I took when I bought back the 124 puts, I ended the day with a 186% profit after selling the 123 puts on 5.3.18.

Also, on 5.3.18 there was another trade that was being challenged.

2. On 4.26.18 the following trade was made:
Sell IBM 5.18.18 – 143 puts@ 1.56
Buy IBM 5.18.18 – 142 puts@ 1.29

On 5.3.18 The Dow Jones Industrial Average moved over a range of 346 points. The result was that the price of IBM fell below 143. I proceeded to buy back the 143 put options I sold. Later during the day the 142 options I owned increased in value as the price of the stock dropped as low as 139.90. Despite the loss I realized when I had to purchase the 143 puts, I ended the day by selling my 142 puts on 5.3.18 for an 87.7% profit.

The unwinding of the JNJ and IBM trades when they came under threat resulted in profits larger than the average winning trade.

Credit spreads provide the opportunity to have a profitable trade even when the price heads in a direction that was unexpected.

WHAT ARE OPTIONS?

Options are contacts that allow you to control 100 shares of stock for a defined period of time. An option costing $50 can allow you to control $5,000 worth of stock for a fixed period of time. Call options increase in value if the stock price rises; put options increase in value if the stock price falls.

Most purchased options, 80%, expire worthless. The purchasers of these options lose all of their money because either the stock price moves in the wrong direction, the stock price takes too long to move in the desired direction, or volatility decreases. Trading credit spreads reverses the odds and the results. It is better to be an option seller than and option buyer.

THE POWER OF COMPOUNDING

Albert Einstein once said that compounding was a wonder of the universe.

The power of compounding can be seen in the following chart. If you earn the following profits on each trade, not including losses or commissions, your money grows as follows:

15%
13%
17%
23%
12%
20%

Profit 251%

Put another way, $1000 traded in the six consecutive successful trades illustrated above grows to $2,510.

You don’t need to hit a home run trade; you just need to minimize losses on the losing trades.