Become a Student of the Game with Stocks

by Jon Najarian

When you’re investing, either with stocks or options, you should become a student of the game and strive to know all you can about a particular company. This knowledge will act as an edge to help you take a more controlled amount of risk. Why? Because fundamental analysis, when used in concert with technical analysis, will help you determine whether or not a stock is likely to make a particular price move within a particular timeframe.

The question then becomes how many stocks you can possibly track with research and price models? If you’re not doing this full time, you could still have anywhere from 10 to several dozen positions in options. With stocks you have a potential undefined amount of price risk for each company in which you invest. But in options your risk can be defined exactly when you enter the trade. If you are an option buyer, your loss is confined by the amount of premium that you paid. This assumes that you are either buying options or doing spread trades that put limits on your exposure, instead of selling “naked” or un-hedged puts and calls. For example, if you buy 10 calls (each representing 100 shares of stock) for a $2 premium, you know that the most you could lose is $2,000 if the option expires worthless. And you would still have a chance to cut that loss, even if the stock made an adverse move, by selling those calls before expiration, say for $1 or $0.75.

In fact, I do not recommend that retail investors hold an option until expiration. Even if a stock is moving strongly in your favor, you probably want to get out of that position – either by taking your profit and initiating a new position, or by rolling the option into another expiration – before the option expires.

But at what point do you get out of a winning trade? Or in other words, how much is enough? Remember, when it comes to options, the variable is not just the price – it’s also time. You may hold a six-month out-of-the-money (meaning the stock is trading below in the case of a call or above the current price in the case of an out-of-the-money put) option that becomes in-the-money far more quickly than you anticipated. Perhaps the $2 call you bought is now worth $4 or even $6 in just a few weeks or even days. What do you do now?

It all goes back to your original plan. Your decision to buy that call was based on your analysis that either the option was under-valued or the stock was poised for a move – or both. As part of that plan, you had a price target for the stock. When that target is reached, it’s time to re-evaluate and decide what the next stop will be. Most likely, if you’ve doubled, tripled, or quadrupled your money, you’ll want to take a profit. You pull that money off the table and establish a new position based on where you think that stock will go from this point. If you’re still bullish, you’ll buy another call with a higher strike price. But you don’t just let it ride in hopes of turning $2 into $20. You take a profit once your target is reached and re-evaluate your plan. Remember, it’s not the house’s money if it’s in your account; it’s your money!

For example, say IBM is trading at $100 a share and I’m bullish on the stock. An at-the-money 100 call would have a premium of about $5. That means the stock would have to rise above $105 a share – the strike price plus the premium – for this trade to be profitable at expiration. The $110 out-of-the-money call would have about a $2 premium (and profitable above $112 a share at expiration). And, let’s say the $120 calls have a premium of $0.75. Now, assume my research indicates to me that IBM is likely to run from $100 to $130 a share in two months, based in part on the company’s fundamentals and the strength of technology stocks in general. If I’m right, the $120 call could go from $0.75 to $10 a share, the $110 call could go from $2 to $20, and the $100 call could go from $5 to $25. Let’s take a closer look at the scenario: The $2 and $0.75 calls rise roughly 1-fold, while the $5 call has a five-fold increase. So the biggest gains are in the $110 call (with a $2 premium) and the $120 call (with a $0.75 premium).

How do you choose your strategy? With the current price of $100 a share, if I bought the $0.75 call – which is the cheapest – I would miss out on part of that run. Specifically, my out-of-the-money $120 call would not see a significant gain on the run from $100 until $110 or so. Therefore, the best value would be to buy the $110 call for $2. If, one month from now, the stock has moved from $100 a share to $115, that premium has increased from $2 to $6 or even $8. That gives me the opportunity to sell that option out, taking a profit, and initiating another position. As I stated before, if you’re still bullish based on your plan, you may decide to buy the $115 or the $120 calls, paying the premium with the portion of the profits made on the previous trade. In that way, you’re preserving your capital and playing with the house’s money, just make sure you pull some off the table for yourself.

Also, keep in mind what your initial investment was. If you bought 10 of the 110 calls for $2, you invested $2,000. The run to $115 brought in a profit of $4,000 ($2 paid for the110 calls minus the sale price of $6 one month later). If you still are bullish on IBM, you may want to still limit your next investment on $2,000.

Take another look at the IBM scenario. Let’s say you bought the $95 IBM calls for $6 and thus, your break-even at expiration is $101. Then in three days, the stock moves from $95 to $112 a share – a $17 move. We “own” from $101 (our break-even price) all the way to $112. Our option has increased in value sharply, especially as an option moves deeper into the money.

The premium on an at-the-money option generally moves $0.50 for every dollar that the stock moves in favor of the option (rising in the case of calls and declining in the case of puts). When it’s deep in the money, the premium option begins to move $0.75 to the dollar and keeps on tracking closer and closer to 100 percent (a dollar increase in option value per each dollar increase in the underlying security). That ever-changing differential between the change in value of the option and the movement of the stock is known as the delta. Because of deltas, you must evaluate your option trades differently. You may see a $2.50 gain in premium on a $97 call as the stock rises from say, $95 to $100. But from $100 to $110, that premium increases $9. So at that level a $6 call is worth $17.50.

Under our “take the money off the table” scenario, you could sell the $95 calls and, if you’re still bullish, buy the $115 call options that have a $3 premium. Or, if you think it’s going down because the stock is overbought, you could buy puts with a strike price below the current market. Again, it all goes back to your constantly updated plan.

Whatever the scenario, it’s important to have a game plan and to follow it!