A Low Cost, High Probability Trading on the Trend
Sometimes, good news clusters. This tends to be the case for stocks that are in strong up trends. It is not uncommon to see the news seems to go from good to better as the price goes from one new 52-week high to another.
Traders who spot this trend as it unfolds could profit. They could position themselves to benefit from the next piece of good news, even after the stock has already moved up a significant amount. But, it is important to keep an eye on the risks of the trade since hot stocks can also decline suddenly.
Managing risk is a difficult task for traders. This especially true when buying stocks in stocks in strong up trends. The fact that the stock is in up trend usually indicates a number of traders have profitable positions in the stock. These traders might be ready to take profits at the first sign of a slowdown in the stock’s trend.
To manage the risk when buying a stock, a trader can set a stop loss order. This is an order to sell that is placed below the current market price. The problem with this type of order is that the stock could move down quickly. In that case, the sell order could be executed well below the desired stop price.
Another strategy for managing risk is to set the stop loss as a limit order. This type of order will only be executed at the limit price or better. The risk is that if there is a sudden decline below the limit order, the stop will not be executed and the position will be held as the loss potentially grows.
Because of the problems with stop loss orders, some traders manage risk with position size. For example, they may decide never to risk more than 2% of their account on any one position. They can then determine how many shares to buy based on the size of the loss they are willing to accept.
Position sizing for risk management only works with large accounts. For a small trader, it might not be possible to take a meaningful position size with limited risk using a rule limiting the loss to a small percentage of an account.
Options Can Limit Risk
Fortunately for small traders, options are a versatile tool that can limit risks to predetermined dollar amounts. The risk for a strategy based on buying options is always limited to the amount of money spent to open the position.
This feature of options makes them ideal for trading volatile stocks that are prone to large moves. There are strategies that allow even the smallest traders to benefit from the potential gains in a stock like that with a small amount of risk in dollar terms. Let’s look at an example.
One example of a hot stock is NetApp (Nasdaq: NTAP). This weekend, Barron’s ran an article on the stock titled, The Hot Stock: NetApp Jumps 5.5%.
Barron’s noted that NTAP was the best performing stock in the S&P 500 index on Friday after an analyst at Goldman Sachs upgraded the stock, “Analyst Simona Jankowski added NetApp to the firm’s Conviction Buy List, arguing that there’s significant upside to estimates, thanks to the company’s storage market share gains, gross margin expansion, and operating leverage. She also boosted her price target by $1, to $47.”
For many traders, the first step in evaluating a potential trade involves a look at the chart. NTAP’s chart is shown below. Friday’s large gain pushed the stock to a new 52-week high and continued an up trend that has been in place for more than a year.
The chart shows that NTAP broke out of a basing pattern on Friday. Since March, the stock has been trading in a relatively narrow range. The breakout indicates a price target of $47, coincidently the same target Goldman Sachs published in their report.
The target is about 8% above the current price of the stock. Based on the chart, a reasonable level for a stop is near $40. That price is about the midpoint of the trading range. Additionally, round numbers like $40 are important psychological levels. A break below that price could lead to heavy selling pressure.
This means the risk of the trade in dollar terms is relatively large, about equal to the potential reward. For many traders, the risk may be too large to accept. Especially when news on the stock is expected within weeks. NTAP is expected to release earnings around August 17.
The stock typically moves an average of 8% in the week after the earnings announcement. That could push the stock to the price target. Or, if NTAP fails to meet expectations the stock could fall sharply and easily break below the expected support level of $40.
Sell A Put and Limit Risk
There is a readily apparent options strategy for this stock. Selling a put is a strategy to benefit from the expected up move. A spread can then be created to limit the risk of the strategy. The potential risk and reward are illustrated in the chart below which is taken from The Options Industry Council web site.
For NTAP, options expiring on August 11 offer low risk exposure to the stock. These options expire before the expected earnings announcement. The stock is likely to be less volatile before that announcement. This offers the chance to generate income from a high probability trade.
The August 11 $42 put is trading at $0.45. This put could be sold to generate immediate income of $45 since each contract covers 100 shares. This example ignores commissions since trading costs should be relatively small at a deep discount broker.
To limit the potential loss, an August 11 $40 put could be bought for about $0.17. This will cost $17. The net credit on the trade, considering the sale of the $42 put and the purchase of the $40 put, will be $28 or $280 per contract.
The maximum risk on the trade is equal to the difference in the option exercise prices less the premium received when the trade was opened. In this case, the risk would be equal to $200 minus $28 or $172. Most brokers will require a margin deposit equal to the amount of risk on the trade.
The potential gain of $28 represents a return of more 16% on the required trading capital of $172. This is an excellent rate of return on a trade that will be open for less than a month. Additional bull put spreads could be opened after this trade expires, compounding gains in the stock over time.
This position has a high probability of success, about 75% based on the delta of the put option being sold. Delta is one the options Greeks, a group of values that describe the individual risk factors that affect the price of an options contract. Delta can be with free calculators at the exchange web site.
Delta measures how much an option’s price should change if the value of the underlying security changes by $1.00. The values of delta will range from 0 to 1 for calls and it will be between 0 and -1 for puts. The absolute value of delta shows the probability of an option expiring in the money.
A put option with a delta of -0.25 would also have a 25% probability of expiring in the money. The lower the delta, the greater the probability of an option expiring worthless. This is a valuable insight for selling options. On this trade, there is a 75% probability of a 16% gain in the next month.