Tag: trading strategy

A rarely heard of investment strategy; The Collar

 

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Many people own or trade stocks.  Investors use fundamental analysis to choose a stock to purchase in hopes that it will go up in value.  Some purchase a stock for the income it may provide via dividends.  Traders purchase or sell stocks based on technical analysis buying and selling often on movement or volatility in the stock price.  These are all very basic and your 401K and IRA’s do the same thing depending on which one you chose your broker to invest in.

 

Photo from this matter.com

 

     A more advanced and even more conservative stragety however is to “write a covered call”.  This means to sell a contract on the stock that you already own.  This will produce an income even if the stock price stays the same, or even goes down in value that month.  It also helps to hedge, or offset the downside numbers in your account if the stock price does go down that month because although your stock went down in value by say 2%, you may have received 1% in income from selling the covered call.  

     This is how it works;  lets say you own 100 shares of xyz stock.  You bought it a while ago at $50/ share.  The price is now $60/ share.  Instead of selling the stock to actually realize a profit, because it may continue to go up in price as the years or months go on, you choose to write a covered call.  This means that you sell a contract to a person, they pay you an agreed upon price to purchase the stock at any time they choose in the next month (or longer if you wish, for a higher premium of course).  So you bought the stock at $50, its already at $60, and you sell a contract to sell it to someone at $65.  For this they premium they pay you for that privilege (contract) may be $.25.  These are all multiplied by 100 so you would recieve $25 income to agree to sell your stock to them at $65 in the next month.  

     So, if the price does reach $65 or higher the buyer of your contract will “exercise” or buy it from you at the agreed upon price of $65.  That means you made a profit of $15/per share plus $25 for the agreement (options contract).  Pretty good deal right.  You locked in a price to sell it at a profit and got money (income) to do it.  If the price never reaches $65 then you keep your stock and the $25 and do it again month after month.  And the great part is that if your stock keeps climbint every month, you simply move your agreed upon selling price up, guaranteeing you more profit and still get the income.   

     An example would be, you did exactly the above for this month.  Your xyz stock price did go up, but it only went up to $62.50.  This means the purchaser of your contract will certainly not buy yours at $65 when they can buy it on the open market at $62.50  So you keep his money, and the contract expires on the third friday of every month.  Now that your stock price has moved up, this month you sell the contract for the same price ($25), but this time you agree to sell your stock at $67.50 instead of $65!  Sound pretty good eh?  It is.  Its a smart and more conservative way to own a stock rather than to just buy it and hold it.  

     Now we get to the more advanced move.  We create what is called a Collar.  This means we own the stock, sell the covered call as above, but instead of pocketing the $25 premium for the contract we put it to work opening another position (opportunity) for us.  We already own the stock, the $25 was free, so we take that money and we buy a call option.  This means that if the stock price goes up, we not only sell our stock at a profit, but we also sell our options contract at an option, and we bought this option with the money we sold the contract to sell for.  So lets look at what happens.

     If the stock price goes up, but doesnt reach $67.50 then we keep your stock, and we sell our call option that we bought at a profit, and it was paid for by the selling of the other option contract.  

     If the price of our stock doesnt change, we keep our stock, and both options contracts expire costing us nothing.

     If the stock price rises above $67.50/ share;  We sell our stock at a nice profit, and we also sell our call option we purchased at a profit as well, getting to profits off of one stock position.

     If the stock falls in price this month;  we keep our stock, and both of our options contracts expire without any money plus or minus.

 

graph from http://collars.optionetics.com/collars.aspx

 

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Forex Trading; Constructing a Spread position

 

WHATS KILLING MY PROFITS?   There are many things that eat away at investors profits.  Most all of them are avoidable.  Of course we cannot control the markets movements, neither its direction nor how far it moves, but we dont have to.  We know the market moves.  For the most part a currency pair will constantly be moving up and down, unless there is a huge national event in a country.  Even then, the currency will move back the other way again.

     One of the biggest killers of profits that I have seen is the use of “strategies” when investing in Forex.  I have an entire article on strategies, so this one will focus on the use of spreads.  Many times investors will attempt to use strategies from other investment vehicles (i.e. stocks, options, futures, etc.) in the Forex market.  Although these can be adapted to work they often are not.  Most investors simply take a proven formula for trading from one investment vehicle to another and they lose money.  

     Spreads are no different.  

WHAT IS A SPREAD?  The concept is easy, the definition of a spread is:  Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates.

 

 

     Many Forex traders have never traded options and dont truly understand how they work.  A spread in an option position means that you bet on two sides, up and down.  This strategy depends on only one thing to win, volatility.  When the market moves a good amount in either direction the option holder can make money.  This is a Very simple definition of a quite complex trading strategy.

     When you apply a spread to Forex you get a buy and sell on the same currency pair.  So you would place a buy and a sell order on the same currency pair, hoping for volatility, the price to fluctuate up and down.  This typically happens every trading day on many different currency pairs.  So why do so many investors lose money with this strategy?  Because they dont adjust the “buy in” position rules to fit Forex trading.   Meaning, they enter the trade in the wrong way, incorrectly constructing a spread for Forex.

     HOW TO CONSTRUCT A SPREAD;  A very simple example is this:  when you construct a spread position on a stock option you will enter a buy and sell order, and those will typically be at different strike prices (target price).  When you apply that same principle to a currency pair the entire dynamic is changed!  Because there is a whole other element that needs considered that you Don’t have with an Option spread, and that is entry price.  I am trying to keep this very simple while explaining very complex actions.  You see, when you sell an option contract (as when building a spread position) you actually Recieve money in your account (because it not only represents your short,bearish, belief of the underlying asset (same as the forex sell),  you Actually literally sell something).  In Forex you do Not get a payment for a “selling” a currency pair.

When you sell an option, you will actually instantly receive the limit price in your account.  

 

That would be buying abc/def currency pair at 107.468 and selling at at 107.348 as an example.  The one part we havnt considered yet is where we buy in at.  This one simple piece can make all the difference in you loosing or making moneu on a trade.  

WHERE DO YOU BUY IN AT?  The key to making money on these swing trades is to buy in right. In the Forex world buying “in the money” on a spread means to overlap the prices where you buy and sell your opening position.  Here below you see an example to make it clear.

 

 

So as you can see from the real spread position above, I entered the spread trade “in the money”, meaning I constructed my spread for optimal profit and probability of profit.  

IN THE MONEY;  In Forex entering a position in the money means buying at a higher price than your selling price.  As you see in the screenshot above, I bought a currency pair, and sold the same currency pair, “in the money”.  You can see that an in the money spread is truly in the money, meaning in the profit at the same time!  Both the buy and sell orders are Both in the profit at the same time.  This is a proper Spread.  Of course the further in the money you enter, the safer and more profitable it will be.  This can be easily done by using “limit” buy and sell orders.