Collect Jumbo Gains on Blue Chip Stocks Using Options

There’s good reason to focus on penny stock plays. After all, small stocks offer supersized moves that their behemoth blue chip brethren can’t match. They’re the best performers coming out of recessionary environments like we’re facing now, and they’re the stocks that give retail investors the biggest chance of having a real advantage over the guy on the other side of the trade.

Those reasons are precisely why we specialize in analyzing penny stocks…

But we wouldn’t pass up a high growth opportunity just because of a stock’s size. Today, I want to tell you about a real trade I placed last week that let me buy into a massive $64 billion firm at penny stock prices… then sell for a 37% gain just a week later. More importantly, I want to share how you can use this strategy in your own portfolio as early as this afternoon.

If you haven’t guessed by now, I’m talking about trading options. Options can be a scary proposition for new traders – after all, with expiration dates, terms like delta, gamma, and theta, and bizarre commission structures, these instruments can be intimidating. Even so, their pure profit potential makes them worth learning about. For our purposes, I’m going to assume you understand options basics (if not, click here to get the gist).

On January 5, I bought Ford $17 March 2011 Call options at $1.39 per contract. In other words, I bought options that gave me the right to buy shares of Ford (NYSE: F) for $17 up until March 19 of this year (options expire on the third Friday of each month). Because Ford was trading for around $17.50 when I bought my options, my purchase price was made up of intrinsic value of 50 cents (the true value of the options) and extrinsic value of 89 cents. That extrinsic value comes from the potential for the options to increase before expiration.

By owning those options, I was able to substantially increase my potential gains – after all, while a mere ten-cent move in Ford’s stock would have been a 0.5% gain in Ford’s shares, that same ten-cent move would have meant a 7.2% move in my much cheaper, $1.39 options (ignoring changes in extrinsic value).

So while shareholders of Ford were stuck with tiny blue chip gains, options gave me penny stock-sized profit potential on this $65 billion company…

Ultimately, my trade worked out as planned, and I was able to close out my Ford options yesterday for $1.90 per contract – a 37% gain in a single week. Obviously, the same rules apply to other blue chip companies, but there are some things to keep in mind if you’re considering trading large stocks for similar profit potential.

1. Picking the Right Play

One of the most intimidating factors about options is the slew of choices you have – with a handful of different strike prices and a dozen expiration dates for each, it can be overwhelming to figure out which specific play makes sense.

There’s no right or wrong answer when it comes to picking an option play. Each offers a different mix of risk and reward. As a technical swing trader, I pick my strikes and expiration dates based on the technical setup for the stock I’m trading – after all, I already should have a pretty solid idea about price targets and time frame before I enter any trade.

Solid options trading takes time and practice – the best way to get good without risking your cash is by paper trading. You can check out a list of paper trading tools on our website.

2. Watch Commission Structures

Commissions are a bit different than traditional stocks, especially if you’re used to flat rate fees from your broker. Typically, brokers charge a flat fee per contract (a contract controls 100 shares), or a flat fee plus some sort of minimum. In the Ford example, a single contract had a cost of $139; had my commissions been 2.95 per contract, a 10 contract order would have cost me $29.50 in commissions each way (buying and selling).

You should always calculate your total round trip commissions before placing any trade, and make sure that the cost makes sense given your potential gains. Remember, most options brokers offer multiple fee structures for different kinds of traders. If one makes more sense financially, don’t hesitate to change it up.

3. Getting Options Approval

Some (but not all) brokerage firms require special authorization to trade options before you’ll be able to execute your first options trade. Most of the time, that’s because brokers want to make sure that you understand the risks associated with these more volatile instruments before you put your cash on the line. On occasion, the lack of authorization for options trading can cause you to miss out on an appealing setup – that’s why you should make sure that you’re set up to trade options before you start researching setups.

If your broker is forcing you to jump through excessive hoops to trade options, consider a new broker.

While options trading does involve a somewhat steep learning curve, the payoff can be massive if you know what to look for. While the benefits of penny stocks are undeniable, you shouldn’t overlook options plays on blue chips for similar-sized gains.

Cheers,
Jonas Elmerraji
Penny Sleuth

January 13, 2011

Collect Jumbo Gains on Blue Chip Stocks Using Options was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

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