If you like the idea of doing short-term trading in stocks, options can give you a great way to do it. Actually, several great ways.
Many good trading opportunities come up in high-priced stocks, those over $500 per share. This is a fairly select group and includes heavy hitters like Chipotle ($508.00 per share), Amazon ($559), Intuitive Surgical ($570), Google ($705), Autozone ($773) and Priceline ($1,292.00).
It takes a pretty fat wallet to trade these stocks. A hundred shares of Priceline would cost $129,200. Using options, though, we can trade them with much less cash out of pocket.
Here is a weekly chart of Priceline as of March 9, 2016:
The company reported earnings that were better than expected in February and had a big spurt into the $1300 area. Since then it’s been stuck in a range around $1250-1300. This was an area where it had previously made a major high in December 2015, before dropping to less than $1000 per share.
If we believed that PCLN was likely to run out of gas here and take a drop, the way to capitalize on that in the stock market would be to sell the shares short. We could sell them now at about $1292 and place a stop above the recent high around $1310. If the price then dropped, we would buy the shares back later at a lower price for a profit. After we had sold it short, if it dropped to $1100, where it was just three weeks ago, we could buy back the shares at that price, pocketing a profit of $1292 – $1100 = $192 per share.
If the stock went up instead of down our short position would go into the red. If it hit our stop-loss price of $1310, we would have to buy the shares back at that price to close out our position. This would be a loss of $1310 – $1292 = $18 per share.
Sounds pretty good so far. We are thinking of risking $18 per share to make potentially $192 per share. For a hundred shares, an $1800 risk for a potential $19,200 profit.
The high price of the stock makes it tough though. To sell short a hundred shares, we would have to put up margin equal to half of the value of the stock. That would be one-half of $129,200 which is $64,600. And with a short stock position there is the nagging possibility of an upward overnight price gap. If that happens our stop could be tripped and the loss could be much more than $18 per share – theoretically our loss would be unlimited.
Options can help here. The most straightforward way to play this would be to buy a put option. Put options’ prices move in the opposite direction of the stock’s price.
A put at the $1300 strike price at this time, expiring in July, 2016, was available for $90.70 per share, or $9,070 per 100-share contract. While still a pretty good chunk of money, it was a small fraction of the share price.
If PCLN should drop to the $1100 area within a month, the put trade would make over $12,000 per contract. And, if instead PCLN should go up past our $1310 stop, the put trade would lose about $1,661.
And, when we buy puts the most we can lose in any case, even if the stock doubled overnight, would be the cost of the puts. With the short stock, the theoretical loss is unlimited.
In summary, compared to the short stock trade, the put trade had:
- 85% less out-of-pocket cost ($9,070 vs $64,600)
- Smaller potential loss at the stop ($1661 vs $1800)
- Profit at the target of $12,000 vs $19,200 for the stock
- 62% of the profit with 15% of the cost of the stock trade
- Limited worst-case loss even in case of a massive gap
On the negative side, the put expires in July. A short stock position can be forever.
For many people, the put would be a preferable way to play the potential downside on this expensive stock.
Next time we’ll look at ways the put trade can be improved even further in terms of cost and risk/reward.