Over the last few weeks we discussed either buying or selling calls or buying or selling puts in our option trading strategies. We determined, that if the stock we are interested in is a good company, meaning, that it has strong fundamentals like good management, good product, increasing revenues or increasing earnings, we would purchase a call option in anticipation of the stock value increasing. On the flip side, if we noticed a company that was showing a poor performance or if we determined that the overall market is bearish on the stock (that is the market thinks the value of the company is overpriced), then we would buy a put option in anticipation of the stock decreasing in value.
But, what if we are uncertain about the direction of the stock? For instance, what if the company showed good earnings, but the market was bearish on the stock of the company. What do we do? Well, I was explaining to a close friend of mine the other day that when we are uncertain about a stock but anticipate some volatility (volatility is large swings in price, either upward or downward), we can either disregard the stock and move on to more certain investment strategies or we can take advantage of the volatility in the stock. But, how exactly would we do this, you ask? Great question and below we are going to walk you through how we would use this option trading strategy nifty option advisory service.
So, we have decided to pursue a company that has a lot of volatility, but are uncertain about the direction of the stock, so here is what we would do to take advantage of a great opportunity. We are going to purchase a call and a put. That’s right! we are going to purchase a call based on the fact that under the above scenario, the company has good fundamentals (earnings, revenues, management, product, etc), so we buy the call in anticipation of the stock increasing. But wait, didn’t we say that we are uncertain about the movement of the stock. Absolutely! So in addition to buying a call, we are also going to buy a put. Holy cow batman, we are hedging our position on this stock! That is exactly correct. We are buying a put in addition to buying the call, because, we recognize that the company has good fundamentals, but the market (the investors buying or selling the stock) are showing signs of fear in the future fundamentals of the company (this is called speculating, because investors can never really know whether or not the future of the company is in peril until it is too late). By buying a put option with our call option, our option trading strategy now will have the opportunity to make a return on the stock as long as the stock has the volatility that we are anticipating.
So what are the costs? Typically, we will pay a small premium for each option we buy. For instance we will pay one price for the call option and we will pay another price for our put option. The great thing about investing in this option trading strategy is we are only risking our premiums. However, if the stock does have the volatility we anticipate, we can close out one of our option positions as the stock moves favorably towards the other option position. This will limit our loss, but give us unlimited gains.
The downside of this strategy is if the stock has no volatility and stays in a low volatile trading range for the life of our option trading contracts. If this happens, we will lose our premiums. But, in my opinion, it is better to take a small premium loss versus buying into a stock (meaning investing a higher amount of capital) that is not going to move at all or buying the stock and it plummets and takes your capital with it.