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Why it Pays to Enter an Option in 2 Trades

The most challenging part of trading isn’t identifying what you should buy, but the when you should buy it.  Often we do our chart analysis, and reach a conclusion that it’s time to make a trade.  But how do you maximize the effectiveness of your timing?

Well, one way to hedge against being too early on a trade is to cut your allotment in half and make two trades instead of one.  I did this the other day, and it paid off nicely for me.

On Oct. 18, sensing that the Nasdaq was becoming overbought and weakening, I bought the ProShares UltraShort QQQ Exchange-Traded Fund (AMEX:QID) Nov 19 Calls at $2.85. (This ETF double-shorts the Nasdaq-100 Index.)

About a half hour after I made my purchase, and with my position basically flat, a British newspaper announced that Germany and France had agreed to boost a Eurozone financial rescue fund to 2 trillion euros ($2.76 trillion USD). This was more rumor than fact, but it nonetheless caused an immediate panic-buying reaction in the U.S. stock market.

Stocks blasted higher over a 15-minute period, pushing QID down from $44.65 to a low of $43.50 (about 2.5%) in only 15 minutes! My call options of course, were crushed.  Before I knew what had hit me, my options were down to about $2.30. (See the two-day chart of QID below.)

Chart courtesy of bigcharts.com

But I have learned from much experience not to panic in those situations.  If nothing else, the Nasdaq market-makers have just bought an awful lot of quickly dumped stock that they will need to get rid of at higher prices.  As they push the bid/ask spreads higher, the stocks will climb back and retrace at least a portion, if not all, of the panic-trading period.

Get Positioned (Again) for a Rush to Stability

One way to really take advantage of this is to buy the second half of your position following the meltdown.  But you must ensure that there are signs of stability, so that you are not simply “catching the falling knife” and about to lose even more money.

Signs of stability will include candlestick figures such as a Doji or hammer, along with some decent-sized volume on the first upside bar.  But you have to react quickly, or you won’t derive the benefit of buying near the bottom.  Stocks can rebound in a New York minute, as they say.

So I bought the second half of my position, at $2.35, and watched intently as the QID wiggled higher.  We were near the closing bell, and I was hoping we would get out of Dodge without another wave of buying.  But not to fear — after the initial panic-buying, a sense of calm had returned to the markets, and they were now shrugging off the news out of Europe.

Perhaps they were now getting wind that the news was unconfirmed, or maybe the news had already been “baked” into prices.

By the time the closing bell rang, QID was trading at $43.97, my calls were back around $2.55, and I was much relieved.  I was closing the gap on the loss of my first half position, and making a profit on the second half.  Right before the bell, the Nasdaq was getting beaten up pretty good, and that was an excellent sign of what might come the following day.

It’s Always the Right Time to Take Profits

The next day (yesterday), the Nasdaq gapped down on the opening, following Apple’s (NASDAQ:AAPL) earnings report.  This meant that QID was gapping up, to about $44.40. Soon thereafter, I sold my $2.35 calls at $2.70.  I could have held the position longer, but I like to take my profits when they are ready for the taking.

Still holding a small loss on the original position, I held on to my $2.85 calls, sensing that we might get a much-weaker Nasdaq market today. The gap up on QID gave me additional confidence that it would go higher later on in the day.

No point in taking a loss when you still feel that you are on the correct side of the trade!

I was right, but it took a while for it all to shake out. QID traded sideways for much of the day before beginning a rally around 1:30 p.m. Eastern that would eventually take it much higher.

I sold my $2.85 calls a little bit after 2 p.m. at $3.25.  The total profit before commissions on both positions was over 14%, not too shoddy for less than a 24-hour period.

As I sometimes tend to do, I sold a bit too early.  However, I maintain that it’s far better to give up some additional gain than it is to give back a nice profit.  So I’m happy.

Lessons learned:  1)  Never panic and sell at the lows.  2)  It often makes sense to cut your money in half and buy your options in two separate purchases.  The additional commissions are chump change when compared to the additional money you can make by buying the second half of your position even cheaper.

And if you happen to be correct in your first purchase, and the call increases in value, you may not have made as much money as you would have by buying all the shares at one time, but at least you are still making some money.

Article printed from InvestorPlace Media, https://investorplace.com/2011/10/why-it-pays-to-enter-an-option-in-2-trades/.

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