Trade of the Day: AOL (AOL)

AOL, Inc. (AOL) is an Internet information provider. The stock has been in a downtrend for most of this year but recently found support in the $38 area. This support runs back to July of last year and should work again if need be.

Today I’m recommending that you trade AOL using one of my preferred option strategies: a put credit spread. Here is the information you need to know to open the position:

  • Underlying stock — AOL (AOL)
  • The stock closed at $39.95 on Friday.
  • Trade Type — Put credit spread
  • This position generates a 10% return on margin for a four-week holding period. Your maximum risk is $270 per contract.

A credit spread involves writing (selling to open) an option and purchasing (buying to open) an option at a different strike price in the same underlying security. The position, or leg, of the spread trade that you sell gives you a cash credit to your trading account. The option you buy limits your risk and lowers your margin requirement for the trade.

In a credit spread trade, you collect more money on the leg you write than you spend on the leg you buy, so you are getting paid to enter the trade! For maximum profits, you want both options involved in the spread to expire out-of-the-money. (For this particular credit spread, we are using AOL puts, as this is a bullish trade on the underlying stock.) But, regardless of what happens to the options, the money you receive for opening the position is yours to keep.

Making the Trade – Use a spread order to sell to open the AOL May 36 Put (AOL150516P00036000) and buy to open the AOL May 33 Put (AOL150516P00033000) for a spread credit of 30 cents or higher.

Note: This is the monthly option expiring on May 15, 2015.

If you are new to trading credit spreads, you will need to talk to your broker first and make sure your account is set up to handle two-legged trades. This is simply being able to place each part of the trade (leg) at the same time as a single transaction. To do this, you will generally need level 4 trading privileges.

Your broker will also require you to have enough cash or margin in your account to “cover” the underlying stock for each put option you write. That’s because if you do not close the position and the AOL May 36 Put expires in-the-money, you will be obligated to buy 100 shares of the stock at $36 per share for each credit spread contract you open. That’s not our goal, but it is possible.

As such, I recommend that you use an auto-stop order to close this position if AOL trades below $35.50 prior to May options expiration and you do not want to buy the stock. If you’d like to hear more about credit spreads before initiating this trade, be sure to check out my free report, Wall Street’s Most Powerful Trading Secret.

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