How to Gain Profits and Minimize Risks when Trading Stocks
Invest in the stock market, leave your money there for a few years, and you’ll likely enjoy a ten percent return. Traders don’t get out of bed for that kind of money. The only way to make a real profit is to actively trade and use derivatives to boost profits and minimize risk.
A derivative is a contract between two parties with a value that is set based on the price of a financial asset, like a stock or bond. This value is “derived” from the current asset value, but it is not equal to it. Think of it as a calculated hypothesis that the price will go up or down.
Real traders don’t gamble. Using technical analysis, we can generally determine when an asset price will increase or decrease in value. Doing that on a short slope during a day trade is easy. Betting on long-term results is more difficult. That’s why derivative payoffs are higher.
For those of you who are new to our application, you’ll see references below to chart patterns. These are graph shapes that are used for a trader’s technical analysis. Visit Trading 101 If you’d like to learn more about these and how they indicate buy and sell activities.
Understanding the Basics: Put and Call Options
Stock options are one of the most common derivatives. Options are agreements to buy or sell a certain security at a predetermined price on or before a specific date. There are two types: put and call. Think of the put as an option to sell. The call is an option to buy.
The agreed upon price that the underlying security will be bought or sold at is called the “strike price.” Keep that term in mind, as we’ll be referring to it again in the sections below. For some of you, this may seem elementary. Don’t worry. This lesson gets more complex as we go.
For beginners, spend some time studying puts and calls. Our section on Trading Options is a good place to start. What we have explained here are just the basics. Tickeron has a complete knowledge base on trading, including techniques for using options properly.
Another derivative, similar to options, is called a warrant. These function in a very similar fashion to options, but are issued by companies, not exchanges. They can be used for hedging against the downside. Warrants are common in Hong Kong and certain European countries.
Strike Price and Break-Even Prices on Call Options
The cost to buy an option is significantly less than that of the stock price itself. Options are sold in lots of one hundred, so if the option is worth $1, you can buy one hundred shares for $100. That $100 is added to the current value of those shares to arrive at a “break-even” price.
Here’s an example. Let’s say you buy a call option on XYZ Company, valued at $10 a share, for $1 per share, with a strike price of $11. If the stock hits $11 before the expiration date, you can exercise the option, but you won’t make a profit. You’ll only break even.
The trick to options trading is to base your decisions on the break-even price, not the strike price. Your trading platform should show you both numbers when you set up the transaction. Look for strike prices below the current value of the asset with a reasonable options price.
Hedging Your Stock Buys with Put Options
When an options play doesn’t covert for you, you only lose the price you paid for the option. The potential upside is higher. If XYZ goes up to $12 a share, you make $100 above the break-even price. That’s a 100% return on your investment, in what is usually a few days.
Now think of this in terms of put (sell) options. Let’s say you think XYZ will go up, but there’s a possibility it might go down. In this scenario, you buy the actual stock at $10 a share, spending $1000 for that lot of 100 shares. You also buy a put option with a strike price of $10 a share.
If the put option costs you $100, that’s the extent of the losses you can take on this deal. Even if the stock price goes below $10, you have the option to sell it at current value. If the price goes up, you’ll lose the $100 you spent on the put, but still earn a capital gain on the stock itself.
The Leverage Advantages of Futures Contracts
Options are optional. You can choose to exercise them or let them expire and take the loss. Futures are a contract. They come in two sizes. Standard contracts have a 250x multiplier. Mini contracts are bought and sold at one-fifth of that size.
Due to the size of the obligation involved on a futures contract, and the trader’s ability to buy and sell that contract for significantly less than the cash value, futures offer a high degree of leverage. That leverage can boost profits. It can also result in huge losses.
Corporations often buy futures to lock in the price of commodities they need for production. Traders use them for speculation and to diversify their trading efforts. Betting on prices to go up is called going “long.” Speculating a decline is known as taking a “short” position.
Simplifying the Math for Derivatives
This may seem a bit complicated for anyone new to derivatives trading. It boils down to risk versus reward. Think of it in terms of hedging your bets, because that’s exactly what it is. Traders use technical analysis to predict market trends. It’s reliable, but not 100% foolproof.
Here’s another example. Our friends at XYZ Company are trading at $10 a share, but that number is below a previous high of $12 per share that the company realized last month. Analysis of past performance shows that there was a drop right before that spike.
If the previous value before that earlier spike was $8, you may be looking at the tail end of a head and shoulders chart pattern, which is a bullish buy indicator. Unfortunately, that pattern could be upside down, signifying a bear market. Which way do you go?
The answer is to hedge with options. Buy the position if your analysis indicates it will go up. Purchase a put option on current value to minimize potential losses. You’ll either lose the price of the put or you’ll make money on the stock trade. That math is pretty simple.
Diversifying a Portfolio by Hedging with Derivatives
When there are two favorites in a horse race, you bet on both of them. A good example of this on Wall Street right now is the pharmaceutical race to develop a vaccine for Covid-19. According to experts, Moderna (MRNA) and AstraZeneca (AZN) are leading the way.
Moderna’s chart pattern shows enough pennants and flags for a blind day trader to make money. AstraZeneca is coming out of a second cup and handle and on a slight downslope to enter a third. These are good indicators for active traders.
Here’s the thing. The successful completion of a working vaccine will launch the winning company’s stock into the stratosphere. How do you make sure you cash in on that? It’s simple. Buy long options on both of them. One will pay big. The other will be a minimal loss.
Hedging for Market-Moving Events
Take this to another level. Experts predict that a presidential change in the United States will send the market into freefall in November. That’s certainly not technical analysis, but it’s a valid concern. You can purchase put options to hedge that. You can also buy S&P Futures contracts.
Another example of this is Brent Oil (BNO) versus EV stocks. When oil prices go down, electric vehicle stocks seem to rise. This is mainly anecdotal, yet worth exploring. Oil stocks are popular with day traders, particularly novices. EV stocks might be the hedge to prevent losses.
The global pandemic of 2020 caused economic unrest and put a huge strain on hospitals and health care providers. For traders, the market volatility opened up new opportunities. When the world shut down, call option holders on Amazon, Netflix, and Shopify made millions.
Learn More about Derivatives at Tickeron
If we presented this to you properly, the door should now be open for you to learn more about derivatives. This article was meant to provide a framework, but it’s certainly not the complete picture of everything you can do trading options, futures, and warrants.
Read our section on trading options and you’ll see that we have merely scratched the surface here. Beginners should not venture into this without reviewing and digesting all the material in that section. When properly prepared, you can make great money trading options.
We invite you to check out our other premium products -- they’ll help you be best prepared to take on the market. Some of the premium products that might be helpful for a new trader are the AI Pattern Search Engine and the AI Trend Prediction Engine. Our Screener is a great way for a continuing trader to pinpoint what you’re looking for and to monitor the securities for an extended period.