How to Make Money Even When You’re Wrong

Editor’s note: With our offices closed this week for the holidays, we wanted to share the best pieces Jeff’s written throughout his career.

With earnings season right around the corner, this classic technique of Jeff’s is something to keep in mind as you take advantage of the market action…

[This essay was originally published in December 2012.]

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People tend to think being successful in options is all about swinging for the fences and trying to make a killing on one big trade. I fell victim to that mentality when I was 19 years old… and it cost me my life savings.

From that day forward, I realized that having a long and successful career as an options trader has to do with consistently taking profits as they come and focusing on managing the risk of every trade.

That focus is the basis of the strategy I now use with my own money… And today, I'm going to show you how to begin using it yourself.

The question I always ask myself when I'm looking at an option trade is, "How can I make money on this trade, even if I'm wrong?"

You're going to be wrong a lot of the time when you trade options. A stock can go up, go down, or go nowhere. When you buy an option, you're betting one of those three things will happen. You're going to be wrong and lose money if the other two occur.

So you need to look for ways where you can turn your position into a profit… even if you're wrong. I'm going to show you how this works with a real trade my readers took advantage of back in May 2012…

I'm going to walk you through this trade step-by-step. It might seem complicated at first… But it will definitely be worth the time you take to understand how the numbers work.

The first thing to know is that, at the time, I liked the idea of owning Seabridge Gold (SA), a Canadian gold explorer. Seabridge was dirt cheap, and I thought it would be trading much higher a few months down the road.

So I recommended buying the Seabridge January 15 call options for about $1.65.

That call gave us the right to buy Seabridge at $15 a share. We spent $1.65 on it. So to be profitable on this trade, we needed Seabridge to trade above $16.65 on option expiration day in January 2013. That was 25% above the price at the time.

If Seabridge fell in price, we would have lost money. We would have also lost money if Seabridge went nowhere. The only way we were guaranteed a profit on this trade was if Seabridge rallied more than 25% by January.

That may seem like a tall order. But I was confident the trade would work out and I was comfortable making the recommendation.

However, I still had to ask myself, "How can we make money on this trade even if I'm wrong?"

As long as we were spending money out of our pocket to make this option trade, the odds were against us. But there was a way to put some money back into our pocket… without taking on any extra risk.

The easiest way to do this was to create a "spread trade." Spreads involve buying one option and then selling another.

Since we owned the Seabridge January 15 call options, we had the right to buy the stock at $15. To create a spread, we sold someone else the right to buy Seabridge from us at a higher price.

My initial upside target for Seabridge was around $20 per share. So we sold the Seabridge January 20 call options, which gave someone else the right to buy the stock from us at $20. We collected $0.85 for selling the call. By doing this, we recouped more than half the cost of the January 15 calls.

Here's how that looked, trading one contract at a time. (One option contract covers 100 shares.)

Per contract, we paid $165 for the right to buy Seabridge at $15 per share and received $85 for taking on the obligation to sell Seabridge at $20 per share. We spent $80 for each spread.

We immediately lowered our out-of-pocket cost for this trade from $165 to just $80. Our maximum loss fell more than 50%.

We also reduced our maximum profit. Since we sold someone else the right to buy Seabridge from us at $20, we wouldn't have made any additional profit if Seabridge rallied above that level. But because $20 per share was my initial target anyway, we would have looked to lock in profits on the trade at that price. So we were really just agreeing to do so ahead of time.

Now, think about this…

If Seabridge closed at $20 per share on option expiration day in January, the Seabridge January 15 call options would have been worth $500 per contract. We spent $165 on the original trade. So we would have had a $335 profit, or 203% gains on our initial $165 investment.

But by creating the spread, we reduced the cost of the trade to just $80. And the spread would still have been worth $500. By adding the second leg for the spread trade, we would have had a $420 gain. That's 525% on the original investment.

The spread position lowered the cost of the trade, so it also lowered our risk and increased our potential percentage profit if the stock reached my target price.

This was a BIG improvement over just buying the January 15 call options outright. But there was still a way we could do even better.

Even with this spread trade, we still would only have profited if the stock moved higher. We would have lost money if Seabridge fell or went nowhere. To increase our chances for a profit, there was one more thing we needed to do… And now, I'll show you how we made this trade even better.

How to Make a Good Trade Great

The "spread trade" strategy I just showed you is a great way to reduce the risk of trading options and increase your chances of making money.

But there's an easy way to make it even better…

In the example I showed you, my readers bought one call option on SA and sold one call option.

While that was an improvement on simply buying the call by itself, we still were only going to profit if the stock moved higher. We would have lost money if Seabridge fell or went nowhere.

To increase our chances for a profit even more, we needed to add one more leg to this option position…

We sold an uncovered put.

By selling uncovered puts, you get paid to agree to buy a stock at a specified price by some date in the future. It's that simple.

Selling uncovered puts is my favorite options strategy. In my experience, it is the most consistent way to profit in the options market.

Now… it's important to only sell uncovered put options on stocks you want to own anyway… and at prices at which you'd like to own them. In a rapidly falling stock market, you may end up having to buy the stocks on which you've sold puts.

Smart folks who use this strategy use it to generate income on stocks they don't currently own but are willing to buy at the right price.

I'm going to walk you through each step of this trade. I know it may appear complicated and intimidating, but trust me, it's worth the time it'll take to learn how to execute these trades.

A quick recap: We first bought the Seabridge January 15 calls, which gave us the right to buy shares at $15. We sold the January 20 calls, which obligated us to sell Seabridge at $20.

That trade cost $0.80 per share. So we were looking to sell an uncovered put option on Seabridge that would give us the $0.80 back and maybe even put a little extra money in our pocket upfront.

Remember… we only sell puts on stocks we want to own anyway and at prices at which we want to own them. Seabridge was a dirt-cheap gold stock I wouldn't have minded buying right then, when it was trading for $12.50 per share. And I would have been thrilled to get paid for agreeing to buy it even cheaper than it was.

So I recommended selling the Seabridge January 10 put options. That obligated us to buy Seabridge at $10 per share if it closed below that level on option expiration day in January.

At the time, the puts were trading for $1.10. That covered the $0.80 cost of our spread trade and put $0.30 per share more in our pocket.

Here's how that looked, trading one contract at a time. (One option contract covers 100 shares.)

We created a trade that paid us $30 to set it up. That $30 was ours to keep no matter what happened to Seabridge.

This trade could have played out in one of four ways…

1. Seabridge closed below $10 on January expiration day. We would have been obligated to buy Seabridge at $10 per share. Figuring in the $30 we received for setting up the trade, we really agreed to spend $970 on 100 shares, or $9.70 per share. So this trade would have been profitable as long as Seabridge held above $9.70 per share.

2. Seabridge closed between $10 and $15 per share on January expiration day. All the options in the combination would have expired worthless, and we would have kept the $30 per contract.

3. Seabridge closed between $15 and $20 per share. The higher Seabridge traded in that range, the more money we would have made. For every $1 Seabridge rallied, we would have collected another $100 per contract.

4. Seabridge closed above $20 per share. The trade would have been worth $500. So our maximum profit would have been $530 ($500 for the combination plus $30 for the original setup of the trade).

In other words, the only way we could have lost money on this option combination was if Seabridge dropped another 25% from its already-depressed stock price. We were going to make money in every other scenario.

Think about that for a moment. We would have made money if we were right on the trade and Seabridge went higher. But we could have also made money even if we were wrong and the stock dropped. That is the beauty of this type of strategy.

Let's recap what we did here…

Instead of having a position that would lose money if Seabridge went down, stayed the same, or failed to move up 25% over the next eight months… we created a trade that would have been profitable under every scenario where the stock didn't fall by more than 25%.

Three months after my initial recommendation, shares of Seabridge had bounced all over the place, trading between $13 and $17. But because we set up the trade with such a large "margin of error," we didn't need to be overly concerned about the day-to-day fluctuations. We could concentrate on the longer-term objective – a higher share price going into January.

By mid-September, Seabridge traded for about $18. I figured for such a short time frame, that was close enough to my original target. And we were able to close the trade for a $250 net credit per contract. Counting the $30 we received for setting up the trade, we had a total gain of $280 per contract.

The Seabridge "spread" I showed you earlier was a good trade. But by adding a third leg to it, we created a GREAT trade. And it worked out perfectly.

Best regards and good trading,

Jeff Clark

P.S. Techniques like this are just a small part of what I bring to my Delta Report subscribers week after week.

And with earnings season just around the corner, I’ve put together a special offer for option traders looking for a way to earn triple-digit gains in just a matter of days.

To learn more, click here.