TradeStops members use options to increase their income, enter stocks at a lower price, or just to speculate with limited risk.
Many of the newsletters our members subscribe to offer suggestions for covered calls, naked puts, spreads, and other options strategies to accomplish the goals listed above. Even our own Ideas by TradeSmith program now has limited options strategies for some of the stocks in TradeSmith’s Lab.
TradeStops can help you manage these trades, but you should understand that there are limitations. It’s important to understand that options (and tracking options in TradeStops) are completely different from stocks. Options are derivatives of an underlying stock or ETF. The price of an option is at least partly based on the price of the underlying stock. Also, every option will expire on a pre-determined date and will then cease trading.
The majority of options traded have a lifespan of less than one year. Because of this, it’s impossible to determine a Volatility Quotient (VQ) for options. Even if we could determine a VQ for options, this number would be meaningless as the option will ultimately expire.
Because it’s impossible to determine a VQ for options, it’s also impossible to determine a Stock State Indicator (SSI). However, we can use the VQ and the SSI of the underlying stock to help manage the trade and to understand how the stock is trending.
For our first example, let’s look at how to track an out-of-the-money call on Franco-Nevada Corp. (FNV). This is a gold-mining stock that is currently in the SSI Green Zone. FNV traded recently at around $85 per share. The 52-week high on FNV was set recently at the $86 level. Someone bullish on gold and FNV might think that the stock could continue to rise to make new all-time highs above $90 per share in the next six months or so.
They might want to buy a January 2020 90 call at $4.00. That’s the most recent closing price of the option as of this writing. As a side note, if you don’t understand the terms discussed here, you might be interested in some of the educational courses provided by the Options Industry Council or the CBOE.
As with many investment strategies, we recommend you set up a separate Watch portfolio to track the options. You’ll notice that we’ve included the underlying stock in the portfolio in addition to the option itself. By adding the stock to the Watch portfolio, we can set up additional alerts to help manage the option position.
We have an alert set up for the underlying stock FNV (the dark bell indicates an active alert). This is an SSI Alert. An option trader might want to know if FNV drops by half of its normal VQ. We can set up a customized trailing stop for FNV by clicking on the “Alert” tab or by clicking on the position itself and then opening the “Alerts” tab from the new window.
FNV has a current VQ of 19.8%. We’ll set up a trailing stop alert to trigger if FNV drops 9.9% from this point in time.
Because there is no VQ alert available for the option itself, we have to enter a customized trailing stop for this position. To do that, we need to create an alert for this position. When we click on the position itself and go to the “Alerts” page, it opens to a trailing stop alert. We’ll use a 50% trailing stop for this position.
We now have two alerts set up for the underlying stock and one for the option itself.
Trading options requires more oversight than just buying and holding stocks. The price of the option is not only based on the underlying stock, but other factors as well. We recommend that you follow these closely and adjust your option alerts as necessary based on your personal trading strategy.
TradeStops also has specific alerts for covered calls and naked puts. We’ll quickly look at each of these in a different Watch portfolio. We’ll also use FNV for these examples.
For a covered call, we’ll buy 100 shares of FNV and sell the August 90 call. You already know how to enter the purchase of the FNV stock. Here’s how we add the option sale. Remember, we’re “Short” the option because we sold the call.
Here’s how the positions show up in TradeStops. You’ll notice that the short options contract is displayed as “-100” shares. That’s because the short option is the equivalent of being short 100 shares at the strike price of $90.
Let’s set up a covered call alert. We’ll click on the option listing and go to the Alerts page. We’ll add the “Covered Call Cost Basis” alert. You’ll notice that there are two boxes to be filled in manually. The first is the “Latest Close is __%”. We used FNV’s VQ of 19.8%, in this box. The second box is “I bought the Underlying Stock,” which is the price we paid for FNV of $84.34.
Take a look at the Alerts page now and you’ll see that the Covered Call Cost Basis alert subtracts the money received from selling the call from the cost basis of the FNV stock. It shows the adjusted cost basis of $83.22.
The cost basis hasn’t really changed, this alert just assumes the cost basis is reduced by the money received from selling the call and then subtracting the VQ (19.8%) from the cost basis adjustment.
To become familiar with these alerts, set up some of your own Watch portfolios with different stocks and different investment goals. We’ll go over these alerts as well as the alert for a Naked Put in our next educational webinar on Wednesday, July 17 at 1 p.m. ET. Click here to register for this presentation. We’ll also record the presentation and post it on the TradeStops site a day or two after the live event.
We tend to receive a lot of questions about options, so if there’s something specific you’d like us to address, please send an email to [email protected]. We look forward to seeing you on July 17!