7 signs we’re near a market top, and what to do now

Opinion: Wall Street is reliving the 1960s — but the ‘Go-Go’ era is ending

Remember March 4, 2014 — a day that will go down in Wall Street history as the beginning of the end for this latest bull market, which is about to celebrate its fifth birthday.

On March 4, the Dow Jones Industrial Average rose 227 points based on a report that Russian troops were pulling back from Ukraine’s border. This “news” lit the market on fire, a sign that the market is heading into a mania stage where it doesn’t take much to boost stocks.

Indeed, nowadays instead of the “Nifty Fifty” stocks that defined the late 1960s market, we have the likes of Facebook, Tesla Motors, and Chipotle Mexican Grill — the new new things.

Can the market go higher? Sure, although the higher it goes, the more dangerous it becomes. Often, during the latter stages of a bull market, the market separates itself from reality and appears to be on another planet.

Such red flags are everywhere:

1. Retail investors have been pouring money into stock mutual funds.
The fear of missing out on the sixth year of a bull market has created something close to a buying panic. Although not as maniacal as we saw in 1999, the stock cheerleaders are back and rooting for their stocks and mutual funds to go higher — just like they always do before a crash or bear market.

2. The Investor’s Intelligence survey is concerning.
The closely watched II survey shows a low proportion of bears (less than 20%), which some have pointed out is the lowest proportion since just before the 1987 crash.

3. Sentiment indicators are pessimistic.
The VIX, the put-call ratio and other major sentiment indicators suggest that investors and traders are getting complacent. Apparently, market participants believe that the Fed, or their fund manager, will protect them in a worst-case scenario.

4. Fundamentals are being ignored.
Obscenely high P/E ratios are passed over, along with soft economic readings (i.e. GDP and ISM). When the fundamentals are weaker than expected, the weather is blamed.

5. The stock market crash of 2008 has been forgotten.
Investors forget, but the market never does. Those who do not heed the lessons of the past will once again learn a painful lesson.

6. The Nasdaq is soaring.
The three-year chart of the Nasdaq has gone nearly parabolic, hitting a 14-year high of 4,351 on March 4. It’s the Go-Go years all over again. (And that late 1960s bull market ended with the 1973-74 bear market.)

7. Fear and greed are taking over.
When the market reaches the tipping point (and we’re getting closer), investors and traders buy “ATM” (anything that moves). The fear of missing out causes a buying panic.

What to do now:

There have been numerous crash predictions over the last five years. As a result, many investors have closed their ears, and who can blame them? The market has ignored the warnings and continued to go up. One thing about crashes: They can’t be predicted (but it won’t stop people from trying). However, it is possible to recognize a dangerous market, which is what we have now.

The market is wearing no clothes

Just like the emperor, the market is wearing no clothes. Right now, many people see only what they want to believe. It’s been a long time since investors felt full-throated fear, and many have forgotten what it feels like. The panic to buy will be replaced by the urgency to get out at any price. No one can know what will cause perceptions to change, but they will.

At the moment, emerging markets are in deep trouble, and what is happening in Ukraine didn’t help. Nevertheless, the CEOs of several major brokerage firms have urged investors to “go long” emerging markets because they are so “cheap.” Once again, these well-educated salesmen are wrong. Emerging markets will recover one day, but not soon. Urging investors to buy on the dip is disgraceful.

Sit and wait?

If we are in the mini-mania stage of the bull market, the market will continue to go higher based on rumors, hope, and greed. Sitting on the sidelines and waiting for the bull market to top out takes tremendous discipline. Trying to capture that final 5% can be costly if you get the timing wrong (and most people do). Be prepared for increased volatility as we get closer to the end.

Of course, it’s not easy to sit on the sidelines when everyone else seems to be making money. Although many investors are dreaming of another 30% return this year, the odds are good that it will be a difficult year. Yes, during a mania stage anything is possible, but with each passing week, the clock is ticking.

Those who have studied market history have seen this story before, and the ending is always the same. No matter how many warnings you give, no many how you urge people to avoid buying the speculative Go-Go stocks and move to the sidelines, few listen until it is too late.

Michael Sincere’s newest books, “Understanding Options” (2nd Edition) and “Understanding Stocks” (2nd Edition) have just been released by McGraw-Hill. Sincere’s website (www.michaelsincere.com) uses indicators and clues to determine if stocks are in a bull or bear market.

6 easy ways to lose money in stocks

Opinion: Ridiculous investment advice you should never follow

MIAMI (MarketWatch) — On CNN, “Anderson Cooper 360” features a segment called “Ridiculist” that showcases certain people’s most ridiculous behavior. That got me thinking about some of the most ridiculous investment advice I’ve ever heard.

Here is my list, though I’m sure you can add ridiculous advice you’ve received from “experts” who should know better.

1. There’s always a bull market somewhere

There might be a bull market somewhere, but it won’t always be in stocks. And if there is a bull market somewhere, there must be a bear market somewhere, too. The problem with this comment is that it makes people believe the stock market always goes up. As many investors already know, that is most definitely not the case.

In truth, bear markets are a natural part of the market cycle, so they should not be feared or ignored. It would be nice if the market always went up, but that is unrealistic and dangerous.

Therefore, telling investors there is always a bull market somewhere makes them feel like they are missing out on something big. It also makes people believe you should only be bullish. If you believe that the market always goes up, as this statement implies, the market will teach you a lesson you’ll never forget.

2. The ‘little guy’ is causing the market to fall

When the S&P 500 or some other market benchmark is falling, analysts always want to blame someone. The retail investor is an easy scapegoat. I heard a commentator make this ridiculous comment during a recent market selloff. Come on! The “little guy” (i.e. retail investors) do not have the power to move the markets (unless there is mass panic). In fact, the retail investor is usually the last to get out of the market, and often at the bottom.

In the early days of a market correction or pullback, it’s almost always institutional investors and other professionals that are rushing the exits. So please, stop blaming the little guy. If anything, blame them for selling too late because they also believed this next bit of ridiculous advice.

3. Your stock will come back to even

The conventional wisdom is this: If your stock goes down, you should buy more because you are getting a bargain. If your stock goes up, you should buy more because you’ll be missing out on a great opportunity.

In reality, there are times when your stocks, even some of the best, do not come back to even or at all (see Bear Stearns and Lehman Brothers). If you are going to invest in individual stocks, ignore this ridiculous advice. Hoping that your stock will come back to even will cost you money. In fact, hope has no place in the vocabulary of any investor. A better strategy is to sell stocks once they decline more than 7% or 8%.

4. Buy on the dip

Buying on the dip during a bull market or when the market is in an uptrend can work, but if you buy on the dip during a downtrend or bear market, you could get slaughtered.

Even worse, some people buy on the dip while they are holding losing positions. Here’s a rule: Don’t ever buy additional shares of a losing stock, especially if it is still going down.

That losing stock is down for a reason, and adding more shares of a loser is ridiculous.

Unfortunately, buy on the dip is repeated often. Recently, some commentators suggested that retail investors buy emerging markets. Ridiculous! It’s highly likely that emerging markets are not going to bounce back any time soon.

Bottom line: Buying stocks on the way down (i.e. the dip) is bad advice, especially in a dangerous market. Instead, buy stocks after they’ve stopped falling and are on the way up.

5. You can get rich quickly

There is nothing more ridiculous than books that promise to make you rich in the stock market. Yes, you can win, build wealth, and make profits, but to believe that after reading a book you will get rich is ridiculous, and is only designed to sell books.

It’s doubtful that even one reader will “get rich” in the stock market after reading a book about the market, especially if they are starting with only a few thousand dollars. Indeed, when get-rich type books appear on the bestseller lists, that’s a signal that the market has reached a top.

6. Buy low, sell high

Similar to buy on the dip, the “buy low and sell high” mantra has been drilled into investors since the early days of the stock market.

Unfortunately, this cliché has caused many investors to lose big in the market. For starters, the terms “low” and “high” are difficult to define. No one knows what is low or high until after stocks have reached these points.

Here’s an idea: Buy when the market is in an uptrend, and sell or reduce your position when the market becomes dangerous. Bernard Baruch, the successful financier and economist, said of this strategy: “Don’t try to buy at the bottom or sell at the top. It can’t be done, except by liars.”


Michael Sincere’s newest books, “Understanding Options” (2nd Edition) and “Understanding Stocks” (2nd Edition) have just been released by McGraw-Hill. Sincere’s website (www.michaelsincere.com) uses indicators and analysis to determine if stocks are in a bull or bear market.

Dow 20,000 here we come: It’s different this time

Commentary: We need more irrational behavior to create a real bubble

Watching the Dow Jones Industrial Average top 16,000, many investors are hoping this market is in a bubble (so they can shrewdly buy stocks at lower prices when it pops). But we have a long way to go for that.

Right now, the most important part of a bubble is missing — the mania. We need intoxicated investors, a buying frenzy, over the top speculation, and a get-rich-quick mentality. A bubble without a mania is like an ice cream sundae without a cherry. We can do better.

Although it’s possible to have a bubble without a mania, those maniacal meltups help historians confirm whether it was a true bubble. Also, meltups make you feel rich before you go broke (be sure to save your statements so you can remember how much you could have, should have, and would have made if you had sold in time).

There are some signs of exuberance. Mutual funds are bringing in a lot more cash, some money managers are afraid to miss the expected Christmas rally (and their year-end-bonuses), the VIX remains in the complacent zone at 12, and the Investors Intelligent sentiment survey is over 50% bullish.

That’s a good start — but nothing like a true bubble. In the old days, bullish sentiment readings were off the charts at 80%. We can do better.

If this were a traditional bubble, I’d be getting stock tips from supermarket baggers, cabdrivers, and my barber (he tells me no one is giving him tips, either).

Rather than bubbling with excitement because the market more than doubled, investors seem disinterested. They aren’t buying stocks like in 1999, or buying houses like in 2007. In fact, I don’t know what they’re buying. Now that those 401(k) accounts are finally getting back to even, investors need to step up to the plate and push this market much, much higher.

Dow 20,000 is possible

After we breached 16,000 for the first time the other day, the folks at CNBC put on their party hats — but you ain’t seen nothing yet. To make this the real deal, we need a little parabolic action.

Dow 20,000 has a nice ring to it. In fact, Dow 20,000 is not only doable, but also reasonable (yes, we can do 25% in six months). It may also boost the bullish juices if someone wrote a book, Dow 20,000 (note to publishers: the title is available).

If you want to see a real bubble in action, take a look at China. Hong Kong’s Hang Seng Index was at 20,000 in July; now it’s around 24,000 (almost 20% in four months beats the U.S. market). On some days, the Hang Seng rallies by 5% to 7% (that’s 1,000 points on the Dow). On a typical day, the Hang Seng might be up 3%. In China, they know how to do bubbles (and like all bubbles, it will not end well).

The Fed can help

Our so-called bubble is boring compared to China. With the helium the Fed is pumping into the economy, it’s going in the right direction, but not fast or high enough. We need to catch up, so I’m wondering if the Fed can do more. Rather than reducing quantitative easing, how about increasing the bond buying to $100 billion a month? That would keep interest rates low and delight the stock market.

The only problem: QE is similar to investing in penny stocks. Easy to buy, but hard to sell. I have no idea how Janet Yellen is going to end this experiment after she becomes Fed chairman, but if it continues, it will really light a fire under the stock market. Maybe then we’ll have the euphoria that is so desperately missing. It would be a short but random walk to Dow 50,000.

Stop talking about bubbles

To my fellow financial market writers: Please stop writing about bubbles. How can we have a bubble if you keep writing about it?

The whole idea is that a bubble is a secret until after it pops. Do you think they announced it was a bubble when the Dutch were trading tulips? In 1929, no one wanted to jinx the market and discuss bubbles, and if you did, they’d recommend a good psychiatrist. In 1999, investors thought dot-com stocks would go up forever. And in 2007, most people didn’t think there was a housing bubble. At the time, it seemed perfectly natural for housing prices to double and triple within a year.

Those were the bubble years, and we can do it again if we try.

Advice from Bernard Baruch

In case anyone mistook my attempt at humor for reality, allow me to redeem myself. Here is some serious advice from financier Bernard Baruch. Asked how he made so much money in the stock market, he replied: “By selling too soon.”

Bottom line: Only you can decide if the potential reward is worth the potential risk. The market is priced for perfection, and nobody is perfect, not even Mr. Market (unless you think it really is different this time).


Michael Sincere is the author of “Understanding Options,” “All About Market Indicators,” and “Understanding Stocks.” His website uses indicators and analysis to determine if it’s a bull or bear market.

Don’t fight the Fed — fear it

Commentary: Bernanke & Co. are looking for bubbles in all the wrong places

MIAMI (MarketWatch) — Now that the Washington debt and shutdown drama is behind us — at least for now — let’s consider a potentially more dire situation: the Fed’s next move.

Do you remember the Fed? Just last month everyone was expecting Ben Bernanke to cut back on quantitative easing (i.e. taper). The high-speed traders had their fat fingers on the keyboard, ready to sell. Would the Dow Jones Industrial Average drop 200 points or 300? It was the easiest trade in the world.

And then, Benny and the Feds surprised nearly everyone by not tapering! The market loved it, and responded with a 200-point rally. It was beautiful. The Dow sailed well past 15,000 and there was blue sky as far as the eye could see. Unfortunately, the next day the market sold off, but it was a fun day while it lasted.

A few economists mumbled that quantitative easing was going on too long, and that if it didn’t stop soon it could cause real damage to the economy. What? Take away the punch bowl? Do you have any idea how the market would react? No, QE must sail on.

And to anyone who thinks that QE could create an asset bubble, St. Louis Fed President James Bullard has an answer. Last month he said that the Fed didn’t see any bubbles. “At least right now,” Bullard noted, “you don’t have anything of that magnitude going on.”

Bubbles are funny things. During the Dutch tulipmania bubble (1634-1637), beautiful tulips were bought and sold for $200,000 each at today’s prices. At the time, few realized they were in a bubble, but who cares? You could make a fortune by buying and selling the tulip without even owning it. Many people got rich before they went broke.

During the Internet bubble (1995-2001), people thought the good times would continue indefinitely; 1999 was a particularly fun year for investors as certain Internet stocks such as pets.com and others with a dot-com name went up by a gazillion points. And during the housing bubble (2007-2009), flipping houses was all the rage. But at the time it didn’t seem like a bubble.

The year of the Fed bubble

If the Fed continues with QE (i.e. excessive monetary liquidity), and it most likely will, the market could rally right into Christmas and beyond. On the other hand, if the Fed even whispers the word, “taper,” the market might convulse. And no one wants that.

One might wonder if we’re now in the middle of a Fed-induced bubble (2009-?). As the market climbs higher because the Fed is reluctant to taper, the bubble might get bigger. Like other bubbles, few will know we’re in one until it pops. That’s the strange thing about bubbles: they can go on for years. Meanwhile, the damage is being done, but no one sees until it’s too late.

If you try to warn people that the market might be rising a bit too fast and too far, they protest. “Don’t fight the Fed,” has been the mantra since the last Fed bubble popped. That’s what they always say.

Yes, it’s true, you don’t fight the Fed — at first. But the Fed is only human, and if it makes a mistake (which it’s prone to do on occasion), anything is possible. The Fed has got itself into a pickle this time. If it continues with QE indefinitely, it could cause economic damage. If it cuts QE, the market will protest.

What to do? Keep your eye on the bond market. If the yield on the 10-year Treasury rises above 3%, that could spell trouble for stocks.

If the stock market is in a Fed-induced bubble (we’ll know after it’s over), it won’t be easy to deflate. The Fed will try to reduce QE slowly, which would be an amazing feat. Bubbles cannot be controlled so easily. In a worst-case scenario, that popping sound you hear is not a Champagne bottle.


Michael Sincere is the author of “Understanding Options,” “All About Market Indicators,” and “Understanding Stocks.” His website lists signals from the most useful market indicators.

3 stock market lessons from ‘The Twilight Zone’

Commentary: You are about to enter Mr. Market’s dimension

MIAMI (MarketWatch) — His name is Mr. Market.

He is many things to many people — a purveyor of dreams, hopes, and unimaginable wealth. Mr. Market can help you or he can hurt you. When you play with Mr. Market, you risk losing not only your money but your sense of reason and reality.

If you don’t turn back now, you will see a signpost ahead, a warning that you have entered another dimension. For your consideration, the following three lessons come directly from a wondrous place universally known as “The Twilight Zone.”

Mr. Market is not your friend

When you trade stocks, do not think of Mr. Market as a partner. If you do, he may lure you into buying more at exactly the wrong time. Even now, the crowd lines up for the easy money as investors blindly take Mr. Market’s gifts without thinking.

In the Twilight Zone episode “To Serve Man,” Michael Chambers, like other earthlings, welcome nine-foot aliens from outer space who arrive with wonderful gifts, including an end to famine, a nuclear cloaking device, and a new energy source. It’s a golden age, everyone thought.

Soon, thousands of people travel by spaceship to the alien planet, which is described as a paradise. When one of the aliens accidentally leaves behind a book, Chambers, a decoding specialist, assigns one of his employees, Patty, to decipher its contents. Patty and her team translate the title as To Serve Man . Chambers is convinced the aliens come in peace.

A year later, Chambers agrees to visit the alien planet. As Chambers walks up the steps to board the spaceship, Patty runs to him and screams, “Mr. Chambers, don’t get on that ship! The rest of the book, To Serve Man …it’s…it’s a cookbook!” Chambers tries to escape but the aliens stop him, and the ship takes off.

Lesson from the Twilight Zone: By the time you realize that Mr. Market is not your friend (or servant), he will have eaten you for lunch.

Don’t get obsessed with Mr. Market

If you participate in the market, it’s easy to become infatuated by the lure of fast money. On one financial TV show, the flashing lights and party atmosphere resemble a casino. The host tells you there’s always a bull market somewhere, so any stock you pick can be a winner — all you have to do is make the right guess (easier said than done).

If you don’t use the market to gamble, you’ll probably stay out of trouble. But if you take stock losses personally or think Mr. Market is humiliating you, you might get overly emotional and perhaps want revenge. This is a serious mistake.

In the Twilight Zone episode, “The Fever,” Franklin and his wife, Flora, arrive in Las Vegas because Flora wins a contest. Franklin hates gambling and is suspicious of the all-expense paid trip. When Flora puts a silver dollar in the slot machine, Franklin berates her for gambling.

As Franklin leaves the casino, however, a drunken man hands Franklin a silver dollar and insists he play the slot machine. Franklin does, and wins. Franklin is amazed by the free money, and keeps playing. In fact, he plays the same machine all night.

After Franklin loses all his money, he angrily accuses the machine of stealing his last dollar. Franklin has a nervous breakdown and is removed from the casino. That night, in his hotel room, Franklin hears the machine repeatedly calling his name. Franklin is afraid as the slot machine rolls towards him. With his wife screaming for him to stop acting crazy, Franklin cowers against the window and falls to his death. The slot machine, flashing a big smile, rolls beside Franklin, and returns the silver dollar.

Lesson from the Twilight Zone: A word to the wise — if the market calls your name in the middle of the night, you are either obsessed, or in the Twilight Zone.

No one controls Mr. Market

Many people think they can control Mr. Market, but he often acts like a dummy, and even lets you win on occasion. During an uptrend, it’s easy to think you are a genius. Using indicators or charts, you may think that Mr. Market is your personal ATM machine.

On the other hand, when you lose money, it’s a mistake to get angry at Mr. Market. Even worse, don’t try and force him to give you money or you may end up as another Wall Street casualty.

In the Twilight Zone episode, “The Dummy,” ventriloquist Jerry Etherson (Cliff Robertson) suspects that Willy the dummy is alive. At their most recent show, Jerry is upset when Willy interrupts with his own lines. Although the act is a huge hit, Willy acts suspiciously, and even mocks Jerry in a threatening manner.

To gain control, Jerry hides Willy in a trunk and replaces him with another dummy, but Willy escapes. Jerry is so afraid he attempts to kill Willy, but accidentally kills the other dummy instead. In a cruel twist at the end, Jerry loses his mind and is transformed into the dummy, while Willy becomes the ventriloquist.

Lesson from the Twilight Zone: Mr. Market is not as dumb as he seems.

Note: Author and stock analyst Amy Smith from Investor’s Business Daily tells Sincere her stock ideas for this month. Read the interview here.


Michael Sincere is the author of “Understanding Options,” “All About Market Indicators,” and “Understanding Stocks.” His website lists signals from the most useful market indicators.

How to survive a stock market crash

MIAMI (MarketWatch) — Investors who are deeply afraid of a stock market crash suffer from a condition I call “crashitis.” Symptoms include anxiety, insomnia, anger, and negative thoughts about the market. People in this condition often move all their money to cash even in bull markets. In extreme cases, investors may avoid the market for a lifetime.

After getting burned in the market twice in the last 10 years, it’s not surprising that many investors are suspicious of this market. It’s been said this is the most hated bull market in history.

Unfortunately, the fear of a market crash — crashitis — is worse than a crash itself. In truth, and based on probabilities and history, there are usually warnings before a correction or crash.

The boy who cried ‘crash’

The worst part of being afraid is the lost financial opportunity. Listening to doomsayers who constantly cry “crash” hurts your portfolio. Just like Chicken Little who thought the sky was falling when an acorn hit her on the head, a market correction will bring forth a wave of new crash predictions.

If there is a correction, don’t be surprised if the market disappoints everyone. Consider: The market bounces back after a pullback or sharp correction. Those expecting a huge crash (so they can buy at lower prices) won’t get it. Those thinking the bull market will continue indefinitely will lose money.

The cure for crashitis

Rather than succumb to your fears, prepare for the worst. Eventually, there will be a bear market. Create a diversified portfolio, understand the stocks and mutual funds you own, and develop portfolios for both long-term and short-term goals.

The cure for crashitis is a healthy dose of knowledge. This will help you to control your emotions and focus on the facts (such as market indicators) rather than your fears.

What the indicators say

Although a major market crash is a relatively rare event, a pullback (3% to 9%) or even a large correction (10% to 20%) is more probable. The odds of a pullback or correction have recently increased.

In fact, the indicators are flashing caution signs:

MACD dropped below the signal line, the Standard & Poor’s 500-stock index (SNC:SPX) fell below its 20-day moving average (a short-term signal), and the put-call ratio is below .75 (option buyers are too bullish, a contrarian signal). It is too early to know if these signals are significant, so we look at outside events for additional clues.

1. Japan’s Nikkei stock index fell by 7 % in a day, rallied somewhat, but was off its peak by 15% at one point.

2. There was an uptick in yields in the U.S. bond market, a signal that bond investors could get hurt, especially as the Fed slows down its bond buying program. Bill Gross, the bond guru at Pimco, warned that the bond rally is over.

3. Emerging market currencies got crushed (South Africa, Thailand, Turkey, Peru) and bond yields spiked (Turkey, South Africa, Mexico, Hungary, Poland). The governments in these countries could react by raising interest rates.

4. A distressing development for the bulls was institutional selling at the end of four days last week (i.e. distribution). This was not a good sign.

Prepare for the worst

When storm clouds appear, you should take defensive actions. This doesn’t mean to panic and sell everything. Here are a few steps you can take to prepare for a correction:

1. Cut back on individual stocks, especially if you have losing positions. If there is a correction, those small losers turn into big losers.

2. Hedge with non-leveraged inverse ETFs. (Avoid leveraged ETFs, which contain questionable securities and have a tendency of doing reverse-splits.)

3. Buy protective put options. Start small with a few contracts. Although you can make money during a correction, it’s not easy; you have to be right about the timing and direction.

4. Have cash set aside for emergencies and to buy into future bull markets.

5. If you know what you own and are comfortable holding, you can survive a correction. It will not be the end of the markets as we know it, but if you believe that, you have crashitis.

The biggest danger is that fear causes you to do something irrational like selling at the bottom or keeping all of your money in cash for years and years.

If there is a correction or crash, the market will survive. No matter how many times the market has been hit, it always comes back eventually.

Why I stopped using stop loss orders

MIAMI (MarketWatch) — I believe in stop loss orders to protect stock positions or to lock in gains. When the stop loss is triggered, your stock is automatically sold at the market at the best available price.

The best available price? Unfortunately, that can be a misnomer.

In a normal market (if there is such a thing), the stop loss can work as intended. You buy a stock at $50, and enter a stop loss order to sell at $47.50, which limits your loss to 5%.

In reality, in a fast market when the stock gaps down (during flash crashes, breaking news, or fake tweets), your stop loss is triggered. The bad news is that it will be triggered at the next available market price, which could be many points lower.

In other words, your stock could be automatically sold at the lowest price, and instead of locking in a 5% loss, you could lose much more.

Another problem with a stop loss order is that when you enter it into the computer, the order is transparent. A game that some market-makers played (these days, it will be computer algorithms) is “run the stops,” when the stock is forced low enough to trigger a large cluster of stop loss orders (usually at round numbers or well-known support and resistance levels). After the stock is sold at a popular stop loss price, the stock reverses direction and rallies.

The biggest problem with stop losses is that you have given up control of your sell order to the computer. During volatile markets, that can cost you money. But there is an alternative.

Price alerts

I still believe in stop losses, but not the automatic kind. Rather than using automatic stop losses, I set up price alerts for the securities I bought (and for those I plan to buy). For example, if I buy XYZ stock at $20 per share, I might set a price alert at $19 (5% loss), and also at $25 (25% gain).

If the $19 alert is triggered, I am notified by email and text message. Next, I’ll turn to my mobile device and decide what action to take. More than likely, I’ll sell depending on market conditions. And if the $25 price alert is triggered, I might sell for a profit or set new price alerts.

The main point is that I am in control of my sell orders. Technology has made price alerts more practicable than in the old days. First, because of mobile devices, you are notified instantly if the target price is triggered. Second, you can take immediate action. Before the Internet, you had to run to a phone and call your brokerage firm. (During the 1987 market crash, phone lines jammed because of the huge influx of orders. By the time brokers entered their clients’ sell orders, stock prices were already at rock bottom.)

Note: Stop loss orders still make sense if you are unable to access your account immediately, for example, if you are on vacation. In addition, if you are not disciplined and ignore price alerts (hoping your stock will come back one day), automatic stop losses might be a better alternative.

Alert prices

Now, let’s take a look how the overall market is doing, and which are the leading stocks within the strongest sectors. Amy Smith, author of “How to Make Money in Stocks Success Stories” and a market expert at Investor’s Business Daily, gave her view of the overall market.

“We’ve been in an uptrend since November and have had a nice move along the way with the indexes moving into new high ground. Although there were a few distribution days (selling), and the market corrected a little bit, we went back into an uptrend. Savvy investors are keeping a close eye on the volume going into the indexes.”

Smith says to watch for heavier volume as the market moves higher. “If volume continues to increase, it indicates institutions are buying shares. The key is whether the major indexes can hold onto their new highs.”

Using the CAN SLIM® investing method, Smith is also looking at how the leading stocks are doing. Are they holding or starting to correct? So far, they are holding on, but that could quickly change. “If you see indexes and leading stocks pulling back on heavier volume, that is an indication that professional buyers are lightening their positions,” Smith says. “That is the time you don’t want to be in the market.”

One group to watch: Biomedical stocks. These companies produce drugs and services to people that need health care. “We have an aging population and people need these products,” Smith says, “but if this group begins to weaken, that could also spell trouble for the overall market unless another sector takes its place.”

According to Smith, stocks in that sector that have had huge earnings increases so far (ranging from 27% to 63%) include Celgene, The Medicines Company , Valeant Pharmaceuticals International, Cigna, and Biogen Idec. There are also several ETFs that focus on biomedical stocks. As always, just because this industry has done well in the past is no guarantee it will do well in the future.

My opinion: Many retail investors are still suspicious of this market. Why? Because they think the market is logical. Well, if you want logic, play chess. Otherwise, until there is evidence of a correction or bear market (indicators turning down, more than two strong down days in a row, strong opening but weak close, and leading stocks unable to advance), this bull market will continue. That said, never let down your guard — this market could turn at any time.

How to survive the next market correction

MIAMI (MarketWatch) — When I interviewed famed mutual fund manager Peter Lynch a few years ago, he told me his winning stock-picking strategy: Go to the mall and observe what people are buying.

Then, he added, do basic research on companies before you buy, closely monitor the company, and understand the reason why you originally bought the stock.

“You have to keep checking the story and the fundamentals,” Lynch said. “It’s called doing research. This doesn’t mean checking the stock price each day. You can sit in a room and look at a stock all day and it won’t help you out one bit.”

Forget about trying to predict the future. As Lynch told me: “I’d love to know what will happen in the future. In fact, I’ve been trying to get next year’s Wall Street Journal for 40 years. I’d even pay an extra dollar for it.”

Bear markets and corrections are a normal part of the stock market cycle. Lynch told me that if you plan to sell your stock in a panic because the market falls by 10% or 20 %, maybe you shouldn’t be in stocks at all.

I thought of Lynch’s ideas when I went to Orlando last week. The theme parks were crowded, the hotels packed, the restaurants full, and the airlines booked to capacity. New York and Chicago hotels are also full, and conventioneers have returned. I know that many Americans are still hurting, but it seems that many in the middle class have opened their wallets.

Airline stocks delayed

Amy Smith, author of “How to Make Money in Stocks Success Stories” and market expert at Investor’s Business Daily (IBD), noticed that travel and leisure stocks had been zooming higher in the most recent quarter. A recent stock idea, Lumber Liquidators Holdings has had a phenomenal run. This stock has done well because the housing market is recovering and homebuilders are doing well.

Smith uses the CAN SLIM® investment strategy, created by IBD founder William J. O’Neil. Based on the strategy, Smith found three airline stocks that have performed well: Alaska Air Group, U.S. Airways Group and SkyWest.

“Alaska Airlines has been amazing,” Smith says, “although it did have a 7% drop on April 2nd. The key is to watch the market carefully. If you had bought Alaska Airlines and it dropped 7% below what you paid for it, the CAN SLIM sell rule would kick in. It’s your insurance against heavy losses.” Smith also says that most growth stocks tend to follow the overall direction of the market.

Should you buy these stocks now? No, Smith says. “Alaska Airlines has made such a strong move it could be ready to take a break and digest its gains.” Smith says it is a little late for these stocks right now but to remember that most big winners give investors multiple opportunities to participate during a price run.

“All of these companies are due to report earnings soon — Alaska Airlines on April 19th, U.S Airways on April 23rd, and Sky West on May 2nd,” she says, “so it’s risky to buy now.” These are examples of how you have to catch an uptrend early, she adds.

Managing a downturn

The strength in the airline stocks and cyclical companies such as Lumber Liquidators is good for the economy. It shows that people are spending money again, as I observed in Orlando. There will be a correction one day, of course, but fear is not a productive strategy.

If the airline stocks have great earnings, and volume increases, then they will continue to do well. Often, strong stocks that have made big moves pull back a bit and digest their gains before moving higher.

Unfortunately, if oil prices spike, all bets are off. Then a correction could turn into a bear market. If you are concerned, you can protect yourself with put options, diversification, or hedging strategies.

On one hand, you may want to sell your stocks if they drop 7% to 8% below your purchase price. On the other hand, Lynch says if you understand what stocks you own, you won’t panic.

During the next correction, only you can decide whether to sell at a 7% loss or continue holding until the worst is over.

Know your options if the stock market corrects

MIAMI (MarketWatch) — I love the stock market, but I hate losing money. This is a serious problem because to make money, you have to learn how to lose. Because of fear, at times I’ve been out of the market during some of the strongest bull markets.

And then I found an answer, one that literally put my mind at ease.

The answer is put options. I wish I had learned earlier about the power of buying puts as a hedge against fear (and potential losses).

Here’s one strategy I like: To protect my individual stocks and mutual fund positions (my long-term portfolio), I buy put options on SPDR S&P 500 ETF Trust (an ETF index linked to the Standard & Poor’s 500-stock index.) You can also buy puts on ETFs based on the Dow Jones Industrial Average, Russell 2000, and the Nasdaq 100.

For example, to help protect a $50,000 portfolio that invests primarily in stocks that track the S&P 500, you would need to buy around three put contracts. Next, you have to choose how long you want to keep the protection (it’s called an expiration date). The longer the protection, the more it costs. You can choose a month, a year — all the way up to three years.

Here’s how it works: Although you won’t get 100% protection in a correction or a crash, as your stocks plunge the value of your put option rises. It’s like buying an insurance policy. You hope that the market doesn’t crash, but if it does, your losses are limited. That should help put you to sleep.

Costs and benefits

Only you can decide if the cost of put protection is worth it. Like any insurance, it’s not cheap. As of March 6, three SPY put contracts with a $150 strike price (or 1500 on the S&P 500) that expire on June 22, 2013 costs $336 each (subject to change), totaling $1,008 plus commissions ($336 x 3 contracts). That’s the cost for three months of protection. If the market crashes anytime before June 22, the put limits your losses.

Your risk: In this example, the most you could lose is $1,008, which is the cost of the three puts. Why three put contracts? Each put represents 100 shares. Since you have the right to sell 300 shares at $150 per share, that is $45,000 worth of stock.

If you wanted 10 months of protection for a $50,000 portfolio, as of March 6, a LEAPS put on the SPY with a $150 strike price that expires on January 18, 2014 costs $808 each (subject to change), totaling $2,424 ($808 x 3 contracts). That’s the price you have to pay if you truly fear a market crash.

What are LEAPS? Their full name is Long-Term Equity AnticiPation Securities, and they are long-term option contracts, identical to standard options except for the longer time period (from nine months to three years) Your risk: Again, it is the cost of buying the options. In this example, the most you can lose is $2,424.

There is another complication when you buy puts. If SPY drops in price, and you have a winning put position on the expiration date, your option could be exercised. This means that your option is converted into a short position in SPY shares. This is not a sound idea. To avoid this from happening, sell your profitable put before the expiration date.

Don’t buy puts if you’ve never traded them before. Start by reading books on options. Also, go on the Internet and visit the Options Industry Council (OIC) and Chicago Board Options Exchange (CBOE) websites, or take free classes with the OIC. You can also call your brokerage firm.

Stock idea of the month

Last month, Amy Smith, author of How to Make Money in Stocks Success Stories, used the Can Slim® Investing System to choose Lumber Liquidators Holdings Inc. as a stock idea. At first, LL went from $58.93 (when it was first mentioned in my column) to $65 (the day earnings were announced two weeks later). It dropped as low as $54 on the one-day stock selloff, and closed Wednesday near $65 again.

Smith’s newest stock idea is HomeAway Inc. This company, which is the world’s leading marketplace for vacation rentals, had its IPO debut in July 2011 and Smith says the stock fits CAN SLIM Investing.

“The earnings in the most recent quarter were up 100%,” she says. “Those triple-digit numbers captured the interest of institutional investors. The stock shot out of price consolidation on very big volume. When a stock gaps up with that much volume (491% above average), institutions have picked up shares.”

Should you run out and buy this stock? In Smith’s opinion, no. “Earnings come out on April 24th,” she says. “Although HomeAway is a little bit extended right now, you can look for a new entry point. If there is a pullback, however, it must be on low volume.”

As long as the stock pulls back on low volume, it means institutions are holding on to their shares, Smith says. “If it’s on high volume, it means that institutional investors are selling.”

Understanding Option Strategies

The following option strategies (and more) are included in my book, Understanding Options:

Did you know you can use options to make money every month or every quarter? And you can use options as insurance, for example, to protect your stock portfolio. And if, on occasion, you wanted to speculate, you could leverage your money to double or triple your profits. It will cost you a lot less than if you bought stocks. And finally, if you like to short stocks, it can be safer to use option strategies than to use the stock market.

Speaking of safety, with most option strategies you know how much you can lose in advance. If used properly, options can be used by all investors and traders to generate income, for insurance, and to speculate. By the time you finish this book, you should have a good idea what options can do for you and whether you want to participate.

Here are the strategies discussed below:

  1. Covered Calls
  2. Buying Calls
  3. Collars
  4. Straddles
  5. Bull Put Spread
  6. Bull Call Spread
  7. Bear Put Spread


Covered Calls

Options strategy: How to sell covered calls
Income potential, while theoretically reducing the risk of simply owning a stock.

If you’re looking for an options strategy that provides the ability to produce income but may be less risky than simply buying stocks, you might want to consider selling covered calls. As long as you’re aware of the potential risks — including transaction costs and tax and wash sale implications — this basic strategy is designed to help generate income from stocks you already own, even within an IRA.

Understanding covered calls
As you may know, there are only two types of options: calls and puts.

Calls: The buyer of a call has the right to buy the underlying stock at a set price until the option contract expires.
Puts: The buyer of a put has the right to sell the underlying stock at a set price until the contract expires.

Although many option strategies have exotic-sounding names, every strategy is based on the buying and selling of calls and puts.

When you sell a covered call, also known as writing a call, it means that you already own shares of the underlying stock and you are selling someone the right, but not the obligation, to buy that stock at a set price until the option expires—the price won’t change no matter which way the market goes. If you didn’t own the stock, it would be known as a naked call—a much riskier proposition.

Why would you want to sell the rights to your stock? Because you receive cash, also known as the premium. For some people, receiving extra income on stocks they already own sounds too good to be true, but like any options strategy, there are risks as well as benefits.

How this strategy works
Before you make your first trade, it’s essential that you understand how it works. For example, let’s say in February you already own 100 shares of XYZ, which is currently at $30 a share. You decide to sell (or write) one call, which covers 100 shares of stock. (If you owned 200 shares of XYZ, you could sell two calls.)

The strike price
You agreed to sell those 100 shares at an agreed-upon price, known as the strike price. When you look up the options quotes on your screen, you’ll see an assortment of strike prices. The strike price you choose determines how much premium you receive for selling the option. With covered calls, for a given stock, the higher the strike price is from the stock price, the less valuable the premium.

Therefore, a $32 strike price is more valuable than a $35 strike price. Why? Because it is more likely for XYZ to reach $32 than it is for it to reach $35, and therefore more likely that the buyer of the call will make money. Because of that, the premium is higher.

The expiration date
In addition to deciding on the most appropriate strike price, you also have a choice of an expiration date, which is the third Saturday of the expiration month. For example, let’s say in February you choose a March expiration date. On the third Friday in March, trading on the option ends and the following day it expires. Either your option is assigned and the stock is sold at the strike price or you keep the stock. Because some people don’t want to tie up their stock for too long, they may choose expiration dates that are only a month or two away. Hint: The further away the expiration date, the more valuable the premium because a longer time span gives the underlying stock more opportunity to reach the option’s strike price.

Note: It takes experience to find strike prices and expiration dates that work for you. As a new options investor, you may want to experiment with one options contract and different strike prices and expiration dates. Eventually you’ll find a combination that works for you.

Your first covered call trade
Now that you have a general idea of how this strategy works, let’s look at more specific examples.

Note: Before placing a trade, you must be approved for an options account.

In February, you own 100 shares of XYZ, which is currently at $30 a share. You sell one covered call with a strike price of $33 and an expiration date of March. The bid price (the premium) for this option is $1.25.

If you were willing to pay the additional commissions and initiated this trade over the phone, you’d say, “I’d like to sell one covered call for XYZ March 33 for a limit price of $1.25 good for the day only.” Hint: It’s suggested you place a limit order, not a market order, so that you can specify the price.

If the call is sold at $1.25, the premium you receive is $125 (100 shares x $1.25) less commission.

Now that you sold your first covered call, you simply monitor the underlying stock until the March expiration date.

Let’s take a look at what could go right, or wrong, with this transaction.

Example one: The underlying stock, XYZ, is above the $33 strike price on the expiration date.

If the underlying stock rises above the strike price at expiration, even by a penny, the stock will most likely be “called away” from you. In options terminology, this means you are assigned an exercise notice. You are obligated to sell the stock at the strike price (at $33 in this example) at expiration. If you sell covered calls, you must expect and plan to have your stock sold. Fortunately, after it’s sold, you can always buy the stock back and sell covered calls on it the following month.

One of the criticisms of selling covered calls is there is limited gain. In other words, if XYZ suddenly zoomed to $37 a share at expiration, the stock would still be sold at $33 (the strike price). You would not participate in the gains past the strike price. If you are looking to make a big score, then selling covered calls may not be an ideal strategy.

Benefit: You keep the premium, stock gains, and dividends, but the stock will be sold at the strike price.
Risk: You lose out on potential gains past the strike price. In addition, your stock is tied up until the expiration date.
Hint: Choose from your existing underlying stocks that are slightly bullish and not too volatile.

Example two: The underlying stock is below the strike price on the expiration date.

If the underlying stock is below $33 a share (the strike price) at expiration, the option has a greater likelihood to expire unexercised and you keep the stock and the premium. You could also sell another covered call for a later month. Although some people hope their stock goes down so they can keep the stock and collect the premium, be careful what you wish for. For example, if XYZ drops a lot, for example, from $30 to $25 a share, although the $125 premium you receive will reduce the pain, you still lost $500 on the underlying stock.

Benefit: The premium will reduce, but not eliminate, stock losses.
Risk: You lose money on the underlying stock when it falls.
Advanced note: If you are worried that the underlying stock might fall, you can always initiate a collar, that is, you can buy a protective put on the covered call, allowing you to sell the stock at a set price, no matter how far the markets drop.

Example three: The underlying stock is near the strike price on the expiration date.

Some might say this is the most satisfactory result for a covered call. If the underlying stock is slightly below the strike price at expiration, you keep the premium and the stock. You can then sell a covered call for the following month, bringing in extra income. If, however, the stock rises above the strike price at expiration by even a penny, the option will most likely be called away.

Benefit: You keep the stock and premium, and can continue to sell calls on the same stock.
Risk: The stock falls, costing you money.

Advanced covered call strategies
Some people use the covered call strategy to sell stocks they no longer want. If successful, the stock is called away at the strike price and sold. You also keep the premium for selling the covered calls.

If you want to avoid having the stock assigned and losing your underlying stock position, you can usually buy back the option in a closing purchase transaction, perhaps at a loss, and take back control of your stock.


Buying Calls

Options strategy: how to buy calls
Buying calls can help to increase the returns, and risks, of your investments.

If you’re looking for a strategy that gives you the potential for larger returns without having to invest a lot of money up front, you may want to consider buying call options. When you buy calls, you profit if the market or an individual stock rises far enough within a certain period of time. If you are right, you can participate in the rise of the stock without actually having to buy it, and only pay a fraction of the cost that would be involved if you purchased actual shares of the stock.

To be profitable, you must be correct both about both the direction and timing of the stock price change. For example, if you believe that a stock will go up within the next month, you could consider buying a call option rather than buying the stock. Like any strategy, the goal is to be profitable while minimizing risk. Buying calls has the potential to help you achieve this goal.

Understanding call options
Before you buy your first call, it’s essential that you understand how they work. For example, let’s say XYZ stock is $30 a share in February. If you wanted to buy 100 shares, it would cost you $3,000. Instead, you could buy one call option, which gives the right to buy 100 shares of the stock at a set price, known as the strike price. The cost of the option contract is usually a fraction of investing in the actual stock. So, in this hypothetical example, instead of paying $3,000 to own the stock, you might pay $300.

Say you are trying to decide between buying a call or the stock itself in the above example—100 shares would cost $3,000, and the option contract would cost $300. If the stock price goes from $30 to $35 by the options expiration, the shares of the stock would rise in value from $3,000 to $3,500, and you would make 17%, or $500, for this time period. As the stock price rises, the value of the option at expiration would rise from $300 to $500, a $200 gain, or a 67% return for the period that you held the option. But what if the stock price falls to $28? At expiration the option would expire worthless and you will lose 100% of your investment. Every options contract has a few key criteria that option traders must be aware of:

Strike price. When you buy a call, you have an opinion about the direction of the stock. Let’s say you believe that XYZ will rise from $28 to $32 a share within one month. Options contracts let you choose the best way to take advantage of your forecast by choosing the best strike price. The strike price is the price at which you can buy the underlying stock for call options. For example, the option may have strike prices of $30, $35, and $40. Every investor needs to review the available strike prices, and find one that matches their investment forecast. For instance, if you think the price of the underlying stock will reach $32, you may want to look at a $30 strike price.

Expiration date. When you buy calls, time is not on your side. In fact, as soon as you buy a call, the clock is ticking. All options contracts have an expiration date. The standard expiration date is the Saturday following the third Friday of the month. It is important that you choose the expiration date that is going to let your forecast be realized.

Commissions. As they do with most investments, brokerages charge commissions when you buy or sell options contracts. Those commissions—which aren’t reflected in the examples used in this article—can reduce your returns.

Buying your first call option
Now that you have a general idea of how this strategy works, let’s take a look at more specific examples.

Note: Before placing a trade, you must be approved to trade options in your account.

In February, you decide to buy one call option (equal to 100 shares) of XYZ, which is currently at $30 a share.

You choose an XYZ April 30 call option currently trading at $1.50.

If you initiated this trade over the phone, you’d say, “I’d like to buy (or go long) one XYZ April 30 call for a limit price of $1.50 good for the day only.” You may want to consider placing a limit order, not a market order, so that you can specify the price you are willing to pay.

If the call is bought at the limit price of $1.50, you will pay a total of $150 (100 shares x $1.50), plus commission.

Now that you bought your first call, you have to closely monitor the underlying stock until the April expiration date. Since time is not on your side, there are a number of choices you have to make.

How a trade may play out
Let’s take a look at what could go right, or wrong, with this transaction.

Example One: The underlying stock, XYZ, rises from $30 to $35 on the expiration date.

You expect and want the underlying stock to rise above the strike price. The higher the stock goes, the more valuable the call option. At any time before the expiration date, you can close your position and take the profits. Many option traders will lock in gains based on their profit forecast, because the price of the stock could fall. In this example, as XYZ rose to $35, the call option at expiration was worth $5 ($35 – $30). You decide to sell the call to close. You are left with a $350 profit ($5.00 gain – $1.50 premium = $3.50 net gain x 100 shares), less commissions.

Benefit: In this example, the call option had a larger return (by percentage) than the underlying stock, while requiring less capital to make the investment.
Risk: The stock could fall and you lose some if not all of the premium paid.
Caution: Although buying calls may look attractive when compared with buying stock, in real life there are many things to consider before making your investment.

Example Two: The underlying stock, XYZ, drops below $30 at or before expiration. If the underlying stock falls below your strike price at expiration, the option will be worthless. In fact, as the stock gets closer to the expiration date, the option can deteriorate quickly because of lost time value.

In this example, the underlying stock fell to $28 a share a few weeks later, causing a partial loss. You sold the call for $0.60 as your exit strategy ($150 investment – $60 sales price = $90 loss).

Risk: You could lose all or part of your $150 investment.

Example Three: The underlying stock, XYZ, is near the $30 strike price at or before expiration.

This scenario is similar to Example Two. Because of diminishing time value, the option may expire worthless. Therefore, in this example, you could lose your entire investment of $150. You always have the choice of selling the option before the expiration date and closing the position to minimize losses.

Risk: You could lose all or part of your $150 investment.

Exercising call options
In the first example, when the underlying stock rose above the strike price (the option is “in-the-money”), you can sell the call and take the profit. You also have another choice, and that is to exercise the option. In this example, you can convert the single call option into 100 shares of stock by paying the strike price. You might be interested in converting shares into stock if you think the stock will continue to rise, and are comfortable owning the stock in your portfolio.

Important: Although you have the right to exercise, many option traders simply buy and sell the option without exercising. By selling the option, the trader does not have to assume the risk and cost of owning the underlying stock.

Options and stocks don’t always move together
Although buying calls is usually a straightforward strategy, there is some nuance. For example, some people are confused when, on occasion, the stock goes up but the option doesn’t follow. “Sometimes a stock could rise in value but an ‘out-of-the-money’ call could drop,” says Joe Harwood, manager of the Options Industry Council (OIC) help desk. The solution is to take the time to learn how options are priced. “Many people think that options are pegged to the stock price, but they are not. Options are a derivative of stocks, but they are not pegged.” This means that prices fluctuate based on the options market and other forces, not purely on the price of the stock.

Bottom line
Buying calls can offer an alternative strategy to buying stock, for investors looking to increase the size of returns relative to the amount of money they choose to invest.


Collars

Put a collar on this market
Here’s a sophisticated options strategy designed to limit losses and protect gains.

The S&P 500® Index has gained 9% so far in 2012. That’s a huge gain over a very short period of time. You may have stocks that have generated strong returns in the rally, and such a big move might raise red flags for a potential correction. If you’re looking to protect gains on current stock positions, or you are moderately bullish on a particular asset but could be concerned about a potential downturn, consider the collar options strategy.

Getting to know collars
A collar is a relatively complex options strategy that puts a cap on both gains and losses (see graphic below). There are three components to constructing a collar:

Purchasing or having an existing stock position (e.g., owning shares of XYZ Company)

Selling a call (the seller of a call has an obligation to sell the stock at the strike price until expiration or until he or she closes the short call position)

Buying a put (the buyer of a put has the right to sell the stock at the strike price until the expiration or until he or she closes the long put position)

This strategy can help mitigate downside risk via the purchase of a put, and some or all of the cost for the purchased put may be covered by selling a covered call on a new or existing stock position.

The premium, or cost of the position, that you pay for the collar is similar to paying an insurance premium. The put could expire worthless if the underlying stock stays the same or rises, but may become more valuable if the underlying stock falls. This allows you to protect the value of the investment by limiting losses in the event of a decline. You are also selling a covered call (to cover some or all of the cost of the put), and become obligated to sell the underlying stock if it rises above your call strike at expiration or is assigned.

You might be asking yourself: Why buy protection for a stock you think might go down in value? Why not just sell the stock? One reason is that there might be significant tax consequences or transaction costs. You may prefer to maintain your position in a stock rather than selling it. However, sometimes selling the stock may be the right answer if you no longer are bullish on the stock.

Let’s take a closer look at collars
Now that you have a basic idea of how this strategy works, looking at a specific example will help you. Please note that before placing a collar, you must fill out an options agreement and be approved for the appropriate options trading level.

In our example, we will look at a hypothetical scenario for XYZ Company.

  1. In January, assume you decide to buy 100 shares of XYZ Company for $53 a share.
  2. Four months later, with the stock trading at close to $53, you become concerned about a potential stock market decline but do not want to sell the shares, so you decide to construct a collar. To do this, you buy a September 52 put selling at $2.45 per contract. Each options contract typically covers 100 shares, so you pay $245 ($2.45 per contract x 100 shares x 1 contract). This out-of-the-money put acts as an insurance policy, effectively protecting your XYZ shares in case of decline below $52.
  3. At the same time, you sell a call on XYZ at the September 55 strike price that costs $2.30 per contract. Each options contract typically covers 100 shares, so you receive $230 ($2.30 x 100 x 1 contract) in premium for this one contract. The primary purpose of selling this call is to cover some of the cost of buying the put.

You now have a collar on your XYZ shares. The net cost of options needed to create the collar is $15 ($245 – $230). The maximum gain on the position is now $185, which is equal to the call strike price ($55) less the purchase price of the underlying shares ($53), multiplied by 100, less the net cost of the collar ($15). The maximum loss is now $115, which is equal to the purchase price of the underlying shares ($53) less the put strike price ($52), multiplied by 100, plus the net cost of the collar ($15).

Breakeven, or the price at which the underlying asset must settle for the costs of the trade to equal profit, is equal to $53.15. This is calculated as the purchase price of the underlying shares ($53) plus the net cost of the collar per 100 shares ($0.15).

Managing the collar trade
Assume that the share price of XYZ rises to $57 on the expiration date. In all likelihood, the holder of the call option that you sold will exercise the call, so you are forced to sell the stock at the $55 strike price. On the other hand, the put would expire worthless because it is out of the money. Although you incurred a net debit of $15 to construct the collar, you made a two-point gain, or $200, on the underlying stock (bought at $53 and sold at the $55 strike price). In this example, the put acts as unused insurance protection.

Now suppose the share price of XYZ falls to $49 on the expiration date. The most obvious impact here is that the value of your stock position falls $400 ($53 to $49 price decline, multiplied by 100 shares you own). However, because XYZ is below $55 at expiration, the call you sold will expire worthless and you will keep the $230 premium received from the covered call. This offsets some of the loss you have experienced on the stock.

Also, while the covered call expires worthless, the put you bought rises in value. In this example the put premium price has risen from $2.45 to $3.00, so you realize a gain of $55 ($300 – $245). As the stock price falls, the put increases in value.

You still have a loss of $115 ($55 put option + $230 call option – $400 loss on the stock). This highlights how the collar provides protection in a down market.

Finally, let’s assume that XYZ rises to $54 on the expiration date. If XYZ moves between the strike price of the covered call ($55) and the strike price of the put ($52) at expiration, no action needs to be taken, as both options will expire worthless. In this event, you lose the $15 difference between the cost of the put and the money you took in for selling the call.


Straddles

Straddling the market for opportunities
Here’s an options strategy designed to profit when you expect a big move.

Stocks have been broadly advancing at a steady pace since mid-December of last year. But in the event that the rally slows or market volatility returns, what will you do? Well, when you aren’t sure which direction a stock is going to go but you are expecting a big move, you may want to consider an options strategy known as the straddle.

Getting to know straddles
You can buy or sell straddles. In a long straddle, you buy both a call and a put option for the same underlying stock, with the same strike price and expiration date. If the underlying stock moves a lot in either direction before the expiration date, you can make a profit. However, if the stock is flat (trades in a very tight range), you may lose all or part of your initial investment.

Here are a few key concepts to know about straddles:

They offer unlimited profit potential but with limited risk of loss.

The more volatile the stock or index (the larger the expected price swing), the greater the probability the stock will make a strong move.

Higher volatility may also increase the total cost of a long straddle position.

In comparison to other options strategies, the upfront cost of a straddle may be slightly higher because you are buying multiple options and volatility is typically higher.

The concept behind the long straddle is relatively straightforward. If the underlying stock goes up, then the value of the call option increases while the value of the put option decreases. Conversely, if the underlying stock goes down, the put option increases and the call option decreases. While it is possible to lose on both legs (or, more rarely, make money on both legs), the goal is to produce enough profit from the option that increases in value so it covers the cost of buying both options and leaves you with a net gain.

What to look for before making a trade
Our focus is the long straddle because it is a strategy designed to profit when volatility is high while limiting potential exposure to losses, but it is worth mentioning the short straddle. This position involves selling a call and put option, with the same strike price and expiration date. This nondirectional strategy would be used when there is the expectation that the market will not move much at all (i.e., there will be low volatility). With the short straddle, you are taking in upfront income (the premium received from selling the options) but are exposed to potentially unlimited losses and higher margin requirements.

Let’s dive into straddles
With a basic understanding of how this strategy works, let’s look at specific examples. Please note that before placing a straddle, you must fill out an options agreement and be approved for options trading.

In our example, we will look at a hypothetical scenario for XYZ Company.

In August, you forecast that XYZ, then trading at $40.75 a share, will either rise or fall sharply based on an earnings report that is set to be released in a week. Due to this expectation, you believe that a straddle would be an ideal strategy to profit from the forecasted volatility.

To construct a straddle, you buy 1 XYZ October 40 call for $2.25, paying $225 ($2.25 x 100). We multiply by 100 here because each options contract typically represents 100 shares of the underlying stock. At the same time, you buy 1 XYZ October 40 put for $1.50, paying $150 ($1.50 x 100). Note that in this example, the call and put options are at or near the money. Your total cost, or debit, for this trade is $375 ($225 + $150), plus commissions.

The maximum possible gain is theoretically unlimited because the call option has no ceiling (the underlying stock could rise indefinitely). The maximum risk, or the most you can lose on this trade, is the initial debit paid, which is $375, plus commissions. This would occur if the underlying stock closes at $40 at the expiration date of the options.

Let’s make use of breakeven here. In this example, the cost of the straddle (in terms of the total price for each contract) is $3.75 ($2.25 + $1.50). Breakeven in the event that the stock rises is $43.75 ($40 + $3.75), while breakeven if the stock falls is $36.25 ($40 – $3.75). With this information, you know that XYZ must close above $43.75 or below $36.25 at expiration to be profitable.

Managing a winning trade when things go right
Assume XYZ releases a very positive earnings report. As a result, XYZ rises to $46.30 a share before the expiration date. Because XYZ rose above the $43.75 breakeven price, our September 40 call option is profitable and might be worth $6.40. Conversely, our September 40 put option has almost no value; let’s say it is worth $0.05.

Before expiration, you might choose to close both legs of the trade. In the above example, you could simultaneously sell to close the call for $6.40, and sell to close the put for $0.05, for a gain of $645 ($6.40 + $0.05). Your total profit would be $270 (the gain of $645 less your initial investment of $375), minus any commission costs.

Now, consider a scenario where instead of a positive earnings report, XYZ’s quarterly profits plunged and the stock falls to $33 before expiration. Because XYZ fell below the $36.25 breakeven price, the September 40 put option might be worth $7.25. Conversely, the September 40 call option is worth just $0.15.

Before expiration, you might choose to close both legs of the trade by simultaneously selling to close the put for $725 ($7.25 x 100) as well as the call for $15 ($0.15 x 100). The gain on the trade is $740 ($725 + $15), and the total profit is $365 (the $740 gain less the $375 cost to enter the trade), minus commissions.

Managing a losing trade
The risk of the long straddle is that the underlying asset doesn’t move at all. Assume XYZ rises to $41 before the expiration date. Although the underlying stock went up, it did not rise above the $43.75 breakeven price. More than likely, both options will have deteriorated in value. You can either sell to close both the call and put for a loss, or you can wait longer and hope for a sudden turnaround.

Let’s assume that with just a week left until expiration, the XYZ October 40 call is worth $1.35, and the XYZ October 40 put is worth $0.35. Since XYZ didn’t perform as expected, you might decide to cut your losses and close both legs of the option for $170 ([$1.35 + $0.35] x 100). Your loss for this trade would be $205 (the $170 gain, minus the $375 cost of entering into the straddle), plus commissions.

The risk of waiting until expiration is the possibility of losing your entire initial $375 investment. Both options could expire worthless if the stock finishes at $40. This is called pinning: the stock finishes at the stock price.

Other considerations
Timing is an important factor in deciding when to close a trade. There are cases when it can be preferential to close a trade early, most notably “time decay.” Time decay is the rate of change in the value of an option as time to expiration decreases and, because of that and other reasons, traders might choose not to hold straddles to expiration. Instead, they might take their profits (or losses) in advance of expiration.

In addition to time decay, there are other factors that can influence options used in the straddle trade. Learn about the factors that influence options used in the straddle trade and keep the straddle in your trading arsenal in case high volatility makes a comeback.


Bull Put Spread

Limit your risk with the bull put spread
Capture profits from a rising stock while putting a limit on your losses.

Volatility in the market has calmed down from the heightened levels that we were experiencing in early fall. But the European debt crisis, higher oil prices, and other risks could renew the market’s uncertainty at any time. If volatility does come back, active investors may want to consider an options strategy called a bull put spread.

Why the bull put spread?
Picking the right stock, picking the right direction, and picking the right time to buy or sell can sometimes be difficult. This is why you may want to consider a bull put spread. A bull put spread offers limited risk, while giving you different ways to profit from volatility in the underlying asset. This strategy is particularly attractive for assets that are expected to rise slightly, may fall slightly, or may remain unchanged, and when volatility—the level of uncertainty in the market or a specific security—is high.

Establishing a bull put spread is relatively straightforward: sell one put option (short put) while simultaneously buying another put option (long put). A bull put spread is also known as a vertical spread strategy (buying and selling options of the same underlying asset and expiration date) and a credit spread (you receive money at the outset of creating the position, and this is the maximum profit for the position). Because you are selling one put option and buying another, you are effectively hedging your position. The result is that potential gains and losses are capped.

When this strategy works
The bull put spread is used if you are moderately bullish on a stock or index, and your preference is to limit risk exposure. The primary goal is to make a short-term profit while limiting risk. You want the underlying asset (stock, index, etc.) to rise above both put options so they are out of the money (strike price is below the current market price), and the contracts expire worthless. If the options expire, you keep the credit you received.

What to look for before you initiate the trade
Before you initiate a bull put spread, it’s important to know what to look for. Here’s some helpful guidance:

Underlying asset—First, you need to identify an underlying stock, index, or other asset that you believe will rise moderately or will remain unchanged over a specific period of time.

Expiration date—Look at the option chain (the listing of put and call options, which shows strike prices, option premium, expiration date, etc.) for your chosen security, and choose an expiration date that matches your expected time frame. In certain circumstances, it may be advantageous to having a shorter time frame for a strategy like a bull put spread. This will most likely reduce the amount of premium (the price of the option) that you take in, but also reduces the possibility of an unforeseen event affecting the outcome of your trade. Make the appropriate selection based on your risk tolerances and investment expectations.

Strike price—Next, assess the various strike prices of the option you choose. For example, you might select strike prices with at least a 5-point difference (i.e., buy the 30 put and sell the 35, or buy the 80 put and sell the 85). Choose strike prices that match your forecast for the underlying security and that may thus allow you to earn the maximum profit potential.

Volatility—This is an important consideration. Think about whether you would prefer to initiate the bull put spread when volatility is relatively high (likely increasing both the amount of premium taken in and the risk associated with the trade) or when volatility is low (possibly reducing the premium taken in and the risk associated with the trade).

Another set of tools at your disposal when trading options are greeks (i.e., delta, gamma, theta, vega, and rho).* Using greeks can help you forecast how changes in price, time, and volatility can affect the value of your spreads.

Once your position is initiated, you should monitor it closely. Action may have to be taken before the contracts expire (we will soon discuss when and how this can be done). The goal is to have both legs (each side of the spread, the buy side and the sell side) expire worthless to earn the maximum profit potential.

Bull put trade, in action
Now that you have a basic idea of how this strategy works, let’s look at a few specific examples.

(Note: Before creating a spread, you must fill out an options agreement and be approved for a Level 3 options account. )

In April, you believe that XYZ stock, which is currently at $33 per share, will rise moderately over the next month or two to $35 per share or higher. You decide to initiate a bull put spread.

4.You buy 1 XYZ May 30 put (long put) for $2.60, paying $260 ($2.60 x 100). Each options contract covers 100 shares, which is why you multiply the $2.60 premium by 100. At the same time, you sell 1 XYZ May 32 put (short put) for a limit price of $3.50, receiving $350 ($3.50 x 100). Our breakeven is $31.10 (highest strike price less the premium received). Notice in this example that the put we bought (long put) is out of the money and the put we sold (short put) is slightly out of the money. The stock could rise, remain unchanged, or fall slightly and still be profitable. Maximum profit: The credit received for this trade is $90 ($350–$260), less commission costs.

5.Maximum risk: The maximum risk is the difference between the two strike prices, minus the credit you received. Therefore, maximum risk for this trade is $110 ($200–$90), plus commission costs.

Now, let’s look closely at what could hypothetically go right or wrong:

A winning trade: The underlying stock, XYZ, stays above the $32 strike price at the expiration date.

If the underlying stock stays above $32 at or before expiration, both puts remain out of the money and will expire worthless.

How to close this type of winning trade
You have a couple of options. First, you can close both legs of the trade. In the above example, if you enter a limit order, an order is placed to buy to close the short put for $90, and sell to close the long put for $40. Your profit is $40: $90 (your original credit) minus $50 ($90 for short put minus $40 for long put). Second, if both options are out of the money, you can consider letting both legs expire worthless, achieving maximum profit. Depending on your specific risk and return objectives, you may want to consider closing both legs of the spread before expiration, once your profit goals are reached.

A losing trade: The underlying stock, XYZ, drops below the $32 strike price before the expiration date.

If the underlying stock drops below $30, and the option becomes in the money on or before expiration, both puts may rise in value. This is not what you expected or wanted. Your goal was to keep as much as possible of the $90 credit you originally received. However, as a trader, you should be prepared with a plan for exiting any strategy when things don’t quite go your way. Although the short put is costing you money, you are protected from the potentially substantial loss of that position by the long put. Nevertheless, in this scenario (both options are in the money), you can lose the maximum, or $110, if the stock drops below $30.

How to close a losing trade
It is worth looking at an example to see how you might close a losing trade like this. The short put might rise from $3.50 to $4.80, while the long put could rise from $2.60 to $3.20. Before expiration, you could close both legs. You would place an order to buy to close the short put for $480, and sell to close the long put for $320. In this example, you must pay $160 to exit the position ($480 – $320), but you previously received a credit of $90. As a result, your total loss is a more manageable $70.

If you wait until expiration, you could lose the entire $110. Depending on your risk tolerance and objectives for the trade, you might choose to close both legs of a losing spread before expiration, especially when you no longer believe the stock will perform as anticipated.

Options traders should always be aware of early assignment, as well. There’s a chance you’ll be assigned early (before expiration) on the short put. Actively monitor your option positions and learn to manage risk.

Investing implications
Options trading strategies have unique risks and rewards. They offer more ways to take advantage of a given forecast. A bull put spread is a great example of the many option strategies that investors have at their disposal.


Bull Call Spread

Options strategy: the bull call spread
A strategy designed to take advantage of price gains while potentially limiting risk.

Options traders looking to take advantage of a rising stock price while managing risk may want to consider a spread strategy: the bull call spread. This strategy involves buying one call option while simultaneously selling another. Let’s take a closer look.

Understanding the bull call spread 
Although more complex than simply buying a call, the bull call spread can help minimize risk while setting specific price targets to meet your forecast.

Here’s how it works. 
First, you need a forecast. Say XYZ is trading at $60 per share. You are moderately bullish and believe the stock will rise to $65 over the next 30 days.

A bull call spread involves buying a lower strike call and selling a higher strike call:

Buy a lower strike call at $60. This gives you the right to buy stock at the strike price.

Then:

Sell a higher strike call at $65. This obligates you to sell the stock at the stock at the strike price.

Because you are buying one call option and selling another, you are “hedging” your position. You have the potential to make a profit as the share price rises, but you are giving up some profit potential—but also reducing your risk—by selling a call. Selling a call reduces the initial capital involved. The trade-off is you have to give up some upside potential. One advantage of the bull call spread is that you know your maximum profit and loss in advance.

How this strategy works 
Before you construct a bull call spread, it’s essential to understand how it works. Normally, you will use the bull call spread if you are moderately bullish on a stock or index. Your hope is that the underlying stock rises higher than your breakeven cost. Ideally, it would rise high enough so that both options in the spread are in the money at expiration; that is, the stock is above the strike price of both calls. When the stock rises above both strike prices you will realize the maximum profit potential of the spread. As with any trading strategy it is extremely important to have a forecast. In reality, it is unlikely you will always achieve the maximum reward. Like any options strategy, it’s important to be flexible when things don’t always go as planned.

Before you initiate the trade: what to look for
Before you initiate a bull call spread, it’s important to have an idea of your criteria.

Underlying stock: First, you want to choose an underlying stock you believe will go up.

Expiration date: Choose an options expiration date that matches your expectation for the stock price.

Strike price: Choose offsetting strike prices that match your forecast For example, the stock is at $40. You believe it will rise to $45.

Volatility: Many traders will initiate the bull call spread when volatility is relatively high, which may reduce the cost of the spread.

Note: These are general guidelines and not absolute rules. Eventually, you will create your own guidelines.

Your first bull call trade
Before placing a spread, you must fill out an options agreement and be approved for spreads trading.

Now that you have a basic idea of how this strategy works, let’s look at more specific examples.

In June, you believe that XYZ, which is currently at $34 per share, will rise over the next three to four months to $40 per share or higher. You decide to initiate a bull call spread.

Options contracts: You buy 1 XYZ October 35 call (long call) at $3.40, paying $340 ($3.40 x 100 shares). At the same time, sell 1 XYZ October 40 call (short call) at $1.40, receiving $140 ($1.40 x 100 shares). Note: In this example, the strike prices of both the short call and long call are out of the money.

Cost: Your total cost, or debit, for this trade is $200 ($340 – $140) plus commissions.

Maximum gain: The maximum you can gain on this trade is $300. To determine your maximum reward, subtract the net debit ($3.40 – $1.40=$2 x 100 shares) from the difference in strike prices ($40 – $35=$5 x 100 shares). In this example, the maximum possible gain is $300 ($500 – $200).

Maximum risk: The most you can lose on this trade is the initial debt paid, or $200. Note: a bull call spread can be executed as a single trade. This is known as a multi-leg order.

Let’s take a look at what could go right, or wrong, with this strategy:

Example One: The underlying stock, XYZ, rises above the $35 strike price before the expiration date.

If the underlying stock rises above $35 before expiration, both legs of the spread (each side of the spread, the buy side and sell side, is called a leg) will rise in value, which is what you want. For example, the long call may rise from $3.40 to $5.10, while the short call may rise from $1.40 to $1.90. Note: Near expiration, as the long call option goes further in the money, the spread between the two call options widens, but it will not surpass the $5 maximum value.

How to close a winning trade
Before expiration, you close both legs of trade. In the above example, if you enter a limit order, you will buy back (buy to close) the short call for $190, and sell (sell to close) the long call for $510. That gives you a net sale of $320. You originally paid $200, leaving you with a net profit of $120. Important: remember that you can close both legs of the strategies as a multi-leg order.

Although some traders try to achieve maximum profit through assignment and exercise, if your profit target has been reached it may be best to close the bull call spread prior to expiration.

Example Two: The underlying stock, XYZ, drops below the $35 strike price before or near the expiration date.

If the underlying stock remains below $35 before expiration, both legs of the spread will drop in value due to time decay, which is not what you’d hoped to see. For example, the long call may fall from $3.40 to $1.55, while the short call may drop from $1.40 to $1.05.

To avoid complications, close both legs of a losing spread before expiration, especially when you no longer believe the stock will perform as anticipated. If you wait until expiration, you could lose the entire $200 investment.

How to close a losing trade
Before expiration, close both legs of the trade. Then you will buy back (buy to close) the short call for $105, and sell (sell to close) the long call for $155. In this example, your loss is $150: ($155 – $105) – $200 (your initial payment).

Early assignment
Although it’s unlikely, there’s always a chance you’ll be assigned early (before expiration) on the short call. If this occurs, you may want to exercise the long call.

Other factors to consider
Trading spreads involves a number of unforeseen events that can dramatically influence your options trades. Make an effort to learn about time decay and implied volatility, and other factors that affect an options price. This will help you understand how they can affect your trade decisions. You should also understand how commissions affect your trade decisions.


Bear Put Spread

Bear Put Spread: Profit from a falling stock price, while potentially limiting risk.
When the stock market is falling, some speculators may want to profit from the drop. But for some situations, simply shorting a stock or buying a put may seem too risky. In that case, the options strategy called the “bear put spread” may fit the bill. To use this strategy, you buy one put option while simultaneously selling another, which can potentially give you profit, but with reduced risk and less capital. Let’s take a closer look.

Understanding the bear put spread
Although more complex than simply buying a put, the bear put spread can help to minimize risk. Why? Because you are hedging your position by buying one put option and selling another put option, which can reduce losses but can also limit your potential profits. And, this strategy involves less capital than simply buying a put.

There is something else you should know about the bear put spread: Because you are paying out money to initiate this strategy, it’s called a debit spread. Your goal is to sell the combined position at a price that exceeds the overall purchase price, and thus make a profit.

Put Basics
A put is a contract that gives the owner the right to sell shares of a stock at a set price—known as the strike price. So buyers of puts hope stock prices fall below the strike price, giving them the potential to profit.

One advantage of the bear put spread is that you know your maximum profit (or loss) in advance. In fact, the maximum risk for this trade is the initial cost of the spread. Therefore, you have defined your risk in advance.

The nuts and bolts
Normally, you will use the bear put spread if you are moderately bearish on a stock or index. Your goal is for the underlying stock to drop low enough so that both options in the spread are in the money (when expiration arrives), that is, the stock is below the strike price of both puts. You want the stock to fall far enough to earn more than the cost of the spread. Here is one example of how it works:

Buy a put below the market price: You will make money (after commissions) if the market price of the stock falls below your breakeven price for the strategy.

Sell a put at an even lower price: You keep the proceeds of the sale—offsetting some of the cost of the put and taking some risk off the table. You also give up any profits beyond the lower strike price.

The best-case scenario: The stock price falls as you anticipated and both puts are in the money at expiration.

Before you initiate the trade—what to look for:
Before you initiate a bear put spread, it’s important to have an idea of your criteria. Here are some general guidelines.

Underlying stock: First, you need to choose an underlying stock that you feel is likely to fall in price.

Expiration date: Choose an options expiration date that matches your expectation for the stock price to fall.

Strike price: Next, you must decide which strike prices to choose.. For example, you may choose to buy the 45 put and sell the 40, or buy the 60 put and sell the 50. The larger the spread, the greater the profit potential, but the difference in premiums might leave you with more risk.

Volatility: Many traders prefer to initiate the bear put spread to help offset volatility or the cost of an option. Volatility is an important factor that will affect options price.

Your first bear put trade
Now that you have a basic idea of how this strategy works, let’s look at more specific examples of this strategy.

Note: Before placing a spread, you must fill out an options agreement and be approved for Level 3 options trading.

In June, you believe that XYZ, which is currently at $31 per share, will fall below $30 per share over the next two or three months. You decide to initiate a bear put spread.

You buy 1 XYZ October 30 put (long put) for $3.80 per share, paying out $380 ($3.80 x 100). At the same time, you sell 1 XYZ October 25 put (short put) for $1.60 per share, receiving $160 ($1.60 x 100). Note: In this example, the strike prices of both the short put and long put are out of the money.

Cost: Your total cost, or debit, for this trade is $220 ($380 – $160), plus commissions. To initiate this trade you can place them as one trade by using the multi-leg option ticket.

Maximum possible gain: The most you can gain from this trade is $280. To determine your maximum reward, subtract the net debit ($2.20 x 100) from the difference in strike prices ($5 x 100). In this example, it will be $280 ($500 – $220).

Maximum risk: The most you can lose on this trade is the initial debt paid, or $220.

Let’s take a look at what could go right (or wrong) with this strategy:

Example One: The underlying stock, XYZ, falls below the 30 strike price before the expiration date.

If the underlying stock falls below $30 before expiration, both legs of the spread (each side of the spread, the buy side and sell side, is called a leg) will rise in value.

For example, the long put may rise from $3.80 to $5.70, while the short put may rise from $1.60 to $2.10. Note: Near expiration, as the long put option goes further in the money, the spread between the two put options widens, but it never surpasses that $5 maximum value.

How to close a winning trade
Before expiration, you can close both legs of the online trade with the click of one button. In the above example, if you enter a limit order, you buy back (buy to close) the short put for $210, and sell (sell to close) the long put for $570. Your profit is $140: Sale price of $360 ($570 – $210) minus $220 (your original payment).

Although some traders try to achieve maximum profit through assignment and exercise, it may be risky—it could leave you exposed to a naked stock position. So it may be worth closing both legs of the spread before expiration once your profit goal is reached.

Example Two: The underlying stock, XYZ, remains above the 30 strike price before or near the expiration date.

If the underlying stock remains above $30 before expiration, both legs of the spread drop in value, which is not what you hoped to see. For example, the long put might fall from $3.80 to $2.10, while the short put may drop from $1.60 to $1.20. To avoid complications, you may want to close both legs of a losing spread before the expiration date, especially if you no longer believe the stock will perform as anticipated. If you wait until expiration, you could lose the entire $220 investment.

How to close a losing trade
Before expiration, close both legs of the trade. You will buy back (buy to close) the short put for $120, and sell (sell to close) the long put for $210. In this example, your loss is $130: ($210 – $120) – $220 (your initial payment).

Early assignment
Although it’s unlikely, there’s always a chance you’ll be assigned early (before expiration) on the short put. If this occurs, you may want to exercise the long put.

Other factors to consider
Trading spreads can involve a number of unforeseen events that can dramatically influence your options trades. Make an effort to learn about time decay and implied volatility, and how they can affect your trade decisions.