Larry’s Note: Right now, the headlines aren’t making sense. Job numbers are getting revised lower. Stagflation signals are flashing. Yet the market keeps pushing higher.

That’s why traders should be concerned. I see a growing disconnect between data and price action. Buyers just keep buying, no matter what the numbers say.

That divergence is creating short-term distortions – and powerful opportunities for fast gains.

To show you exactly what’s going on – and my strategy to profit from it – I’m airing a special briefing tomorrow at 2 p.m. ET. I’d love to have you join me.

To attend, just RSVP here with one click.

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Anybody who knows me appreciates how much I love options. I believe they’re one of the greatest inventions of all time for traders.

You can potentially control thousands of dollars of stock with just a few hundred dollars. All the while, you know your maximum risk is just what you paid for your contract(s).

They let us take part in a move in either direction, too. You don’t have to rely on a stock going up. That’s why buying options is a cornerstone of my trading strategy.

But it doesn’t end there…

I also use options because of their flexibility.

And today, I want to show how to combine buying and selling strategies simultaneously. In effect, it can give you a free trade.

So let’s check it out…

Buying Strategy

To begin, let’s consider the “buying” strategy…

If we think a stock is going to rally, then we’d buy a call option. A call option increases in value when the underlying asset rises.

Alternatively, if we thought the stock was going to fall, we’d buy a put option. A put option increases in value when the underlying asset falls.

By paying just $300, for example, we could control 100 shares in a stock that trades for hundreds of dollars per share (one option contract is for 100 shares).

That might seem a “cheap” way to gain access to a move, but I like to take it a step further. And if I get things right, I can effectively buy that option for zero dollars.

And that’s where the “selling” part of the strategy fits into the picture. By placing a spread trade to generate a credit, we can offset the cost of buying that option.

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Selling Strategy

To see what I mean, let’s consider an example using JPMorgan Chase (JPM). (Please note that this is an example, not a recommendation.)

JPM recently traded around $295. But you believe it could be headed for a fall. So you want to buy a $275 put option for around $3. That equates to $300 per contract.

To help you finance the trade, you decide to use a bear call spread strategy. A bear call spread involves selling a call option while simultaneously buying a call option with a higher strike price. Both options have the same expiration. (I use this spread strategy almost daily at The S&P Trader.)

Take a look at the chart…

JPMorgan Chase (JPM)

Source: eSignal

In this example, you sell the $305 call option for a $5 credit and buy the $315 call option for only $2. So the bear call spread generates $3 (or $300 per contract).

That credit from the bear call spread covers the $300 cost of buying the $275 put option. That effectively lets you into the put trade for free.

If JPM falls as expected, you can make a solid profit from your put trade with essentially no upfront cost.

All the same, you need to understand the risks of this trade.

When you write a bear call strategy, you’re aiming for the stock price to be trading below the lower leg ($305 in this case) at expiration. That way, you keep the maximum profit from the spread trade. In this example, that’s $300.

However, if JPM rallies above the upper leg of the spread (the $315 written call), you’re facing a maximum loss scenario.

Your loss equates to the difference between the call option strike prices ($315 − $305 = $10) less the credit received for the trade ($3). That works out to a max loss of $7, or $700, on a one-contract basis.

Plus, in this case, you’d lose the money from the put trade ($300).

As you can see, you need to be confident of the down move before committing to the trade.

Yet combining strategies like this is a great way to use options.

And keep in mind, this is just one of the many ways we can use options to help us build a position. That flexibility is one of options’ greatest strengths.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict

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