The power of options is evident in a stock substitution trade in Morgan Stanley (NYSE: MS). The stock is up about $2.25 since my recommendation on Aug. 29, an impressive 15% gain in just over a week's time.
The payoff on the deep in-the-money MS April 2013 12 Calls is much more impressive, however, with the options jumping more than 30% in a few short days -- double the profit that could have been made from purchasing the shares with the bonus of absolutely limited financial risk.
Two important things need to be pointed out here. First, the stock has moved solidly above the option breakeven at $15.75 ($12 strike plus $3.75 premium paid).
Second, the long-term outlook is even more bullish than when the trade was initiated with seven months for further upside development before the April expiration. In essence, the in-the-money option acts like the stock from here with close to a 90% delta relationship.
The following disciplined four-step trading plan should be applied to all investment candidates:
With the crucial components of identifying an opportunity and executing the trade with solid risk control now producing profits, it is worth investigating some trade management strategies.
For example, if traders sold the MS April 2013 18 Calls for $1.75, this would lower the position risk to $2 ($3.75 paid for call option purchased minus $1.75 premium received for call sold), or $200 per contract, regardless of what happens between now and expiration.
However, the covered option sale also limits the profit, with gains capped at the $18 strike of the option sold. The $6 profit maximum ($18 strike minus $12 strike), or $600 per option contract, triple the money at risk, would be captured at expiration if MS is above $18 on the third Friday of April. Though attractive, this is not the best choice right now.
Another strategy is to move the stop-loss up to protect current winnings. The original exit point was half of the premium at $1.85. A quickly developing windfall suggests moving that protection to breakeven. In that case, if the stock reverses, no money will be lost. And a new stop-loss at $3.75 is wide enough that the normal market fluctuations should not flush us out of the position.
Action to Take --> Managing your trades to protect gains and not allowing them to turn into losses is crucial to long-term success. Time and price are a trader's allies as Morgan Stanley powers higher. Protecting gains, while maintaining flexibility for the future, is the best plan for now.