Specific Strategies: Raging Bull & Doomsdayer’s

By: Dave Caplan

The following is an excerpt from Dave Caplan's The Option Secret

Let me dive right in and begin with “Raging Bull Strategies”.  You think the market is grossly oversold – poised for a major move higher.

Let’s use silver as an example.  Your analysis indicates that it is about to make a move from the $3.50 level to over $5.50.  Your best estimate calls for $6.00 silver within the next 60 days.

The simplest and most common approach for a new investor is to buy a call.  The call gives you the right, but not the obligation, to take a long position in the underlying futures.  As the underlying futures gains, so does the call.  You can either exercise the option and take your long futures position, or you can offset your option positions at a profit as it gains intrinsic value.

The more difficult question is which strike price to buy.  Below is a table showing your choices for calls with 60 days to expiration on 5,000 troy ounces of silver.

The $3.00 strike price option has 50 cents intrinsic value and 5 cents time value.  The $3.25 strike price is a quarter in-the-market with a nickel time value.  The at-the-market option has no intrinsic value and 5 cents time value.  The two out-of-the-money options only have time value.  The farther out-of-the-money, the less time value.

Studying these values indicates the market doesn’t agree with your analysis.  Sellers of out-of-the-money options are making them very attractive.  A $4.00 call carries a $50.00 premium (5,000 oz. x $0.01).

The at-the-money strike price is very reasonable, if your analysis proves to be anywhere near accurate.  At 5 cents per ounce, the call costs $250.00 plus transaction costs of, let’s say $50.00 for a total of $300.00.  A $2.00 per ounce gain in silver would amount to $10,000.00.  The ratio of profit to loss would be 33 to 1.

Another way of looking at this trade would be to calculate the breakeven.  How much does sliver have to gain just to get your $300.00 back?  Each penny gained adds $50.00 to the intrinsic value of the at-the-money option.  Therefore, all that is needed is no more than six cents and maybe a little less, if the time value increases as well.

A put works the same way but in the opposite direction.  We call it the “Doomsdayer”.  You think, for example, the shares of ABC Company now at $50.00, are headed south in a big way, maybe even as much as 50%.  Calling your broker provides you with the prices in the table below.

Again, the market isn’t bracing for a major slide in the price of ABC’s stock.  It is only asking $75.00 (100 shares x $0.75) for an option with a strike price of $10.00 out-of-the-money and $100.00 for one $5.00 out.

The breakeven for the at-the-money option would be a decrease in the per share price by approximately $1.00 plus 1/8 in time value (plus transaction costs).  The reward to risk ratio, if the shares do drop $25.00 per share before the at-the-money option expires, would be approximately 16 to 1 ($2,500.00/150).

We call these two strategies the “Raging Bull” and “Doomsdayer” because that is the way they are often presented to investors.  For these strategies to work, you need a major price move, which is rare.  Additionally, you really have only one opportunity to profit and that is if your analysis is absolutely correct.  Experience has shown that the odds of this happening consistently are remote.

One of the most expensive errors people new to options make is getting caught up with the excitement a broker may create regarding a trade.  “Silver is headed off the charts!  Get in now!  What can you lose?”  The answer is 100% of your investment.

This trading strategy requires you to hit home runs every time.  If they pay off big, they are grand slammers!  It is for this reason, in our opinion, most options traders, particularly new and/or small traders, are net losers as options traders.  There are occasions when you should swing for the fence, but most of the time you should try a strategy with a higher percentage success rate.  Unfortunately, many stock and futures options traders never get beyond this point in the learning curve.