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Trader Savvy Newsletter

September 28, 2006

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How to Maximize Profits When You Buy Options

Name: Ken Trester

Company: Phillips Investment Resouces

Learn More About Today's Author
Years Trading: 33

How to Maximize Profits When You Buy Options

Finding undervalued options is the cornerstone of making profits when you speculate with options. But just as important as selecting the right option to buy and paying the right price is knowing when and how to take profits.

Most option buyers lose not because they take the wrong positions, but because they fail to take profits properly.

To make the biggest potential profit your first objective is to protect profits, and your second objective is to hit home runs. Most important, when your option begins to profit you must be ready to act.
I have found that the best way to do this is to know exactly what you will do with a position when the option hits a specific price. Deciding this in advance, and sticking to your decision when the time comes, removes a lot of emotion from your decision making.

When you buy an option, you should decide in advance what your target price for the option will be. This is why I always give you our target prices when I recommend options to buy in Maximum Options.

If the option hits the target price, sell half of your position. This takes your original money off the table. Capital preservation is paramount when you speculate with options.

Then let the rest of your position ride for possible future gains, using a 5% trailing stop on the underlying stock. A trailing stop can be a "mental" stop, though more and more brokerages are allowing this to be done automatically. The trailing stop adjusts when the stock moves in your direction, and stays the same when the stock moves against you.

For example, when a Halliburton (HAL) LEAP call option we recommended hit its target price, we advised subscribers to sell half their position. Then if the stock kept rising, they would hold the option and adjust the trailing stop higher so that it would still be 5% under the current stock price. But if the stock fell, they would keep the trailing stop the same.

The process is reversed for a put option. If the stock continues to fall, keep lowering the trailing stop. But if the stock rises, keep the trailing stop the same.

Another key for taking profits -- if your option is in the money (goes past the strike price) and enters its last week before expiration, close the entire position and take profits. Don't wait for it to expire.
Taking half of your profits at the target price serves two beneficial purposes. One, it forces you to take some money off the table, protecting you from a sudden reversal in the stock price. And two, it leaves money on the table for possible future gains. Protecting profits and preserving capital is critical when you buy options.

As it turned out, Halliburton kept rallying and we continued to raise our trailing stop. Then, when the stock did reverse course by 5%, we closed the rest of the LEAP position for a 147% profit. This profit would have been much less if we had simply taken all of our profits at the target price, or did not keep tightening the trailing stop as the stock continued to rally.

As important as taking profits is cutting losses. Losses are part of the game, and if you don't take them and move on you will soon be out of the game.

There are two ways to cut losses. One is by setting a stop loss on the underlying stock. If the stock closes below (for a call option) or above (for a put option) its stop loss, close the option position the next day.

Another way to cut losses is to use the option price. If an option falls in value by 50% after you buy it, sell it and close your position.

We can't stress this enough -- if you do not cut your losses quickly, you will not last as an options player.

That, in a nutshell, is how we maximize profits with options. It is a system that takes profits when they are available, and cuts losses when necessary. Most important, it removes emotions from your decision making.

A key to the tremendous success enjoyed by Maximum Options subscribers is the specific buy, target and trailing stop points on all the trades we recommend in Maximum Options.

Follow the above profit-taking rules and you'll have your best shot at real success when you buy options.

Yours for Maximum Profits,
Ken Trester

About Today's Author

Ken Trester started trading options when the first exchanges opened in 1973. As the nation's foremost professional options trader Ken is not just an "options educator." He also actively trades his own account.

Ken has been a computer science professor at Golden West College in Huntington Beach, California, where he also taught a popular course on stock options trading. Ken is also widely quoted in publications such as Technical Analysis of Stocks & Commodities and Barron's. He has an MBA and has worked as a stock broker and an investment manager.

Ken's options success secret is startlingly simple. It's a strategy basic to all investing. Ken only recommends cheap, underpriced options. In other words he "buys low and sells high." It's a simple theory but hard to put to work unless you have a math genius and computer whiz like Ken Trester on your side. The trick is knowing how to find and buy underpriced options. Ken does this by using his computerized modeling system (based on three decades of real time, real life trading) that tells Ken, and you, which options are underpriced.

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