Top-Down Options Trading

03/20/2014 9:10 am EST


Gregory Harmon, CMT

Founder and President, Dragonfly Capital Management

Greg Harmon of Dragonfly Capital explains what top-down options trading is and how traders can use the strategy to identify trade candidates and control risk.

SPEAKER:  I'm here with Greg Harmon, author of Trading Options, talking about top-down options trading.  What is that, Greg? 

GREG:  Well, it starts as top-down technical analysis and then works its way into options, so it starts with looking at the broad indexes, what could affect the indexes to determine the trend in the marketplace, then finding individual stocks that are going to move with that trend that have a good setup, and then moving further into, "Well, how do you develop an options strategy to make money off of those at either a higher rate or at the same rate but with controlled risk?"

SPEAKER:  What does it mean to have controlled risk? 

GREG:  Well, options you can use for many different things.  You can use them to increase the leverage in your trade, or you can use them to control your downside risk, so buying a put will control your downside risk in a long trade. 

SPEAKER:  People talk about this all the time, and I know this is a common thing for someone like you, a veteran options trader, but I hear this all the time, and for those people thinking about getting into options, what does it mean when you've capped the amount of money you can lose on an options trade because that sounds almost impossible to some people? 

GREG:  Yeah, but yet it's possible, and there are many options strategies where you could do that.  For example, if you buy a call, you spend $2 buying a call on Tesla stock; that's the most you can lose.  That's all you have at risk.  Even if the stock gaps down 20 points tomorrow, all you can lose is your $2, and that's where options can be a lot safer than trading in stocks themselves. 

SPEAKER:  Risk management is important from whatever perspective you take it, but that sounds exactly like the kind of thing that would benefit a lot of traders who already hold a stock that they're afraid might go against them. 

GREG:  Yeah, and I see it all the time on social media; people saying, "I'm holding this stock.  It's going to report earnings.  I don’t want to hold it anymore.  There's too much risk in the stock," but options can help you stay in that position by putting what's called a collar on, so a collar is just a simple selling a call on the upside, so capping your upside benefit in that stock, to be able to buy a downside put as protection so that if it does fall, you make money dollar for dollar on the put on the downside.  The collar is really just combined so that the cost of the put that you buy is equal to the cost of the collar you sold, so then it's a free trade to put on to protect yourself. 

SPEAKER:  Greg, that's great information.  Thank you so much. 

GREG:  Thanks. 

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