Hi, I’m Jon Wirrick joining you once again in the Coaches Corner. Those of you who have had me as a coach know I’m a big fan of the “keep it simple” philosophy. As such, I thought I’d take a different approach and focus on helping newer traders break down and understand the types of stock trades available in trading.
In my experience, traders often get overwhelmed by so many of the different strategies out there. Strategies with multiple legs in them, often referred to as spread trades, can be particularly difficult for those new to trading. I’ve found that by stepping back and dissecting the various trade options, traders generally find them easier to understand—and in turn execute.
The reality is that there are three main instruments you can trade in the equities market; a stock, a call option or a put option. That’s it! With each of these there are only two things you can do—buy or sell. This means that there are really only six basic types of trades you have to focus on as a newer trader.
1) Buy a stock long, which is a bullish debit trade.
2) Sell a stock short, which is a bearish credit trade.
3) Buy a call, which is a bullish debit trade.
4) Sell a call, which is a neutral to bearish credit trade.
5) Buy a put, which is a bearish debit trade.
6) Sell a put, which is a neutral to bullish credit trade.
All trades are made up of some combination of these elements, which I refer to as the six building-blocks of trades. If you’ve been feeling confused with some of the different strategies, take the time to learn these six trades inside and out. When you’re analyzing a position you just have to break it down.
Buy a Stock Long – You buy a stock with the hope that it will increase in value. You can then sell the stock at a higher price and you make the difference. Example – Buy XYZ stock at $50. If the stock goes up to $60 and you sell it, you make $10 per share.
Sell a Stock Short – Selling a stock short is the exact opposite of buying the stock long—you’re anticipating the stock dropping in price. In a short, you reverse the order of buying and selling, so you sell the stock first. You can then buy the stock to close the trade at a lower price and you make the difference.
Example – Sell XYZ stock short at $60. If the stock drops to $50 and you buy it back to close the position (referred to as a buy-to-cover order), you make $10 per share. Other than short-term day trades, I don’t typically sell stocks short. Buying a put or employing a spread strategy involves far less risk and offers the advantage of greater leverage. When selling a stock short your risk is theoretically unlimited because the stock price can rise infinitely and the money you’d have to pay to purchase shares would rise with the price.
The reality is that you can make or lose money whether you buy a stock long or sell a stock short and no stock goes to infinity (except maybe AAPL). You should always define your risk when you enter a position and manage it accordingly. Plan your trade and trade your plan.
Buy a Call – You buy a call in anticipation that the call will increase in value. You can then sell the call back to the market at a higher price. Example – Buy an XYZ Dec $50 call for $3. If XYZ goes up in value and your call increases to $6, you can then sell the call to close the trade and you make $3 per share, equating to $300 per contract. Keep in mind that a call option represents the right to buy the stock at a set price. Calls typically increase in value as the stock rises.
Sell a Call – You sell a call in anticipation of the call dropping in price. You can then buy the call to close the trade and you make the difference. Example – Sell an XYZ Dec $50 call for $6. If XYZ stock drops in price and the value of the call falls to $3, you buy the call back for $3 to close the trade and you make $3, equating to $300 per contract.
When selling option premium you can also let the option expire worthless if it is out of the money at the time of expiration. In this case, you achieve max profit, which was your initial credit—the $6 per share you sold the contract for. Assuming the call had extrinsic value when you sold it, the call will decrease in value if the stock stays where it is or goes down. Inversely, your risk is unlimited as the call increases in value as the stock rises.
Buy a Put – You buy a put in anticipation of the put increasing in value. You can then sell the put for a higher price and you make the difference. Example – Buy an XYZ Jan $100 put for $4. If XYZ stock drops and the value of the put goes up to $7, you can sell the put to close the trade for $7 and you make $3. Puts are the opposite of calls. A call is the right to buy while a put is the right to sell. Puts increase in value as the underlying stock drops in price, so if you thought a stock was going to drop, you could buy a put.
Sell a Put – You sell a put in anticipation of the put decreasing in value. You can later buy the put back at a lower price and you make the difference (or let it expire worthless). Example – Sell an XYZ $100 put for $7. If the put decreases in value and you buy it to close for $4, you make $3 per share. If the put had intrinsic value associated with it when you sold it, the value would decrease if the stock price stays the same or goes up. The next trades I want to cover are called spreads. Spreads are really just a means of reducing risk in a trade. There are many types of spreads but the most common are called vertical spreads.
Bull-Call Spread – You buy a call and sell a call at a higher strike price with the same expiration date. Since the call you are buying is more expensive than the call you are selling, this is considered a debit trade. The call that is purchased is the dominant part of the trade.
A bull-call spread provides a means for buying a call while lowering your risk. When you sell the higher strike price call you reduce your debit in the trade. Given that your debit in the trade represents your maximum risk, by reducing your debit you’ve reduced your risk in the trade. Bear-Call Spread – You sell a call and buy a call at a higher strike price with the same expiration date. Since the call you are selling is more expensive than the call you are buying, this is considered a credit trade. The call that is sold is the dominant part of the trade.
A bear-call spread provides a means for selling a call while lowering your risk. When you buy the higher strike price call, you eliminate potential infinite risk and effectively cap the amount of risk you have in the trade.
Bear-Put Spread – You buy a put and sell a put at a lower strike price with the same expiration date. Since the put you are buying is more expensive than the put you are selling, this is considered a debit trade. The purchased put is the dominant part of the trade.
A bear-put spread provides a means for buying a put while lowering your risk. When you sell the lower strike price put you reduce your debit in the trade. Given that your debit in the trade represents your maximum risk, by reducing your debit you’ve reduced your risk in the trade. Bull-Put Spread – You sell a put and buy a put at a lower strike price with the same expiration date. Since the put you are selling is more expensive than the put you are buying, this is considered a credit trade. The put that is sold is the dominant part of the trade.
A bull-put spread provides a means for selling a put while reducing your risk. When you buy the lower strike price put, you gain the right to sell the stock at a lower price, thus limiting the amount you can lose in the trade. There are myriad strategies available to be implemented in trading, but all equity trades boil down to these six basic trades. Remember that you can buy or sell a stock, buy or sell a call, or buy or sell a put…and that’s it!
Jon Wirrick
Jon is an active trader and private coach to Traders Edge Network investors needing help learning to apply a consistent trading method. Through his mentoring, he has helped hundreds of people change their financial situation through trading in the financial markets.