Option Trading School: Our Winning Broadcom Trade Reminds Us Option Prices Aren't Purely Mathematical

Posted by jbrumley on November 7, 2017 4:45 PM
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This week, our Grand Slam options trading advisory booked a sizable winner, netting a 50% gain on some Broadcom (AVGO) calls purchased back on Wednesday, November 1st.

Though the trade is in the past, there are several things about the trade -- and the chart of AVGO -- worth going back and studying, as they provide some lessons we can all bear in mind that will make us better traders in the future. Let's just start, however, with the chart of Broadcom itself. Take a look. The pink arrow marks the Wednesday we stepped into the position.

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One detail stands out above all else... we got into our AVGO calls in the midst of a major bullish thrust, but at a point it had peeled back just a little within the confines of that bigger move higher.  This may mean we save only a few pennies on our entry, but when the option in question is priced at less than a dollar (or less than $100 per contract), every penny counts.

It does beg the question, however -- how did we know the lull wouldn't turn into a full-blown pullback? Well, we didn't know for sure, but we had good reason to believe that was what was in the cards. Take a look at that day's volume, also marked with a pink arrow. There was never a great deal of volume behind the selling effort, and certainly much less than the volume behind the upward thrust we had seen over the course of the prior three days. There was certainly some risk to it, but it was a good calculated risk. We opted to buy the Broadcom (AVGO) December monthly (12/15) 320 calls (AVGO 171215C320), paying 75 cents for them, or $75 per contract.

The very next day, things got.... interesting. That's when AVGO fell back from the close of $259.29 to a low of $248.87, calling into question our guess that the undertow was still bullish. Take a look at where that pullback reversed course, however. It was the 20-day moving average line (blue), right on cue. This brush with the critical line in the sand resulted in a rekindling of the uptrend, and on even stronger volume than the initial breakout thrust.

On Monday, we sold half of our Broadcom calls at $1.50, or $150 per contract; that day is marked by a blue arrow. We only sold half, because we wanted to keep some of the initial position and take aim for a huge target. With a 100% gain on half the trade already in the bank, the absolute worst we could do was a breakeven on the trade... and that assumes the remaining half of the AVGO calls fell to a value of zero (something we'd never let happen if given a choice).

As it turns out, AVGO wasn't going to move any higher -- at least no right away. Moving from an offensive to a defensive posture, we proactively sold our remaining calls at 75 cents each, or $75 per contract, for a breakeven on that portion. Between the two halves, we banked a 50% gain on the December Broadcom calls.

The lessons learned? Several of them, actually.

First though not foremost, while it would have been easy to be spooked out of the trade the day after we entered it -- when it plunged to that low of $248.87 -- it would have been easy to justify a quick exit. AVGO didn't break under the critical 20-day moving average line though. Being patient while the market was testing traders' conviction paid off big-time.

Second, by splitting our trades into two pieces and banking a profit on the first half, we give ourselves a chance (and a safety net) to take huge swings on the second half of our positions. Most of them may never pan out, but even if only one out of five "second halves" of our trade move to a 200%+ gain, it will be worth the effort and risk. The fact is, most of a traders' gains are driven by just a handful of his or her trades.   You have to give yourself a low-risk way of reaping those big winners when you don't know which trades will end up being the big winners. Our approach does this.

Third, and above all else, not how volatile the option's price was. We paid 75 cents per contract on November 1st when AVGO was trading at $259.30, and we sold those same calls at 75 cents per contract on the 7th, when AVGO was valued at $271.32. Some of that can be attributed to time decay and the bid/ask spread, though most of the odd difference is chalked up to the market's ever-changing idea of what an option is worth. Context, frustratingly, is everything. This is one of the reasons young and new options traders may not want to "go it alone." Indeed, it's this kind of inconsistent pricing action that should make even veteran traders want some help.

If you'd like this kind of help picking targets and stops, or just want a  constant flow of trading ideas, our Grand Slam service is one of BigTrends' most popular advisories. It dishes out at many as eight trading ideas every month. You can go here to learn more about how the Grand Slam newsletter generates trading ideas, and chooses the most appropriate option in a risk/reward basis.

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