[Options] Like a Fly to Honey

Sean McLaughlin
May 17, 2019

Like a fly to honey, I'm always attracted to asymmetric opportunities that offer limited risk and the potential for unlimited gains. Trading options allows us to quite literally create these types of risk/reward opportunities every day. It's built into the very structure of your basic call or put option! And when we can spot a stock chart that offers us a little bit of an edge on the future direction of prices, it is time to take action.

In a recent All Star Charts conference call for subscribers, JC highlighted a setup in Honeywell $HON, showing a past resistance level that is now acting as strong support. This level, if held, can help catapult shares of $HON to our next target level of interest -- the $195 area.

With a solid chart and worthwhile price target in hand, the next thing I notice is the volatility being priced into $HON options. After their most recent earnings release, the volatility levels (and therefore options prices) are at or near their lowest levels for $HON all year:

This sets up a wonderful opportunity to play for an upside breakout in the easiest way possible -- with some long-dated call options.

Here's the Play:

We're going to buy $HON September 180 calls for approximately $2.55. We'll pay up to $2.75 if we have to, but with S&P futures indicating a down open this morning, we should have little trouble getting into these calls at or near our price.

The beauty of this long call position is manyfold:

  • Our risk is defined. We cannot lose more than the initial debit we paid to enter the trade. $HON can do to zero, we'll only be out our $2.55.
  • We have until September expiration for our bullish expectations to play out. Four months should be plenty of time to know if we're on to something here.
  • Low volatility lowers our cost of entry, therefore keeping our risk lower
  • If/when HON moves higher, there is a simple way to take our initial risk capital off the table and then enjoy a "risk-less" ride higher as far as the stock will take us.

A best practice I often adhere to when trading long calls is to sell half of my position when prices have doubled. So, if I pay $2.55 at entry for 10 contracts, I'll sell 5 of them at $5.10. This gives me back all of my original risk capital, but still leaves me long 5 contracts at a net zero cost. This gives me the ability to ride out any future pullbacks in price action with much more confidence -- because the only thing I have to lose is the house's money. I love being in that situation.

Once we get into the month of September and expiration approaches, we'll close this position if our options are out-of-the-money (anywhere below our 180 strike price). Whatever premium is left in these calls will begin to rapidly erode at this point, so we want out. If we are firmly above our strike price, then we'll treat the position as a stock position and look to close if/when $HON breaches any notable recent support levels.

If at anytime $HON shares close below $160, I'll consider our thesis busted and will close the position to salvage whatever premium is left in the calls (won't be much).

~ @chicagosean

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