Masters Series: How to Make a Good Trade Great

Editor's note: You can make money in the market even when you're wrong... You just have to use the type of trading strategy Stansberry Research Pro Trader editor Jeff Clark shared yesterday.

In today's Masters Series essay – originally published in December 2012 in our free Growth Stock Wire ­e-letter – he explains how to give yourself an even greater chance for profit... and how to get paid to make the trade...

How to Make a Good Trade Great
By Jeff Clark, editor, Stansberry Research Pro Trader

The "spread trade" strategy I showed you yesterday is a great way to reduce the risk of trading options and increase your chances of making money.

But there's an easy way to make it even better...

In the example I showed you yesterday, my readers bought one call option and sold one call option on Canadian gold explorer Seabridge Gold (SA).

While that was an improvement on simply buying the call by itself, we still were only going to profit if the stock moved higher. We would have lost money if Seabridge fell or went nowhere.

To give ourselves an even greater chance for a profit, we needed to add one more leg to the option position...

We sold an uncovered put.

By selling uncovered puts, you get paid to agree to buy a stock at a specified price by some date in the future. It's that simple.

Selling uncovered puts is my favorite options strategy. In my experience, it is the most consistent way to profit in the options market.

Now... it's important to only sell uncovered-put options on stocks you want to own anyway... and at prices at which you'd like to own them. In a rapidly falling stock market, you may end up having to buy the stocks on which you've sold puts.

Smart folks who use this strategy use it to generate income on stocks they don't currently own but are willing to buy at the right price.

We used this strategy to pay for our Seabridge call-option trades. I'll show you how today.

I'm going to walk you through each step of this trade. I know it may appear complicated and intimidating, but trust me, it's worth the time it'll take to learn how to execute these trades.

If you don't remember the details of the trade I wrote up yesterday, go back and review.

Here's a quick summary: We bought the Seabridge January $15 calls, which gave us the right to buy shares at $15. We sold the January $20 calls, which obligated us to sell Seabridge at $20.

That trade cost $0.80 per share. So we were looking to sell an uncovered-put option on Seabridge that would give us the $0.80 back and maybe even put a little extra money in our pocket up front.

Remember... we only sell puts on stocks we want to own anyway, and at prices at which we want to own them. Seabridge was a dirt-cheap gold stock I wouldn't have minded buying right then, when it was trading for $12.50 per share. And I would have been thrilled to get paid for agreeing to buy it even cheaper than it was.

So I recommended selling the Seabridge January $10 put options. That obligated us to buy Seabridge at $10 per share if it closed below that level on option-expiration day in January.

At the time, the puts were trading for $1.10. That covered the $0.80 cost of our spread trade and put $0.30 per share more in our pocket.

Here's how that looked, trading one contract at a time. (One option contract covers 100 shares.)

We created a trade that paid us $30 to set it up. That $30 was ours to keep no matter what happened to Seabridge.

This trade could have played out in one of four ways...

1. Seabridge closed below $10 on January expiration day. We would have been obligated to buy Seabridge at $10 per share. Figuring in the $30 we received for setting up the trade, we really agreed to spend $970 on 100 shares, or $9.70 per share. So this trade would have been profitable as long as Seabridge held above $9.70 per share.

2. Seabridge closed between $10 and $15 per share. All the options in the combination would have expired worthless, and we would have kept the $30 per contract.

3. Seabridge closed between $15 and $20 per share. The higher Seabridge traded in that range, the more money we would have made. For every $1 Seabridge rallied, we would have collected another $100 per contract.

4. Seabridge closed above $20 per share. The trade would have been worth $500. So our maximum profit would have been $530 ($500 for the combination plus $30 for the original setup of the trade).

In other words, the only way we could have lost money on this option combination was if Seabridge dropped another 25% from its already depressed stock price. We were going to make money in every other scenario.

Think about that for a moment. We would have made money if we were right on the trade and Seabridge went higher. But we could have also made money if we were wrong and the stock dropped. That is the beauty of this type of strategy.

Let's recap what we did here...

Instead of having a position that would lose money if Seabridge went down, stayed the same, or failed to move up 25% over the next eight months... we created a trade that would have been profitable in every scenario in which the stock didn't fall by more than 25%.

Three months after my initial recommendation, shares of Seabridge had bounced all over the place, trading between $13 and $17. But because we set up the trade with such a large "margin of error," we didn't need to be overly concerned about the day-to-day fluctuations. We could concentrate on the longer-term objective – a higher share price going into January.

By mid-September, Seabridge traded for about $18. I figured for such a short time frame, that was close enough to my original target. And we were able to close the trade for a $250 net credit per contract. Counting the $30 we received for setting up the trade, we had a total gain of $280 per contract.

The Seabridge "spread" I showed you yesterday was a good trade. But by adding a third leg to it, we created a GREAT trade. And it worked out perfectly.

Best regards and good trading,

Jeff Clark

Editor's note: Gold is a terrific long-term investment. But if you simply buy and hold gold stocks or gold bullion, you could be leaving thousands of dollars in profits on the table. Jeff just put together a video presentation explaining the opportunity he sees in gold – and how you can use his trading advice to make five or 10 times bigger gains than typical "buy and hold" strategies. View it here.