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The Challenge of Options Trading: PayPal's Dramatic Fall in a Volatile Market ⚠️


Options trading can be a valuable addition to your portfolio, as long as you manage it in a disciplined manner. By integrating it as part of an overall strategy, you can generate consistent monthly income, define risk, leverage a minimum amount of capital, and maximize return on investment. But let's not fool ourselves, it's not for everyone.


Options allow smooth and constant appreciation of the portfolio without the need to guess the direction of the market.


An options-based portfolio, in good hands, can provide durability and resilience to drive results with much less risk.

But, participating in this type of trading is synonymous with understanding that it is a kind of “ecosystem” with specific rules and one of the most important is to structure each operation in a defined way in risk (through buy-sell spreads, sell spreads- purchase, iron condors, etc.).


We will talk in another article in more detail. For now, let's analyze the case of PayPal.


The PayPal Case


PayPal (PYPL) is a recent (2021) example of how a poorly advised acquisition target and disappointing quarterly results can cause a massive share price drop.

These events caused a 35% crash from a high of $310 to $200 after earnings. Hence the importance of defining risk in all options trades to limit any downward price movement beyond the protective strike.

Experts say that all this could have been avoided with better decisions and better management of risk-defined options.


What are Risk Defined Options?


They are simple operations. Let's look at a theoretical example using a put spread on a stock trading at $100:


You sell a put option at a strike of $95 and receive $1 per share in premium. You commit to purchase shares at $95 by the expiration date and receive $100 in option premium income.


You purchase a put option at a strike of $90 using part of the premium received (for example, $0.40 per share). You have the right to sell shares at $90 per share by the expiration date.


In this scenario, the premium income was $60 per contract ($1.00 - $0.40) and the maximum risk was $440 ($95 - $90 = $500 - $60 net premium income). If the stock remains above $95 by the expiration date, the option expires worthless and the seller of the put spread makes a realized profit of $60 or a return on investment of 13.6% ($60/$440).



Advantages of Risk Defined Options:


Limit losses: No matter where the stock moves, losses are limited to $440 per contract, even if the underlying price falls to zero. This is due to the protective put option purchased at the $90 strike.

They do not require large capital: You don't need to invest a large amount of money to establish the position.

They avoid the allocation of shares:You won't be forced to buy or sell unwanted stocks if the trade doesn't go as you expected.

They reduce unrealized losses: Compared to a covered put sale, where shares could be allocated and result in unrealized losses, the put spread limits your downside exposure.


Conclusion:

The PayPal case reminds us that even solid companies can experience significant drops in price. Especially in options trading we must be aware of the risks and take measures to protect ourselves against these possible adverse market movements.




Bye bye!






REFERENCES


For this article, prompts have been used to request information

interpreted and provided by AI (Google Bard). Written and edited

by Kevin David Terán and verified by Pedro Arizaleta and Erwin Sánchez


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