Options Trading

Along with penny stocks, stock options are to Wall Street what the roulette wheel is to Vegas. The allure of stock options is understandable: they’re risky, profitable, and have probably made more millionaires than most other financial products. These little financial products also serve a valuable purpose, and help us understand the connection between risk, stock price, and time.

So can you make a living trading options? Absolutely. Many professional traders use stock options as their own intraday cash cow while many others instead rely on long-term, covered call options strategies. While both strategies are popular for churning big bucks on Wall Street, each has their own advantages and disadvantages.

Short-Term Options Trading
In the short-term, there are few financial products as volatile as options. Because a very small move in the price of a stock can be magnified ten to twenty times on the price of an option, traders can win quickly and lose quickly. There are two different short-term strategies:

Volatility Plays
Because stock options are priced based on the current volatility on the market (how likely is it that the stock price will reach the current strike price), options are used by many traders to profit off short-term changes in volatility. Imagine for one moment that the markets are cool, calm and collected, as they most often are when there is little information to trade. You think that the markets are going to become more volatile in the short-term, however, since earnings season is right around the corner. With earnings coming out, you believe that prices will move wildly as companies meet, beat, or miss their earnings mark.

In order to take advantage of the change in volatility, you purchase options on the S&P500 index three-months into the future at equal points above and below the current price. You are not essentially hedged against the market, that is, you lose equally when the price changes, but each position wins or loses individually on a change in volatility. If all of a sudden the market changes, and several days of movement are recorded in either direction, your positions are sure to increase in value.

This is because the change in volatility means that traders suspect it is more likely that your options will reach strike price, and are thus willing to pay higher premiums (the difference between the strike price, the current price of the stock, and the option price.) You win whether the market goes up, down, or nowhere as long as the volatility in the market increases.

Earnings Calls
It is no secret that earnings calls are generally good for massive shifts in stock price of anywhere form 3-10% changes in price in minutes. If a company misses estimates, then the stock price falls considerably. If the company hits estimates or exceeds them, the price usually rises.

Options are the perfect way to play earnings calls intraday. Because you can purchase options very near the current share price, options are an excellent way to leverage up.

For example: XYZ company currently trades for $100 per share, and you believe it will exceed earnings expectations. In order to profit, you pay $2.00 for call options with a $100 strike, thus allowing you to make money should the price of the stock rise past $102.00 (the strike price + option price) or by selling your options as the premium grows.

XYZ releases earnings and rises to $104.00 per share, giving your options a natural price of $4.00, doubling your money on a 2% rise in stock values. However, investors, feeling more optimistic about the future of the company, are willing to pay as much as $5.00 for your options, giving you a $3.00 profit on a $2.00 investment, or a 150% return. Those investors would paid $5.00 for your calls would have to see the stock price rise to $105.00 from $104.00 to profit, assuming they held until expiration.

Long-Term Strategies
Dividends aren’t the only way to generate an income with stock holdings. In fact, by using a covered call option strategy, many investors can generate a monthly income as high, or even better than the dividends on high-dividend stocks.

How it works: When an investor buys an option, they are buying the option to buy stock at a certain price. Thus, if you were to buy an MSFT option with a $30 strike, you would have the right to buy that stock at $30 at any point until expiration. This is very much like putting a down payment on a product at the store…you have a right to buy it because you put up the down payment. Should you fail to buy it before the expiration period, you forfeit your right to buy it at the stated price, and you lose the money you put down.

By using a covered call strategy, investors write options against their portfolio. So, I could own 1,000 shares of GOOG stock at $400 per share, and sell covered calls to other investors allowing them to buy my shares for $425 any time in the next month. For that right, I collect a “premium” of $1. If the stock does not rise to $425 or above, they’re unlikely to exercise their options and I keep $1 per share, $100 per lot, or a grand total of $1,000 for that month.

Extrapolate that over a year and you could earn an additional 3% per year on your stock holdings, a significant amount, especially in these periods of low-yielding stocks and fixed income investments.

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