Terrified of Options Trading? Get Over It!
I frequently get queries from readers who want to better understand how to make money from options trading, but they find the concept daunting.
Today, let’s take a step back from the day-to-day gyrations of the stock market to look at options trading. I turned to a colleague who’s one of the world’s top options traders: Dr. Joe Duarte, chief investment strategist of Profit Catalyst Alert.
Dr. Duarte (pictured here) has been a professional investor and independent analyst since 1990. He is a former registered investment advisor and author of the bestselling Options Trading for Dummies, and several other books including Market Timing for Dummies and Successful Biotech Investing.
Many investors are afraid of options trading, but Dr. Duarte explains the basics in simple, easy-to-understand terms. My questions to him are in bold.
Hiya, Joe. You hail from Texas, and as your editor, I can attest to the fact that Southwestern slang sometimes sneaks into your prose.
[Laughs] I wasn’t born in Texas, but one day that y’all stuff showed up and it hasn’t left.
When we last spoke, you gave our audience a great overview of how options are affecting the market’s volatility. How can investors, especially those who may not trade options frequently, use that information?
Yeah, on any given day, the options market is a more powerful influence on the stock market than the other way around.
So how can investors learn to deal with that dynamic?
The simple answer is to first accept that fact. As I wrote in the introduction to the fourth edition of my book Options Trading for Dummies, impatience, when we trade, is our worst enemy.
Explain that.
When you buy a stock, you’re doing so in expectations that the stock will rise and you can sell it for a profit at a higher price. You can wait for the results for a while.
With options, you must think in terms of multiple components of the trade. There is the underlying stock on which you will trade the option. There is the overall market environment. There is the time limit to expiration. That means that you must be right by a certain time or you will lose money.
Why are those factors important?
Well, which option trade you choose to make is based on the action of the underlying stock and its relationship to the market. So, if a stock is in an uptrend, you would consider buying a call option or perhaps selling a put.
On the other hand, a stock in a downtrend may be best suited to buying a put option, or perhaps avoiding it altogether. In a sideways market, you may want to implement more sophisticated strategies such as using spreads. And when you hedge an event, such as an earnings result, you may want to use a collar, a straddle, or a strangle.
A lot of my readers are saying to themselves right now: Whoa, that’s complicated.
Yeah, that’s a lot of information, but I cover it all in detail in my book, which incidentally was reviewed by Investing Daily’s options guru Jim Fink, for which I’m grateful.
Yes, Jim Fink is one of the top options traders around and we’re glad to have him on the team. Okay, so buying a call option and hoping it rises is not a good strategy?
Not at all. Buying calls and puts can be very rewarding under the right circumstances, such as when an expensive stock is in the early stages of a long-term uptrend. In that case, you can profit from the uptrend at a fraction of the price.
For example, let’s say XYZ stock is trading for $500 per share but is showing signs that it’s about to move higher. In that case, a $505 strike price call option may be trading for $8. You could buy 100 shares for $50,000 or you could buy a call option for $800.
If the stock goes up, the option will go up. And if the stock moves above $505, it will be in the money. That means that $1 gain in the stock, will mean a $1 gain in the option.
I remember making one trade many years ago where I bought a put option on medical supply wholesaler McKesson (NYSE MCK) that delivered an 800-plus percent profit on a missed earnings report.
I can’t remember the exact numbers, but I think I spent $300 on buying the put and sold it for $2,400 or so.
Oh, that’s a nice one.
It sure was. But as it turns out, the most consistent way to make money in options is to sell options, not buy them. I describe those types of trades like an old fashion Texan would describe nickel chuckers. You pick up $100 here, $250 there. It starts adding up. Pretty soon, you’ve got a car payment.
You mean, like when you sell covered call options?
Yeah. That’s a great strategy when you have a stock that’s been moving higher and it begins to consolidate. If it still looks good after a long move up, you can sell call options on the shares and collect some income as you wait for the next up leg.
But again, as I wrote in my book, because markets change, it’s more advantageous to have more than one strategy so you can make money in different sets of market conditions.
For example, a more profitable approach in markets that are moving sideways, especially after a market bottoms out, is to sell put options.
Why is that?
It’s actually a bit sneaky [laughs]. And who doesn’t like being sneaky when you’re up against giant trading houses?
I like the sound of that.
Yeah, it’s good to pay back the scoundrels, i.e. algos and hedge funds, who make money on every trade because they have an advantage by knowing the inside of the market.
Here’s how it works. After a market sells off, many put options have gone up in price. And if there is still fear in the air, the put premiums. i.e. the price of the put, are in many cases high enough to where you can gather a nice bit of income in the process.
How does that work?
For example, let’s say the market has been in a down trend for a month and XYZ stock is down from $100 to $75. A put option with a month left to expiration and a strike price of $70 might be worth $5. If the stock looks as if it has bottomed out, this is a great opportunity to bag $500 in income.
The trade is based on time value. The closer the option gets to expiration, the more it erodes the time value, which is a component of the price. As expiration nears, if the stock remains above the strike price ($70), time value erodes and the price of the option falls. If the stock remains above the strike price at the expiration date, the option expires worthless and you’ve got $500.
Nice. What’s the risk?
Good question. If the stock falls in price, your premium erodes. If the stock falls below the strike price ($70) by the expiration date, you face the risk of assignment, which means the counter party to whom you sold the put can choose to sell the stock to you for less than $70. At that time, you would own the stock in your account, which would be debited for the sale price.
That’s no fun.
It can be if you choose the right option on the right stock, within the right time frame. And if the trade goes your way, you can brag a little, because you probably took money from a big Wall Street firm’s market maker algo robot that was likely the counter party.
Moreover, if the trade isn’t going your way, you can always close it out before expiration and limit your losses.
Now that I like.
Yeah buddy! Anytime you can take money from a big guy you should celebrate.
What’s your favorite option trade?
I like selling cash covered puts. That’s where you don’t own the stock but you have enough money in your account to buy the stock if you’re assigned.
What attracts you to that trade?
It’s a great way to produce income, plus I like the fact that I can combine my price chart analysis into the trade.
Do you have an example?
Sure. I recently sold some puts on Amazon.com (NSDQ: AMZN). The stock bottomed out in late 2023 and started rebounding. But because it had missed badly on its earnings report, people were negative on the stock, making put options prices rise.
In my personal account, I chose a put option with five days to expiration which was offering about a $0.50 cent premium. The stock was in an uptrend, so the risk reward/ratio was low. I sold two puts. The stock climbed nicely over the five days prior to expiration and I pocketed 100 bucks. You make a few of those trades per month and you’ve got a BMW payment.
That’s not a bad five days’ work. Do you have any final pointers for people who might be interested in trading options?
Sure. Here are a few from my book:
- Be patient and paper trade your strategies until you master them, one at a time;
- Learn to manage risk and think about your exit point before you enter any trade;
- Become proficient in price chart analysis. This will help you to pick good option candidates; and
- Never trade with money you’re not willing to lose.
Thanks, doc.
Sho’ nuff.
Editor’s Postscript: Thursday was a good day for the stock market, with the major U.S. equity indices closing sharply higher as follows:
- DJIA: +1.57%
- S&P 500: +1.96%
- NASDAQ: +2.43%
- Russell 2000: +1.20%
Driving Thursday’s rally were stellar earnings results this week from mega-cap technology companies, as evidenced by the tech-heavy NASDAQ’s outperformance. After a dismal 2022, the tech sector so far this year has rebounded.
Accordingly, you should know that my colleague Dr. Joe Duarte, chief investment strategist of Profit Catalyst Alert, has just pinpointed a tiny, unknown company that has developed a revolutionary “black box” technology.
You need to get in on the ground floor of this game-changing opportunity before the investment herd finds out and sends the share price soaring. Visit this URL for details.
John Persinos is the editorial director of Investing Daily. You can reach him at: mailbag@investingdaily.com.
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