Options are versatile investment tools and can be used in a wide variety of strategies.
One problem for the options trading newbie is recognizing which strategies offer a high probability of earning money, and which are high-risk plays. Too often rookies buy options that are far out-of-the-money — simply because those options seem to be inexpensive and offer the possibility of making a killing. That’s not a viable plan.
As a way of introducing readers to more efficient ideas for using options, let’s take a look at a frequently-occurring situation: how a trader can handle earnings season.
When a trader has an opinion on the future price of a stock, she wants to make a play that offers a reward for making the correct prediction. It’s also a solid idea to adopt limited loss strategies, just in case the unthinkable happens and the trader is not correct in her prognostication.
Owning a stock position (long or short) gives the trader an opportunity to earn a reward. However, stocks can be expensive and some traders, especially those who are just beginning, often have small accounts and cannot afford to buy or sell enough shares to generate a meaningful profit.
When an announcement of quarterly earnings is pending, traders with an opinion are anxious to bet on market direction. If their expectation is accurate, then the earnings results for the chosen company should reflect their optimism (pessimism). They buy puts or calls, expecting to be handsomely rewarded for making the right guess. What they fail to realize is that a gigantic number of other players want to buy those same options — and the price has risen too far to make the purchase a reasonable gamble (yes, it is a gamble).
So how can the trader — with limited knowledge about options and how they work — participate in pre-earnings trading with an improved chance of earning money? Let’s examine a few ideas — with the following understanding:
If a specific trade feels right to you — please take that as the starting point. Your next task is to learn all about the strategy and how it works. It is far too soon to use the strategy. Learn first; trade later.
Example: Stock is $100/share
January expiration arrives in two weeks
Earnings news to be released tomorrow, before the market opens
Today is the day to make the earnings play
The bullish investor can:
- Buy calls. Most new traders choose the near-term, out-of-the-money (OTM), call. That is the Jan 110 in our example. Some would target the Jan 120s as the option to buy. Note: The stock does not have to move all the way to 110. The rookie’s plan is to sell the calls when the stock rallies, and collect her profit. Under normal circumstances, this plan fails far more often than not. In the earnings season scenario, it is not a good idea (more on this below).
- Sell puts. This trade becomes profitable on the expected rally. However, this idea is risky for inexperienced traders. For that matter, many brokers restrict accounts that can sell naked put options.
- Sell OTM put spreads. A lower risk trade than selling puts (naked), and it typically has a low margin requirement. Suitable for any trader. However, there is one warning that must not be ignored: When selling these spreads, it is tempting to sell far too many. The low-margin requirement makes the trader believe that these trades are sure winners and that losses are very unlikely. I love this spread idea but the trader must be careful to sell an appropriate number of spreads.
(InvestorPlace’s first Twittercast, Option Speculation the Smart Way, will take place on Thursday, April 28th at 1:30 p.m. EST and will feature options expert Mark Wolfinger. Read Mark’s first article in this series “Speculating on Market Direction for One Stock“.
Please tweet your options questions using the hashtag #smartoptions anytime between Tuesday, April 18th and Tuesday, April 26th. Mark will be answering your questions live starting at 1:30 p.m. on Thursday, April 28th.)
- Buy at- or OTM call spreads. Limited gains, and limited losses. One advantage of trading spreads is that if you pay too much for the option bought, you also get to collect too much for the option sold. This translates into a reasonable position cost.
o Keep in mind that selling the put spread, in our example the Jan 80/90, is much more likely to return a profit than buying the Jan 110/120 call spread. The call spread requires a decent price increase for the trader to earn a profit. Selling the put spread can earn money when the price increase is small. Indeed, it can earn a profit even when the stock declines by a few dollars. The offset is that the potential profit from the call spread is larger than from the put spread.
- Buy an OTM call calendar spread such as: Buy Feb 110 calls and sell Jan 110 calls. However, there is more to this trade and it is important to understand the implied volatility difference between the Jan and Feb options.
- Buy an OTM butterfly, such as the Jan 100/110/120 call butterfly. Or, if much more bullish, buy the Jan 110/120/130 call butterfly. This requires a substantial price increase to make money, but the original cost is fairly low,
- More experienced traders have more choices, if only because their brokers have given them the ability (as designated by permission level) to use a wider variety of strategies when trading options.
Bearish players have exactly the same opportunities by using puts instead of calls, and choosing strike prices that are 100 and lower.
The objective here is to illustrate a few of the option plays available to a trader with a basic understanding of options and who is willing to discard the simple approach of buying options and hoping for a good result.
Follow Mark Wolfinger on his ‘Options for Rookies’ blog: http://blog.mdwoptions.com