Talk about a volatile stock market! The current high levels of volatility have forced many investors to look outside the box for consistent profits.
One of the primary ways investors are using the volatility to their advantage is via a variety of option strategies.
Here are 5 easy to understand and execute option strategies for today’s highly volatile stock market.
- Straddles-Profit No Matter What Way The Stock Moves
Straddles are one of my favorite option strategies. It is a trade that will profit if a large move occurs regardless of direction. A straddle is buying both a put and a call at the same strike price and the same expiration month on the same stock. The design being that a sharp move in either direction will profit enough to absorb the losses in the opposite direction and still create an overall profit.
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Here’s a simple example:
You know that XYZ Company will announce earnings on December, 10th. Based on the past price movements of the company during earnings announcements, you think that share price will either soar or collapse after the December 10 announcement. Let’s say the stock is trading at $10 and you buy one $10 December put for $2 and one $10 December call for $2. Earnings are released and it’s a surprise to the downside. The stock price plunges and the $2 call quickly become worthless. However, the $2 put soars to $6 creating $4 of profit. Remember, you need to subtract your losses of $2 from the call side of the trade but you are left with a $2 profit overall.
2.The Collar—Protect Your Gains
A collar is used by investors who seek to limit the downside risk of a winning stock position at little or no cost. In fact, some collars can be designed to earn a profit just for using one. Sound amazing? You bet it does!
What Is A Collar?
A collar is the concurrent purchase of a put option and the selling of a call option.
Each options is out of the money and usually have the identical expiration date.
For every 100 shares of stocks whose profits need protected from, one put is bought, and one call is sold at the same time.
For example, if you own 500 shares of XYZ, a collar would consist of buying ten put options and selling five call options to protect all 500 shares. The options are purchased out in the month representing the amount of time you are seeking downside protection.
For example if you think your stock will stabilize in 3 months, the options chosen for the collar would be 3 or more months until expiration.
The collar strategy is ideal for investors seeking a risk adverse approach providing a realistic rate of return with managed risk.
The secret to being successful with collars is choosing the appropriate put and call mixture that allows gains while mitigating the downside risk.
The neat thing is that you can roll the puts and calls from month to month creating a stable 3-5% monthly return is the stock behaves as expected.
Rolling means to repurchase short calls and write fresh calls for another month and sometimes different strike price, and buy new puts for that month.
In other words, adjusting the collar to fit the price of the stock in that particular month. This is a very popular strategy among professional option traders. Many earn their living doing this consistently.
Believe it or not, corporate executives often use this strategy to protect their capital if it is concentrated in the company’s stock. The collar protects the executive’s wealth without forcing the expense of costly put only protection.
3.Calendar Spreads: Control Your Risk
Calendar spreads are a highly effective risk controlling strategy.
The strategy involves the combination of a risk reducing spread trade with the profit making opportunity of a directional trade in the same trade.
The cool thing about Calendar Spreads is their flexibility. Calendar Spreads can be used in multiple market conditions.
First, this type of spread can be a market neutral position that can be extend (rolled over) to cover the cost of the spread while taking advantage of time decay. As you likely know, time decay is the bane of option buyers. Every day that passes for option buyers reduces the price of the option. The blunt weapon method of taking advantage of time decay is to be an option seller. While selling options can create a steady stream of income, the risk level is very high when selling naked. Naked means to sell a put or call without any type of hedge that will protect your equity should the option take off on the upside. Even professional option traders sometimes get burned when selling options. I know of several large hedge funds that were nearly wiped out when their option selling programs hit black swan style adverse market conditions.
The great news is Calendar Spreads allow you to take advantage of time decay without the outright risk of selling options.
Secondly, Calendar Spreads can be used to initiate short term market neutral positions that have a longer timeframe directional bias yet can participate in unlimited upside potential.
- Selling Puts: Earn a profit while waiting to buy stock at a discount.
This strategy has a two prong effect. It can be used to generate income and at the same time allow you to purchase the underlying stock at whatever discount you wish. I know this sounds hard to believe, but it is very true!
This tactic involves the selling of put options. Every put option represents 100 shares of stock. This means that for every 100 shares of stock that you want to purchase, at a certain price, you sell one put option at the strike price at the discount you want to buy the shares.
One of two things can happen.
First, the stock never drops to the strike price. If this happens, you get to keep the premium for selling the put option.
Second, the stock drops to the strike price or below. If this happens, you will be “put” to the stock. This means forced to buy the shares at the discounted level you already agreed was a great price to own the shares.
The best news here is that you get to keep the premiums earned no matter what happens. These premiums earned by selling the put will allow you to buy the stock by using even less of your own money therefore, in effect, getting an even steeper discount. This is the bad news!
Many professional traders and investors use this tactic month after month just collecting the premium and rarely being forced to buy the shares. By doing this, a steady income can be created but always with the caveat that you may have to actually purchase the shares at the price you agreed with.
Managing The Worst Case ( If you don’t want to own the stock)
Pro traders always think of the downside first. Amateurs only think about how much they can make. With this said, there is another way to handle an adverse move instead of buying the stock.
It is to buy back the put options at a loss.
The decision you make will depend on whether your bias towards the underlying stock has changed since selling the call.
You should probably buy back the put options at a loss if a significant piece of bad news had surfaced which negatively impacted the fundamentals of the underlying stock, causing you to be no longer bullish on the stock. The premiums that you received will help to cushion some of the losses.
Otherwise, if the descent in stock price is minor and your target price is hit, you will be able to buy the stock at a reasonable discount along with the extra cash received from the sale of the put options.
- Covered Calls: Juice your returns
Covered call writing is the selling of calls against shares of stock that you already own. Therefore, the calls are “covered” by the stock in your portfolio.
One call option offers the buyer the right to buy one hundred shares of the stock for a particular price during a pre-determined time frame. By selling the call option, you are selling the right to the buyer to purchase one hundred shares of stock from you at the agreed upon price. This price is known as the strike price.
Traditionally, the time frame is monthly but weekly options are also available.
For every one hundred shares of stock, covered call writers sell one call option. Being covered tremendously reduces the risk when compared to “naked” call writing. Naked call writing means selling calls without owning the stock first.
When you sell a call option, you receive the amount the buyer paid for it, less commissions in your account.
This option premium is the income that you get to keep.
As a mental exercise, imagine the call option you sold were $5.00. Since an option represent one hundred shares of stock, you will instantly receive $500 minus commissions in your account. Times this by 1000 shares and ten options, you would earn $5000, minus commissions!
Just imagine how this simple strategy can ramp up your returns!