Options trading can be confusing and risky. Fortunately it can also be safe and profitable. Like most things in the investment realm, there are bad options trading strategies and good options trading strategies.
The main idea to remember when using an options strategy is it’s meant to increase your returns and/or lower your risk. Therefore you should stick to strategies that have been proven to do these things and ignore the ones that promise untold riches but expose you to absurd risks.
A big point of confusion when trading options is found in the jargon and the technical explanations of how options trading works. Add to the fact that traders sometimes refer to the same strategy by different names, and it’s no wonder beginners are confused.
If you’re new to options and don’t fully understand them, I highly recommend you purchase a good book on the subject and educate yourself on exactly what options are and the mechanics of how they work. Go to Amazon.com and search for “options trading” to find some excellent books on the subject. You’ll be able to read reviews and see other people’s ratings before you buy.
I’m not going to explain what options are in this article, but I’ll introduce two excellent options trading strategies (one in this article and the other in a follow up article) that can enhance your returns while minimizing your risk. I’ll assume you know the basics of trading options and understand the terminology.
The first thing you need to do before doing any options trading is to look at the underlying stock. A big mistake traders make is ignoring the underlying stock and just looking at the premium level hoping to make a quick short-term profit. That’s a HUGE mistake and has no place in an investor’s bag of tools. If you’re a speculator or like to roll the dice in the stock market, then perhaps you can ignore the underlying stock, but if you’re an investor, then don’t ignore it.
With over 9600 stocks trading on U.S. exchanges alone, the overwhelming problem facing most investors is how to select good stocks. There are many ways to do this but, in my opinion, the best way is to use Warren Buffett’s techniques to rate a stock on its fundamentals strength and its moat strength. Buffett has proven that he knows how to select strong stocks, so rather than trying to reinvent the wheel, it’s better (and more profitable) to simply piggyback on what he’s already discovered and revealed.
Warren Buffett’s Stock Selection
Strategy for Options Trading…
Buffett usually goes through a 3-step process that consists of asking some relevant questions, calculating a company’s fundamentals strength and determining its intrinsic value. For our first options strategy, we’ll skip the intrinsic value calculation because we’ll be working with whatever price the market is currently valuing the stock at.
However we’ll still need to perform the first two steps. If you haven’t already, sign up for the free report, Stock Market Investing for Maximum Profits, and study it carefully. It describes, in complete detail, the important questions to ask, how to rate a company and determine its moat strength and how to calculate its intrinsic value (you won’t need this last piece for the first strategy I’ll describe, but it is interesting to go through the exercise nonetheless).
Once you’ve rated your stocks, select only the very best ones. Underlying stocks should stand on their own merit. Picking stocks based on premium levels usually translates into picking the riskiest stocks which further translates into losing positions. If you remember one thing, remember this: always select fundamentally strong stocks. Period.
Well researched stock selections are the foundation of any consistently profitable strategy, whether using options or not. With options, however, stock selection is the key.
Writing Covered Calls…
The first options strategy I like is writing (or selling) a covered call. As long as you hold a portfolio of well-selected stocks, a minimum profit level is very likely (on the other hand selling an uncovered, or naked, call is a very risky options strategy that no true investor should follow).
The key to a solid covered call strategy is to base it on high-quality stocks that have appreciated since you purchased them. You then have to monitor the option premiums to determine if it’s worth the risk of having your stock called away from you. If your purchase price relative to the striking price is not great enough to ensure a reasonable profit, then you should not write the call.
The stock price in relation to the striking price of the call also has to ensure you a reasonable profit and there has to be a reasonable volume in the stock and the related options so liquidity is assured.
Finally the premium should be great enough to compensate you in the event of exercise.
Basically you need to ensure the following conditions are met:
- The striking price is greater than what you paid for the stock. In that case exercise will give you a capital gains profit in the stock in addition to the premium you received. If your cost basis is higher than the striking price, then your profit will have to come entirely from the premium (which would also have to cover transaction costs). Therefore it’s preferable to only write calls when you can profit from both the premium and the capital gains.
- The underlying stock’s price is close to the striking price, either just in the money or just out of the money, but not deep in or deep out of the money. In the first case, the option premium should move in step with the underlying stock value so you have the highest chance of profitably closing the call even if the underlying stock moves very little. In the second case, all of the premium is time value, so as long as the stock’s price doesn’t rise above the striking price, the option will expire worthless.
- The expiration is three months or less. You don’t want to be locked into a striking price for long periods of time. In general you want to write a call just before time value starts to accelerate its fall (which is usually at about the two month mark). In addition, the stock market has an upward bias, so the longer you hold a good stock, the greater the chance its price will rise. As a call seller, you want to minimize the probability of the stock’s price rising above the striking price, so shorter periods are better.
Keep in mind there may not be too many times when all these things come together for a fundamentally strong stock, so patience is important. Wait until the market gives you what you need and don’t try to force things. Impatience is one of the biggest factors that contributes to stock market losses.
The downside to this strategy is that if exercise occurs, you’ll have to sell your stock at a price below the current market value. However as long as you’ve followed the rules I’ve just outlined, you’ll realize a profit. You can then invest that profit into another fundamentally solid stock and repeat the process.
The upside is that the call may expire worthless and you’ll keep your stock as well as the premium. In that case you can simply write another covered call, theoretically over and over again. Another benefit this strategy gives you is a definite exit price. Many investors find it difficult to know when to sell. Sometimes they hold on too long and watch their paper profits disappear when a stock rises and then falls again.
By selling carefully researched covered calls, you guarantee you will sell at a certain price if the stock’s price rises that high. The decision to sell is removed from your control (at least temporarily).
Finally, this strategy allows you to discount your cost basis. Since you’ve been paid the premium, your cost basis is reduced and therefore gives you a buffer if the price of the underlying stock falls. In effect your losses are less than they would otherwise be had you not written the call.
Covered call writing is an excellent options trading strategy that, when done correctly, can make your portfolio more efficient, more profitable and less risky. In my next article, Options Trading: Selling Puts, I’ll discuss another terrific options strategy, that’s not used as much, but works very well with Value Investing. In fact, Warren Buffett uses it when he invests.
Next Article: Options Trading Part 2: Selling Puts
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