Can stock options be risky investments? Yes, they can be if you do not know how to properly trade them. This includes understanding all the available strategies option traders can use, which stocks simply cannot provide.
For the past seven years, I have been a full-time options trader. This is how I make my living. This is easier said than done. However, by reading and actually trading you will learn how to be successful. The key is to find how you like to trade options and to stay consistent.
In this article, I will mention the many successes and pitfalls that I have had trading options and what I have learned over the years, but also the mistakes I have seen others make. While my trading style may not suit everyone, my hope is that it may provide some clarity about options and the many different strategies they offer traders.
One of the most important aspects to being a successful options trader is finding a strategy and method that fits your expectations and style of trading. This can take a long time for beginners to figure out. I do recommend "virtual trading," to test out different strategies. The list of available option strategies is vast. Here are some of my personal favorites:
- Buying long calls
- Buying long puts
- Iron condors
- Reverse iron condors
- Butterfly spreads (long put butterfly)
- Weekly options strategies
- My daily options trading strategy
Often times, a beginning options trader is bouncing around from different strategy to different strategy. One of the first things I tell a new options trader is to focus on a select number of stocks initially. If you are interested in technology, then following Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Intel (NASDAQ:INTC), Research In Motion (RIMM), and others in the same sector is a great start. Understanding how a stock moves is beyond important.
One of the key aspects with my daily options strategy that I developed over seven years ago is that I mainly focus on nine stocks exclusively. Every single day, I have the same stocks up on my grid chart.
I currently use the following stocks for the daily options trading strategy:
- CF Industries (NYSE:CF)
- Wynn Resorts (NASDAQ:WYNN)
- F5 Networks (NASDAQ:FFIV)
- Intuitive Surgical (NASDAQ:ISRG)
- Chipotle Mexican Grill (NYSE:CMG)
- VMware (NYSE:VMW)
- Baidu (NASDAQ:BIDU)
- Salesforce (NYSE:CRM)
- Las Vegas Sands (NYSE:LVS)
- Direxion Financial Bull 3X (NYSEARCA:FAS)
- Direxion Financial Bear 3X (NYSEARCA:FAZ)
- EMC Corp. (EMC)
- Marvell Technology (NASDAQ:MRVL)
- MGM Resorts (NYSE:MGM)
- Alcoa (NYSE:AA)
- Citigroup (NYSE:C)
- Nvidia (NASDAQ:NVDA)
- SanDisk (SNDK)
- Research In Motion
- AK Steel (NYSE:AKS)
The point here is that after watching these stocks on a daily basis for such a long time-frame, it is easy for me to spot when a particular stock has bottomed or topped daily while also using the technical indicators. If I were to put a stock on that list tomorrow that I was not familiar with, I definitely would not be comfortable making a trade as quickly as I would with the stocks I do follow. This applies to all trading. It is never a good idea to try to catch a upward or downward trend with unfamiliar stocks. The chances are high that by the time you are in the trade, it has already topped or bottomed. Stick to what you follow.
If you have not read any of my daily options trading strategy articles, I highly recommend that you do. There are literally hundreds of comments on those articles and I have answered just about every question asked. It is really a great strategy. One of the reasons I wanted to share it with the public is because I knew how successful it would be for so many traders. Here are the links to all five of the articles in the series:
- Part 1: seekingalpha.com/article/296636-profiting-daily-with-cf-industries
- Part 2: seekingalpha.com/article/304428-a-daily-options-trading-strategy-for-high-flying-stocks
- Part 3: seekingalpha.com/article/310018-daily-options-trading-strategy-charts-notes-a-new-addition
- Part 4: seekingalpha.com/article/310018-daily-options-trading-strategy-charts-notes-a-new-addition
- Part 5: seekingalpha.com/article/314770-the-daily-options-strategy-part-5-final-notes-charts-and-alternate-stocks-to-use
The daily options strategy took me a long time to develop. I back-tested it for years and knew that I was really onto something. It came about because of my frustration with the lack of any information or strategies on how to trade options daily with any sort of success. There was nothing concrete. I hope my strategy fixes that problem for you.
What I have also learned over the years with options is that being a neutral-based trader is the quickest way to success when there is not a value play (buying long call options) or extreme overbought circumstances (using put options only). Options can be tempting with the leverage they provide. If you continue to only take one side of a trade (calls or puts), you will have difficulty maintaining any sustained profitability. This is especially true when trading earnings releases.
I personally refuse to trade earnings releases using only a bullish or bearish position. It is simply playing with fire. You will hit some major winners by taking only one side of a trade, but your losses will wipe out any profits you did have. I could write a book on the horror stories I have heard over the years from option traders who picked the wrong side of the trade before earnings, including some of my own in the early days. It is not a good spot to be in and it is extremely stressful. You are at the mercy of the numbers that a company reports and how the markets react to it. Owning only call options for an earnings trade presents the following problems:
- a company must usually meet or exceed estimates on earnings-per-share (NYSEARCA:EPS), revenue, and margin.
- the company must give positive future guidance and estimates
- the conference call must go well
- market conditions as a whole can also play a major factor in deciding how the stock trades post-report.
Two trades I really like to use for an earnings trade are the 'strangle' and the 'reverse iron condor' spread. Both are neutral strategies, with the reverse iron condor' requiring much less of a price move, but also limiting upside potential.
The 'strangle' limits your overall investment and is a great strategy to use with the following stocks:
- Netflix (NASDAQ:NFLX)
- Mastercard (NYSE:MA)
- F5 Networks
- CME Group (NASDAQ:CME)
- Akamai Technologies (NASDAQ:AKAM)
- Intuitive Surgical
- Amazon.com (NASDAQ:AMZN)
- Priceline (NASDAQ:PCLN)
- and more
The 'reverse iron condor' is a great trade to use before a company reports earnings. What I really like about this strategy is that it can be used with a larger amount of stocks than the 'strangle' or 'straddle' trade, but especially with stocks that have weekly options. For example, it is a bad idea to use a 'straddle' with JP Morgan Chase before earnings. The stock does not move enough post-earnings report to offset the cost of the trade. The 'reverse iron condor' spread, on the other hand, fits perfectly.
I will show you an example of two JP Morgan trades, the first using a 'straddle' strategy and the second using a 'reverse iron condor' spread. I will use January 2012 as the expiration date and $2,500.00 as the amount at risk.
Trade #1: JP Morgan 'straddle' - January 2012 expiration. The stock was trading at $33.25/share on December 30, 2011:
|Buy 10 JPM Jan12 33 Call||$1.23||$1,230.00|
|Buy 10 JPM Jan12 33 Put||$1.22||$1,220.00|
Current Price: $33.25- ( ) = in the negative
|Price||Profit / Loss|
Trade #2: JP Morgan 'reverse iron condor' spread. January 2012 expiration. The stock was trading at $33.25/share on December 30, 2011:
|Buy 35 JPM Jan12 33 Put||$1.20||$4,270.00|
|Sell -35 JPM Jan12 32 Put||$0.78||($2,800.00)|
|Buy 35 JPM Jan12 34 Call||$0.74||$2,660.00|
|Sell -35 JPM Jan12 35 Call||$0.41||($1,435.00)|
Current Price: $33.25
|Price||Profit / Loss|
It is important to remember that JP Morgan does not have a history of making extremely large moves after reporting earnings. To an inexperienced trader not familiar with JP Morgan, the 'straddle' trade may look more enticing. After all, the potential profit is much greater than the 'reverse iron condor' trade. However, looks can be deceiving.
With the 'straddle' trade, the two break-even points are $30.55 and $35.45. With the 'reverse iron condor' trade, the two break-even point are much narrower, at $32.29 and $34.71. This may not seem like a big difference, but for a stock such as JP Morgan, this is significant. There is a possibility that the 'straddle' trade could work, but it is more risky that the 'reverse iron condor' spread. A 'strangle' should never be used for JP Morgan Chase as an earnings trade.
Currently, the 'reverse iron condor' spread could have been sold for a profit, as JP Morgan is trading at $36.05/share. The strangle trade still needs more upside price movement over $2.00/share and looks shaky right now.
There are many other option strategies that work great using a neutral strategy that requires little price movement. The 'long put butterfly' spread is such a strategy.
The 'long put butterfly' spread is a three "leg" trade that is a limited profit, limited risk options trading strategy. This trade can be used to great effect with the following stocks or ETF's using weekly or short-term expirations:
- Microsoft, Inc. (NASDAQ:MSFT)
- Intel (INTC)
- American Express (NYSE:AXP)
- General Electric (NYSE:GE)
- Johnson & Johnson (NYSE:JNJ)
- and many others
Here is how the 'long put butterfly' spread is accurately placed:
Long Put Butterfly Construction
- Buy 1 OTM Put
- Sell 2 ATM Puts
- Buy 1 ITM Put
This is an example of a 'long put butterfly' spread trade I will place on Wednesday with Microsoft trading at $27.84/share.
- Buy (10) MSFT January Week 2 $27.00 put options
- Sell (20) MSFT January Week 2 $28.00 put options
- Buy (10) MSFT January Week 2 $29.00 put options
Current Price: $27.84
|Price||Profit / Loss|
Ther are many great websites available that provide a lot of valuable tools and information. Here is a list of a few that I recommend visiting:
- www.cboe.com/ - The chicago Board Options Exchange homepage.
- www.cboe.com/framed/IVolframed.aspx - CBOE IVolatility Options Calculator.
- www.theoptionsguide.com/ - The Options Guide - great site with many different option trading strategies. Highly recommended.
- www.finviz.com/screener.ashx - FinViz homepage. One of the best stock screeners around.
I will have another article next week on some more exotic options strategies that may appeal to traders.
If you have any questions, please do not hesitate to ask me in the comment section or by e-mail. I will try to respond as soon as possible.