Options in Three Rules
We are here to make money. My rules to trade options are directed at the use of options to make money, sometimes, lots of money. If you are looking to learn what the terms mean or about a dozen different complicated uses of options, Google it. I am a practical man (except when it comes to women) and what I am presenting is a practical approach and strategy for the of use options in trading. This is not meant to hold your hand, it is meant to open your eyes.
First you have to let go of everything you have learned from other sites about options. What a bunch of crap and that goes for those guys on CNBC during the middle of each day. Spreads, credit spreads, butterflies, reverse butterflies, writing calls, protective calls, writing puts, protective puts, bums, thumbs, thumbs up your...well, you get what I mean. All of these are designed to to be risk averse, limit losses, limit gains, generate high win rates and tiny profits. Give me a break, that's not why I buy options.
I buy options for two outcomes: Home Runs and Grand Slam Home Runs. Anything less and you may as well stick with leveraged ETFs which will generate much better returns then fooling around with exotic option strategies while taking a whole lot less time and generating a lot less anxiety.
THE THREE RULES
Once I get a good set up like a fresh Trend Signal or a Wave Five Signal I look at the chart and see just how volatile the stock has been in the past. A stock that has the habit of moving 10% in one or two months is a prime candidate for options. A stock that has more of a sideways tilt moves too horizontal for me. I like the more vertical charts for options.
click to enlarge
VXX Daily Trend Model: Vertical
We have seen VXX pop 25-50% on 5-10% declines in the market averages and as you can see above, the pops in price usually take place in 4-6 weeks. My latest option trade, the VXX at-the-money calls (ATM = stock is at 23; call with a strike price of 23), went from 4 to 26 in about six weeks. That is a gain of about 550% - a grand slam home run. That is the why and how you buy options. Not a stupid spread where, "if VXX goes to 25 and you make 30% but you can't lose more them 10%." Yes, that's how some option strategies work and there are services out there that get good money for that kind of advice.
Above is Verizon (VZ). Most of us use their network, but it is a poor candidate for options. It has drifted between 32 and 38 for the past six months. Sure, you can make 25%, maybe even 50% if you were lucky, but why waste your time and money? If I can't make 100% or better on an option opportunity, I'm passing. This is the same theory that guides our trend following system. If a stock/ETF/index has a tendency to trend for long periods, it's tradable. If it is a choppy house salad, pass.
MCP - Short, But Vertical Trends
The chart of Molycorp (MCP) illustrates how sneaky some option opportunities can be. At first glance, it looks choppy. But take a closer look at the size of those moves: 55-75 in two weeks; 75-45 in two months; 45-65 in two months; 65 back to 45 in ten days. That's four opportunities to at least double the value of your option each time.
RULE NUMBER ONE IS TO FIND A STOCK THAT HAS VOLATILITY; THE TENDENCY TO RISE OR FALL VERTICALLY WITH RELATIVELY LARGE PERCENTAGE MOVES.
There are a lot of option strike prices and months to chose from. Believe it or not, we are looking for the same characteristics as above. How far (in percentages) does a stock/index/etf move and how long does it take it to move there? Note that I bought the December VXX calls and I bought them in July. Why? Because I thought that sometime between July and December there was a high likelihood of the market falling 10% which would have resulted in a least a 100% gain in VXX and a 400-500% gain in the VXX calls. I got lucky, the market dropped 15% in about two months. You read the results above, 550%.
Below is a wide angle shot of IWM covering one year. The price decline was a no brainer, put options went up triple digits easily. But what about that long rise between September and May? Just eyeballing the x and y axis, it appears that IWM went up at the rate of about 5% per month. That means 10% in two months and 15% for three months. If you look at the option tables, a 2-3 month option would have risen about 10% for every 1% that IWM went up. If you bought an ATM call (because the IWM Trend Model was bullish that entire move) 2-3-4 months out, it would have at least doubled after two, maybe three months and the rise lasted long enough for you to slap another call on when the first one expired and pyramid the trade.
IWM: Wide Angle View of Tradable Trends
RULE NUMBER TWO IS TO GIVE YOUR OPTION ENOUGH TIME FOR THE PRICE MOVEMENT TO PLAY OUT.
There is one more rule but before I get to it I need to explain a commonality of Rules Number 1 and 2. They are my rules, they are not taken from any text on options (of which there are plenty) or any options "guru" or any options oriented subscription service. They have been formed from my experience trading options which goes back to the summer of 1978 when my friend Jack and I doubled our money on Occidental Petroleum calls that were recommended by a Merrill Lynch stock broker. The broker had phoned me with the trade idea while Jack and I were renting, "The Jason" house in Chilmark on Martha's Vineyard. We didn't know what we were doing, hardly knew what options were and found out many losses later that as little as we knew about options, that Merrill Lynch broker knew a whole lot less.
RULE NUMBER THREE: GET LUCKY
This is how it works for me and there is no reason it can't work like this for you. I plan and implement my option trades in accordance with the first two rules above. Sometimes they work, sometimes they don't. On any one option trade the maximum loss is 100%. On any one option trade the maximum gain is theoretically unlimited. A handful of 100%, 200%, 300%, 400% and 500% (and up) gains covers a lot of failed option trades. Using the rules above along with our Trend Models and our designated pinch-hitter, the Wave Five Buy/Sell Signals, we have a huge advantage getting the direction of the move right, which weighs the trades in our favor.
With the right stock/ETF/index, the right direction, enough time and a little bit of luck, options can be a very lucrative tool in our trading arsenal. Remember, you can lose it all if these factors don't come together just right, but when they do, expect an explosion of gains and ego.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.