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Why Stock Options?



Stock Options – Potential is Phenomenal for Profit Making!


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stock options

February 18, 2012

The barrier to entry for options is now next to nothing. Any investor can participate. More products with highly efficient markets are being introduced. These are indeed exciting times in the options arena.

But because options remain so foreign to many, the self-directed investor is hesitant to participate.

Stock options are considered too complex! Most professional brokers know next to nothing about options. And even the people who know how to use them don't know how to use them effectively.The most common strategy is buying out-of-the-money calls or puts. It is complete speculation -- a trade with a very low probability of success – if certain strategies are not employed! However, you could make quick money and lots of it -- but if there is a lack of a statistical advantages encompassed, the strategy would inevitably fail.

Most traders today still use stock options as pure speculation and don't realize the true potential of stock options. They don't want to actually think about using an options strategy to gain a true statistical advantage. They would rather guess, just like buying or selling a stock, if the stock or ETF will go up or down. Playing in such a zero sum game is a losing proposition over the long haul.

Now that we've reached a period that offers a low barrier to entry, it makes perfect sense to use options to their full advantage. Commissions are low and products are highly liquid. If you use the appropriate products, there is truly no edge now for the market makers.

Simple Strategies To Use

Two stock options strategies that are simple to understand and implement are:-

• A directional strategy of buying calls and puts. The strategy is based on overbought/oversold indicators.

• A credit spread strategy. Again, the strategy is based on overbought/oversold indicators.

Both are easily turned into bread-and-butter strategies.

Indicators to use for the Stock Options Strategies

Keep it simple – K.I.S.S. -- follow what you know -- trade what you are comfortable trading.

An example

Keep a list of 30-40 ETFs that have highly liquid options. By using ETFs they offer some of the most liquid products in the options market. And you don't have to worry about unforeseen risk, such as bad earnings, that often occur with owning individual stocks.

However, the strategy can also be used for individual stocks, which is fine. It's all about your comfort level.

By keeping a list of ETFs it is easy to follow the short-term, overbought/oversold readings of each on a daily basis.

This can be accomplished with the RSI (5). RSI, otherwise known as the "relative strength indicator"”, is a technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of the ETF.

It is now a case of being patient and wait for a short-term extreme to enter one of the ETFs and then you need to begin to seriously consider a trade opportunity. Waiting for the opportunity is one of the hardest aspects to learn as a trader.Traders inherently like action, but patience can be a virtue – and in this scenario – win or lose – profit or loss!Opportunities can be made up easier than losses.

An Example of how to use RSI (5) in a Trade

June, 2011 -- the market surged for eight straight days starting at the end of the month. The surge lasted until July 7, at which time the Nasdaq ETF (QQQ) had pushed into a short-term overbought extreme.

If you look at the RSI (5) reading in the chart below, you'll see that a short-term overbought extreme had been hit (green circle). The next step is to make sure the other proprietary indicators line up. If they do, then fade the move.

Fading just means that you place a trade that opposes the current trend. In this case the move was higher, and therefore you buy puts. If the market had declined sharply and moved into a short-term oversold extreme, you would have bought calls.


stock options


The Trade

When entering the trade, always look for a ”delta” between 0.50 and 0.70. This means that for every one-dollar move in the underlying ETF, the option will move between 50 and 70 cents, so you will make $50 to $70 per contract. Moreover, look for an option price in the $2.50 - $3.00 range.

The reason to choose a delta in the 0.50 - 0.70 range is for risk-management reasons. Choosing an option with a delta of 1.00 is way too risky and potentially fatal if the underlying ETF moves in the opposite direction of your position. A delta below 0.50 would require a large move in the underlying ETF and you don't want to wait for an extended move.

Remember, this part of the strategy takes advantage of short-term extremes. The idea is not to be in a trade for longer than a week if you have to.

Therefore, with QQQ moving into a short-term extreme on July 11, you would have bought QQQ puts for $2.77. Two trading days later, you could sell the puts for $3.23.

Again, keep it simple - very simple.

Simple equals boring, and often that does not entice traders. But you are not here for excitement; you are here to make sound options strategy work which in turn will make money over the long haul.

With these short-term directional trades, tend to keep your position size small. However, when diversified with a credit spread strategy you are able to take care of short-term moves while generating monthly income. It's the best of both worlds.

Expectations from the Market in 2012 as a Stock Options Trader

Try not to guess where the market is headed over the intermediate to long term. It is truly a fool's game. The crystal-ball approach is basically useless to investors. No one knows where the market is headed over the next year. If they say they do, then you might want to reconsider where you get your information from.

What is important is that 2012, like every year, will present short-term extremes in the market. As always take advantage of these extremes by applying sound, logical options strategies. Eventually your approach becomes mechanical. Patiently wait for short-term extremes, apply the right strategy to fit your assumption on the extreme and then allow time decay or your directional conviction to play out. It is quite simple – if your approach works and provides profits keep it the same -- whether it's 2012 or 2020!

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