Up, Down or Sideways
by Kevin MatrasNovember 18, 2011 | Comments : 0 Recommended this article: (0)
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After an historic rally in October, but a rather disappointing start to November, everybody is now wondering if the next move will be up (with the S&P 500 reaching 1,350) or if it will be down (with a retracement back to the lows of 1,075).
There's enough ammo out there for both camps to assert their opinion.
On the bull side, the most recent US economic numbers are leading forecasters to raise their Q4 GDP estimates to over 3%, which would be the fastest growth rate in more than 1½ years.
On the bear side however, we have this seemingly never ending European crisis weighing on the world, with everyone wondering if their problems will spread beyond the Euro-zone.
The bull side could easily win out and trump a contained Euro mess. But the bear side could win out and overshadow everything. Or each one could cancel the other one out and we'll muddle thru with no clear direction for a while.
All three scenarios are possible. And it's the question on most investors' minds, because the answer will likely dictate the next move in the market.
But, quite frankly, knowing the answer right now may not be all that necessary to make money in the market, especially if you're an options investor.
Know Your Options
While it's important to plan for any contingency when trading, the fact of the matter is not all stocks are created equal. And regardless of the overall market direction, some stocks will go up, some will go down, and some will go sideways.
And that's perfectly alright.
With options, you can take advantage of all these scenarios.
Buying Calls and Buying Puts
Buying calls and buying puts is one of the most common ways investors trade options.
If you believe the price of a stock will go up, you can buy a call option on it and make money as it goes higher. If you believe the price of a stock will go down, you can buy a put option on it and make money as the price goes lower.
Buying options also provides great benefits such as increased leverage and limited risk.
For instance, buying 100 shares of a $90 stock would require a $9,000 investment.
But instead, you might be able to buy a $90 call option for just $800. That's a significantly smaller investment with a guaranteed limited risk.
If for example the price of the stock fell $20 to now $70 a share, your stock investment would have lost $2,000.
However, at expiration, the maximum you could lose on your option investment would be only $800 (plus your commission and fees).
The option gives you great upside as well.
A $20 move up in the stock price to $110 would mean a $2,000 increase in your stock investment.
However at expiration, that $90 call option would give you a $1,200 profit or a 150% gain.
The $2,000 gain on your $9,000 investment represents just a 22% gain.
A put option works the same way except you're profiting if the market goes down. And buying puts is a great alternative to short-selling.
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Covered Call Writing
Covered call writing is an excellent strategy to use in both up, down and sideways markets.
This is a strategy used to reduce risk and generate income.
In fact, you can even execute a strategy like this in many retirement accounts.
Writing an option is different than buying an option in that you're collecting premium instead of purchasing it.
For example: let's say you have 100 shares of a stock at $110. For every dollar that stock goes up or down, your investment will increase or decrease by $100.
Now let's say you wrote a $125 call option at 6.50. You stand to collect $650.
With me so far?
If that stock were to go down $6.50 to $103.50 between when you wrote the option and expiration, you've just offset $650 worth of your stock's downside risk.
Because while the stock went down, the $650 premium you collected on the option offset it.
If you're worried about downside risk in your stocks, this is a great way to hedge your investment and potentially make money at the same time.
Now let's say your stock stays flat. It doesn't go up or down. Just stays where it is. You haven't made anything or lost anything on that stock. But at expiration, that call option you wrote would have made $650 even though the stock didn't budge.
If the market enters into a period of sideways action, this is a great way to generate returns if your stocks are stuck in a sideways pattern as well.
Now let's say your stock goes up instead. It rallies all the way up to your strike price of $125. That's even better. You've just made $15 on your stock or $1,500. And at expiration, that call you wrote will expire and you'll pocket $650. Your grand total is now a $21.50 gain or $2,150 on a $15 move.
Even if the market goes up, you can profit on the stock movement and the option's income.
Put Option Writing
Another great option strategy is put option writing.
Writing puts lets you collect premiums like writing the calls did. But you can potentially get into a stock you'd like to own at a much cheaper price and get paid in the meantime while you wait.
When you write a put option, you're essentially agreeing to buy that stock at that lower price, if it ever gets to that level. And you'll get paid a premium to do that.
The benefits to this are: if you write an out-of-the-money option on a stock you wouldn't mind owning if it went down, you might just get the chance to own it at a cheaper price than it's currently trading at. If, however, it never gets to that level, you made money by writing the option.
For example, if there's a stock you'd like to own, but at a cheaper price, you might decide to write a put option on it. Let's say the stock was at $110 and you wrote the $95 put option for a premium of 6.00 or $600.
If the stock never goes down to $95 by the option's expiration, you won't get to buy the stock at $95, but you'll have profited $600 for your wait.
Now let's say it does go down to $95 this time. If it does, the option could be exercised and you'd own that stock at $95 a share. But you win again because you now have the stock at the price you wanted and you still made $600 on the option.
Put option writing is a great way to collect premiums and generate income while you wait to buy stocks you like at a cheaper price.
Of course, you don't have to want to own the stock to use this strategy. If you have a belief that a certain stock simply won't go down below a certain price, writing a put option is a way to make money on that.
The Option is Yours
As you can see, there are many different ways to make money in options. And these are just some of the ways you can do so, no matter what happens in the market.
Of course, I hope Europe's problems get solved, the US economy soars and everything is right in the world. If not, however, you can be prepared for any outcome, and make money in options regardless.
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Thanks and good trading.
Vice President, Zacks Investment Research
Kevin Matras is our world-class research expert who has developed more than 30 market-beating strategies using the Zacks Rank. He also directs our service that combines the Zacks Rank with the best options strategies for today's volatile market, Zacks Options Trader.
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