Why Would I Want to Learn About Options? (Part 2)

rianieriIn my last article, I started to detail the advantages that options give to the individual investor and trader. I did this with the sole purpose of showing you why it is important; and possibly more critical, show you how to use options properly…before for you spend the time, effort, energy, AND money.

In this article, I am going to continue to give you more reasons why options are advantageous to your ability to make money in today’s ever-changing market. In order to increase your chances of making money in today’s market, you better realize that you need to be able to play both directions. The days of simple “buy and hold” are long gone.

Today, you need to be able to make money… not only when things go up…but also when they go down! In order to do that, an investor would need to be able to short stock. However, between SEC and individual brokerage firm rules, shorting stock can be very difficult. The best way to get around this is to use options.

Using Options to Short a Stock

Depending on the broker you use, there are a mess of rules that can make it nearly impossible to short a stock. Certain types of accounts don’t allow you to short stocks. The ones that do often make it cost prohibitive. But, every broker, in every account, allows you to buy puts. Puts give you the right–but not the obligation–to sell the stock at a pre-arranged price (strike price) by a certain time (expiration date).

When you own a put, you have initiated a short position. For example, say the stock is trading at $100. You think the stock is going to go down. If you were to buy the 105 strike put, you will have the right to sell the stock at $105 anytime between now and expiration. The value of that put will be at least $5 because if you can sell the stock at $105 while it is trading at $100 in the open market, then there is a $5 value (intrinsic value) to that.

Now, if the stock were to trade down to say $90, then the puts value will increase. With the stock now down at $90, the right to sell it at $105 is now worth at least $15. So, the increase in the value of the put as the stock goes down is your profit. You have now profited from the stock going down. Your long put worked mechanically the same way a call would work on the way up. The reason you can buy a put so easily (at least much more easily than shorting stock), is that you only risk the amount of money you spent on buying the put. This sets up a risk scenario that brokers and the SEC alike find more acceptable than shorting stock.

This limited loss scenario is another one of the advantages of options. When you buy an option, you can only lose what you spent on the option. With that said, buying options allows you to have complete control of your risk by allowing you to manage the total dollars you have invested. You can’t lose more than you spent no matter what! Control what you spend and you control what you can lose.

Is Selling Options to Generate Income Ever a Good Idea?

Buying options does help you control your risk but selling options allows you to generate income. By selling options, you take advantage of the decay of the options extrinsic value. While I do not allow any of my students or traders sell an option without owning another option against it (no unhedged positions allowed by me), I do value the ability to collect premium while being fully hedged. Generating income is very important to consistent market returns and options allow you to do this in a safe and efficient manner.

Where there are a few more advantages that options offer to the investor, there is one that stands out more than the others. It is the one that I use to sway the opinion of the most staunch critics and doubters of options. This is a big advantage that options give you that stocks don’t; it is the ability to lock-in profits and diminish risk… without decreasing your position size. This can be done using the Rolling Technique.

How many times have you sold out your stock position due to the fact you were worried about losing what you have made in profits… only to watch the stock continue to trade up but without you? Rolling can solve this problem for you!

Using the Rolling Technique to Purchase Cheaper-Priced Options

The Rolling technique involves the sale of the option you currently own and the purchase of the same amount of another, cheaper-priced option. The credit generated by the transaction is a portion of your profits being locked in. Further, the option you are now in is a cheaper dollar option, thus exposing you to less risk than the option you were previously in. This will allow you more room and time to be patient and really let your winners run!

There are other advantages, but I think you have enough now between these two articles, to see that spending the necessary time, effort, energy, and money in learning how to properly use these techniques is critical to your ability to safely and efficiently make money in the market today… and in the future!

Ron Ianieri is owner of Ion Options a company he started in 2010. He is also lead instructor at Options Monster Education and editor of the highly successful newsletter “The Income Strategist”. Ron has been trading options for more than 27 years and is also the author of the book “Options Theory and Trading” published by John Wiley and Sons.  Currently Ron travels the world teaching investors the same successful Options class he developed during his years on the trading floor.