Simple Stock Option Trading Strategies for Success in 2012

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Simple Stock Option Trading Strategies for Success in 2012

In similar fashion to the previous decade, the S&P 500 finished 2011 in the same place it started. Incredibly though, from July 27 through year end, the Dow traded up or down by more than 100 points in two out of every three trading days. Despite the broader markets finishing the year flat or slightly higher, many traders and hedge fund managers were positioned incorrectly for the high volatility and suffered extreme losses.

Macroeconomic uncertainty remains high and this year will likely be highlighted by more dramatic market swings and lack of direction. Despite slight improvement in some U.S. economic indicators, conditions in Europe appear to still be worsening, most notably the fiscal problems plaguing southern European countries. As such, a strategy to capitalize on high volatility will again prove valuable in 2012.

For success in years like 2011, decades like 2000-2010, and likely again in 2012, one must have a strategy to capitalize from high volatility while not getting shaken-out by being wrongly positioned to the market’s direction. Fortunately, an option writing strategy can provide high returns while limiting risk, regardless of market direction, or lack thereof. Such a strategy not only benefits active traders, but can also provide longer-term investors needed protection for an equity portfolio.

(Writing an option contract is selling a contract, or contracts, to buy or sell 100 shares of an underlying stock. By writing one call option for XYZ stock at a $50 strike price, the buyer of this contract has the right to purchase 100 shares of XYZ stock from you at $50/share if XYZ closes above $50 on the option contract’s expiration date. Similarly, by writing a put option contract on XYZ at $50, the buyer of the contract has the right to sell XYZ stock to you at $50/share if XYZ closes below $50 on expiration day.)

In 2011, option writers were provided some of the best opportunities I have seen in 12 years trading. Due to high overall market volatility, many individual stock options were, and remain, consistently overvalued; however, the historic probability for profit has remained the same: 70% of all stock options expire worthless, thus, writers have a 70% probability of profit.

Now, remembering that historically 70% of all options expire worthless on their expiration date, the probability of profit for the option writer is already much greater than that of the option buyer. Without doing any due diligence, the option writer already has history on his/her side. To shift the probability for profit even more in the writer’s favor, one must identify options that are fundamentally overvalued. (Inversely, option buyers must identify options that are undervalued.) A basic option-pricing program (which can be found for free on many financial websites) can provide this information to any trader.

Two components comprise a contract’s value: time value and intrinsic value. Time value is the premium one pays for the time remaining until expiration. Intrinsic value is the dollar amount above (for call options) or below (for put options) the underlying stock’s strike price. Time value’s core component is volatility. The greater the volatility of an underlying stock, the higher time value attributed to its corresponding options.

Furthermore, before writing a put or call option contract, the prudent trader will not bet against the broader market’s underlying direction. A successful option trading strategy, whether as a writer or buyer, should align with the direction as the broader markets, not against it. Option traders lose fortunes attempting to call a top or bottom in a market in hopes of hitting a home run. The broader market trend is a trader’s friend, not enemy. To consistently achieve above average, consistent returns, resist the temptation to attempt to call a market top or bottom. When direction is more difficult to determine, focus on the three-month trend, and adjust strategy accordingly before writing new positions.

A final, but very important, point is a reminder to contain losses. Logically, a trader can’t make money unless he or she can come back to play again tomorrow. This may seem obvious, and easy to control, but countless traders become emotionally attached to their positions and won’t admit defeat. Based on probabilities, we are all going to experience losing positions. Do not «average down» in hopes of salvaging a position, cut your losses at 10-15%. Contained losses are part of the game. Extended losses can, and will, ruin any trader.

Whether your goal is trading for income, protecting an equity portfolio or increasing returns, employing an option writing strategy encompassing the above-mentioned factors can greatly increase one’s probability for consistent profits in 2012 and beyond.

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