As you know, buying and holding healthy stocks is a very successful long-term profit strategy. When you find a company you believe in, and it performs well for you, you might hold onto its stock for 10 years, 20 years, or the rest of your investing life.
That kind of investing can certainly make up a significant portion of your portfolio - see our guide on the 50-40-10 model for allocation guidelines.
But as you grow more comfortable with the investing process, you can try for bigger, faster returns with options trading.
Options can be low-risk, high-reward - and help you meet your financial goals faster than simply buying shares of a company.
The advantage of options is that you can make money from a stock moving up or down, or even standing still.
And you can do it with relatively little investment up front. The options trade for a fraction of the stock's price.
Money Morning's options trading specialist, Tom Gentile, regularly delivers a wealth of information for those in the options-trading game. If you've been hesitating to make your first trade because you're not sure where to start, we've got a primer to show you the ropes and prepare you to benefit from Tom's expert, proven guidance over the next year and more.
First, let's go over some definitions...
Your First Step to Bigger Profits: Options Jargon Explained
Here are a few terms you'll need to understand in order to begin trading options...
OPTION: A contract to buy or sell a security, at a set price, on or before a set date. Typically in 100-share bundles.
CALL: An option to buy the underlying security.
PUT: An option to sell the underlying security.
PREMIUM: The price paid up front for the option; non-refundable.
STRIKE PRICE: The price at which the option holder can buy or sell the security.
OPTION WRITER: The seller of the option, who sets the terms and takes the opposite position of the buyer (and can then be forced to buy or sell the underlying security by the buyer).
EXPIRATION DATE: The last day on which the option holder can exercise the option.
EXERCISING AN OPTION: When the option holder buys or sells the security at the strike price, thus completing the contract. For a "U.S.-style" option, the holder can exercise the option any time up to the expiration date. For a "European-style" option, the holder can only exercise the option on the expiration date.
CLOSING YOUR POSITION: If the share price hits your target, you could exercise the option and thus buy or sell 100 shares of the stock. But most traders just want their profits. In this case, you would close your position by selling the option on the open market. The price will be adjusted to reflect the change in share price. According to Options Clearing Corp., 70% of options are closed rather than exercised or expired.
AT-THE-MONEY: When the strike price for the option is at or near the current trading price for the security.
IN-THE-MONEY: When the strike price is favorable to the buyer (i.e. lower than the current trading price for a call option, or higher than the current trading price for a put option)
OUT-OF-THE-MONEY: When the strike price is unfavorable to the buyer.
LEAPS: Long-term equity anticipation security - basically an option that expires more than one year from the issue date.
Some Considerations Before You Dive In
In one sense, options trading involves less risk than stock trading, because you are putting up less money on each trade.
It's important to understand that when an options trade goes bad, you can easily lose all of that money. And a string of losses can add up quickly if you're not careful. Even if you're right about a stock's price movement in the long term, you'll lose money if the price doesn't do what you need it to before the expiration date of your option.
So always be aware what you're risking up front, and take emotion out of the equation.
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Of course, options can also be used to manage risk. For example, if you're concerned about the short-term volatility of a stock you hold, you can buy put options that give you the right to sell your shares at a specific price (the strike price) no matter how much the stock falls.
If employed intelligently, options trading can be a great enhancement to your portfolio. So with that in mind, let's look at how you can easily make the most of your trades.
The Simple Steps to Make Options Trading Profitable
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Here are Tom Gentile's four simple steps for successful options trading...
- Find a reward-to-risk trade setup that favors reward: Find a stock that's ready to move. This involves looking at charts and finding repeatable price movements. You'll want to get acquainted with reading a risk chart, which Tom explains here. And you'll want to learn the calculation to find stocks with the lowest "percent to double." That means the stocks with the least distance to move before your option doubles in value, as Tom explains here. We'll also offer a few more ideas to get you started below.
- Utilize a low(er)-risk trading strategy to take advantage of: Options are already a lower-risk strategy to take advantage of stock price movement, because you're risking less capital than buying the stock directly. "Buying longer-term call options that are close to the money can offer both lower cost and lower risk," Tom says, "as well as higher upside returnon investment" than traditional stock investing.
- Have a clear entry and exit plan: For every trade, establish ahead of time how much you want to risk, and under what circumstances you will get in and get out, both on the profit side and the loss side.
- Stay disciplined: Once you've set your plan, stick to it. Don't let emotion derail your trading. Make strong decisions and stay consistent.
With these rules in mind, let's take a look at a few of the ideas Tom has shared to help readers narrow in on the most profitable trades out there.
Three Ideas to Get You Started
You can use options to place low-risk bets on any stock. To help you be even surer about what trades you want to make, here are three ideas to get you started...
- Play a dead cat bounce: This is a strategy to take advantage of a big drop in a stock. This is not for stocks you think are good bets in the long term, but a quick profit play that depends on good timing. When a diving stock approaches its 52-week-low, a call option lets you take advantage of a temporary surge in price. Tom Gentile explains the strategy in more detail here.
- Follow the stock split: Anyone can tell you that when a stock splits, the total value of the shares outstanding doesn't change. That is, if a share valued at $10 splits in two, those two shares will be worth $10 total. But a stock split itself tends to be the sign of a healthy company. After they split, shares tend to find their way back to the original price. This is a perfect chance to double your money with long-term options. Tom explains more here.
- Bet on this one "killer stock" for 2018: Airline stocks aren't known for being the best ones to buy. But Tom has identified one airline stock that showed strong indicators in 2017, and he expects a strong performance again this year. This is perfect opportunity to use LEAPS to take a nice profit without having to invest directly in the stock. "A nice, leisurely, potentially very profitable trade is the perfect way to get even for a miserable flying experience," Tom says. Find out what the stock is here.
Follow Tom Gentile for more ideas throughout the year, and let 2018 be the year you see how rewarding options trading can be.
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About the Author
Stephen Mack has been writing about economics and finance since 2011. He contributed material for the best-selling books Aftershock and The Aftershock Investor. He lives in Baltimore, Maryland.