Traditional stock investing follows one straightforward principle – buy stocks that you think will go up in value. On the other hand, there are dozens – or maybe hundreds – of option trading strategies that can make money. Fortunately, you don't need to be a Wall Street whiz to be a successful options trader.
Choosing one options trading method that works for you may seem especially intimidating to beginners. Here are three simple options trading strategies that can turn modest stock gains of 5% or 10% into 50% or 100%. One of these options trading strategies even shows you how to take a stock you own that isn't going anywhere and collect an instant, low-risk premium.
Here's a breakdown of three popular option trading strategies for beginners: long-term options (LEAPS), short-term options, and covered calls.
Options Trading Strategies for Beginners, No. 3: LEAPS
Most option contracts have a lifetime of six months or less. But for those looking to trade options over a longer time period, "LEAPS" is the perfect answer.
LEAPS stands for long-term equity anticipation securities. Like any options contract, a LEAPS contract gives you the right to purchase a stock for a certain price on a certain date. However, one significant difference is that LEAPS contracts are long-term stock options with an expiration period that exceed one year. Some contracts may even stretch for as long as three years.
With the extended time frame, a LEAPS contract is not an options trading strategy that you would use if you're expecting a quick movement in a stock's share price. Instead, a LEAPS contract gives you a way to boost your potential earnings if you're expecting a significant long-term movement in a stock's price while reducing risks.
Key Features of the LEAPS Options Trading Strategy
- A LEAPS contract gives you access to many more shares than you would be able to buy for the same price.
- LEAPS can also limit your losses if the trade goes against you. When you buy LEAPS, you can only lose as much as you put up in the first place. That would be significantly less per share than you would have spent buying the stock outright.
- LEAPS tend to be more expensive than shorter-term options. The longer time frame means it's more likely for the stock price to move by large amounts. So, if you're expecting a particularly big move in a stock's price to play out over the course of a year, LEAPS contracts offer a way to maximize your profits.
- Long-term options are more sensitive to the underlying stock's volatility than shorter-term options. More time plus more volatility mean more opportunity for the share price to move in a favorable direction.
How to Make Money Using LEAPS
The LEAPS options trading strategy has distinct advantages with substantial money-making potential.
Maximize Your Profits
If you're expecting a stock to rise 50% over the next two years, for example, you could just buy the stock outright and enjoy your 50% gains. But if you bought LEAPS, with the right market factors, you could invest the same amount and triple or quadruple that gain.
Let's say shares of XYZ Company were trading at $15.50. You believe that this stock will be significantly higher within a year. So, you purchase a call option that expires in one year with a strike price of $18.60.
The contract costs you the fee, or premium, of $2.00 per share. Since call options are sold in bundles of 100 shares, say you purchase 1,000 shares. $2.00 x 1,000 shares bring your total investment to $2,000.
You have the option to buy the stock at $18.60, and you bought this right for $2.00. Therefore, your breakeven point is $20.60. In other words, if the stock trades between $18.61 and $20.60, you'll suffer some losses. But if it trades below $18.60, you will have lost money.
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A year later, let's say the stock rises to $23.50. You should close your position and lock in your gains. On the other hand, if you chose to exercise your options, your contract would enforce that you could buy the stock at the strike price of $18.60 and turn around and sell the shares at $23.50. That's a difference of $4.90, or a net profit of $2.90 per share with your investment of $2.00 per share.
You turned a 51% rise in stock price into a 245% gain by using a LEAPS contract instead of purchasing the shares outright, thereby maximizing your profit.
Additionally, unlike trading on margin to purchase stocks outright, this options trading strategy won't put you at risk of a margin call, being forced to sell early, and you won't owe interest on any borrowed shares.
Look for Low Implied Volatility
When you're shopping for LEAPS, you might want to look for stocks that currently have low implied volatility. Option prices typically increase as implied volatility increases. Similarly, option prices, or the premium, normally decrease as implied volatility decreases.
In other words, low implied volatility translates to cheap options. Plus, if that implied volatility rises while you hold the LEAPS contract, the premium would likely be in your favor – even if the share price of the stock isn't.
Bet on a Downturn
Like regular options, LEAPS can be bought as both call options and put options. So, in addition to betting on a stock going up over time with a LEAPS call contract, you can use a put contract to bet on a downturn.
If you see a possible market downturn or predict a decline in a particular sector, you can use a LEAPS put contract to capitalize on the downturn when that time comes.
Hedge Against Your Portfolio
If you are mostly long on the market, as most investors are, LEAPS can provide a way to protect against a crash in a specific sector or the broad market for relatively little risk.
Index LEAPS allow you to track indices, such as the S&P 500. With an index LEAPS put, you can protect your portfolio against adverse market movements. Therefore, if the market keeps going strong, the gains from the rest of your portfolio should cover the cost of your LEAPS. And if the market crashes, your LEAPS puts will rise significantly and makeup for some or all of your losses.
If you're looking for some quick profits, of course, you'll want one of the shorter-term options trading strategies available.
Options Trading Strategies for Beginners, No. 2: Short-Dated Options
While LEAPS contracts may stretch for a year, short-dated options have a closer expiration date, which allow for quicker profits. The duration of standard short-dated options contracts can range from one week to several months.
One distinct advantage of short-dated options is the price. This options trading strategy is cheaper because the window of time for share price movements is shorter with a closer expiration date. As a result, the odds of favorable price movements and substantial profits are lower – along with the price of the contract.
Fortunately, as the price goes down, the potential profit goes up. Short-term options are extremely sensitive to share price movements in the underlying stock. So, if the share price moves in your favor in that short window of time, you can expect an exponential gain.
How to Make Money Using Short-Dated Options
Using short-dated options is one of the best options trading strategies for multiplying your gains more than nine times over during the earnings season.
Earnings season is the period when companies report their performance for the last quarter. It is the ideal situation for options traders because rapid price movements are common when investors try to guess whether companies will meet, beat, or miss earnings expectations. As investors gear up for a company's earnings report, prices swing up and down accordingly.
For example, a stock's share price might rise in the days or weeks before an earnings call as investors anticipate an earnings beat. But even if that earnings beat happens, enthusiasm often wanes, and the share price falls back down near previous levels. So, your best bet is to buy a short-term option and get in and out before the earnings come out.
The strategy is simple.
- Find a stock that has a history of price swings ahead of its earnings call.
- Then, buy a short-term option a few weeks ahead of the earnings report. Call if you're betting on a rise, put if you're betting on a fall.
- Finally, sell the option a day before the earnings call. Remember, you're not betting on the company's performance. Instead, you're taking advantage of traders' tendencies to push the stock price up or down ahead of earnings. Set your exit date and stick to it, no matter what.
You don't have to be successful every time you make this trade in order to reap big profits in the long run. Most investors only put up small amounts of money for each option. However, one big winner can more than make up for a few unsuccessful trades.
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Take the case of Yelp Inc. (NYSE: YELP), which had a continuous pattern of beating market expectations with its earnings as it headed into its May 2018 earnings call. As expected, its stock price rose in the weeks leading to that report. Shares went from $44.83 to $47.92 between April 18th and May 9th, the day before the announcement.
That's a modest 6.9% gain in less than three weeks all because traders were excited about Yelp's earnings call. On the other hand, if you had bought a short-term in-the-money option for $3 per share, you could have sold it on May 9th for $4.92 per share.
That's a 64% gain. If you had put $900 into that trade, you would have collected $576 in profit in just 20 days.
That gives you an idea of the kind of money you can make from a simple options trading strategy.
Options Trading Strategies for Beginners, No. 1: Covered Calls
Some investors sell call options rather than buying them. They "cover" the call by either buying shares upfront or by selling options for stock they already own.
When you sell covered calls, you collect a premium from the option buyer when they purchase the option contract. Of course, the contract stipulates that the buyer then has the right to buy the underlying stock from you at the strike price when the option expires.
How to Make Money with Covered Calls
Covered calls are best used when you already own the stock and plan on holding onto it for a while. It is also critical to employ this strategy when you don't expect significant movement in share price.
The inherent risk with this strategy is that the underlying asset's share price might rise beyond the contract's strike price. If the share price goes up in the options buyer's favor, the buyer will exercise his options and you'll to sell your shares for less than the current market rate. Fortunately, according to the Chicago Board Options Exchange (CBOE), only about 10% of options are exercised.
Even in this worst-case scenario, a covered call is still less risky than many other options trading strategies. You get to keep the premium that you collected when you sold the option contract no matter what. Additionally, the premium should more than cover any loss from selling your shares at the strike price.
Alternatively, if the share price stays the same or goes down, the buyer won't exercise his or her option. Ultimately, you'll keep both the premium and your shares.
This strategy lets you capitalize on a lull in the stock's otherwise strong long-term trajectory. It is perfect for the investor who wants to utilize more conservative options trading strategies.
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