When I was in seventh grade we had a big science project. I decided I wanted to do a mouse maze to see if mice could be trained to navigate a real-life maze with increasing speed, given various rewards, etc.
Building the maze required cutting a lot of pieces of wood to fairly exact specifications. My dad taught me how to measure accurately, mark the wood, and make a clean cut with a hand saw.
After an hour, I had about four or five pieces of the maze done - about 35 to go...
My dad, comfortable with my level of care in using the hand saw, showed me the hand-held electric reciprocating saw.
Used correctly, I could cut 10 times as many boards in the same amount.
The problem was that used carelessly, it could make a bad cut or, worse yet, could endanger a whole finger...
So dad took great care in showing me the safety rules and procedures for using the power saw. After significant training and under his watchful eye, I transitioned to using the much more powerful tool, with fantastic results.
Despite the added risk, dad showed me how to use a power tool to get the job done fast and safely. I'd like to reintroduce you to one of our most potent trading power tools today...
I recently put out an options trade idea (QQQ calls) that sprang up 49% within two days and then dropped back to breakeven as I write this. (More on the state of the markets - and your QQQ trade - at the end of this article.) However, many of you are new to options and were having difficulty piecing my instructions together.
Since the "how to" of options trading has not been a recent focus in our articles, I'd like to take some time to do three things:
- Explain the benefits of options
- Give you a special look at the "how to's" of call options, first published in my elite service, Stealth Profits Trader
- Bust some common options myths and explain how to use options properly (getting the greatest reward while managing your risk)
I've enlisted the help of one of my great friends and longtime collaborators, Money Map Press Editor William Patalon III, to help with the mythbusting section. I always enjoy my conversations with him, and I know you will, too.
Here's what you need to know in order to use these very powerful tools to profit.
How to Use Options to Get Incredible Profit Leverage
Options are one of the simplest ways to multiply your money. While they're not right for every trader or investor's risk tolerance, for many people they're the best way I know to take a small underperforming part of your portfolio and multiply it rapidly on the way to your first - or your next - million dollars.
In simple terms, options are tradeable instruments that allow a trader to do the following:
- Use a small amount of money
- To control a much more expensive thing (asset)
- For a set period of time
In the case of options, we use a small amount of cash to control a large amount of stock for a set period of time. Because that stock is under our control, we receive the gains and losses made in the stock while we control it.
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We have a term for this control of a much more valuable thing with a small amount of money. We call this leverage - the same term we use when a lever is used to move a big thing with only a small amount of force.
This use of the leverage of options is a power tool for your trading. And like any power tool, we can be excited about the great benefits it brings us while being very aware of the safety practices needed to use them properly.
Options Myths - Busted
The next time you're talking with a group of "informed" investors, bring up the topic of options trading. Before long, someone in your group will cite the supposedly well-known statistic that more than 90% of all options expire worthless.
And most of the other folks will nod in solemn agreement.
Because options have big potential rewards and substantial risks, regulators want us to believe that options are to retail investors what Kryptonite is to Superman.
Because of that, the "90%" stat is presented as trading gospel and is cited over and over and over again - in speeches, in magazines, and in investing analyses of every type.
In fact, I was at a recent conference where a well-known investor quoted the number he learned in business school as 98% of all options expire worthless.
There's only one problem.
It's just not true.
In fact, it's one of the biggest investing myths of all time.
Here's how I answered this very line of reasoning in a conversation with Money Map Press Editor William Patalon, III, just a few months ago...
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William Patalon, III: D.R... you and I are talking here to, in essence, "bust the myth" about options trading... to blunt the belief that trading options is the stock market equivalent of a "fool's errand."
In fact, just the opposite is true... isn't that right?
D.R. Barton, Jr.: That's right, Bill. Traded correctly - with the right underlying "mindset" and with the correct trading system - options are certainly the quickest and most-powerful way to string together really outsized gains.
WPIII: And with lower risk.
DRB (nodding): With specifically managed risk - especially relative to potential reward.
WPIII: Let's go through all of this... because it's a conversation you and I have had many times... and I'm betting folks will find it as fascinating - and as downright surprising - as I did.
DRB: Fire away.
WPIII: And let's start with the obvious.
There's a good reason the idea of trading options terrifies so many investors: The statistics that are often bandied about make it seem like a losing proposition.
DRB: That's exactly how it appears.
But it's a myth... and a myth I can "bust"... fairly easily.
Let's start with the myth itself...
A few years back, the Chicago Mercantile Exchange (CME) did a very detailed study looking at options. It looked at expiring and exercised options over a period of three years - 1997, 1998, and 1999 - and found that an average of 76.5% of all CME options held to expiration expired worthless.
WPIII: Out of the money...
DRB: Yes... out of the money... worthless.
And this was a pretty consistent finding - across all three years - with 76.3%, 75.8%, and 77.5% expiring worthless, respectively.
WPIII: So, from this general level, we can say that for every option exercised "in the money" at expiration, there were three options contracts that expired "out of the money" - hence, worthless.
That means option sellers had better odds than option buyers for positions held until expiration.
DRB: That's right, Bill. Except that there are several problems with the way the results are interpreted.
First, let's talk about the numbers and the fact that the "picture of futility" that the CME data represents is based on holding options to expiration. But we're traders... so, by definition, when we buy options, we never hold them until expiration.
Second is the fact that many folks treat options as "lottery tickets." People buy options that are really, really far from the current price - which, in the language of trading, is referred to as "deeply out-of-the-money options." They do this because the options are cheap in price. And because they're "moonshots" - meaning that, if they hit, they hit big. That's their allure. But it's also their weak point. Like most long shots, these don't pay off: Practically all of these lottery-ticket style options expire out of the money. And worthless.
WPIII: And that drives up the overall percentage of options that expire worthless as reported by the study.
DRB: Exactly. So instead of looking at what would happen if held onto options in the least advantageous way, as the study suggests, we focus on probabilities for profit opportunities on shorter-term plays. And, of course, on managing risk.
WPIII: Let's start with the "opportunity" concept.
DRB: Sure. There are opportunities to use the leverage of options to make very large profits in a short amount of time.
WPIII: And what's really striking is that you're able to do this - even if the market or the stock you're trading is making very small moves.
DRB: Yes. That's because - if we use the natural monetary leverage of options - we can find trading opportunities with high probabilities for quick moves and make big returns... with only a modest move in the stock or index we're trading.
WPIII: And when you say "big returns," you're even talking about the potential for triple-digit returns.
DRB: That's right.
WPIII: OK... and I can almost hear some folks out there saying, "That's great, D.R., but how can I build large amounts of wealth if so many options expire worthless?"
DRB: I'm glad you asked that.
Remember how - just a moment ago - I said that those daunting, high percentages for options expiring worthless was just an "average?" Well, here's where that comes into effect.
WPIII: As well as the concept of "probability."
DRB (nodding and smiling): And the concept of probability.
Those terrible CME numbers were averages of options trades across ALL sectors, across ALL time frames, across ALL markets, and across ALL situations (backdrops).
As a trader, I don't operate in that manner.
In my book, The 10-Minute Millionaire, I explain how my trading strategy is designed to identify stocks (and therefore, the associated options) that are trading at an "extreme."
Said another way - I only have us buy options when the market probabilities are in our favor - when we have an edge.
That's why I developed my 10-Minute Millionaire system, to take the guesswork out of something that's otherwise very tricky. The system serves as a kind of "radar" that lets me zero right in on stocks that are trading at "extreme" highs or "extreme" lows.
This means the stocks in question have been driven by investors up to their euphoric apex (highs) or beaten down to their doleful nadirs (lows).
WPIII: And that's very, very important... and, in fact, is where increased probability comes into the picture.
DRB: Yes!
You see, when a stock has been driven to an extreme, the odds are very good that its next move will be in the opposite direction. I don't necessarily mean the next move a second later... nothing that granular. I'm talking about the next trend... be it an intermediate-duration move or even a longer-term one.
Take a stock that's been driven to a euphoric high...
The fact that it's at "an extreme," by definition, means it's not going to continue in that same direction. It's going to reverse course and go down.
Conversely, a stock that's been beaten to an "extreme low" is poised for a reversal to the upside.
In both instances, the probability is high that the stock will change direction. And if you understand that, you can make money. You can make money with the stock itself. Or you can "leverage" that opportunity and make an even bigger return by trading the option.
WPIII: And to profit, you want to sell (go short on) stocks that are trading at extreme highs since they are poised to reverse course and fall. And you want to buy (go long on) stocks that have achieved an extreme low since they are poised to reverse course and climb.
DRB: In a nutshell, Bill, that's really it. Trading the stocks can be very profitable. But using options allows you to leverage those opportunities and make even more money because you're risking small amounts of capital for very big gains.
WPIII: That's the essence of your system... using mathematical probabilities to ID stocks trading at extreme highs or extreme lows - even if those extremes are intermediate ones - and using options to grab "leveraged" windfalls when they reverse course.
And that's why the options trades that you do aren't going to track the horrendous overall options record depicted in the CME study.
DRB: That's it... In fact, my experience and that of my subscribers shows it's the exact opposite of what those numbers seem to say about the futility of options trading...
WPIII: So myth busted.
DRB: Busted.
But let's be honest - no system is infallible... no system is perfect.
Even with a system as good as the one we've designed... the fact is that we're going to ID promising stocks that don't reverse course - or that DO reverse course, but then don't follow through as quickly or as powerfully as expected.
That's OK.
Here's where the risk-management component of my options strategy factors in.
WPIII: How so?
DRB: My management of risk starts before we initiate the trade.
And it has several features.
First, to protect us in case we're wrong and the trade goes against us, we pre-establish an "acceptable amount" of loss per trade...
WPIII: Kind of a "loss threshold?"
DRB: Right. And if the loss goes over that threshold, it automatically triggers a "sell"... and the trade is closed out. Experienced traders know this as a "stop loss."
WPIII: And that's true of stocks and options.
DRB: It works with both - and equally well.
WPIII: And your risk-management strategy goes even deeper than that, doesn't it?
DRB: It does, Bill. It even tells us how much to risk on each trade, so that we're not overinvesting or underinvesting. That, too, is mathematically guided... making it simple to calculate.
WPIII: And your risk-management strategy also reaches out to include the "profit" side of your trades, correct?
DRB: Absolutely. Just as some traders hang with a losing trade so long, some traders can hang with a winning trade too long. In cases where you have a profit on an "open" trade, you want to be sure that you "keep" what you've made. My risk-management tools set up a "sliding stop" that lets you stay in a trade as it's rising - but gets you out if it starts backsliding.
WPIII: The takeaway, here, is that - under your system - options are an instrument you'll want to trade... and that you're likely to profit on... and profit handsomely on. In fact, because you're putting probability firmly on your side, and are "leveraging opportunities," it's to your decided advantage to trade options.
DRB: No matter what the pundits - and those CME statistics - would have you believe.
Get Ready for Your QQQ Options to Head Back Up
As I mentioned before, your QQQ trade has dropped back to breakeven after an initial pop of 49%. But I still expect upside, and here's why.
Markets have gotten "jumpy" over the last few days. After last Friday's big up move across all the indexes, Monday and Tuesday of last week saw the first significant two-day down move of the new year.
A down market, even one that is very modestly down, is a very new experience this year, and traders and investors are seeing these nerves reflected in very jittery price moves.
After the president's State of the Union address on Tuesday night, markets recovered some of the lost ground from Monday and Tuesday's trading sessions. But by mid-afternoon, any optimism had given way to selling pressure, and the big U.S. stock indexes had given back much of their gains from early in the day.
Importantly, there is big market-moving news coming quickly upon us as all five of the biggest tech stocks - Apple, Alphabet (Google), Microsoft, Amazon, and Facebook are scheduled to announce earning either Wednesday afternoon or Thursday afternoon.
This will be market-moving news, especially with Thursday's announcement from the first-, second-, and fourth-biggest companies in the world (AAPL, GOOGL, and AMZN).
I believe the odds are strong that four of these five companies report good news and that the market moves higher on the news.
If you are in the QQQ trade, odds are likewise good that you'll see a significant up move soon. Keep an eye on those options.
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You don't need any special training… any insider knowledge of the markets… or any exceptional skills.
In fact, all you need is a computer or smartphone and just 10 minutes of "work" to potentially put $1 million in your bank account faster and easier than you ever dreamed.
The post How to Use Options as a Trading "Power Tool" appeared first on 10-Minute Millionaire.
About the Author
D.R. Barton, Jr., Technical Trading Specialist for Money Map Press, is a world-renowned authority on technical trading with 25 years of experience. He spent the first part of his career as a chemical engineer with DuPont. During this time, he researched and developed the trading secrets that led to his first successful research service. Thanks to the wealth he was able to create for himself and his followers, D.R. retired early to pursue his passion for investing and showing fellow investors how to build toward financial freedom.