Q&A: Why Options Make Sense Now
Think options trading is too complicated and dangerous? If you do, you’re leaving a lot of money on the table.
To prove the point, I spoke this week with Derek Myers, a skilled options analyst for Investing Daily. His story is one of hard work, tenacity and self-reliance, all traits that were ingrained in him as a child and throughout his military career.
At 17, Derek joined the Army National Guard before being deployed as an active duty soldier in Germany. It was there that he began his self-taught journey to investing success. He devoured classic investment books, bought his first few stocks, and even started an Army investment club that is still active 20 years later.
In 2015, Derek’s wife Alicia joined the Air Force (see photo of the couple).
That’s when Derek decided to take options trading more seriously. After an extensive search to find investment advice he could trust, Derek discovered Investing Daily.
Derek spent the next two years honing his trading skills and supporting his family as a full-time options trader before earning a spot on the Investing Daily team educating thousands of other new traders.
I recently sat down with Derek and asked him questions about options trading. His answers have universal applicability for all types of investors.
Investors use options for different reasons. What are the main advantages?
The first advantage I would say is cost-efficiency. Options have great leverage power and when deployed properly you can use this leverage in your favor. For example, if I want to buy 100 shares of Apple (NSDQ: AAPL) at today’s price that would cost me $26,500! That’s a lot of money.
What can I do to bring my investment cost down? Well, that’s where options and leverage come into play. I can control the same 100 shares of Apple by buying a call option.
A call option gives me the right, but not the obligation to buy 100 shares of Apple per contract. Using the power of options, I could buy one contract of Apple for only $840. That’s a discount of $25,660. Now that’s what I call leverage and cost-efficiency.
Another advantage is the potential for higher returns. Let’s compare the percentage return from buying stock for $100 per share. If the stock rises $10 that would give me a 10% return. However, if I buy a call option for $4.00 that has a delta of 80, that same $10 rise in stock value would increase the call option $8.00, giving me a total return of 200%.
Of course, these examples are simplified, but this is a general idea of using options for cost-efficiency and higher returns. As mentioned, there are many advantages in using options, all of which we use in Jim Fink’s Inner Circle, the premium trading service where I work as an analyst.
These advantages ultimately help investors reduce risk and bring in higher returns, all for as little investment as possible.
Many investors are afraid of market volatility. But why is volatility an options trader’s friend?
Another great question. Volatility brings about opportunities that can make or break investors. That’s where strategy and discipline come into play.
To be honest, I really don’t care if volatility is high or low. As an options trader, I can adjust the option strategies to account for what volatility is doing or is expected to do.
For example, if volatility is high and is expected to drop, this is the perfect time to sell options because it allows the option trader to collect a much bigger credit which ultimately reduces the overall risk. Additionally, as volatility decreases, so too will the options I sold. When selling options this is the ideal situation.
However, if volatility is low and is expected to rise, we have an options strategy that fits the bill. In Inner Circle, we could use the double diagonal strategy to account for rising volatility. Double Diagonals work well going into earnings announcements because volatility tends to rise.
When it comes to volatility, we use it to our advantage. The key is to use the proper strategy that gives you the highest probability of profit for the market we’re in.
What’s the difference between futures and options?
Futures and options are financial tools investors and traders use to make money or to hedge current investments. Both are agreements to buy or sell an investment at a predetermined price and date.
A futures contract is the obligation to buy or sell an asset at a predetermined price and date. On the other hand, an options contract gives an investor the right, but not the obligation, to buy or sell shares at a specific price and by a specific date.
Futures by nature are riskier. Simply the obligation to buy or sell an asset can get investors in trouble if they don’t know what they’re doing. Personally, I rarely trade futures, but when I do, I structure the trade to reduce as much risk as possible.
Many of the risks associated with options can be mathematically modeled and understood. How does this particular feature make options less risky than other asset classes?
Black-Scholes is a pricing model used to determine the fair price or theoretical value for a call or put option based on six variables. The six variables are the type of option, underlying stock price, strike price, time, volatility and risk-free rate.
Modeling options mathematically takes the guess work out of the trade. When I set up a trade, I can adjust the variables so that I can see what the various outcomes could be, which allows me to build a trade that gives me the highest probability of profit and returns.
When I set up a trade, I want to be the house at the casino. I’m going to do everything in my power to tilt the probability of profit in my favor. By knowing the variables and the ability to manipulate the variables, I can see all the possible outcomes. This capability is unlike any other asset class. Having this ability removes the guesswork and helps me determine the best move forward.
As we face the start of 2020, risks in the economy and markets are growing. Options were invented for hedging purposes. Hedging with options can reduce risk at a reasonable cost. Explain how options can be used to insure your investments against a downturn.
There are two simple strategies that an investor can use to protect their investments against a downturn.
First, let’s assume you own stock worth $100 per share. What you could do is buy a put option at a strike price of $100 or lower. If the stock price drops to anywhere below the strike price, you have the right, but not the obligation, to sell the stock for whatever strike price you chose.
It’s always a good idea to use your brokerage software to build a risk graph, which will help you determine what put option strike price is best and most cost effective to buy. If you don’t know how to build a risk graph, you can call your broker and they will walk you through the process. It’s something that every investor should learn how to create.
The second alternative is to buy a put option on an ETF such as the SPY. This will give you broad market protection, but you will need to figure out how much to risk based on your current portfolio size and how much of a downturn you expect.
There are many other things you can do as well, such as buying gold or high-risk leveraged ETFs that make money when the market goes down. However, in my opinion the most cost effective and safest way to protect your portfolio is through buying puts on individual equity holdings or through a broad market ETF such as the SPY.
Editor’s Note: My colleague Derek Myers just shed light on options trading, to show you that it doesn’t have to be a scary experience. But the above Q&A only scratches the surface of our team’s expertise.
In fact, we just pulled the wraps off the groundbreaking Income Millionaire Project. The goal of this program is simple: Show 1,000 regular investors how to generate $1 million in retirement income. Each.
That’s a total of $1 billion, to be exact. Spaces are going fast. Want to get on board? Click here for details.