Understanding Options:
The difference between being right vs being profitable.
To profit when buying a stock, you must ultimately be right on the direction after entering the trade. If the stock goes up, you make profit, and if the stock goes down, you lose. When you short a stock, if the stock goes down you make a profit, and if the stock rises you lose. Pretty simple concept, right?
However, once I learned how options work, and started to trade them many years ago, I realized Newton’s law of motion could allow me to profit regardless of whether a bullish trade went up, or a bearish trade went down. As long as I understood where it was going, or not going.
To quote Isaac Newton, and I humbly paraphrase…”A body in motion, will remain in motion.” Until it doesn’t.
The Moses corollary to that would be…”A stock in a trend, will remain in a trend.”
Until it doesn’t. But until it doesn’t, it does, so until it doesn’t break the trend we can profit where the stock doesn’t go, as opposed to needing it to go somewhere.
This means its possible for a stock to go nowhere, trade sideways, or to even be wrong directionally…and still be able to profit. Now when I say wrong, I don’t mean Enron wrong! But it is possible to have a trade go against your direction by perhaps 5-10%, and still profit. Yes, you can enter bullish options trades, the stock can drop, or enter bearish options trades and the stock rallies up…and still profit.
Now while I can’t speak for everybody, the only reason I’m in the markets, is to…make a profit. So how liberating is it to know that you can profit even when wrong on the direction your analysis suggested a stock would move in?
Here are five non-directional options strategies designed to profit when stocks either go nowhere, just stay above or below specified demand or supply levels, or stay within a defined range, for a specific period of time:
- Bull/Put Spread- Sell a put option at the strike price you expect the stock to stay above, and buy another put option further out of the money to not be in a naked short position.
- Bear/Call Spread- Sell a call option at the strike price you expect the stock to stay below, and buy another call option further out of the money to not be in a naked short position.
- Iron Condor- You enter a Bull/Put spread and a Bear/Call spread at the same time, looking to capture a range you believe the stock will stay between.
- Cash Secured Puts- You sell a put at a strike price you expect the stock to stay over.
- Covered Call- On a stock you already own, you sell a call option at a strike price you either expect the stock to stay under, or a price you’d be willing to sell your stock at.
The above strategies are non-directional, meaning that the stock doesn’t need to do anything to profit. There are two additional strategies, directional in nature, where you can limit your risk and add to your reward if correct on the direction:
- Bull/Call Spread- You buy a call option, and offset/reduce that risk by selling another call at your upside profit target.
- Bear/Put Spread- You buy a put option, and offset/reduce that risk by selling another call at your downside profit target.
Now while the concept of being wrong directionally and still be profitable can sound amazing, the flip side to that is you can be right directionally on a trade and lose money?!
Simply put, we’re able to trade this way because options have more moving parts than all other asset classes. There is no such thing as a guaranteed trade. Every option trade carries the risk of loss, up to and including 100% of the premium invested, or even unlimited risk with naked options.
