How to use options and understand what they are good for...

How to use options and understand what they are good for...

Outline of their uses...

Before we get into any fancy trading terms and strategies like bull spreads, ration back spreads, butterflies and condors, which just baffle the novice and are more often only traded in books, let's look at a few more practical uses.

Here I think you might want to check out my credentials at the end of this article. OK, hopefully you're back now. Well, what can a normal stock trader or investor use options for?

I see three main uses that they are broken into.

1. Hedging - this was the original use of options and is an area much misunderstood by traders, investors and advisors.

2. Increasing yield on an owned stock/share. It is possible to increase your yield on a stock you already own by between 1-4% per month.

3. Trading. This is where instead of using stocks, indexes or futures you use their options. Here options can leverage your gains and limit your risks. It seems, however that a lot of people unhappy on the return stocks give them, generally because they do not have a good system, they then try options and for the same reason they did not make money on shares lose more money on options, but faster.

Using Options to Hedge

Simply put hedging allows the share trader or investor to put in place insurance. Just as everybody should have insurance on their life, house and car you should have insurance on you share portfolio.

Just like any insurance it is there to cover you in a worst-case scenario. It has all the same features, price of risk, price of time, and trade in value and guaranteed payment on write off as normal insurance.

Let's look at an example (the figures are close enough)

Recently one of my friends who I have been helping with his wealth creation took my advice and bought insurance on all his shares, including AMP. At that time AMP were around $7.80, he had bought them around $7.45. He insured them for $7.50 at a cost of around $0.35 for about 5 months.

Now when AMP dived to $5.00, he had an insurance policy, that is he had the right to sell AMP at $7.50 to somebody - he did not know who and it does not matter.

Now in that case the $0.35 insurance was worth every penny. But what would have happened to the insurance if they had gone to $9.00? Simply he would have been happy with the $1.55 increase and taken the $0.35 insurance cost as a cost. Or as I like to call it the cost of SANF, Sleep at Night Factor.

There are also ways to get other people to pay for this insurance but that will have to be covered in another article.

Increasing yield on owned stocks.

*This is a great strategy for DIY retirement funds when used conservatively (Always check with you advisors - if they do not know what you're talking about dump them).

You may have already heard of this strategy, but if you do not I guarantee you know how if works, its just that nobody has told you its name yet.

Covered calls work in this way. You own a stock, just like owning a property you can rent out that stock, with the right to buy at a certain price to somebody else.

Let's look at an example

I bought NAB last year at around $31.20. For a number of months I sold call options on it for about $0.50 in rent at a strike price, the price somebody could buy it from me, of $32.50. As the share did go to about $33 I did have to sell it. I made a rental of about $1.50, took the Dividend in November and sold the stock for a profit of $1.30.

All in all a monthly yield of 1.6% per month (19% per year) as opposed to the dividend of about 5%. The $32.50 strike also acted as a profit stop, which meant I took profit when they were there.

In other examples, I have make 7% per month on renting shares. But remember some of this should be set against insurance. Are you starting to see a bigger picture here?

Options Trading

Trading in options can be an excellent way to make money and manage risk if taken on correctly. I am not, however, going into options strategy in this article, but we'll look at what outcomes you can achieve.

OUTCOME Find the outcome you want, for example high compound growth of retirement funds, replacement of salary etc...

STRATEGY which options strategy should I follow. Long big wins and large margin requirement, shorter periods, small gains low risk and lots of trades...

PLAN then you then need to build your trading plan.

RULES when you build your plan it should just be an extension of your existing trading plan. Plan your exit, plan your risk and plan your entry, in that order. This will be on top of all your entry signals, gates, filters etc.

OK, now once you have all of that in place then you can start to trade options. But wait this is where the fun starts and this is the reason that I put the outcomes first.

With Options there are at least 28 trades you can do, if not more. However, you only need to know the ones that fit your criteria. Let's say that you are happy to just do long term stuff in the up direction in your retirement fund. Therefore you only need to know about 4 strategies. Therefore you can miss out the other 24 and that makes it a lot easier to become good at it and make money.

Note of using options to go short.

One of the biggest issues I see when I talk to people about trading is that 90% of them never trade the short side of the market, that is make money when the market is going down. I think some of this is due to the issues of using shorts on stocks with margin, limited short stocks and the risk is limitless.

However if you only use options to do one thing, let it be going short. You can buy Put options on a share you think is going to plummet. Buy one with about 3 months of time and in the money, that means just above the share price. And enjoy the concept of making money when 90% of people are losing theirs. Remember markets go sideways and down more than they go up. And they go down very quick.

This artical on options appeared in the SuperWatch News letter to make sure you keep up to date with important information about DIY Retirtment Funds fill in your details below...