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Option Trading Strategy That Works!

By Charles Hopkins Published 03/13/2006 | Finance

An option is a contract conferring to the owner the right to buy or sell a specific stock at a specific price in the future.

Call options give the right to BUY the stock at a certain price, and put options give the right to SELL the stock at a certain price. That particular price is called the strike price, and owner is allowed to buy or sell at that strike price at any time before the expiration date of the option.

Being an active investor in option trading requires knowing the in-s and out-s of buying and selling options. To win the gains and rewards from option trading, you will have to learn the basics of various trading methods. You need to get up to speed with various strategies and learn to use them efficiently, in order to survive in the options market. If youre averse to this kind of hard labor, you had better follow a mutual fund manager who will do this for you.

You should note that option stocks have some differences with share stocks or bonds. An option stock may consist of commodities or any marketable product. Option trading strategy involves taking contingent plans of action to buy and sell these options in a manner that entails maximum expected profit.

The profitability in this trade comes from the volatility (a measure of shift potential in prices) in the prices of these options. In general, when you experience very high option implied volatility (meaning downfall is highly imminent), selling should get priority over buying, because in these situations options become quite expensive.

What kind of strategy should you follow in options trading? Which stock do you invest in should you just follow a tip, or quality, or analyze trends in the market to get the best deal?

For making profits in option trading, you must have a measure of volatility and your strike price at the right time. For beginners or those who have little time to spare, it is often wise to get a membership of agencies with expert trading advisers. They alert you when they see great trading opportunities, and also remain for you in their trading room to answer your questions. There are plenty of them these days.

Besides, there are good dependable software programs that analyze and measure volatility with acceptable accuracy. As for example, the OptionVue 5 options analysis software helps you survey all options according to specified criteria such as implied volatility and statistical volatility levels. It also helps to identify markets that might be tradable using a ratio writing strategy. Many different kinds of market are included in these programs, and trends are worked out on the basis of past six years information.

High implied volatility is a situation when options are expensive in terms of historical average levels. Since option implied volatility eventually returns to its historical mean, it would make good sense to sell at this high volatility when it is at the extreme levels (say the 99th percentile).

Another strategy is to work out your contingent plan of action through your own analysis of volatility and the expected range of strike prices using software and detailed stock information.

By mixing and matching various options trading strategies cleverly, you can sometimes even profit from stocks that have little or no movement over time. This is not a very easy thing to achieve, though.

Sometimes even when there are consistent bull and bear debit spreads and high implied volatility, buying strategies are often very poorly priced. When it reaches a trough, the collapse in high-priced options right after a sharp drop in implied volatility takes out much of the profit potential.

So, as has been pointed out time and again, even if you are correct in timing a market bottom, there may be little to no gain from a big reversal move following a capitulation sell-off. There are strategies for avoiding this. One needs to learn these strategies from professionals or academics studying this sector, or from quality agencies. Option trading is a big money game, provided you play it right.