Using Options as a Profit Center

04/02/2013 8:56 am EST

Focus: OPTIONS

Michael Khouw

Partner, The Options Edge

Options expert Michael Khouw talks about how to use options as a profit center while owning an underlying stock.

Option popularity has exploded for the retail market in the past five or ten years, even 20 years.  Some people are using it for directional trades in and of itself rather than a hedging tool.  My guest today is Michael Khouw to talk about some of those strategies, so Michael, options trading exploding in the retail market; a lot of people using it just for profit by themselves rather than hedging.  Any ideas for some advice strategies there?

Well sure, I think that the most basic, an investment strategy of sorts if you're only going to trade the option would be covered put writes.  I see a stock, I'd like to own it, I'd like to collect some premiums, so I sell a put that's maybe at or slightly below at-the-money; 90 days to 30 days in expiration, get paid in the meantime.  Maybe the stock declines and I own it, maybe it rises, and I do it again. 

I think that's the most basic strategy, but I think the most tempting thing that leads people to options in the first place is usually the element of leverage, right.  People are tempted; they think I could get extraordinary returns, I see Boeing's trading $70, if it goes to $80 and I buy the 72-1/2 call, I can make multiples of my money where if I buy the stock I'm only going to make $10 over $70. 

The tricky part, of course, with doing that is that you significantly reduce the odds of success.  That doesn't mean you shouldn't do it; I recommend it from time to time, but when you do, you just have to recognize that you're taking a lower probability bet.  If I buy a 30 delta call option one way to think about it, this is actually back of the napkin, but one way to think about it is maybe I have a 30% chance that the stock is actually above that strike by expiration. 

I think that's just the important thing to remember.  It's really tough to pick the direction that a stock's going to take.  You know if it was that easy, you know people would be doing a lot better in the markets then they are.  It's tough to pick direction.  It's tougher to pick direction in timing, and it's tougher still to pick direction, timing, and then spend a premium on a decaying asset and overcome that hurdle.  When you combine those three things, it's okay to use long options to make directional bets.  Just understand that your thesis really has to play out for it to work.

Yeah, we're all enticed, I think, by seeing that $0.25 option thinking we can just buy a ton of these and if the underlying moves a little bit I can make a lot of money.  It looks cheap, but it's probably cheap for a reason.

It is probably cheap for a reason, but that doesn't mean it's not justified to do it from time to time.  We saw recently, you know we've obviously had the Fed injecting a lot of liquidity into the banks and a lot of people recognized, well that would potentially be a positive for the bank, so what you often see before FOMC announcements is you see a lot of call buying in the financials; in the XLF, in the money center banks like Bank of America, Citi, JP Morgan, and so on, and what people are trying to do is they're saying okay I have a known catalyst. 

I'm expecting the Fed to step in and prop these guys up, but if they don't they could fall out of bed.  I'm going to buy those cheap options and hope, but the thing is, if you do that, make sure you do it with a really small percentage of your portfolio because it is only a speculative bet.  It is okay to make speculative bets, but you can't do it with everything you've got because if you have one chance for it succeeding that means you have a 75% chance you will be broke the next day.

Yeah and on the other side if you're selling say a put we start to see in the option chain the closer we get into the money those premiums really increase and I think maybe I should do this a little bit closer in the money and get that extra dollar that the option may be offering, but that can be dangerous as well, right?

No, that's right.  I mean one of the things about at-the-money options a lot of options traders, market makers love to be actually short near dated at-the-money options.  Maybe you would be happy to hedge that by being long longer dated ones, but those at-the-money near dated options that's the fastest expiring option on the board.  If you're owning it you're renting that thing at a very high price each day.

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