In the heart of the hot, lazy days of summer it’s easy to imagine that the warmth will last forever, and all you will ever need are t-shirts and shorts. Bull markets are like summer days. They lull you into believing that they will last forever; that all you will ever need to do is throw darts at the stock market and bring in the profits. But winter always comes and so do bear markets. Trading without the tools to navigate all the seasons of the market is like living in Maine without owning a winter coat. It severely limits your ability to function during the bad weather that always comes sooner or later. In more turbulent times, success in the market takes practice, skill and most importantly, a toolkit that allows you to take advantage of the many different ways the market can move. One of the best ways to do that is through the use of options.
A look at 2015 is instructive. The major averages ended flat for the year. The S&P returned only 1.4% including dividends. Without knowledge of options, there are very few ways to profit reliably from a volatile but ultimately stagnant market like 2015. You could have been lucky and invested in the stocks that outperformed. Alternatively, you could have been lucky and brave and shorted the stocks that tumbled. Either alternative entailed a great deal of risk. On the other hand, with knowledge of a few basic, relatively low risk options strategies, it was entirely possible to profit from such a volatile and range bound market. Strategies that involve selling options provide the enormous benefit of being able to profit simply from the passage of time and allow a margin of safety for the stocks to move without losing profitability. For example, selling calls against the SPY each time that it approached the top of its range and selling puts as it approached the bottom, could have brought in income throughout the year. The risk of selling naked short options could easily have been reduced by the use of spreads. Bull Puts, for example, which involve selling a put and buying a protective put at a lower price, provide limited risk and can profit if the stock moves higher, stands still or even pulls back a bit. Other, more complex trade structures such as Calendars and Diagonals can bring impressive gains during many different market scenarios.
At OptionsAnimal, the instructors post live, real money trades each week. Throughout all of 2015, we posted new trades and closed the vast majority of them profitably. For example, in December, I placed an Iron Condor (a trade that combines both a Bull Put and a Bear Call) on KORS, a stock which had been remarkably stagnant. The trade was designed to profit as long as KORS stayed within a fairly wide range while limiting my risk. I was able to close that trade with a more than 20% gain in 28 days.
2016 is providing a new challenge. As I write this, the S&P is down nearly 9% year to date, and its only January 20. The precipitous decline in oil and other commodities, the slowdown in China, interest rate hikes by the Federal Reserve and various other headwinds, have pushed the market into a bearish mode. Options make it much easier, not only to survive but to profit from a downturn. Shorting stock is speculative and confers unlimited upside risk. Long Puts, on the other hand, provide a similar profit potential to short stock with a very limited risk. More complex strategies can profit from a downturn as well as from the passage of time. Last week, my technical analysis led me to a bearish expectation for Facebook (FB). I placed a Bear Call designed to profit as long as FB stayed at or below the price at which it was currently trading. FB dropped and the trade made over 20% in less than a day.
The point of this article is not to brag about successful trades but to highlight the need for the versatility that options can provide. Options make it possible to profit from all the different trends that the market can throw at you. They are an important addition to any trader’s toolkit. A knowledge of options can allow you to survive and thrive in all market conditions. No one should have to brave the winter without a coat.