How to Use Options to Beat the Market

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Sooner or later, most investors realize that the stock market isn't completely insane yet. Good stocks don't always go up. Bad stocks don't always fall. Reality is rarely as bullish or as bearish as Wall Street analysts and strategists have predicted. All that is certain is that this virtually invisible force known as volatility is always lurking, threatening to upset the delicate balance of markets. Investors have two primary ways to react. You can sit tight and act like long-term investors. Time tends to reward such behavior, although research has shown it to be as difficult to practice as it is uncommon. Most investors never hold stocks long enough to take advantage of the fact that the market rises over time. Investors usually buy too late and sell too early. They are routinely greedy and panicked out of stocks. They only hold stocks for a few years, or worse, a few months, rather than carefully curating a portfolio over decades, meaning most investors act like salmon swimming upstream. They fight against the natural rhythms of the stock markets. Fortunately, investors can do something about this bad cycle while smoothing the odds. All that is required is a willingness to use options to navigate the stock market more effectively. A well-placed put or call can make all the difference. Options have been around for centuries, but the investment product has only been listed on exchanges since April 26, 1973, when the Chicago Board Options Exchange began trading. Since then, the options market has enjoyed exceptional growth. For example, in 2000, about a million options were traded daily. In 2016, about 15 million options are traded every day, and daily trading volume often exceeds 20 million contracts on days when the Federal Reserve's Interest Rate Setting Committee meets or some other important event. Who Uses Options? Pretty much everyone. There's a good chance your mutual fund manager relies on options to manage their stock portfolio. The same is true for pension fund managers, executives with concentrated equity positions, stockbrokers, registered investment advisers, and self-determined investors who are very interested and concerned about what is happening with their investments. All of these different types of investors have one thing in common: they know that a well-placed options contract can turn the unpredictable of an investment into a defined outcome. First, let's define some basic terms and concepts. We all know that stocks rise and fall. As such, people are willing to trade the rights to buy or sell a stock, and that's a good definition of an options contract. All options have an expiry date. After a certain date, the contract expires. This means that in order to benefit from an option, you must be right about a stock price movement within a certain period of time. There are two types of options. A call option gives investors the right to buy a stock at a specific price and time. 

A put option gives investors the right to sell a stock at a specific price and at a specific time. A simple way to remember the difference between puts and calls is that a call gives you the right to call a winning stock, while a put gives you the right to put someone else's bad stock on hold. Puts and calls are the basic building blocks of the options market and give investors exceptional flexibility when dealing with stocks. Investors can use combinations of puts and calls to express virtually any opinion they have about stocks, indexes, and exchange-traded funds. But it all starts with two simple trades: buying a call or buying a put. Let's say you want to buy 100 shares of Amazon.com (ticker: AMZN) because you think the company is going to take the world by storm. You're using Amazon's services like everyone you know, but you don't have RS84,000 left over to buy 100 shares of the stock. This is where options come into play. A call option gives you the right, but not the obligation, to buy 100 shares for less money than it costs to buy the share. All you have to do is determine at what price you want to buy the stock and how long you want to own the contract. At Amazon, for example, at around RS833, you could spend RS81 to buy the june 900 call that expires in June 2022. You could also choose a call that expires in a few months, but remember we use options to implement conservative investment goals. Our goal with Amazon is simple. We like the stock and think it will go higher and we want to give ourselves enough time to do so. Therefore, we have chosen an expiry that is well in the future to give the stock enough time and opportunity to rise. (Remember, call holders don't receive stock dividends. That doesn't apply to Amazon, which doesn't pay dividends, but many other stocks do.) If Amazon stock continues to rise, perhaps because it continues to report big gains, the call will increase in value. At RS1,100, the call that cost RS81 is worth RS200. If you wish, you can exercise the call, that is, convert it into shares at the RS900 strike price. Essentially, you can buy the stock at RS900, although it's significantly higher. But if you're like many options investors, you won't. Instead, you'll sell your call and reap the hefty profit and look for another call to trade on Amazon. Therein lies the power and appeal of options. If everything goes as you planned, you can control the shares for a little money while limiting your risk to the amount of money it takes to buy the call without giving up the opportunity to make a big return. But what happens, you rightly ask, is Amazon stock not behaving as expected when you bought the call? This is important. If the stock price is below the strike price, the trade will fail and you will lose money. Let's take the downside of this Amazon trade. Let's say you happened to buy 100 shares at a price of RS200 many years ago. You have exceptional earnings that exceed RS600 per share. Still, they worry that the stock price is so high that it will have a hard time recovering or that Amazon may struggle when it releases its next earnings report. But you don't want to sell. They have no better investment ideas and believe that Amazon will continue to innovate and change the way people interact with the world. This is where puts come into play. Investors buy puts when they want to protect stocks they own from falling in value. With Amazon stock at RS833, you could buy the june 750 put that expires in june 2022 for RS69.25. Your Amazon inventory is secured until the contract expires. This means that if the share price falls, the loss is offset by an increase in the value of the put. Remember that when stock prices fall, value increases. So if Amazon stock falls to RS600, the put is worth RS150. If the stock never falls, the money spent on the put is lost. Although we used Amazon as an example, not all option premiums are that expensive. Many are RS5 or less. This reflects the fact that most stocks trade between RS30 and RS60. Also, many people choose options that expire in three months or less. When you buy an options contract that expires in a year or more, you're spending more money because time equals risk. Of course, not everyone buys options. Many investors prefer to sell puts and calls to generate income - a topic we'll cover in the next part of this series.