Options are a great tool in any market — especially volatile ones.
They offer the ability to make massive profits on rising and falling prices, giving us the best of both worlds.
But they’re not without their own pitfalls.
There are several nuances of options trading that you need to understand. It’s why we take time in True Options Masters to walk you through all of these details. To make sure you’re prepared to take advantage of this trading tool.
And today, we’re going to focus on one critical options pitfall.
With the market volatility we just went through, it’s the perfect time to talk about this.
And once you understand it, you’ll learn how to sidestep some of the quirks of options trading that can frustrate new traders to no end…
Options Volatility Moves Both Ways
When stocks suddenly drop like they did the day after Thanksgiving, you may think buying options is a great idea because stocks are on the move.
You’d be right… But it may not be as good of an opportunity as it seems.
Playing dips like this can be challenging with some options due to the volatility premium. That’s what you have to look out for.
Let me explain…
As stocks drop, volatility goes up for options across the board. This can inflate the premiums on them (essentially, the price you pay for an option contract).
So while you believe a quick rebound is coming, like we saw last week, playing a bullish call option is a bit more challenging than in a normal environment.
It’s still doable, and can generate sizeable gains. You just need to make sure the option premiums make sense instead of blindly buying options.
For that, you’ll need to understand what kind of bounce you expect, compared to what the options are already pricing in.
For example, if the options are pricing in a quick return to where the stock was trading before the dip, you need to see an even bigger jump to turn a profit.
In other words, you’ll need the underlying stocks to move more than normal, because you’re paying a greater premium than normal.
When buying put options, it’s almost intuitive. As stocks drop, the premiums on put options get juicier.
But, what we may not notice is that call options also get a higher premium than usual.
It’s simply because volatility works in both directions.
When stocks experience a sudden drop like we saw the day after Thanksgiving, if we got a quick rebound, traders would expect it to be bigger than the day-to-day rallies from before.
And in turn, you’ll need to see an even bigger rally to generate a similar gain to a typical bounce in the market.
Learn to Love the Volatility Premium
This doesn’t mean you should avoid trading in volatile markets.
Actually, quite the opposite.
Options can provide gains on both sides of the trade, whether you’re buying or selling them. In higher premium markets, where options prices are higher than normal, it may be a great time to sell put options or covered call options to generate income.
And, when scanning the market, you may find some stocks simply aren’t pricing in the extra volatility at the time.
But, at the end of the day, the number one thing we need as options traders are stocks that are on the move. And we get that in volatile markets.
So just be aware of higher options premiums when volatility strikes, and use it to your advantage to spot the best possible opportunities.
Chad Shoop, CMT
Editor, Quick Hit Profits
Chart of the Day:
Just Watch the Channel
It’s time we had a fresh look at one of the cleanest uptrend channels in any market: on the Invesco QQQ Trust (QQQ).
This uptrend channel goes all the way back to September 2020, and QQQ has dutifully traded inside this trend practically ever since.
Every time it’s escaped the channel, it’s quickly rejected back in, either from the upside or downside.
Viewed this way, the recent market volatility in high-growth and tech stocks should really come as no surprise. QQQ escaped the uptrend channel to the upside right before the Thanksgiving holiday, and then it got smacked back into the channel as Omicron fears overtook the market.
If you’re trading options, it’s hard to find a chart giving clearer signals right now. Buy calls at the bottom and puts at the top — minding the volatility premium, as Chad points out — and you have a dead-simple trading plan that makes money.
QQQ is approaching the top of the channel once again, so be prepared to make a move if and when we tag that top blue line, around $407.
If you’re an investor, just sit on your hands. Stocks are in a long, long-term uptrend. For Mike Carr’s money, that uptrend will last several more years, with stocks more than doubling in that span. You don’t want to get spooked out and miss out on that.
Managing Editor, True Options Masters