Over the past few decades, we've seen many advances in how the stock market functions. Today, exchanges and brokerage houses exist almost entirely online, and everyone is competing for microseconds of speed.
We've also seen the idea of "investing" evolve into something much more advanced and complicated than it was in the early days.
I've spent my entire 18-year career immersed in the finance world. And in my experience, no matter what data, methods, techniques, witchcraft, mojo or voodoo you choose to use for your investments, it is absolutely critical that you understand what you're doing. If not, you're just another amateur grasping for success.
The truth is, today's "game" requires an increased arsenal of tactics and methods to prosper. And for the average investor, a powerful options strategy is one tool that should be used.
Options can be as simple or as complicated as you want to make them. Just know that when you purchase options as a means to speculate on future stock price movements, you are limiting your downside risk, yet your profit potential can be unlimited.
Aside from speculation, investors use options for hedging purposes. It is a way to protect your portfolio from disaster. Hedging is like buying insurance -- you buy it as a means of protection against unforeseen events. You hope you never have to use it, but the fact that you have it helps you sleep better at night.
Today, I want to talk about one of the most basic ways investors use options -- buying call options -- and how to select the right one.
Investors generally buy calls on stocks they expect to move higher. Let's say stock XYZ is trading at $100 per share. Now, let's say an investor purchases one call option contract on that stock with a $100 strike price at a premium of $2.
That premium is the price you're paying for the right to buy 100 shares of XYZ for $100. But rather than costing us $10,000, like it would on the open market, we're only paying $200 (100 shares times $2 = $200).
The call option gives the buyer the right to purchase shares of XYZ at $100 per share. In this scenario, the buyer could use the option to purchase those shares at $100, then immediately sell those same shares in the open market for $105. Because of this, the option will sell for $5 on the expiration date.
Since each option represents an interest in 100 underlying shares, this will amount to a total sale price of $500. Since the investor purchased this option for $200, the net profit to the buyer from this trade will be $300. That's a 150% return on a 5% move in the underlying shares.
If XYZ only trades to $101 at expiration, the call option will now be worth $1 (or $100 per contract). But since the investor spent $200 to purchase the option in the first place, he or she will show a net loss on this trade of $100.
If XYZ ends up at or below $100 on the option's expiration date, then the contract will expire "out of the money," meaning it will now be worthless. In this scenario, the option buyer will lose 100% of his or her money (in this case, the full $200 spent for the contract).
That alone isn't the end of the world, since we're only talking about $200 and not thousands of dollars. But many people choose to trade with larger position sizes, so there are five important things I look for when selecting the "perfect" option.
1. Choose a call with a delta between 0.70 and 0.92.
You can deviate slightly from this rule, but buying an in-the-money option helps increase your odds of success drastically.
2. When selecting an expiration date, add 30-40 days to the maximum you anticipate being in the trade.
Before you get into any trade, you must have an idea of how long you anticipate being in the trade. This is imperative when trading options because all options have an expiration date. Be honest with yourself and know your style. If you're a longer-term trader, buy more time in your options.
3. Avoid wide bid-ask spreads.
Just like stock, we usually have to buy at the ask and sell at the bid. The larger the spread, the longer it takes for you to start making money. Think of the bid-ask spread as a commission. If you're trying to make a $0.50 profit on an option but the bid-ask spread is $0.50, then that really puts you at a disadvantage.
Look at the at-the-money options and go three strikes up and three strikes down. If the average bid-ask spread is more than $0.20, use extreme caution. But remember that expensive stocks and expensive options may have larger spreads.
4. Look for high option interest/options volume.
Open interest in your option should be greater than 50, although 100 or greater is preferred. Open interest means there are already people holding those options (long or short) who may want to buy or sell them at some point.
Also, the more options volume, the better. When you're trying to buy or sell something, it's always better to have more competition for whatever it is you're trading. This holds true for stock and options alike.
5. Aim for a minimum of 500,000 average daily volume in the underlying stock.
It's always better to trade options on higher-volume stocks, and there is no upper limit on volume.
By following these rules, my Profit Amplifier subscribers have enjoyed some massive winners. Last month, for example, we generated 27.3% in seven days and 31.6% in 35 days using call options.
If you've never considered using call options as a way to amplify your gains, now is a great time to start. I've put together a short presentation that explains how options work and details how my Profit Amplifier readers and I have been able to achieve our record of success. To view it, simply follow this link.
This article originally appeared on ProfitableTrading.com