With financial markets experiencing incredible volatility (200+ point daily swings), some investors understandably are looking for ways to avoid it. Unfortunately, I don’t think market volatility is going away anytime soon, but options are one way to take advantage of it.
How Options Can Help You Take Advantage Of Volatility
Options give you the right, though not the obligation, to purchase or sell an investment at a predetermined price within a predetermined timeframe. They’ve become more popular lately with investors that want to enjoy the market’s upside potential but avoid some of the downside risk.
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As far as options strategies, there are dozens, if not hundreds, of different ways to utilize them in your personal portfolio. The important thing is to try some practice trades in a virtual account like the one offered at optionsXpress. There are covered calls, strip and strap strategies, butterfly spreads, and protective puts. Some of the strategy names are comical, but they make sense once you have some understanding of how they work.
Let’s look at a covered call.
Example of a covered call options strategy
Let’s say you bought stock “A” at $40 and it increased in value over the course of a few months to $60. You’d like to sell and take your profits, but you wonder if you couldn’t squeeze a few more dollars out of it. To do so, you decide to sell a call option. You’re selling the right to buy your shares to another investor at a certain price — say $62 — during a specified time period. It’s called a covered call because you actually own the shares that you’re selling this call option on.
If the shares don’t increase or decrease in value very much, you won’t be too concerned since you’ll still collect a small fee from the investor who bought the call option. Plus you still keep your shares in the stock! If the stock price rises above the price you agreed to sell at (the strike price), you get more than you would have if you just sold ($62 vs $60) instead of selling the call. If you were planning to sell the stock anyway, it’s ideal.
But not everything always goes as planned. If the stock jumps higher than your strike price to $70, than you can miss out on the upside beyond the strike price of the option. In this case, you’d miss out on $10/share. And remember that you’re not protected if the stock price falls (to say $56) because the person buying your call will not want to purchase your shares at the strike price of $62. Why spend $62 for a $56 stock? One upside though is the small income you received from selling the call option. That would help soften the blow a little but make no mistake, options trading involves risk! Make sure to educate yourself first!
This is just ONE of hundreds of options strategies
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