5 Ways to Profit from Volatility
1. Put Surprise Volatility to Work for YouSo, how can you protect yourself when you are buying options in this volatile market? Try buying options on stocks that have the greatest potential for surprise volatility by looking for stocks that are particularly vulnerable to surprise news or events.Take a look at tech stocks, overvalued stocks with a lot of hype, single-drug pharmacy stocks up for FDA review, stocks in industries that are in flux and stocks with unpronounceable names.The higher the volatility (that is, the higher the perceived risk), the greater the premiums they will demand -- and the bigger the profits you can make.
2. Catch the Draft From Expiring OptionsHave you ever heard of "expiration plays?" These are short-term plays made during the last week before expiration. Very close-to-the-money options traded during this week can make dramatic moves in value very quickly.The best "expiration plays" are index options, such as options on the S&P 100 Index (OEX). The key to success in this strategy is to buy on weakness in the option price.In expiration plays, you are betting on surprise volatility swinging the price of a stock or index -- and, thus, the option -- in your favor. Given the current level of volatility, you certainly have the advantage now.This trade has one caveat: You can incur a fair number of losses with this strategy. However, just one big move in the index price can give you the jackpot of a lifetime. (Try paper trading this idea to get a feel for the results of this type of play.)However, if a quick trade is not your style, don't be afraid to take your time with an options trade…
3. Give Yourself Time to be RightOption buyers often complain that they never make as much money as they should. This may be true, but the reason isn't because the pros have conspired against them; it's because they've stacked the odds against themselves!One of the biggest mistakes options traders make is they don't give themselves enough time to be right with a trade. Options as a wasting asset -- not perpetual investment instruments like stocks. The closer you get to expiration, the faster the option price decays.Option buyers who find they are frequent losers have stacked the odds against themselves by buying near-term options that give them too little time to be right. In most situations -- unlike the previous example -- I recommend giving yourself 30 days or more to allow an option play to work in your favor.
4. Cover Me: Writing Covered Calls and PutsIf you're holding equities in your stock portfolio, it's likely that you're in a world of hurt right now. You can generate extra income -- and give yourself some insurance -- by selling covered calls and puts on the stock.You can sell covered calls on your stock if you believe the price is going to rise or sell puts if you are feeling bearish. Let's look at a covered call example.Suppose you sold options with a strike price equal to or greater than the price you paid for the equity. If the stock remains flat, declines in value or even increases a little, an at-the-money or out-of-the-money call will likely expire worthless and you'll keep the premium you received when you sold the calls. If that happens, you can sell another covered call in a subsequent month.If the stock appreciates above the strike price by the option expiration date, your stock will likely be called away. This is not necessarily a bad thing. If you sold at-the-money or out-of-the-money calls, you will generally make a profit -- possibly one that could exceed the profit you would have made had you simply bought the stock outright.
5. Run With the Bears. It's been difficult to guess the direction of the market from day to day, but human nature tends to lean toward optimism, even as the market falls. Don't let that type of thinking cost you profits.Sometimes the best-run companies and the strongest stocks get taken to task during a panic period like right now. And there's nothing wrong with buying some put options on even the best companies when they're going down -- options are not a permanent bet.The beauty of trading options is that you can capitalize on the near-term direction of a stock. Even if you're absolutely certain that a stock price would be going up under "normal" trading conditions, there's nothing wrong with making some quick profits if it unexpectedly moves in the "wrong" direction.