Market risk exists whether you own shares of stock or use options to anticipate marketwide movement. In that sense, options are not higher-risk than stocks. In fact, because one option lets you control 100 shares of stock, they are far less risky. If you can benefit from stock price movement for about 5% of the cost of those shares, your risks are lower.
The problem in these uncertain market conditions is known by most traders: When do you put money in the market, and where is your capital safe? Because the answers cannot be known, many people are simply on the sidelines waiting for a clearer picture to emerge.
The debate over tax rates has political implications; but perhaps more immediately, the debate also may have dire consequences in the market. For example, if capital gains rates were to go up on January 1, many investors would want to sell shares ahead of time to avoid a higher capital gains hit a couple of weeks later. This could have caused a huge drop in the overall market, not only because of the tax implications of waiting to sell, but because of the wider fear created by the uncertainty.
There are four ways you can use long options to anticipate expected stock market price changes, either in the entire market or individual stocks. These are:
1. Use options on broad indexes. Few strategies beat the combination of leverage and diversification. Options are one of the best tools for leverage. And buying options in broad market indexes diversifies your risk. It also enables you to expose that leveraged capital to a potential big move in the market. If you think the market is going to rise, buy calls in an index. If you think the market is going to fall, buy puts. You can also sell options to benefit from the same movements, but shorting options is a much higher-risk venture.
2. Consider ETF options as an alternative. When exchange-traded funds (ETFs) began gaining in popularity, most emphasis was placed on the diversification and fixed basket of securities they provided, not to mention ease of trading on the public exchanges. Another feature available on many (but not all) is options trading. Just as you can control 100 shares of an individual stock or index with options, you can also control 100 shares of an ETF. This is especially flexible when you are interested in commodities but you do not want to buy shares of one company or, even higher-risk, trade futures. So you can trade options on oil through the U.S. Oil ETF (USO) or in gold through the SPDR Gold Trust (GLD), for example.
3. Use sound reasoning for your timing decisions. Try to time speculative option plays based on a sound reasoning. For example, if you know capital gains rates are about to rise, you expect the market to fall, perhaps hundreds of points. Buying puts in an index fund is sensible and allows you to benefit from an otherwise catastrophic turn of events. If you expect good economic news and a resulting rise in a particular industry, buy calls in the leading competitor in that industry or in an industry-specific ETF.
4. Focus on short-term options combined with timing for market moves. Most options strategies involve an unending conflict between time value and time decay. Long options traders need time for value to develop, but the longer the time the higher the cost and the greater the risk of time decay. In a timing strategy, short-term options -- those expiring in one month, for example -- are the best candidates. There is very little time value remaining and if you are exercising reason in timing your strategy, it should play out before the options expire.
Michael C. Thomsett is an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks.