You Can Make Money in this Market… Here's How Volatility Rising Can the 'Smart Money' Outsmart This Market? OK, Market–Make Your Move Election Considerations

Andrew Houghton and Nick Atkeson work together to identify options trading opportunities on the institutional level through their hedge fund and, now, for OptionsZone.com readers. They are the editors of Big Money Options, an options trading service that provides one to two new opportunities each week based on their findings. You can check out more about their trading strategies at TradeBigMoneyOptions.com

You Can Make Money in this Market… Here's How

Lots of traders and investors are asking, "How can we make money during this time of economic and financial market crisis?"

There are plenty of opportunities to profit, especially – and, perhaps, only – if you're an options trader.

To have a real chance of building profits, we will need to understand the trading landscape to find the "sweet spot."

Where Should You Start?

The sweet spot is the part of the market where – by using repeatable, quantifiable investing methodology – we can consistently make money because the structure of the market works in a predictable fashion. It is clear that many of the tried-and-true forms of investing from the past 25 years will struggle in a market that has and will continue to structurally transform.

The big question is whether anything really changed and, if so, how. Investors generally do not recognize the market high or low until it is well past and the chart image is well-established. If it is difficult to assess if we are at a low or high, then it is even more difficult to know if the world has changed and, if so, in what ways.

One important change that has occurred on what looks to be a secular basis is that market volatility is on the rise. The root causes and ramifications of this change are becoming much clearer.

Volatility Rising

At the end of 2006, the VIX was at about 12. For much of October 2008, it was at 70 or higher. It is very likely that 70 is a range-end high. But it is also very likely that the VIX trades on average substantially above its ten year average measured from 1996 to 2006. In fact, since mid 2007, the VIX has spent considerable time above 25. Not so long ago, a VIX of 30 or higher was considered a measure of extreme fear.

Why should we expect volatility to rise on a secular basis? From a broad array of possible global issues, we will only address what we see in the financial markets.

1. The financial markets are more globally linked today than ever. Large, developed, mature markets will become less stable because they are more tightly linked with the immature, emerging markets of developing nations and countries where capitalism is just now being discovered (e.g., China, Russia). When the foreign markets rip up and down, global money managers make position changes that add volatility to our markets.

2. We have had an explosion in the development of newly created levered financial instruments. Collateralized debt/mortgage obligations and credit-default swaps are examples of financial instruments that have experienced logarithmic growth over the past decade. This "leverage on leverage" inherently drives volatility higher.

3. The concentration of assets in hedge funds has increased volatility. Hedge funds tend to be active traders and, lately, seem to be crowding too much money into asset classes that do not allow for orderly liquidation when everyone wants out. The run-up and collapse of commodities is an example of what a crowded hedge fund trade can do to pricing on a short-term basis.

4. There has been tremendous growth in black box, statistical model computer trading. Concentrated institutional orders being driven by very similar software rules go a long way to explaining the wild intraday and end-of-day market volatility. These computer-controlled trading systems change the structure of the market's trading activity and permanently add to volatility.

5. After a multi-decade trend of rising credit availability and declining borrowing costs, hard assets of all types experienced tremendous inflation. To add to the upward pressure on hard-asset prices was the belief that the developing world had an insatiable demand for oil, lumber, copper, etc. With input costs rising, hard assets only went higher. However, all of the above has now gone the other way, at least in the minds of investors, and hard assets are experiencing deflation. This could be a multi-year trend that further adds to stock price volatility.

Would You Like a Little Turbulence in Your Portfolio?

Ironically, volatility is on the rise when many market participants would love to see less of it.

The technology and housing bubble pops and the credit crunch have hurt many people financially and left them wondering whether there is any way to make money in stocks when they move so far, so fast. Those of us who are meaningful investors are getting older and becoming much more focused on having enough money to sustain us over a longer-expected lifespan.

In some sense, investors are asking for Vanilla and the market is serving Rocky Road. The market has what we want, but we have to know where to look, given the structurally elevated volatility levels.

Day Trading Hurts

At the other end of the spectrum from buy-and-hold is the day trade. But how do you day-trade a market that can move 7% in any direction within an hour? The radical, intraday moves of the market have become virtually unpredictable as global financial factors that are not transparent are driving the market in the very short term.

The professional traders at hedge funds, with the best information flows and fastest trading technologies available, are generally getting hammered when attempting to keep pace with the daily market moves.

While it's a trader's market and adding trading strategies to your investment arsenal can yield big profits can be made on both longs and shorts, don't get discouraged and cash out if you feel you don't have enough time to dedicate to watching your portfolio on an hour-to-hour, or even minute-to-minute, basis.

If you can't watch the ticks or have little experience with day trading, it's better to gain experience with paper trades before going for the real thing. You can also shift your focus to other profit strategies (in the form of longer-dated options instead of playing the ones that expire in the next month or two) that give you a little more time for your trades to play out.

As the market became more volatile in September and October, average losses at hedge funds for each month exploded upward. Long/short hedge funds lost more money in September alone than they had year-to-date through August, although their October losses make those in September look small.

Can the 'Smart Money' Outsmart This Market?

We make option trades by following what we call the "smart money," the funds and institutions that are throwing big amounts of cash down on the bets they're making that an option is going to take off when the stock soars or stumbles, as they expect it to.

When we see these gigantic moves taking place, without the headlines or other catalysts that would typically precede (and therefore explain) this type of activity, we start calling the actual traders on the floors of the option exchanges to get their professional opinion about the truth behind the trades.

And if it truly looks like something "they" know is something the public isn't privy to, that's when we find ourselves with some potentially explosive options trading opportunities.

But in this volatile trading environment, where practically every move seems to be an extraordinary – and certainly inexplicable – one, the smart money is being careful. It's still active, but its bets are presently less telling than "usual."

Going forward, we expect the market to normalize at higher average volatility levels. When that happens, the smart money will become more active and discernible again as fear subsides, and we will track it and trade on it as we have in the past.

But for now, there are other ways to stay in the game.

Given the tremendous change in the trading landscape during the past month, the smart money has been selling volatility rather than making strong directional bets recently. We are right there with them and putting up profitable trades again.

Here's how you can make those profitable plays, too. 

Profiting from the New 'Normal'

Intermediate market trends that last anywhere from a few weeks to several months are predictable and profitable. They allow for the investor to capture the bulk of the value from a longer-term trend while lessening overall market exposure and capital commitment.

The intermediate trend also allows the investor to hang on through the crazy day-to-day swings without being whipsawed out of every hard-earned dollar.

It is our belief that the intensity of this current crisis will subside and market volatility will "normalize" at some new, higher level. With more-normalized patterns in place, our options indicators will once again regain their predictive force.

Options have been, and are likely going to once again be, excellent predictors of intermediate-term trends. On a stock-by-stock level, they track many of the most sophisticated, leveraged market participants. On a broader-market level, they capture current market sentiment in real time.

With the intermediate market trend identified, we seek to take the extra step of finding the most lucrative, low-risk options plays available. By going long an option versus the underlying equity, we effectively implement a stop-loss trade. Capital is protected in the event the underlying stock moves in the wrong direction by a large amount (an everyday occurrence, lately) and the upside is captured in a levered trade.

Keep Your Swing Under Control

One of life's great little pleasures is watching a golf ball fly long and straight after having hit it in the middle of the sweet spot with a nice, easy swing. The same is true with options.

If you try to "kill it," you will likely lose money. When trading options, you should invest a comfortable amount where, even if the trade goes badly, no sweat. With too much money on the table, fear may make you lock in losses as the volatility of the trade moves through its normal course.

Don't worry about missing the big one. When option trades go well, they usually go very well.

OK, Market – Make Your Move

The United States and world stock markets crashed in October. The government has responded with almost every conceivable rescue action. The question is: Now what?

In the big picture, the worldwide leverage bubble was the largest bubble in the past 150,000 years, which covers the time period of modern man. It would be a fair assumption, then, to believe that the bursting of this bubble will have more than a one-year impact on our market and economy. Hence, the October crash may have been the sharpest angle of descent but may not have marked the final bottom.

Remember that we are experiencing a crisis of credit. The credit market is leading equities, and currently it is indicating that the S&P 500 has 20% to 30% downside. We fully expect to hear horrible economic news through the rest of the year and be surprised by negative announcements from companies that we had previously thought were well-protected from the financial storm.

But the markets are moving fast. Given how oversold they currently are and how stretched the measures of oversold are, it is very possible we have a tremendous bear market rally that lasts for weeks, if not months.

OK, Investor – Make Your Move

During the week of October 20, Warren Buffett, Bill Gates and Carlos Slim Helu – the three richest people on earth – started buying U.S. equities. One month ago, the ratio of insider buying to selling was 1-to-1. In the past several weeks, buyers now outnumber sellers by 3-to-1.

The point is, you should buy when fear is at a high and sell when fear is at a low. As Warren says, be greedy when others are fearful and fearful when others are greedy.

Although the negative news and credit crisis issues are not going away immediately, you may start to look at companies with top-notch management, strong balance sheets and secular growth stories. The markets may be in turmoil but there are always strong companies turning out solid results, and you should continually be ready to play these opportunities that aren't making it to others' radars.

One area that strikes us as attractive is the oil service industry. With the liquidation of several commodity hedge funds and with the commodity cut in half from its high, this sector could do well.

Long-Term Credit Crisis Concern

Our biggest long-term concern with the current financial market turmoil is what happens to all of our debt. Rather than reducing America's debt burden, the actions of the government so far have been to transfer debt from the private sector to the public sector.

For example, we are committed to injecting $123 billion into American International Group (AIG-http://optionszone.com/getaquote/index.html?symbolsearch=AIG). Where are our taxpayer dollars going? They are going to hedge funds that bought credit-default swap (CDS) contracts from AIG-http://optionszone.com/getaquote/index.html?symbolsearch=AIG.

The company's CDS portfolio is estimated to be $447 billion. How does transferring our tax dollars to several large hedge funds through the payment of AIG's CDS contracts make America stronger?

In plain English, we believe you fix a problem of too much debt by reducing debt. The debt load is to big even for the U.S. government. To saddle the taxpayer with this debt will hamstring the economy for decades and very much restrict the ability of our leaders to lead.

Taxpayer revenues will be almost entirely used to pay debt-service and support-entitlement programs. Almost no budget dollars will be available for programs that represent investments in America.

We believe that, when the dust settles and historians are able to perform a detailed study of why the credit market is not responding to government stimulus programs, it will be in large part caused by the massive, unbalanced potential liability of credit-default swaps.

Anna Schwartz (a highly respected and experienced economist – she has worked with the National Bureau of Economic Research since 1941) stated that banks are not lending because credit-default swaps make unclear who is solvent and who is not. The problem is not liquidity; it is not being able to judge counter-party risk.

According to Federal Reserve statistics for the week ended Oct. 1, banks held $167 billion of balances with the Federal Reserve. On July 2, the balance was $14 billion. Banks are hoarding cash because of the unknown liability embedded in the $55 trillion CDS market.

Rather than having the problems of the CDS market transferred from banks and insurance companies to the taxpayer, the federal government should declare these contracts invalid, thereby reducing our nation's debt load by trillions of dollars and restoring transparency to our financial system.

Bottom line: The CDS market is a major obstacle in the path of recovery. (For more information about the CDS market, check out our article "Using Credit-Default Swaps in Your Options Trading" here.)

Election Considerations

Barrack Obama has been elected President and we have elected a new leader and, in turn, a new administration that's responsible for leading us out of the economic, banking and housing crises while fixing, furthering or finally implementing the projects that will not only set our country's future direction, but power it as well.

Speaking of power – specifically, alternate forms of it – we believe development of a comprehensive energy policy will be a major new course of action for America during the next four years.

Clearly renewable, clean energy will be an important part of our new energy policy. And so will oil and gas drilling.

In our stock market today, some sectors have yet to be fully sold and others have been oversold. In our view, many of the oil service stocks have been oversold and are trading at single-digit multiples. Unlike the exploration and production companies, oil service companies generally do not need lots of new capital to conduct their business.

Another new reality is, with the transfer of huge amounts of debt from the private sector to the public sector, the U.S. government will be very much restricted in its ability to maintain its military presence abroad. Funding for Iraq and other military ventures is likely to be reduced; in fact, a reduction of troops has started already.

Just as the Great Depression shaped a generation of Americans' views about risk, spending, savings and debt, this yet-to-be-named financial crisis/crash will forever change how investors view risk and how our government views unbridled free market forces.

From the investor's point of view, risk needs to translate into reward.

So if volatility equals risk, and if volatility is going to be higher on average over the coming decade (which we strongly believe will be the case for a multitude of structural reasons), then the stock market rewards must be higher than they have been historically or else money will flow to places where the risk/reward relationship is more in balance.

During the past two months, more than $70 billion came out of U.S. equity mutual funds. From the government's perspective, it will clearly have to regulate the financial markets more deeply and begin the process of working the taxpayer out of the current $3 trillion bailout hole.

We will have to wait and see whether the events of the past year finally are sufficient to cause our legislators to become fiscally responsible with the budget.

Dear OptionsZone Insider Reader,

The election is over. But there is still a lot of uncertainty and volatility in the markets that makes for a great trading environment.

You want to be ready to profit in this brave new world with the right tools and information to make consistent and profitable trades.

thinkorswim has always had an ambitious goal - to transform the way self-directed investors trade stocks, options, mutual funds, futures and forex.

Thanks to unprecedented client-side technology and the delivery of practical investor education by industry veterans, the plan has worked.

Want speed, features and fun? thinkorswim’s flagship trading platform sets the bar for the industry. An easy-to-use interface combined with powerful trading tools, the TOS software is built for all levels of trading, from beginners to seasoned pros. There’s even a version with training wheels, paperMoney, that lets you practice before you trade for real…Click here to get your free trading software download.

Check this out . . .

• NEW — Live, streaming video! thinkorswim is excited to offer exclusive access to CNBC Plus directly within thinkDesktop. It’s instant replay for the financial markets - except better.

• Forex (FX) currency trading is now available on thinkDesktop!

• A state-of-the-art system for monitoring, analyzing and trading equities and option derivatives - efficient, feature-packed and powerful.

• Java-based, browser-less application checks every time you log into it for any software updates and then updates itself.

• thinkDesktop can be run using either “real” or “paper” (fake) money. In the paperMoney mode every user has two virtual accounts each funded with $100,000 of “play money”. Enjoy all of the same features except that the trades aren’t real and you can start over anytime you like, what could be better?

• Scan Tab to let you search for stocks based on fundamentals, personal and/or sector watch lists, top tens and implied volatility. Coming next month we’ll be adding chart recognition scans, option activity and historical implied volatility.

• Powerful analytics, streaming quotes, two charting packages, we could go on and on.

And, thinkorswim is rated highest software-based online broker and “best for options traders” in Barron’s 3 years straight.

An easy-to-use interface combined with powerful trading tools, the thinkorswim software is built for all levels of trading, from beginners to seasoned pros. Click here to download your free trading software download.

The Hedge Edge

The vast majority of options trades are executed for the purpose of hedging – that is, protecting the value of what you already own. Investors generally buy and hold stock, or what's known as "being long" stock, and one of the most-straightforward ways to protect the value of the stocks in an existing portfolio is to buy a put option.

If your stock declines in value, the put premium should rise and help limit any losses you may incur in the event of a pullback in the share price. If the stock appreciates, however, the option's loss in value is limited to the cost of the put.

The same is true for short-sellers (i.e., someone who borrows their broker's money to short stocks or options) who buy call options to cap their potentially unlimited loss in case their short trade goes against them.

A 'Premium Blend' of Investing Strategies

Collecting premium, or selling volatility, is another reason why people trade options. The more movement that's taking place in the markets and in individual stocks, the higher option premiums tend to go. And during less-volatile times, investors who want to enhance the value of stocks held long can sell covered calls.

A "covered call," which is also called "writing" covered calls, means "selling to open" a call – using your long stock as a hedge – to generate income while the stock value is remaining fairly steady. Although the stock may not be making great advances, you are simulating gains by creating them yourself through the short sale (and, therefore, premium collection) of a call option.

In this case, an investor sells calls at a higher strike price than the current value of the underlying stock. For example, if you hold shares of Apple (AAPL) at $100, to benefit from this strategy, you would sell AAPL calls with strike prices of $105 or above.

The hedge portion of this trade is to effectively lower the cost of your stock by collecting option premium. If your stock is not called away – that is, the holder of the option (i.e., an individual who "bought to open" a call option with the same strike price of the option you sold) does not exercise the option – because of appreciation through the strike price, it helps to juice up your portfolio returns.

Think of it this way: In this example, you are holding a profitable position in AAPL and enjoyed gains even when the stock was trading flat. It doesn't matter how you're making gains – just as long as you're making them! Trading options can generate returns faster and more frequently than simply buying and holding the stock by itself.

However, there are risks to selling covered calls. First, the stock could drop way down and the premium you collect is peanuts relative to your loss in the equity. Or, if the stock rips up and through the strike price in the contract you sold, you could lose the stock and potential upside. Having the stock called away can also trigger unwanted tax consequences.

During the past 10 years, selling covered calls became very popular, as implied volatility was typically priced higher than actual volatility. In the past year, however, actual volatility levels have increased making this strategy less attractive.

A Step in the Right Direction

The third reason why people trade options is to leverage a directional bet. Big Money Options is focused on this type of options activity. We look for trades where the options investor believes he has information that is highly directional in nature and where he is seeking the maximum leverage and return on his investment.

(Check out some of the recent items that have hit our trading radar – and see what's new each week at absolutely no cost to you – by clicking here.

Trading options allows investors to greatly extend a small amount of capital (relative to buying the underlying stock) and earn hundreds, if not thousands, of percentage returns.

It is important to remember that options carry a certain amount of risk. Options investing involves making a prediction about the future, which includes a probability that pricing will change by at least a specific amount within a specific time frame. The accuracy of your prediction about the future is what option traders call your "edge."

Remember, too, that options have an expiration date. If the underlying stock has not moved sufficiently in the direction you thought it would, it is likely that your option will expire with no value.

If you paid a high premium for your option (which means there is a lot of volatility priced in) and volatility falls, it is possible to have an in-the-money option at expiration where you have no gain or even a loss in the investment. Time is not your friend with options, as they deteriorate with the passage of time.

While almost any investor can find a way to boost their returns or limit loss with options strategies, make sure you study a full listing of the risks associated with options trading before making an option investment.

Good luck trading,

Nick Atkeson & Andrew Houghton
Big Money Options

PS – Once you've identified the types of trading strategies that work for you, it's time to find options to trade. Nick and Andrew provide options trading ideas AT NO COST to you on OptionsZone.com. See their newest trades in our Unusual Trading Activity section. You can also click here to subscribe to their RSS feed and have their trading ideas delivered straight to your feed reader!