Chris Rowe

The Secret to Market-Beating Returns

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Options are the greatest way possible to invest in the stock market for several reasons.

The first is that you can dramatically decrease risk without decreasing potential reward.

The second reason is that, no matter what the market is doing, you can insulate yourself from activity in the broader market and even position yourself to profit from it!

No one knows, for sure, what's going to happen to this market next. But one thing that's very possible is, while the economy is working out some very serious long-term problems, the stock market will reflect that process.

This means that, while the market will encounter spikes and drops, it just might end up in the same long-term range for quite some time, which has happened several times before.

Check out this chart of the Dow Jones Industrial Average (DJI) from 1965 to 1981.

Does the current state of the broader market matter to me? Nope.

Why? Because when you're trading stock option contracts, it's possible to take advantage of "direction" or "fear" (implied volatility), or both.  

For example, in the chart above, you can imagine (and many of you can remember) how fearful investors were in 1970 after the Dow declined by about 35% and bounced up to the red dot. Using options in a situation like this, you can profit in two ways:

1. By betting on the market trading higher.
2. By betting the amount of fear in the market will decline.

One strategy you would use in this case could be selling a vertical put spread.

Typically, the two things will happen at the same time (a reduction in fear when the market moves higher). But what if the market traded sideways for a period of time instead of moving higher?

What would likely happen in that case is the fear in the market would still decline, which means you would have generated a profit even when the market didn't budge!

You would do the opposite in 1973 where you see the green dot. Using options in a situation like this, you can profit in two ways:

1. By betting on the market trading lower.
2. By betting the amount of fear in the market will increase.

Typically, the two things will happen at the same time (the market moves lower while fear increases). You can see on the chart that the market dropped by 40% relatively fast.

This would cause a double-whammy for people who owned put options. They would become more expensive as the market traded lower, but since it happened so fast, the fear level in the market absolutely exploded!

What if the fear level didn't explode? If the market just gradually lost value, you would still profit because you were right about the direction. 

What's amazing about options is it doesn't have to be a 50% bet on direction and a 50% bet on fear. Depending on the option you choose to trade (in this case, the put option you decide to buy) you can bet more on the direction and less on fear or vice-versa. If you want to bet more on the "directional play" you would do what I like to do: buy deep in-the-money puts.

On the flipside, what if you were betting the market would move higher by buying call options? Well, the smartest way to make that bet is to buy deep in-the-money (ITM) call options. But if you made that bet at the green dot on the chart, you would probably have lost money.