Ken Trester

Making Consistent Option Returns

by Ken Trester   08/27/08

Anyone can buy the popular clothing brand (or stock) du jour, but if it doesn't serve its purpose and make you (or your portfolio) look amazing, then it's better left on the shelf.

But nothing's more satisfying than looking for the option that's "just right" and having it work like a charm, all because you invested the effort that leads to a bigger, better payoff.

When you buy options for speculation, I believe that bottom-fishing in the markets is the best approach to follow. Cheap options have the potential for spectacular gains, but finding bona fide options that are underpriced and have home-run potential is not easy. You need tremendous patience and, no doubt, you might have to enter a lot of orders before you get one filled at your price.

More cheap options expire worthless than don't, so you must have the patience, discipline and resources to keep trying for a home run. To do this, try to find options that are priced below $1.50 that also have a strike price (or, exercise price) that is close to the market price of the underlying shares.

For example, if a stock is trading at $79, you might want to check out the call options at the $80 strike because a $1 move up during the life of the option might be very realistic and could pay off handsomely if you don't pay much for the option.

To get your best deal, buy put options on downtrending stocks that are temporarily rallying, and call options on uptrending stocks that are temporarily falling. Just like you want to step in to your long stock investments on pullbacks, it increases your profitability potential to buy your options on sale as well.

Most importantly, buy options on stocks that have the potential for surprise volatility. Stocks tend to fall much faster than they rise, so having some long put options in your trading account tends to be a better bet on surprise volatility. Many options traders who had bought puts before the Dow Jones Industrials suffered one of its many triple-digit drops probably enjoyed having their puts performing well while a number of their bullish positions took a temporary hit.

When you're trading and investing in options, spending the least amount of money on the biggest-potential positions allows you to capture anywhere from decent to mind-blowing percentage returns. Also, having both call and put positions will keep your bases covered, no matter what the individual stocks or the markets themselves might bring on any given day. And in the worst-case scenario, even if your trade doesn't work out in your favor, it hurts a lot less when you've only spent a dollar per share instead of buying the stock itself and having it crack!

Whether you're just getting started in the options-trading game or if you're looking to enhance your success rate, below are my 10 basic rules for speculating with options.