As a former college professor, I know this time of year means that after a semester full of toil and frustration, many college students are packing up and scattering to the wind for a much-needed summer vacation. The same is true for a lot of investors and many in the finance world.

You've heard it before: "Sell in May and go away."

Is it true? What happens if you do and, more importantly, what won't happen if you're not participating in the markets (i.e., what will you miss)? As an options trader, it might mean missing out on some quick, easy profits.

Think of the stock market as a swimming pool filled with hordes of kids splashing around and having a great time — waves are created and water is thrown everywhere, even onto the folks lounging at the side of the pool.

Now, if the majority of the kids leave the pool — or the majority of investors "sell in May and go away" — and seek refuge on the sidelines, what happens? The splashing and the waves and, essentially, the fun all die down. The swimming pool becomes very calm with much less movement.

Don't get me wrong, sometimes it's nice to have the pool all to yourself. But in the investing world, more people who want to get into a trade means bigger demand and, in turn, more people you can sell it to (and bigger money for those who got in early).

Come On In, The Water's Fine!

When it comes to investing, there are all sorts of adages but most of them truly don't apply. The most-important "trend" for options traders is volatility — the splashing in the pool, if you will. Yes, volatility — the very thing that many long stock investors fear — is exactly what we thrive upon!

It's been a hard, painful lesson for many investors to learn that stock prices don't move in fixed or predictable steps — just because a stock should move a certain way, doesn't mean that it will. It's fair to say that many stocks' pattern of movement can be called "randomness," as they often move too far to the upside, or the downside, in relation to a company's real value.

Let's look at the overall market to illustrate what I'm talking about. It's been a wild ride this year, but investors reacted predictably. If the market moves too fast to the upside, then traders overreact and push it too far in the other direction.

It happens again and again, like a yo-yo.

The same thing occurs with individual stocks — they get pushed to the extremes. I know that in recent weeks, we've been lulled into a sense of security because the stock market has settled into a kind of trading range. But I, for one, hope for more volatility ahead. And so should you!

Pop Champagne When Stocks Pop or Drop

Far too often, people mistake volatility as a bad thing, but our goal is actually to buy options on high-volatility stocks. You have a limited amount of time to work with, and your best options plays are on stocks that move — ones that make big advances or declines, at that!

Why? Because...

1  |  2

next >>

higher volatility leads to higher option premiums and increased income generation. I always only buy inexpensive (OK, cheap) options around $2 or less in our Fast Options Profits trades, but options on volatile stocks also tend to have better liquidity (i.e., more people and money moving in and out of positions), which could help you to secure better option prices both when you're buying and cashing out.

Simply put, the more certainty there is about the future of an investment, the lower the return. For an options trader, upward volatility means two key things.

First, rallies often draw out the more maverick professional traders who will happily sell into rallies and downturns bring out pirates who scoop up discounted equities. They hope to procure profits from later repurchasing what they sold at cheaper prices or selling what they bought on discounts for higher returns.

The second thing that can impact your cash flow is that persistent rallies or downtrends actually bring is a decrease in volatility, which is the option trader's perception of risk in the stock market.

Learning how to invest successfully often means that you need to stop listening to your intuition. What I mean is that this is all counter-intuitive — a rally feels great when it's under way, but it ultimately leaves the market at a higher level. On the other hand, your stomach can sink during a decline, but a downtrending stock market offers some great buying opportunities.

Believe it or not, a higher market carries more risk than a market churning at lower levels. Options premiums typically contract during rallies with almost near-perfect regularity, while volatility can open doors to a lot of money-making positions.

Get to the Head of the Class — and the Cash

Some options traders are OK with accepting a financial pundit's interpretation of what is a volatile market, but the professor in me prefers to give you the know-how to measure it yourself.

The measure of risk in the S&P 500 (SPX), one of the bellwether indices, is charted by the Chicago Board Options Exchange's Volatility Index (VIX).

It's expressed as a percentage, where a higher percentage, or value, is accepted to mean there's a greater degree of market uncertainty. Conversely, a lower VIX value generally portends greater stability.

You can monitor volatility on the Nasdaq (NASD) as well, via the CBOE Nasdaq Volatility Index (VXN), and you can also check out volatility on the Dow Jones Industrials (DJI) via the CBOE's Dow Volatility Index (VXD).

In the past year, the VIX has ranged from 12.08 to 37.57. Currently, it's nestling in the 18 to 20 range, which lets analysts surmise that the S&P will fluctuate nearly 18% on an annualized basis.

With recent multi month-low readings on the VIX, you have a recipe for a larger-than expected pullback for stocks in the making. A low VIX reading implies an overly bullish and complacent market, and with the VIX index back down from 35 to a reading of 20, a period of backing-and-filling looks imminent.

Because of unpredictable variables that are described in the chaos theory, we never know what event could send the stock market or individual sectors tail-spinning or skyrocketing — sometimes it's a simple as the "sell in May and go away" belief.

But, as an options investor, the volatility is welcomed. Remember, the prudent course of action is to buy both calls and puts to profit from possible stock market volatility in either direction.

If you'd like to start profiting from market swings with options trading, join Fast Options Profits for a risk-free trial subscription to get access to the next batch of soaring options trades.  Get 2-3 of the Ken Trester's top trades that are backed by his nearly 35 years in options trading and extensive research. Sign up today!

<< previous

1  |   2