After reading our previous article (Time to short stocks in the NYSE?), one of our readers asked us a very practical question on using options to successfully trade the market. For those who are thinking of making their wealth with options, please read and understand what we wrote to this reader:

But one thing you have to bear in mind: learning about the technical aspects of options (e.g. delta, gamma, theta, delta-neutral, options strategy) is the easy part. We have quite a few good book recommendations that can teach you the technical aspects of options very well. The difficult part is to be a good trader. Even if you are an options expert, you will still make plenty of losses if you are a bad trader. On the other hand, if you are a good trader, you can still make good money with the most basic options strategies.

Options is just a tool. A bad trader who uses a powerful tool will lose money regardless of how well he/she understand about the tool. A good trader, coupled with a strong basic understanding of the tool, can make good money.

Options trading is a very vast field of study (for example, the topic of volatility in itself can cover a thick volume). Therefore, this is something that we cannot cover in just one article. For this article, we will give a little preparatory background about options before going into something more practical. For those who are totally uninitiated to options, please read Introducing options as insurance and How not to use options first before continuing.

For budding options trader, the thing to remember about options is: statistically, around 80% of options expire worthless.

• Therefore, buying options (whether call or put) is likely to result in loss.

BUT…

• But the other 20% of options (that are not worthless when they expire) have the potential to yield fantastic profits.

Therefore, buying options allows you to profit from Black Swans. If you have not already, please read Failure to understand Black Swan leads to fallacious thinking. Put it simply, even though you are more likely to lose money buying options, you will make lots of money should you win the unlikely-to-win (based on statistical probability) bets.

• Conversely, if you write options, they are likely to result in profits.

BUT…

• But on the other 20% of options (that are not worthless when they expire) expose you to a contingent liability that can result in substantial loss.

Therefore, writing options makes you vulnerable to Black Swans. Put it simply, even though you are likely to make a nice income writing options, you are exposing yourselves to contingent liabilities that can result in substantial losses (if you are not hedged).

In options trading lingo, buying options gives you positive gamma while writing options gives you negative gamma. If you have no idea what “gamma” is, forget about it because it is a specialised jargon used in the options universe. If your options position have positive gamma, you will benefit in sudden increase in volatility. On the other hand, negative gamma positions will benefit from little volatility in the market.

When options traders construct an options position, they are using a combination of buying and writing options to adjust between the positive and negative gamma according to their tolerance for risk and their conviction of the market.

In the current market, if you believe that there’s a likelihood of sudden unexpected increase in volatility, your options position should have positive gamma (e.g. from simple buying of put options to the more complex put ratio backspread). Positions with negative gamma are vulnerable (e.g. writing put options in the belief that a nice gradual up-trend will continue) to sudden increase in volatility. To explain this in more detail, let us give you a few examples:

1. If you buy out-of-money put options, you are likely to lose 100% of your money, based on statistical probability. But if the market suddenly crashes, you will make many times the return on your capital.
2. If you write out-of-money call options, you are likely to make a little money most of the time. If the market crashes or rises a little, you will profit a little. But if the market rises significantly (e.g. a stock that receives a takeover bid), you will likely to suffer heavy losses.
3. If you buy out-of-money call options, you will suffer limited loss should the market crashes. But if the market sky-rocket suddenly (e.g. if the Fed announces that they will drop freshly printed US$100 trillion from the sky via helicopters), you will make big money.
4. If you write out-of-money put options, you will make a little money if the market rises or falls a little. But if the market crashes, you can lose a lot of money.

That’s all for today on options. If you do not understand what we are talking about, don’t worry. Options traders live in a different planet from the rest of the world.

One final note: in a recent interview, Marc Faber said that he believes that the market will make a big move in the next 10 to 14 days.