The market correction last week was a great time to dip your toes into the options markets. Some stocks cratered, while others were just down. It was a wholesale correction that hit every sector except for precious metals.
When every sector falls, I get interested in a hurry. It usually signifies panic-selling, and all companies get hammered regardless of fundamentals or potential. It could get much worse, so taking a position in stocks and risking a ton of capital could be a mistake.
Buying short-term options is speculative, to be sure. It’s not something I would recommend unless you have one very important ace up your sleeve. That ace is volatility.
When you get massive volatility in a very short period of time, like we did last week, you also get the potential for a very sharp move back in the other direction, as we saw earlier this week. This is not to say that the correction is over, but understanding that panics don’t last makes for profitable trading.
I tiptoed in the market last week and took up five new options positions. These positions were all in high-volatility companies, mainly in the technology and social media space. These are the highfliers when the markets move higher. But I wasn’t about to spend anywhere from $45 to $155 per share, which is what the shares were trading for.
Instead, I exposed less than $8,000 to positions that I would have had to pay more than $150,000 for if I had purchased the shares. No thanks!
After the rally this week, each options position was profitable. I will be taking my profits well before expiration.
The worst-case scenario, to me, is that I could lose my entire investment of $8,000. If I held the shares and used a 25% stop loss, I would be on the hook for $37,500!
Here’s how I look at it: If shares were to fall 25% or more because the market went into a full-fledged correction, I would want cash on hand to buy some stocks as longer-term investments. It’s hard to do that when I am getting stopped out left and right and hemorrhaging cash.
This type of trading is not for everyone. Trading short-term options is risky. But if you are disciplined and use these strategies, trading short-term options in a period of high volatility can be very profitable.
- Use only a small amount of your portfolio for short-term options – less than 1% – thereby limiting your total loss to 1% at the most.
- Trade only the short-term options when volatility, as measured by the Volatility Index, moves up at least 50% in less than a week. Once it hits 50% (say from 16 to 24), then you should dip your feet in.
- Don’t buy all at once – the markets can go down more than you think. Save some powder for another leg down in the very near future. If the market turns back up, you will still have exposure.
- Be ready to pull the trigger to sell on any rally higher. Set profit targets and follow them. The biggest mistake investors make is not having a plan to get out!