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Outsmarting the Options Market

by Ken Trester

When was the last time you got 140% profit on a stock in just 30 days?

That's what I thought. In the options world, however, this is a pretty common occurrence.

One of my recent favorites involved an American Airlines (AMR) put option trade that we opened on Dec. 10. Just 30 days later, on Jan. 10, we closed it for an average return of 140%.

But even though this was a nifty put trade, there’s an important options trading lesson that I gave to my Fast Options Profits subscribers that actually helps them get even bigger returns.

I’m a former college professor of statistics, and a lot of my options research is based on statistics.

My analysis has a second critical focus, and that is getting positioned to take advantage of the all-important component of surprise volatility. Option traders need volatility because the quick and decisive movement in the stock is what allows the option's value to pop.

We got the required volatility and profits with AMR because the stock price sank quickly and decisively for 30 days. Volatility was the reason we were able to ring the cash register. However, we were also taken out of the position by volatility caused by surprise news.

On the morning of Jan. 10, the day we bagged our profit, the leading financial headlines touted a possible airline merger between Continental (CAL) and United. That surprise news boosted AMR stock by 77 cents in the morning, with AMR closing up about $1.57, which brought our profits down a bit.

An 'Average' Strategy

You might say, 'Live by the sword, die by the sword.' As a professor, I prefer to put it this way: “regression back to the mean.”

This is a statistical law indicating that when the trend is extremely good or extremely bad, you can expect the results to move closer to 'normal,' or the long-term average.

Applying that law to AMR, we knew that the stock would never sink to zero. We also knew that the profit train would stop eventually -- we just didn’t know when or how much money we’d make.

Here’s another way to look at it: If a baseball team is really hot and wins a lot of games in a row, it is likely to win fewer games in the future -- the team regresses back to the mean, where it is really 'supposed' to be.

The same applies to stocks and options. A fund manager who is on a 'hot' streak right now is likely to cool off next year.

Options that are cheap and undervalued -- as was the case with AMR -- are likely to become properly valued or expensive. The surprise news of airline mergers did the trick of sending AMR back closer to the mean.

“Regression back to the mean” is one of the few tools that we can use to forecast where stocks and options should be trading, if they aren't there already.

The problem is that surprise volatility is just that -- it's a surprise -- so we don’t always know when or by how much this “return to the mean” will be or from where it will come; we only know that it will come eventually.

Here’s the money-making lesson that I gave to my readers to help them maximize their returns: I aim to help protect options profits by recommending that traders implement a trailing stop-loss on the underlying stock. Thus, by using an end-of-the-day stop-loss, you are positioned to exit the trade with the bulk of your profits still intact.

For those of you who are new to options or using this type of stop-loss, trailing stops protect you as the option value increases due to a rise in the stock (for call options), or a drop in the stock (for put options). As the stock price moves in the desired direction, you keep moving the stop loss so that it is 3% below the market price of the stock (or above it if you bought puts). But if the stock price changes direction and breaches the trailing stop level, you do not adjust the stop, as it serves as your signal to take profits.

In the end, we operate to create a very strict and codified track record, and using stop-losses helps us to adhere to a winning, disciplined formula.

BUT … by spotting the surprise merger news on Jan. 10, and then factoring in the statistical law of “returning to the mean,” my readers likely opted to sell before the close when our sell alert actually went out.

Selling before the close would have given them a profit nearer to 280% and they would have outdone this old college prof by a mile.

While we all want the biggest-possible return on any position, stop-losses have undoubtedly saved traders more money than they've cost them. When a stock is going in the 'right' direction (depending on how we played it, whether with a call or a put) and it makes a significant turn for the worst, there's no telling how much longer/more it will continue going in the 'wrong' direction.

Many traders have lost huge gains because they didn't close a portion of their position while its value was on the way up and because they didn't take the stock's performance as a sign to hit the bricks. And these are two very critical steps to options-trading success that are always included during your journey to Fast Options Profits.

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The journey of a million bucks begins with one options trade. Join us now at Fast Options Profits to take the first step toward incredible wealth.

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