Can you really make money in the market even when you’re wrong?
Sounds crazy, but it’s true – up to a certain point of course.
That does not mean you can blindfold yourself and start randomly picking stocks. (If you can still make money whether you’re right or wrong, then who cares, right?) Not quite.
But most investments are exacting in that it either has to go up to make money or down to make money. One or the other.
However, there are some strategies where you only need to estimate a range for the stock and still make money.
What Are Your Options?
Some options strategies require you to be right-on (just like a stock, if not more so) when it comes to picking a direction.
But with other option strategies, simply identifying a range is all you need to succeed. In fact, you can even be wrong on the underlying stock’s direction and still profit.
My two favorite option strategies for this are: Writing Calls and the other is (probably my all-time favorite), Writing Puts.
Writing Calls
First let’s review:
- Buying a call option gives you the right but not the obligation to purchase 100 shares of a stock at a certain price within a certain period of time.
The price you pay, let’s say $500 for example, is the ‘premium’. In general, if the stock goes up, the call option will increase in value. If the stock goes down, it’ll decrease in value.
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If you write a call option, you’re collecting that premium. Someone else is buying the right to own 100 shares of a stock at a certain price within a certain period of time.
If that stock goes down and the option expires worthless, the buyer of the option loses -$500. But the writer of the option makes $500.
We are the option writer in this example.
Example:
Let’s say a stock was at $70.
For whatever reason, you determined it was unlikely it would go much higher than that and probably headed for a fall.
So let’s say you wrote an $85 call for a premium of $5.00 (or $500). That means your account would be credited $500.
Win
All the underlying stock has to do for you to make money and keep the entire premium (in this case $500), is to stay below $85 by the time the option expires.
Here’s where the ‘being wrong’ part comes into play and you still make money …
Even if you’re wrong on the stock going lower and instead it keeps on going higher — $15 higher in this example – as long as it stays below your strike price of $85 by expiration, you’d still profit by the full $500 you collected.
Thought the stock was going down. Instead it went up. Still made money.
Pretty exciting.
Of course, there are ways to lose and draw on this strategy too. Let’s see how.
Draw
Continuing with the example above, at expiration, the stock could literally be at $90 (that’s $5 above the strike price of $85) and you would still not lose any money.
Why?
Because if the stock was at $90, that means the $85 call would be $5 in-the-money. As the writer of the option, you’d either have to deliver 100 shares of stock at $85 (and be down -$500 since it’s now at $90) or simply buy back that option for $500 meaning the $500 you collected in premium you’d have to use to exit the trade resulting in a scratch ($0 gain or loss).
Lose
The way to lose on this trade is to see the stock go up past the strike price plus the amount commensurate with what you collected in premium to start losing on this trade.
If the stock went to $93 for example, that $85 call option would now be $8 in-the-money, which means it would cost you $800 to buy that option back, resulting in a $300 loss.
However, once the stock looks like it’s breaking out above your strike price, you should consider buying that option back to limit your loss (or depending on where you are in the trade, protect some of your gains).
When done right, this can be a strategy with a high rate of success.
Writing Puts
Put option writing is probably one of the least known strategies but possibly one of the best kept ‘secrets’ for options traders.
This too is a great strategy to profit from multiple directions in the market, i.e., up, sideways and even down to limited extent.
(This is also a way to potentially get into a stock that you’d like to own at a much cheaper price.)
The Difference Between Buying a Put and Writing a Put
- As you know, if you BUY a put option, you’re buying the right to sell a stock at a certain price within a certain period of time. The buyer pays a premium for this right. He has limited risk – which is limited to the price he paid for the option.
- However, the WRITER is taking the other side. He has to buy the stock if it’s put to him at a certain price within a certain period of time. As in the call example we went through earlier, the option writer collects a premium.
Once again, we’re, going to be the option writer.
How Does This Work?
If you believe a stock will go up in price – this strategy will make money.
If you believe a stock will go sideways in price – this strategy will make you money.
Even if the stock goes down in price (but not too much past the strike price that you wrote) you can still make money.
And in this strategy, you are taking on no more risk than you would have by getting into the stock. In fact, since you’re collecting a premium, there’s even less risk than owning the stock because of the extra premium collected for writing the option in the first place, which can offer an extra buffer if the price fell against you.
Example:
Let’s say a stock was at $50.
You think to yourself that it’ll probably go up, or at least not go down much. Although you aren’t ready to commit to buying the actual stock just yet, as you would prefer to get in at a lower price instead (like $40, even though you believe that’s unlikely). But you also don’t want to miss out on a potential opportunity to make money because you think you have correctly identified its likely range and outcome.
So you decide to write a $40 put option and collect a premium of $400.
Win
As long as the stock is anywhere above$40 or higher at expiration, you would keep the entire premium (in this case $400) as your profit.
If it went higher as you expected, you win.
If it went sideways, or down a little, you win.
Once again, here’s where the ‘being wrong’ part comes into play and you still make money …
Even if you were wrong on the stock going higher (or just a little lower), and instead it goes a lot lower – $10 lower in this example – as long as it stays above your strike price by expiration, you’d still profit by the full premium you collected.
Pretty cool.
If at expiration, the stock price is at $40, the buyer of the option could exercise it and the writer would now be obligated to buy that stock for $40 a share.
If that’s what you were hoping for, that’s great news. Now you’ve got the stock at the price you wanted and got paid $400 for doing so. You can then happily hold the stock or choose to sell it, whatever you want to do. It’s just as liquid as if you bought the stock on your own.
Or if you changed your mind, you could always buy the option back for next to nothing right before expiration, thus locking in your gains and not even having to bother with the stock.
Of course, as with any investment, there are ways to lose and draw on this strategy too. Let’s see how.
Draw
If at expiration, the stock was at $36, (this would be your breakeven point) the option would now be $4 in-the-money. At that point you could buy that option back for $400 (essentially using the $400 you collected for writing the put in the first place), with the trade resulting in a scratch, ($0 gain or loss). This would also relieve you of having to buy the stock at $40.
You could also choose to do nothing with the option, and have the stock put to you at $40, thus creating a -$400 loss on the stock ($40 basis less $36 = -$4 or
-$400) which would offset the $400 gain for writing the option, but still resulting in a scratch ($0 gain or loss).
Lose
If at expiration, the stock was below the breakeven point (the strike price plus the commensurate amount of premium collected), let’s say $35 for example; for each $1 the stock went below that breakeven point, this would result in a $100 loss.
Of course, if you thought the stock could fall below your strike price and even below your breakeven point, and you didn’t want the stock to be put to you at that price, you could do what’s known as ‘rolling down’ your option before expiration.
This is done by buying back your current put option and writing a new put option with a further down strike price. (Although, often times, just exiting the trade can be the best course of action.)
Put It There
Simply put (no pun intended), if you have a belief that a certain stock won’t go down below a certain price, then writing a put option is one way to make money, especially if you believe there’s more upside risk than down.
But if you really are interested in buying a stock, albeit it at a lower price, instead of waiting and hoping it’ll get there (and not making any money in the meantime), you can write puts and earn income while you’re waiting for that price to be hit, and still get paid even if it doesn’t.
Up, Down or Sideways
Options give the investor numerous ways to make money.
Some strategies are designed to make money if the stock goes up. Some are designed to make money if it goes down. And others are designed to make money if it goes sideways.
But being able to make money even if the stock goes in the opposite direction you expected (albeit within your range of course), is a great strategy to know.
And through the use of options, you can greatly increase your odds of success no matter what’s happening in the market.
Interested in Taking Advantage?
If you’d like to get in on precisely timed moves triggered through these and other professional strategies, I invite you to look into our new Zacks Options Trader. It blends timely stock-detecting power of the Zacks Rank with my personal options techniques and perspectives. Along with the recommendations, you’ll be briefed on the reasons behind them.
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Thanks and good trading,
Kevin
Kevin Matras
Vice President, Zacks Investment Research
Kevin Matras is our world-class research expert who has developed more than 30 market-beating strategies using the Zacks Rank. He is currently directing a new initiative to take full advantage of volatile market conditions, the Zacks Options Trader.
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