It is well- known that options are like double-edged swords. If you use them well, they will earn much higher profits than your investments in stocks. If you are clueless about how to use them, you lose your money and a margin call might be in front of you.
What I want to discuss today is how to let the market fight against you instead of you fighting against market.
Be thankful for the options and their liquidity provided by day-to-day market-makers (MM).
The option traders try to hedge their risks through delta and gamma. These two terms are first mathematical in nature and second, derivatives of the underlying stock prices. We don't need to discuss them in a quant manner, but what you need to remember is that option traders always hedge their positions.
What does this mean? When they buy some options, they short underlying stocks according to some calculated numbers. When they short options, they long their stocks.
It's clear to see that when short-squeezing happens, option traders find it difficult to do an "exact hedge" and the option prices may simply go in one direction only.
This is what I did last Friday after I received a flash alert to buy SCOK from a subscription.
SinoCoking Coal & Coke Chemical Industries, Inc. (SCOK) produces and markets coal products, including coke, raw and washed coal and chemical byproducts in the People's Republic of China.
This company was oversold in the middle of August, 2010 and people overreacted to the bad news.
After carefully examining the fundamentals and speaking with some analysts, I am ready to enter with a catalyst. Ten minutes before the market closed on August 20th,2010, I received a flash alert urging people to buy SCOK, and that really drove the price up by 10% during the last five minutes. To profit from this rally and limit my risks, I sold some 10 Sep 2010 Puts at 1.6$. I begin to sell the options right after rally, as it is rare for the stock to drop below 10. By writing the options, I earn both time decay and value depreciations at the same time. (When you write options, you receive fees upfront and expect to receive all of them when it runs out of money.)
On August 23rd, 2010, I closed all of my Put positions by buying them back at about $1.05$. Because of uncertainties, it is not recommended to hold your option positions for too long. This made me a quick return of more than 30%; compare this to the 15% one can expect when fully invested in stocks.
Other successful examples are selling 9 Aug 2010 Puts for RINO and 10 Aug 2010 Puts for CAGC. Both of these are companies with good fundamentals that I like very much. Their values are hard to beat below those levels.
Small-cap companies' stocks are very volatile, so their OTM options may always bear more premiums compared to their large-cap peers. (Option theory tells us that this is called volatility smile, but that is beyond the scope of our current discussion.) Because of this, selling deep OTM options for companies with good fundamentals is an effective way to earn high yields each month.
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