Although you we are not brokers like the guys in the movie, we can still learn to make money in any market environment.The spirit of market turmoil is still wandering in the market: after all, despite the recent rally, the market is down about 7% year-to-date. There is still a lot of volatility, both in general sense and among individual stocks. The recent earnings season, which has not ended yet, has been devastating for a few companies on the market (we all know the names). Maybe I am inexperienced or inattentive but this earnings season is unprecedented to me: I have never seen so much action on the market driven mostly by analysts’ estimates. With oil halting its decline at the $30-per-barrel mark, it looks like the equity markets have calmed down, even though the options’ market makers are a bit heavy on implied volatility (i.e. pricing). Nevertheless, there is always somebody rocking the boat. I do not endorse pessimism, nor am I necessarily against it. Alternative opinions will always be there, as long as people have the freedom of thought. In fact, opinionated people help keep markets in check. An example of that is a warning given by technical analyst Tom DeMark, who states that, if the S&P 500 index closes below the level of 1,917 points, “the benchmark index will decline at least 8.2 percent from Monday’s close to 1,786”. In the stress case, the index can drop below 1,740: (Source: ZeroHedge) I do not know what agenda Tom DeMark has. I also do not trust “experts”, no matter how many times they have been right or wrong in the past. Moreover, I like to use risk management as the foundation of my investing decision-making process. Nobody knows where the markets are going to be tomorrow, let alone a week or a month from now. However, we can use historical probability distributions to model the boundaries of the future market movements in order get an idea where the market will probably end up in time t. On the other hand, some people think that market movements do not resemble random walk. I could not care less whether this is true or not, to be honest. As an investor, I care to preserve my money at a reasonable cost and/or profit regardless of what direction the market will take. Not long ago, I began to broaden my knowledge of options. Although I started studying finance in high school and encountered options many times before, the most recent intellectual “renaissance” opened my eyes on many things in the options market I either did not understand in the past or did not care to understand. I found out that options are incredibly useful in both profiting and managing risk. Contrary to the popular opinion that options are complex and dangerous instruments (the “magic” derivatives, which, according to Michael Moore, nobody on Wall Street actually understands) used primarily for trading and speculating, I found that almost any type of investor can employ option strategies to his/her own benefit. One just needs to know how the option strategies work, what limitations they have, what particular benefits each one of them can bring, and the risks they carry. Today, I would like to share a few of my favorite strategies that can help you profit/save your capital no matter, if the markets keep recovering or tumble, like in DeMark’s scenario. Options’ prices are skewed in the way the best describes human nature: people are terrified of market meltdowns, even though the markets have always come back up in the long-run. Hence, they are more willing than not to pay for downside protection. You should keep that in mind when I present my strategies. Of course, in particular cases, such as for depressed stocks or biotech companies, calls are actually more expensive than puts because market makers know how investors behave when good news come out. Essentially, if you follow the herd, you will be charged more for protecting your downside or placing your money on presumably winning bets. Most of us know that the simplest strategy to protect ones portfolio from market declines is to but ATM or nearby OTM puts on each security held in the portfolio. This is also the most expensive option out there and not the most logical one. After all, when asset prices fall, rational investors should be greedy and rushing to buy them because they get the opportunity to buy good businesses at great prices. Of course, this is true when no structural changes that affect the businesses in the long-term have taken place. In other words, investors should worry about valuation risk, not market risk, as Erik Kobayashi-Solomon, the author of one of my favorite books on options, stated. A less expensive strategy is to buy puts on broad indexes (or their ETFs). It is cheaper because major indexes have less room for market makers to jack up prices on options. However, it is still expensive and less effective than the first strategy because some stocks/bonds in your portfolio may have little or even no correlation with the index. There is also beta risk: stocks with above-market betas will fall faster than the index. Hence, you will likely incur greater losses than in the first case. A new strategy I learned about just recently was described well in an article written by a WhoTrades contributor. The strategy is called “options wheel”. The first part of the strategy works as follows: investors sell puts on securities (or an index ETF, as well) at strike prices they actually want to buy the underlying securities. In other words, instead of shorting the market, you let the market “come to you”. If the market does not “come to you” in the form of a stock/index dropping below the strike price, you get paid a premium (or I should say you get to keep it). If it does drop below the strike price, you simply pay the buyer his profit and own the stock/index from the strike price and higher. Another interesting, yet more complex, strategy is to buy a straddle (that is, buy at-the--money puts and call simultaneously) and sell a strangle (that is, sell out-of-money puts and calls simultaneously). Unfortunately, I do not remember the name of this strategy (let me know in the comments sections, if you know the name). This way, your expensive straddle (keep in mind that implied volatility is high now) will be subsidized by the proceeds from the sale of the strangle. In exchange, you accept a limited upside: if the market goes really far in either direction during the lifetime of the options, your profit will eventually become capped by the losses from OTM calls/puts. Finally, there is the Iron Condor strategy. This strategy is opposite to the previous one. In essence, you bet that the market will stay within a certain range, and you receive a premium upfront hoping that you will get to keep it in its entirety. To create an iron condor, you would sell out-of-money puts and calls and simultaneously buy puts and calls at higher/lower strikes than those you sold the initial options at. This how the payout matrix for this strategy looks like: (Source: knolpad.com) The benefit of this strategy is that you receive a premium upfront. This way, you know what your maximum profit is beforehand. You also know what you maximum loss can be. Keep in mind that selling out-of-money puts and calls is very risky, especially, selling naked calls. Remember that stocks have unlimited upside. The premium you receive from the sold call is just not worth the risk you agree to take with the trade. If you are selling puts without the intention to buy the underlying at a discount, if its price falls below the strike, or you do not carry enough cash in your margin account, you are also taking enormous risks (although limited because stocks cannot drop below zero). With this strategy, I would recommend choosing options with short tenor (i.e. expiring soon) – for example, one- to two-month contracts. This way, you face a smaller probability of the options becoming in-the-money. On the other hand, do not forget about your transaction costs. Because out-of-money options are usually inexpensive (also called “lottery tickets” in Chicago, as I heard from a trader on CBOE), and you are selling short-term options, you are not likely going to receive fat net premiums (the difference between the premiums received and the premiums paid to hedge your position). Add transaction costs and taxes to the equation, and your iron condor strategy suddenly becomes a lot less attractive than pictured before. I also think that it is very important to keep it simple with options strategies. First of all, you do not want to second-guess yourself or constantly run numbers in your head at night. Secondly, transaction costs do add up. You need to remember that – we do not live in the textbook world. Thirdly, I recommend using options as a supplement to your core portfolio. Remember that options are risky, although their risks are overrated by the general public. The last thing you want to do is expose your portfolio to options only. Keep it balanced and do not fall in love with any specific instruments or names – these are all just numbers on your screen. What are your favorite option strategies?