“We always make money…”
That’s what a pro trader told me while standing beside me in one of Chicago’s most raucous trading pits.
The words would run through my head over and over again in the days which followed.
It was brilliant, I thought.
But then I really started studying.
It didn’t take me long to learn this simple technique could be even better than anything regular investors are doing.
In good times, the strategy was good.
But it was even better in bad times.
Here’s an inside look at how this strategy and how, in a really quick and simple way, you can get all the advantages of it too.
The Perfect Investment Strategy
Most investment strategies are flawed.
Value investing, day trading, buying dips, following insider buying, dividend investing, and dozens more all have one major flaw.
They only work most of the time.
And during those periods they don’t work well, the outsized gains earned from the times they do work quickly disappear.
There is one strategy that’s an exception to that though. And it was created decades ago by professional traders at the Chicago Board Options Exchange (CBOE).
I know what you’re thinking...stock options are traded on the options exchange. Options are risky.
You’re right. The way most investors use options is incredibly risky. In fact, the way most investors use options, they’re practically guaranteed to lose money over time.
But this strategy turns all that risk inherent to options trading into safe and consistent profits.
An option is a contract to buy a preset amount of shares at a preset price.
Optionseducation.org further defines an option as:
An option is a contract to buy or sell a specific financial product known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange traded fund (ETF) or similar product.
The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon.
Contracts also have an expiration date. When an option expires, it no longer has value and no longer exists.
Options come in two varieties, calls and puts. You can buy or sell either type. You decide whether to buy or sell and choose a call or a put based on objectives as an options investor.
Most investors use options to speculate on the future price of a stock or index.
If they think a stock is going higher, they buy a call option to buy the shares at the preset “strike” price.
If the stock goes above the strike price, they will be able to exercise the option and profit from the difference between the market price and the strike price.
If they think a stock is going lower, they buy a put option so they can force someone to buy the shares at the option’s strike price.
If the market price of the stock falls below the strike price, they will make a profit on the difference between the market price and the strike price.
It’s a really simple way for most investors to get big leverage without using too much capital.
For example, if an investor believes Apple (AAPL) is going above $110 a share (currently right around $107 as I write) within the next three months, he may not be able to afford 1000 shares to really profit from the move. That’s $107,000 investment after all.
But with options he can get exposure to 1000 shares for about $4,000 ($400 current price of the AAPL 110 call option X 10 contracts).
If Apple goes above $110 a share, these options will be “in the money.” And if Apple passed $114 a share, he will make $1000 profit (after accounting for the $4,000 cost of the options) for every dollar it goes higher.
So if he’s right, and Apple goes higher, a 5% to 10% move in shares can quickly turn a $4,000 stake into $8,000 or $12,000 or more.
That’s the power of leverage options provide.
Of course, leverage works both ways. if Apple doesn’t reach $110, all of the $4000 worth of options will simply expire worthless. A 100% loss.
That’s how options work, how most investors use them, and how their extreme volatility makes them so risky.
I mean, what other investments offer 100% risk of loss in as little as a few days or weeks? Not many.
If you’ve been reading the Profit Alert for awhile though, you know what most investors do is usually precisely the wrong thing to do.
The same is true with options.
And in the case of options, these wrong moves are counteracted consistently by another group of traders that “always make money” by taking the other side of the trade.
Time Really Is Money...
The floor traders on the CBOE are professional traders. They buy and sell massive amounts of options every day. Millions of dollars worth.
But they’re not lying awake every night hoping a stock or ETF goes up or down because they are highly leveraged to it.
They really don’t care at all because of the way they trade options.
These traders trade options differently than the way most investors do and, as a result, they take practically no risk while the regular investors take massive risks.
These pit traders use an option trading strategy called “Delta Neutral” trading.
It’s a bit complicated (there are complete books that just cover this strategy).
But to sum up the strategy, they buy and sell enough puts and calls on stocks, ETFs and indices that they have no net exposure to the price of the underlying asset price.
Hence the term “neutral” in the name of the strategy.
They are not affected by the price swings of the asset. They make money because of time.
Take that Apple option example we used above.
The regular investor bought $4,000 worth of options. He has multiple ways of losing or making a lot of money depending on whether Apple moves up or down in the next three months.
The professional trader will sell that option to the regular investor and sell many more options with different time frames and strike prices to many other investors.
It involves some complicated math, but if done properly, they will have no net exposure to the price swings of Apple.
They will make money as what’s called the “time value” of the option slowly deteriorates.
For example, those Apple options that expire in three months with a strike price of $110 cost $4,000.
The same number of options that expires in one month are worth $2,000.
The reason the options with a shorter time horizon are cheaper is because the chances for a bigger move in the stock are smaller than the shorter the time period covered by the option is.
All else being equal, that $4,000 position will be worth $2,000 in two months when it has just one month until expires.
That $2,000 didn’t just disappear though. Odds are it ended up in a professional trader’s pocket that’s on the other side of the trade of the regular investor using the options to speculate.
Time is the enemy of an option buyer and it’s the advantage of the person on the other side of the trade.
You Can Be the House
This type of trading where you’re selling options (called “writing”) really is like being “the house” in a casino.
The gamblers will make and lose money on any given day.
But over time the house always wins.
The same is true with options trading.
Most investors gamble with options. Sometimes they win and sometimes they lose. Overall, they all lose because the “time value” of an option is always slipping away.
This concept may seem a bit advanced. It took me months of reading, some professional trading courses, and spending some time on the floor of the CBOE to really understand how it works.
But once I did, I saw how they always made money in any market.
It really is the perfect investment strategy.
And those words, “we always make money,” have always stuck with me and why I continue to advocate learning this strategy.