Okay, if you trade options, it's time to face an unpleasant fact. The truth is that the masses will always to some extent look down their collective noses at options and at option trading - and especially at option traders - as some sort of second cousin to their beloved stocks. Ah yes, ownership. That's what it's all about. Or at least so they say right up until the point that the stock of their well-researched company with the improving fundamentals and/or bullish chart pattern plunges so far and so fast that they can't take it any more and sell in a panic.

But never mind all that. For in fact, a little bit of disdain may be somewhat justified. First off, remember that stock options are a form of derivative, and that without the stocks in the first place there are no stock options. Secondly - let's be honest - when we option traders start talking about "shaving the spread on a straddle" or "legging into a condor" we don't exactly do ourselves any favors. In fact, I think we basically just creep some people out.

And thirdly, in an ironic twist, it can be said that:

• The best thing about option trading is that there are so many choices.
• The worst thing about option trading is that there are so many choices.

In other words, the best and worst thing about option trading is the same thing. While one trader who is educated about options sees myriad opportunities and has some basis for choosing one trade over another, another trader who has decided to "dabble" in options ultimately ends up confused and/or making it up as he goes along.

Investment Rule #2,712 - If you plan to "dabble" in the some segment of the investment markets, don't quit your day job.

Investment Rule #2,712 (updated for 2009) - If you plan to "dabble" in the some segment of the investment markets, don't quit your day job - assuming you still have one.

So what's the difference between trading stocks and trading options? Choices.

Let's say for example that a trader was bullish on the stock market. To capture "the market" he or she could pony up the money to buy 100 shares of SPY (the S&P 500 tracking ETF). And this may be all well and good. But as options traders, we are not quite so limited and can examine other possibilities. Such as?

I thought you'd never ask. For the beauty of options is that they give us, well, options.

PLAYING THE BULLISH SIDE

First off let's establish a simple "buy rule." If the Vanguard Total Stock Market ETF (ticker VTI) is above its 200-day moving average and the 2-day RSI index drops below 10, we will call that a "buy signal." (For the record I am not suggesting that you adopt that as a mechanical rule, although it does give good signals more often than not). As you can see in Figure 1, this occurred several times in the past few months, with signals in July, September and October. We will focus on the signal dated 10/1/09.

Figure 1 - "Buy" signals on VTI

Now a trader could simply buy 100 shares of SPY. With SPY at $103.72, the trader would need to put up $10,372. Doing so would result in the risk curve displayed in Figure 2. This one is pretty straightforward. Every time SPY goes up a point you make $100 and every time it goes down a point you lose $100.

Figure 2 - Risk curve for long 100 shares of SPY

Point-for-point movement is a good thing - as long as you're right about direction. Of course not all of us are entirely convinced that our market timing capabilities are impeccable. This is one of the reasons some of us turn to options - to enjoy upside potential with a limited, pre-defined amount of risk. So what is the best option trade to make? There is no "right" answer to that question. Or more accurately, there is a right answer, but different traders will have different "right" answers.

#1. Buy a Call Option

The simplest approach as a bullish option trader is simply to buy a call option. Using the Search Wizard in the Find Trades III routine in Optionetics Platinum software, and then sorting the results for "gamma," results in the top trade being the one shown in Figures 3 and 4.

Figure 3 - Long November 104 SPY calls

Figure 4 - Risk curves for long November 104 SPY calls

This trade costs $340 and enjoys unlimited profit potential. If you are confident about direction and are willing to risk a maximum of $340, you have roughly the same upside potential as the guy (or gal) who dropped $10,372 to buy the shares, with roughly 97% less risk. The rub is that SPY must be above the breakeven price of 107.40 (104 strike price plus 3.40 premium) in 50 days (i.e., at the time of November option expiration).

#2: Buy a Bull Call Spread

Another possibility is to buy a bull call spread as shown in Figures 5. This involves buying one call option and selling another with a higher strike price.

Figure 5 - SPY November 105-115 bull call spread

This trade risks just $261 and roughly double if SPY rises just a bit more than one standard deviation higher.

#3: Sell a Bull Put Spread

This strategy involves selling an out-of-the-money put option and buying a further out-of-the-money put to cover the one sold short. Unlike the previous strategies - which involved "buying premium" and that require SPY to advance in price in order for a profit to accumulate, this strategy is an example of "selling premium" in order to take advantage of time decay. This trade makes money as long as SPY is above 101.82 at the time of option expiration.

Figure 6 - Risk curves for SPY 103-98 Bull Put Spread

The good news regarding this strategy is that you have some downside protection (i.e., your breakeven price is below the current price of the underlying stock) and can even make the maximum profit if the stock simply stays unchanged. The bad news is that the maximum risk exceeds the maximum profit potential. So some sort of stop loss is essential.

#4: Buy an Out-of-the-Money Butterfly

This strategy is new to many traders but is one that can offer a very low risk way to play a stock or index that you think might "drift" higher (or lower) over a given time period. This strategy involves entering a butterfly spread (buy a lower strike price call, sell two higher strike price calls, buy one more even higher strike price call), however, instead of entering a neutral at-the-money spread, you move the whole spread to strike price at or above the current stock price.

Figure 7 - Risk curves for SPY OTM Butterfly

In this example we buy the 109, sell two 119 and buy two 129 calls. If SPY moves higher there is a very wide profit range, particularly prior to option expiration. In a strange quirk to this strategy, as expiration draws closer, the profit range narrows somewhat but the profit potential increases. In any event, if SPY falls in price the maximum risk is just $170.

#5: Buy a Call Ratio Spread

This is one more strategy that - if used properly - ensures that the trader enjoys a very low dollar risk. To use this strategy in a bullish manner you would sell a lower strike price call and buy more of a higher strike call. Typically this trade is done in a 2x1 or 3x2 ratio, however, there is nothing to keep one from using a different ratio. To limit the risk on a ratio spread you should not hold the trade in its original for until expiration. As you can see in Figure 8, the maximum risk on this trade is $933, but this would only occur if the trade is held until expiration and SPY closed at exactly 100.00 on that day. Through November 22, the maximum risk is no more than about $300.

On the other hand, if SPY does rally then this trade enjoys the potential for point-for-point movement with the underlying shares and unlimited profit potential.

Figure 8 - Risk curves for SPY Ratio Backspread

SUMMARY

Any time you buy a stock, your risk curve looks like the straight line that appears in Figure 2. Every point up is a profit; every point down is a loss. Simple. As you saw in Figures 3 though 8, different option trading strategies offer you different opportunities. Each strategy offers a unique tradeoff between reward and risk, and in some cases you can enter a trade with roughly the same profit potential as the long stock position with a fraction of the risk.

Some look at Figures 3 through 8 and see opportunity; others are simply bewildered. The trick is to learn how and when to use each strategy and to take advantage of various opportunities as they arise.

Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site

Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.

NOTE: To learn more about Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.

Please look for the interview with Jay Kaeppel in the upcoming November 2009 issue of Technical Analysis of Stocks and Commodities magazine.