In basic terms there are only 2 types of options you can trade, Calls and Puts. As a buyer of options you always want the underlying stock to go up if you buy calls and down if you buy puts.
Determining which way a stock is likely to go is the challenge. However if you know a stock is going to move strongly in one direction or another, then you might consider buying a straddle.
To buy a straddle you simply by the At/Near-the-money Call and the At/Near-the-money Put option. In order to profit from using this strategy, you would need the premium of one of your options to rise by more than both the Call and Put premiums put together.
One way that I have profited using this strategy is to follow companies that have pending announcements with the http://www.fda.gov (particulary drug/biotech stocks) and buy a straddle the day before the announcement is due to be made.
If the announcement is good and the stock rises strongly my call options will rise strongly and I can still profit, even though my put options will probably be worthless.
If the announcement is bad and the stock falls strongly my put options will rise strongly and I can still profit, even though my call options will probably be worthless.
As a buyer of a straddle we don't really care which way a stock moves, so long as it moves far enough in one direction for us to profit on the trade overall.
However, there is one important thing to take into consideration here and that is Implied Volatility.
Implied Volatility, which is really a measure of potential 'future' volatility, can inflate the time value of options greatly. As a buyer of options and in particular At/Near the money straddles we need to be careful of this because should the underlying stock 'not' move strongly in either direction after we buy the straddle, this Implied Volatility can fall or deflate and therefore erode the value of our options.
As we have purchased two lots of options (calls and puts) to create the straddle, this can be a double whammy if we are not careful.
A great indicator that we can use to warn us of high implied volatility is Bollinger Bands. When the bollinger bands are wide (expanded) compared to the past few months, than this can suggest that implied volatility is high and options may be 'overvalued'.
A warning sign here is when the bands have been wide/expanded and have started turning inward or contracting.
This can suggest that the implied volatility is now declining and 'dragging' on the premium (time value) of the options on that stock.
As an option buyer, we ideally like to see the bollinger bands coming from a 'narrow' contracted state and starting to 'flare' out.
This can be an indication that implied volatility is on the increase, which will support the premium of our options and even increase their value, without the underlying stock needing to move substantially.
Please note though that this insight should only be used as a guide and is based on my own personal observations and experience, nevertheless if used as part of an effective overall strategy/system, it will certainly help to stack the odds of success in your favor.
Happy option trading!
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James Thomas is a successful private option trader and creator of www.option-trading-tips.blogspot.com - an informative resource full of useful option trading tips, including free video tutorials.
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