Let’s face it… the main goal for most traders is to beat the markets.
And there are thousands of books out there that promise to reveal the single method for beating the market. Some have even made it to the New York Times’ best seller list.
The problem is… they’re just not accurate.
Truthfully, there’s no ONE way to beat the stock market.
And even if you’ve had some luck following “that one” tactic, it’s just not a winning strategy to use in the long run. Actually, you risk losing profits you’ve made so far and your immediate (and future) capital.
So forget those 100 “only ways” you’ve seen to beat the markets.
This three-fold approach will tell you the direction a stock is heading, how much money you can make, and how long you have to capture those profits.
It’s a solid strategy no matter how experienced you are – and one that works in any market environment.
Now let’s get to it…
Single-Tactic Traders and Stock Investors Stand to Lose the Most Money in the Stock Market
One of the best benefits options traders have over stock investors is leverage. And as an options trader, you can control high-priced stocks for a fraction of the cost of owning the stock outright. But one of the risks you face over a stock trader is losing your money when neglecting to pay attention to all of the factors that will make or break your trade.
That’s why those “beat-the-markets-with-this-single-simple-trick” books can set you up for short- and long-term failure. These one-size-fit-all fail to incorporate all all of the various components that can influence, and move, the markets – especially major, shocking events, like Brexit. Instead, to maximize the number and frequency of your winning trades, you’ll want to evaluate and adjust your trading strategy as necessary.
So today, I want to focus on the best three-pronged approach you can use to land on the winning side of options trades. But the principles behind it also work for stock investors. You’ll see why in a moment…
First, let’s get into this three-legged tactic that will tell you where a stock is heading, how much money you can make on your trade, and how long you have to capture those profits…
Part 1: Price
Price is more important to options traders due to volatility sensitivity of the underlying stock. But it’s not the only thing you should pay attention to…
But if you’re not aware of time value and implied volatility, you may find yourself in a situation where the stock isn’t moving in your favor, and time value as well as implied volatility are preventing your options trade from increasing in value as much as you’d like – if at all.
Part 2: Time Value
In order to talk about time value, we need to touch on intrinsic value first. Both go hand in hand with price.
Intrinsic value is how in-the-money a stock is compared to the option’s strike price. It indicates the value of the option if there there was no time remaining to expiration and the stock was still at that price.
Time value (also called “theta”), however, is what’s left after you remove the intrinsic value from the option’s premium price. You can determine the time value of your trades by subtracting the intrinsic value from the premium. The more time until expiration the greater the time value component of the option.
The reason time value is so important is that an option loses one-third of its time value during the first half it’s life and the rest of its value as it gets closer and closer to expiration.
In its simplest form, options traders who don’t pay attention to time value don’t recognize the potential depreciation of time as the option gets closer to expiration.
Part 3: Implied Volatility
Implied volatility is the anticipated volatility of a stock (or other security). Generally speaking, it increases in bearish markets and decreases in in bullish markets.
Options buyers want low implied volatility when they open their positions with the anticipation of it increasing over time. And when it does, it increases the option’s premium faster and by a larger amount so that the trade can be closed for a nice profit.
When you don’t follow implied volatility closely, you run the risk of buying-to-open an option in which the implied volatility is already too high, making it challenging for that premium to increase. And that means it’s harder for you to cash in on the trade.
Take a look at the chart below and see where the implied volatility is the highest, prior to earnings…
If you buy-to-open your option and it goes through earnings, (either good or bad) report, the implied volatility typically drops by a huge amount. This often causes a “volatility crush” that can severly reduce the value of your trade.
So you want the assessment of the stock to be one that will increase in price quickly and substantially enough to offset the decay of time and volatility.
Now there’s a formula that can calculate the percentage the stock needs to make (that’s favorable to your trade) in order for your trade to double in value, called “percent to double.” My proprietary tools have this capability, and your broker may have the same. So I would suggest contacting your brokers to see if they have it or if their online trading platforms have that capability.
How that “Only Way” to Beat the Markets is Dangerous to Both Options Traders and Stock Investors
One of the strategies that’s often toted in the types of books we’ve been talking about is price action trading.
Price action trading is when you basically rely on a stock’s charted price movements. It’s a trading technique that’s become especially popular among beginner traders and stock investors because it has only one ingredient – price.
As a price action trader, your focus is on where the stock is and what it may be doing in the near future. Price action traders may use technical analysis to measure where a stock is in regard to its support and resistance areas, and they may even look at technical oscillators, such as candlestick patterns. But they look at virtually nothing except price.
Price action traders tend to keep their blinders on to everything but what’s happening to a stock’s price and neglect important upcoming events and announcements, like earnings. And as we’ve seen… neglecting events like these absolutely destroy trades.
Now price movements are even more important to options traders than stock investors due to the volatility sensitivity of the underlying stock. But when options traders only look at price action, they end up buying options that are too expensive or holding them up until expiration when time decay (also called theta) accelerates the most.
And when it comes to stock investors, watching price action alone puts them in the stocAnd stock investors find themselves holding shares they’re unable to sell for a profit.
Ultimately, price action traders stand to lose the most money because they’ve locked themselves into that single-method approach to beating the markets.
So don’t be that trader…
Here’s Your Trading Lesson Summary:
As an options trader, take into consideration price, time, AND volatility. And as a stock investor, look at price movements AND other indicators, such as the relative strength index and Bollinger bands.