Over the past year, there has been a steady rise in the use of stock options by investors aiming to maximize their leverage and returns. The Chicago Board Options Exchange recently reported that March was their busiest month ever, with trading volume up 55% compared to the same period last year. In fact, all previous records were broken, with over 5.6 million stock option contracts traded in a single day.
Stock option trading allows investors to significantly increase their leverage, leading to potentially much higher returns compared to traditional stock trading. If an investor has a reliable strategy for picking stocks that are likely to increase in value in the short term, those returns can be boosted by 10 to 15 times using stock options. However, the trade-off for this increased return is that the investor also needs to correctly predict the time frame over which the price movement will occur.
To be successful with stock option trading, investors must accurately predict not only the stock’s direction but also the time period within which the movement will take place. A recent statistical analysis of over 30 years of stock data has revealed certain recurring patterns that can yield significant returns through stock option trading. Custom-developed software was used for this analysis, and the strategy was applied to all stocks over the last five years. The results showed that while stock trading had an average return per trade of 3.2%, stock option trading provided an average return of over 55% for 2005.
Investors have already begun to take advantage of these patterns and are reporting highly profitable trades. Whenever inefficiencies are discovered in the market, there tends to be a rush to exploit them.
Although not all stocks have stock options available, approximately half of the stocks analyzed did have tradable options. If the trend of increasing investor use of stock options continues, it is expected that more stocks will add options for investors. It is conceivable that 60 to 70 percent of actively traded stocks will have option contracts available in the coming year if this growth trend persists.
When considering which option contract to buy, investors should carefully examine open interest and volume. Low volume or low open interest can lead to large bid-ask spreads, reducing potential profits and making it difficult to sell the option contract.
Another factor to consider when selecting an option contract is volatility. Stocks with high price fluctuations tend to have more expensive options since these options are more likely to end up “in the money.” If you have a reliable method for predicting stock movements, this increased cost may be justified by the higher potential returns.
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