Investors use options because they are the most important financial tool of our generation. In fact, elite investors use options to generate outsized profits. For this reason, every investor, active or passive, should have a clear understanding of the product.

1. What are they?
2. Who uses them?
3. How do they profit with them?

In this article, we will focus on the two ways to profit using options.

How to Profit With Options?

It's important to distinguish the two distinct ways to trade options for profit:

1. Volatility Trading
2. Directional Leverage 

1. Volatility Trading

Generally, Volatility Traders have degrees in mathematics, financial engineering, or statistics.

Volatility Trading involves extracting profits from the measured movement of the underlying asset primarily using a mathematical formula and its derivatives. The formula is called the "Black-Scholes formula" and its derivatives are called "The Greeks."

Profits = How the Stock Gets There

Volatility Traders attempt to forecast volatility using powerful computers and mathematical factors. Opportunity arises when that forecasted volatility is different from the market's view. 

It's important to understand that a Volatility Trader focuses on how an asset gets to its future price, as opposed to anticipating the future price.

In fact, to execute a volatility strategy the Volatility Trader is required to remove any directional price risk in the sock (or underlying asset). This ensures that the general direction of the stock, whether up or down, has little effect on the profitability of the strategy. For a Volatility Trader, how much the stock moves and the frequency of those moves are the greatest determinant of profitability. 

Volatility Trading: For Institutions or Retail?

Due to the mathematical nature of Volatility Trading, traders attempt to capture profits over hundreds of trades. This type of trading requires research, substantial capital, expensive software, continuous trading, and low cost transaction fees. Thus, Volatility Trading is mainly reserved for the Investment Banks and a few Hedge Funds. These institutions use their well-developed platforms and seemingly infinite pools of capital to profit from Volatility.

"Volatility Trading" is often confused by misinformed investors as a directional view on the "Implied Volatility" in the market. The "Implied Volatility" in the market can be reflected in products such as the VIX and the VXX. However, buying or selling these products, or buying or selling options on these products, is not "Volatility Trading" as described above. It is trading the "Direction of Volatility." There is a significant difference.

This leads to the second and most widely used form of options trading... 

2. Directional Leverage

I've coined this phrase, "Directional Leverage Trader," to describe how most investors use options to profit. They use options to trade the leverage and to trade the direction of the underlying asset.

This is the simplest form of options trading, yet the industry has complicated the educational process by conflating the issues faced by the Volatility Trader and the Directional Leverage Trader. Remember, Volatility Traders care about how the stock gets to a future price and then extract profits through management of the Greeks. The primary concern of the Directional Leverage Trader is whether or not the stock gets to a specific future price by the expiration date of the option.

Buying and Selling Options

A Directional Leverage Trader can profit with options by either buying or selling them. The elite traders, the Top 1%, mainly buy options.

For example, an investor looking to hedge a portfolio or stock might buy options to gain leverage. This is similar to buying insurance for a home.  Should there be an adverse move in the stock, the Directional Leverage Trader's hedge could profit and offset some of the losses. Another example may see a confident investor buy options to leverage a certain idea or direction of the stock.

Many retail investors sell options to profit. They view the upfront payment of the option as "income." Unfortunately, that "income" doesn't come without absorbing risk. Equally unfortunate, most investors are under a misguided assumption that selling options, or "selling volatility," offers them an advantage. In fact, they ultimately learn that the directional risk of the asset outweighs any volatility advantage they assumeto have found.

A Dangerous Misconception

This dangerous misunderstanding by options sellers is a primary example of the options industry's failure to better explain the differences between a Volatility Trader and Directional Leverage Trader.

For example, it is very possible to get the volatility risk right, yet still experience significant losses because the underlying asset traded to a specific price level. Remember, in order to make a pure Volatility Trade, the investor must neutralize all directional risk. These nuances are rarely explained in the available Options Education, possibly because it reveals how hard it is to be a Volatility Trader.

Let me be clear. You are a Directional Leverage Trader. The only question is whether you are an options buyer or seller. Keep in mind that the Top 1% of investors generally buy options.

Either way, the primary risk is the future price of the stock (or underlying asset) within a predefined period of time.  

Profiting With OptionsGeek

• Risk Reward
• Probabilities / Odds
• Confidence
• Mathematical Edge

Once investors understand these concepts, they can practice using them to make the right investment decisions. I've created a tool (The New Options Chain) that makes the process simple. It does all the calculations, analysis, and takes out all the guesswork.

This New Options Chain captures the thought process used by the top Hedge Fund Managers in the world. It does what the industry has been trying to teach for years - how to shift the odds in your favor to maximize your returns.