There are a myriad of reasons to trade options. However, the biggest reason most option traders trade options is to take advantage of the tremendous leverage that options provide. As a testament to this, do you realize that Hedge Funds that produce very high returns, traditionally for the rich, accomplish this primarilly with the use of leverage by trading options?

In contrast, mutual funds are not allowed to invest in options and are only allowed to buy stocks long. That's why there is such a vast difference in their yields. Some Hedge funds yield many times what the best mutual funds yield.

Here is an example of the leverage options can provide:

Example

Lets say Google is trading at $540.00. To buy 100 shares, would cost you $54,000.00. By contrast, you could control the same 100 shares if you bought a call option trading at $24.00, with a strike price of $540.00. 1 contract would cost you $2,400.00 ($24.00 X 100 shares) as opposed to $54,000.00 ($540.00 X 100 shares).

If GOOG moves up to $560.00, and the option rose in value by $15.00 to $39.00, your return on investment would be 62.5% ($15.00/$24.00) as opposed to 4% ($20.00/$540.00) if you bought the stock. Of course, our only problem with this example, is GOOG has to make a move in the correct direction, and do so enough for us to make money.

Because of the uncertainty involved with buying options, our question then is not "Why trade options?" but, "why buy options when there are so many reasons you should be selling options?" The Chicago Merchantile Exchange estimates over 80% of all options sold expire worthless. So why aren't you selling them instead of buying them?

In option selling time works for us not against us. The buyer of the option pays us a premium for that option. If you sell an out of the money option, the entire value of that option is in time value. As time passes, all other things remaining constant, the option will gradually lose its value.

An option is considered a "wasting asset."  Time value erodes as each day passes, accelerating as the option's expiration nears. This is referred to as "time decay". If the underlying contract does not move far enough by expiration, the option will have no value left and expire worthless and the option seller will keep the premium. When selling (or writing) an option, we get paid the premium up-front and we take advantage of "time decay".

Also, by selling options, we avoid the game of trying to predict where prices will go. Instead we are projecting where we think prices won't go, and we have an astonishing 80% probility that it won't. For instance, when we sell an out of the money straddle, if the market moves up, down or sideways, it make no difference to us, as long as it is between the range of our strike prices upon expiration, we will still take our full profit.

Why Strangles?

We are essentially playing both sides of the market. Stocks go up, down or stay the same. At any point, a directional move will increase one side of the option play, and decrease the other side. So even if you may loose money in one position, we are gaining money in another. And since these are out of the money positions, unless the stock breaks through the strike price, at expiration, best case scenario is we come out on top. Worst case scenario is we loose on one position, and we gain on the other, comming out with a wash. Or the more likely scenario, is both option legs are reduced to a level which we are happy to take profits.

Even though we believe selling options can potentially put the odds of success in your favor, it still requires good, solid market analysis. After trading options for many years with so much success, we see no reason to buy options. We have discovered, when options are sold correctly and carefully, they can generate a higher percentage return than any other option or stock trading strategy. The difference is, selling options gives you a larger margin for error. You don't have to be exact, only close.