Beginner option traders ask all of time, why am I not making money if I am right most of the time? Our quick answer is usually, " I don't believe you!" But consider this: Is it possible to be on the right side of a stock and still lose money? Of course it is. But why?

Once again, it's our stock trading knowledge that we have to unlearn. We must remember that options trading is an entirely different game. It's like moving from the minor leagues to the majors. It's like changing from an aluminum bat to one made of wood.

The most common reason for losing money in options even while being on the right side of the stock, is time decay. In this case, a trader is right about stock direction, but it takes too long to pan out. The second most common reason is the bid/ask spread. We discussed this reason in the previous article in October of 2005 . There are many instances where a stock moves 10% over a 3-month period, and yet the option goes nowhere. What do we do about it?

Let Volatility Pay You

Let's talk about 2 ways to get paid using volatility changes. Here at BigTrends.com, we usually focus on price action before volatility, but in every case, volatility affects pricing and we will now discuss how traders can use it to increase the probability of profitable trades.

One of the first strategies to look at is selling options after a major swing in volatility. After years of trading, we have noticed that one aspect of stocks that does often return to the mean is volatility. That means that record volatility does not usually last. Let's look at an example of how we can profit from this:

In August 2005, a slightly in-the-money call ($.30 in the money) for Sandisk Corp (SNDK) had a cost $1.40 with 6 weeks left to expiration. The same call now, costs $3.90. That's an increase of 178%! The main factor here is expected volatility. Because the option is only $.30 in the money, most of the option's value is time value. That is, the reason why a trader has to pay this price is that he has an opportunity for a large return if the stock goes North.

Such changes in volatility turn into outstanding opportunities to sell covered calls particularly if the selling is done as the stock moves sideways. Assuming implied volatility and the stock price remain steady for the next 12 months, a trader could earn a $4 premium every month by selling at-the-money calls on SNDK.  For 12 months in row, that would be $48 in premiums and an 83% return on SNDK's current price of $57.60. In summary, times of high volatility combined with sideways price action are ideal situations for significant income generation via covered calls. Take advantage of these situations!

Volatility Can Be Used as a Filter

Here is another way to profit from volatility readings. We always use filters to narrow down our selection of potential option buys. Here's how it's done:

We have several criteria in this trading system including:

1. MACD- we are looking for either a crossover or a divergence between the moving average and price action. Where 1 day is written, it means that the crossover occurred 1 day ago. Near means the signal is close to confirming or crossing over.
2. MA- for a short term trade we are looking for the price to explode above the exponential moving average
3. ADX- for a bullish signal, we are looking for the DM+  to cross over the 50 line or the ADX to crossover the DM-. No means it has not happened.
4. Volatility- We used 20-day volatility here.
5. Option Price- This is the cost of the time value portion of the option.

There are many factors in deciding on which option to buy. Traders can use volatility here as another tool to filter down their potential trades. For example, look at MDC and  XYZ (fictional stock). They are almost the same in every respect except volatility. If our view is equally bullish on both positions, we would choose the call option on XYZ stock because the volatility is twice as high (however, we don't like to buy calls on stocks that are going sideways). In summary, traders should use volatility as a final factor if they can't decide between two similar stocks.

Make Money

So, take this information and use it. Sell options in periods of unusually high implied volatility and use higher volatility as one of your last filters to select winners. Once again, we want to do as much as we can to improve our probability profitable trades. Be disciplined and trade well!

Price Headley is the founder and chief analyst of BigTrends.com.