Welcome to the most exciting part of our journey into stock index options. By now, you likely understand the various characteristics and potential "pitfalls" of stock index options. Now, it's time to discover the strategies that can help you maximize your potential and achieve your investment goals!
Valuation: Your Key to Options Success
Stock index options are essentially derivatives linked to stock indices. Therefore, if you can determine the direction of the stock index's movement, you can basically solve the problem. For example, if you predict that the S&P 500 index is about to surge, you can simply buy a near-term S&P 500 call option. The key question is, how do we judge the movement of the stock index?
For fundamental considerations, firstly we recommend focusing on valuation. For instance, in mid-October 2022, the P/E ratio of the S&P 500 index was only 18, compared to its historical average of 24. An 18 P/E ratio was cheaper than 98% of historical periods, indicating that the U.S. stock market offered excellent value. Not long after, U.S. stocks entered a long-term upward trend, and investors who bought call options at this time reaped substantial returns!
Of course, historically, it's not always the case that the market immediately rebounds when valuations drop to low levels. It may continue to fluctuate at the bottom. In such cases, buying index ETFs is fine because, given the history of U.S. stocks, their long-term returns are very high, and buying at low valuations will eventually lead to a rebound. However, if you buy stock index options and the index doesn't rise in the short term, the time value of the options will continuously decay, resulting in losses. Therefore, using valuation as the sole indicator is not enough.
The Impact of Economic Data
Economic data is also crucial. There's a saying among stock investors that the stock market is a barometer of the economy, which is especially true for developed markets like U.S. stocks. From the 2008 financial crisis to before the COVID-19 outbreak in 2020, the U.S. GDP compound growth rate maintained around 2%, while many developed countries during the same period had economic growth rates below 1%, essentially stagnating. The excellent performance of the U.S. economy has been an important foundation for the long bull market in U.S. stocks.
Of course, options trading focuses more on the short term, so we need to pay more attention to marginal changes in economic data. For example, in 2023, while the market expected a U.S. economic downturn, consumption and other data remained strong, driving the recovery of U.S. stocks.
The U.S. economic structure is primarily consumption-driven, so we recommend that you pay attention to indicators such as the University of Michigan Consumer Sentiment Index, personal consumption expenditure, non-farm payroll additions, and PMI index.
- University of Michigan Consumer Sentiment Index: This index reflects the level of confidence ordinary consumers have in the economic outlook. Higher consumer confidence indicates that consumers are more optimistic about their current income levels and expected income growth. It also suggests they may be willing to spend more on consumption, thereby stimulating economic growth.
- Personal Consumption Expenditure (PCE):This indicator measures the actual spending of consumers on goods and services. Personal consumption expenditure accounts for about 70% of the U.S. economy, therefore this indicator can directly gauge the temperature of the American economy.
- Non-Farm Payroll Employment: This data reflects the growth in employment numbers across non-agricultural industries. Generally speaking, higher employment numbers indicate a more robust economy, suggesting that businesses need to hire more workers to meet their operational needs.
- PMI (Purchasing Managers' Index): This index reflects the level of activity in the manufacturing sector. A reading above 50 indicates expansion, while below 50 indicates contraction. As a leading indicator, the PMI can foreshadow future trends in the economy and corporate earnings.
Monetary Policy
Finally, the Federal Reserve's monetary policy is also a key factor. When the U.S. economy enters an interest rate cut cycle, the attractiveness of risk-free returns like deposits decreases compared to the returns of risk assets such as stocks and funds, and investors tend to allocate more funds to the stock market. Conversely, during an interest rate hike cycle, funds tend to flow out of the stock market. Therefore, when the Federal Reserve adjusts or plans to adjust its monetary policy, it's often an opportunity to change asset allocation.
Combining Key Factors for Strategic Options Trading
Today we mentioned three major factors for stock index option allocation. In fact, when used individually, each factor has limited odds of success, but when used in combination, the odds can increase significantly. Generally speaking, when market valuations are cheap, the economy is transitioning from weak to strong, and monetary policy is loosening. It's often a signal for stock indices to strengthen!
Additionally, there are some points to note: For call options, you can choose slightly out-of-the-money options (strike price slightly higher than the current market price). This can reduce the cost of options while retaining sufficient upside potential.
The choice of expiration date should balance time and cost. Typically, choosing options expiring in 1-3 months can strike a balance between sufficient time and cost.
Also, pay attention to risk control. It's recommended to limit the funds used for options trading to 5%-10% of your total investment portfolio.
