First, let me say this: Most people lose money trading options.

It’s a very difficult game. But if you can find an edge, the returns can be huge. One of the best option-trading hedge funds in the business, Cornwall Capital, has averaged 51% annualized over the past 10 years. That turns a mere $20,000 investment into $1.2 million, in less than 10 years.

Two of the best option strategists that have ever worked on Wall Street are Keith Miller, formerly of Citigroup, and John Marshall, of Goldman Sachs. Both Miller and Marshall happen to be Blue Jays (i.e., Johns Hopkins University grads), like me. If you can ever find any of their research studies, print them out and examine them closely. They are excellent — and will give you an edge.

Below are the rules the best hedge funds use when trading options:

Rule #1

Options are like a coin toss; you’ll be lucky if half your option trades are profitable. That is why you have to make sure you get paid for the risk you take.

Only trade an option if your projected return is a triple or better. To do this you will have to buy an out-of-the-money option. And you should go out at least two months, preferably longer. Now, here’s the math:

Let’s say you make 40 option trades a year. Odds are at best you will only make money on 50% or half of these trades. Therefore, if you had 40 options trades and 20 of those trades expired as worthless, and the other 20 option trades averaged a triple or more, you would still make 50% a year. For example, on a $40,000 account taking 40 trades a year, if 20 option trades lose everything and the other 20 trades give you an average return of 200%, your account would be worth $60,000, giving you a 50% return.

So $20,000 would go to zero on the option trades that expired worthless. The other $20,000 would go to $60,000 on a 200% return.

Rule #2

Price predicts a stock’s earnings and fundamentals 90% of the time. According to Keith Miller of Citigroup, a stock will start to move one to two months ahead of its earnings date, in the direction of the earnings report. This means if a stock starts trending higher or breaks out higher before the company reports earnings, the earnings report will be positive 90% of the time.

Rule #3

When you are buying options on a stock, make sure the stock is owned by an influential investor or activist. These investors, such Carl Icahn, Barry Rosenstein of Jana Partners and the rest, are always working behind the scenes to push the companies to unlock value; this can come in the form of incremental positive change or big one-time catalysts. This positive announcement or catalyst usually emerges after the stock has moved up in price. So when you see an activist-owned stock breaking out, or trending higher, there is usually a good chance change is coming. Thus, you’ll want to buy calls on this stock immediately.

Rule #4

Only trade an option if there is an event or catalyst that will reprice the stock. This could be an earnings announcement, a company’s Investor Day or an annual meeting.

Rule #5

Only buy options when both implied volatility and historical volatility are cheap. Be a value buyer of options. Watch volatility. Buy volatility only when it’s cheap.

A perfect example of an option trade that fits all of the above criteria is Walgreens ($WAG).

> Jana Partners, run by billionaire Barry Rosenstein — one of the top 5 activist hedge funds on the planet — owns more than $1 billion of Walgreen’s stock. That’s more than 10% of the fund’s overall assets invested in Walgreen’s (Jana has $10 billion under management). Even better, they just added to their position last week, buying $77 million more during the market correction.

> Walgreen (WAG) just broke out of a consolidation pattern, and it looks like it is ready to make a big run (see chart below).

> Walgreen reports earnings on December 22nd. So whichever way the stock moves over the next month or two will predict whether the company’s earnings are positive or negative. Based on the stock’s current price momentum, the report will be positive.

> The Walgreen $65 calls are cheap, especially since they expire only two days before the company reports earnings. You can buy the Walgreen December $65 calls for just $1.10. That means, at $66.10 or higher, you will make money on this option. My price target for Walgreen, based on its recent breakout, is $69. That also happens to be where Walgreen gapped previously.

> If Walgreen stock trades just 10% higher to $69 by December 20th, you will more than triple your money on this option in less than two months. This is the risk-reward profile you want when trading options. Your goal should be to make 50% a year.

Will Meade
President of The Billionaires Portfolio