Are you interested in options trading? Don’t worry, it’s not as scary as it sounds. In fact, with a few important points, you can easily grasp the basics.
When investors create their portfolios, they typically spread their investments across different types of assets like stocks, bonds, ETFs, and mutual funds. But have you ever thought about adding options trading to your mix?
While it might seem intimidating initially, options trading has its own unique advantages that you won’t get from stocks and ETFs alone. Ready to find out more? Let’s get started!
Table of Contents
Basics of Option Profitability
Options are a type of derivative security, which means their price is tied to something else. If you buy an options contract, it grants you the right (but not the obligation) to buy or sell an underlying asset at a set price on or before a certain date.
A call option gives you the right to buy a stock at a certain price (called the strike price) on or before the expiration date. Think of it as a down payment on a future purchase. The more the underlying stock price rises, the more valuable the call option becomes (calls have a positive delta).
A long call can be used to speculate on the price of the underlying rising. It has unlimited potential for profit, but the maximum loss is limited to the premium (price) paid for the option.
On the flip side, a put option gives you the right to sell a stock at a certain price (called the strike price) on or before the expiration date. If the underlying stock price falls, the put option becomes more valuable (puts have a negative delta). A long put is essentially a short position in the underlying stock.
Protective puts can be purchased as a sort of insurance, providing a price floor for investors to hedge their positions.
How Does Options Trading Work?
1. Open an Options Trading Account
Before you start with options trading, there are some important things to know. First, opening an options trading account requires more capital compared to a regular stock trading account. Since options trading is more complex, brokers want to ensure you’re well-prepared before you begin.
When you’re ready to start, your broker will ask you some questions about your experience, risk tolerance, and financial situation. They’ll use this information to create an options trading agreement that you’ll need to sign before you can start trading.
2. Choose Options to Trade
Quick reminder: a call option allows you to buy a stock at a specific price (strike price), while a put option lets you sell shares at a set price before the contract expires. Your choice of options depends on your expectations for the underlying stock’s movement.
- If you expect the stock price to rise, consider buying a call option or selling a put option.
- If you anticipate the stock price will remain stable, you can sell a call option or a put option.
- If you think the stock price will drop, consider buying a put option or selling a call option.
Think of options like insurance—you don’t buy car insurance hoping for an accident, but because you never know what might happen. Similarly, options provide a safety net in your trading.
3. Predict the Right Strike Price
To profit from an option, selecting the correct strike price is crucial. The strike price is where the option can be exercised and is valuable if the stock price closes “in the money” (above or below the strike price for call and put options, respectively). To choose the best strike price, you must predict where the stock price will be during the option’s lifespan.
For example, if you expect a company’s stock to rise from $100 to $120, buy a call option with a strike price lower than $120. Ideally, it should not exceed $120 minus the option cost to stay profitable at $120. If the stock price goes above the strike price, your call option is “in the money.”
Conversely, if you predict the stock will fall to $80, buy a put option with a strike price higher than $80. Ideally, it should not be lower than $80 plus the option cost to remain profitable at $80. If the stock drops below the strike price, your put option is “in the money.”
Note that you can’t choose any strike price you like; available strike prices are standardized in increments (e.g., $1, $2.50, $5, or $10) based on the stock price.
4. Determine the Option Time Frame
When buying options contracts, pay attention to the expiration date—the last day to exercise the option. Two types exist: American (can be exercised anytime before expiration) and European (can only be exercised on expiration day). American options are more flexible but pricier.
Consider the expiration period that suits your needs:
- Short-term: Daily or weekly options for experienced traders, but riskier.
- Long-term: Monthly or yearly options for long-term investors, offering more time for your thesis to play out.
Longer expirations allow options to retain time value, even if the stock is below the strike price. As expiration nears, time value decreases, potentially causing the option to lose value. A longer expiration increases the chance of selling any remaining time value.
How to Make Money from Options: 6 Best Ways
There are various ways to make money with options. As you become more experienced, you can explore more advanced options strategies to help you achieve your financial goals. Here’s a quick overview of your options, along with some basic information about options in general.
1. Buy Calls
One straightforward options strategy is buying a call. It’s considered relatively low-risk because the most you can lose is the premium you paid for the call, while the potential reward is unlimited.
However, keep in mind that the chances of making a substantial profit are usually not very high. The term “low risk” assumes that the cost of the option is only a small portion of your total capital. If you put all your money into a single call option, it becomes a very risky trade because you could lose everything if the option expires worthless.
To figure out the potential gain from a long call, simply add the option’s premium (cost) to the strike price. For example, if you have a $100 strike call with a $1.50 premium, it would start making a profit if the underlying stock rises above $101.50 by the expiration date.
2. Buy Puts
Here’s another strategy that carries relatively low risk but has the potential for high rewards if it goes as planned. Buying put options provides an alternative to the riskier approach of short selling the underlying asset. Puts can also act as a hedge to safeguard against losses in a portfolio. However, it’s important to note that since stocks and equity indices generally tend to increase over time, the risk/reward balance for put buyers is somewhat less favorable compared to call buyers.
A long put option operates in the opposite way compared to a call. If you have a 100-strike put with a premium of $1.50, you would start making a profit if the stock falls below $98.50.
3. Sell Covered Puts
Selling a covered put is a method to earn income when you already have a short position. If the stock remains steady or decreases slightly, you’ll make some extra profit from the premium you receive for selling the put.
However, if the stock unexpectedly goes up significantly, you’ll experience a loss, but it will be smaller compared to holding the short position without the put option as a cover.
In other words, it’s a way to potentially boost your earnings while managing the risk of a rising stock price.
4. Sell Naked Puts
Selling a naked put is a bold move that’s essentially a bet on a stock going up in value. When you sell a naked put, you’re granting the option buyer the power to make you buy the stock at the agreed strike price whenever they want. Even if the stock plummets to zero, you’re still obligated to buy it at that strike price.
On the bright side, if the stock goes up, you get to keep the premium you received when selling the put, and there are no additional consequences.
5. Sell Covered Calls
Selling covered calls is a safer option strategy with less risk but also less reward.
Here’s how it works:
- You sell a call option on a stock you already own.
- You earn income from the premium received for selling that call.
- If your stock remains steady or goes down, you profit from the premium.
- However, if the stock goes up, you might miss out on some potential gains because the buyer of the option can buy your stock at the agreed-upon price.
In simple terms, selling covered calls provides a steady income but limits your potential for higher gains if the stock rises. It’s a conservative strategy.
6. Sell Naked Calls
Selling a naked call is the riskiest option strategy, and it comes with potentially unlimited losses. You make a profit by keeping the premium you receive when selling the call if the stock stays the same or goes down.
However, if the stock goes up, you’re on the hook to buy the stock at its current market price and deliver it to the buyer of your call option.
The problem is that a stock can theoretically rise to any price, which means you could end up paying a substantial amount to fulfill your obligation. In simple terms, selling naked calls is a high-risk strategy with a potential for significant losses if the stock price soars.
In short, options trading is a tool to manage risk and uncertainty in the market. It can provide opportunities for quick gains, but it’s important to think about your portfolio and objectives before getting started.
If you want to keep things safer, you can use simple strategies like buying calls or puts. On the other hand, if you’re an experienced investor willing to take on more risk, you might consider more advanced strategies like writing puts or calls. Options can be tailored to match your risk tolerance and profit goals, offering different ways to make money.
Frequently Asked Questions
1. When to Buy Options?
Options work best when markets are moving a lot. It doesn’t matter if the market is going up or down; you just need some price action. Generally, it’s a good idea to start using options when you expect the market to get more volatile and to stop when you expect things to calm down. Options don’t do well when prices aren’t changing, especially if your option is “out of the money.”
2. How Do Options Get Their Value?
Think of options as custom-made financial tools. They have value because they give you special rights related to another financial product.
The price you see for an option comes from two things:
Intrinsic Value: This is how much the option is worth if you were to use it right now. For example, if you have a call option for a company with a strike price of $200, and the stock is selling for $250, you’re “in the money” by $50. That $50 is the intrinsic value of your option.
Time Value: Options also have a “time” value. This value grows if the option has more time before it expires. More time means more chances for the stock to become “in the money.”
3. Can I Sell Options Right Away?
You can usually buy and sell options whenever the market is open through a broker on many regulated exchanges. So, if the market is open today, you can buy an option and sell it tomorrow, as long as the market is open again.
4. How Do Call Options Make Money?
Call Option Writer: The person who writes (or sells) a call option makes money from the premium they get for creating the contract. This premium is the price the buyer pays to enter the deal.
Call Option Buyer: The person who buys a call option makes money if the stock’s price stays above the option’s strike price. This means they can buy shares at a lower price than what the market offers, which can lead to a profit.
5. What does it mean to exercise an option?
Exercising an option means executing the contract and buying or selling the underlying asset at the stated price.
6. Is trading options better than trading stocks?
Options trading is often used to hedge stock positions, but traders can also use options to speculate on price movements. However, options contracts, especially short options positions, carry different risks than stocks and are often intended for more experienced traders. For more information, you can check out our article “How to Invest in Stocks“.
7. What is the difference between American options and European options?
American options can be exercised anytime before expiration, but European options can only be exercised on the stated expiry date.
8. How are options taxed?
Call and put options are generally taxed based on their holding duration and incur capital gains taxes. Beyond that, the specifics of taxed options depend on their holding period and whether they are naked or covered.