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Learning how to make money trading options can help you reduce risk, multiply your gains, and build wealth.
There is nothing mysterious about them, either. They are available to buy and sell on major exchanges at a fraction of the cost of their underlying stocks.
They are even less risky than traditional stock trading, especially shorting stocks.
In fact, learning how to make money with a safe options strategy can help reduce your investment risk, multiply your gains, and ultimately build your wealth.
What Is Options Trading?
Simply stated, an option gives the holder the right, but not the obligation, to buy or sell a certain amount of an underlying stock at a specific price by a specific date. All of these parameters are set when you buy or sell them.
When you trade options, you only pay pennies on the dollar in relation to the stock’s actual share price. It is possible to make money trading options, no matter which way the market moves. Additionally, you can make money trading options even if the market doesn't move at all!
Of course, there's no free lunch. You can leverage your winnings, but you can lose all of your initial investment. Fortunately, since options trading requires less initial capital, your possible losses are limited.
In general, options trading has significant upside potential with limited downside risk. Here’s what you need to know about the best ways to make money with options no matter how the stock market performs in 2020.
What Are Calls and Puts in Options Trading?
Similar to trading stocks, to make money trading options, you want to buy an option at a low price and sell it at a higher price.
There are two main types of options: calls and puts.
Calls give the holder the right, but not the obligation, to buy stock at a specific price. In other words, you "call away" the seller's stock, and they have to deliver it to you at the agreed-upon price, no matter what the underlying stock is worth at that time.
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If you are bullish, you want to own calls. Call contracts mean you can buy the stock at a lower price than it’s trading at.
Puts are the opposite. You get the right to sell stock at the agreed-upon price. You "put" your stock to the buyer.
If you are bearish, you want to own puts. Put contracts mean you can sell the stock at a higher price than it’s trading at.
How to Make Money Trading Options With Calls and Puts
All call and put options have an expiration date. This is the date you can buy or sell the underlying stock, which is also known as exercising the option. This could allow you to sell a stock for a higher price than it's trading at or buy a stock for a much lower price than it's trading at.
The strike price is the agreed-upon price you can buy or sell the underlying stock when you exercise the option.
Here is a simple example.
An XYZ company call option with a $55 strike price expires on Oct. 18, 2019. It has four key parts:
- Underlying Stock Name: XYZ company
- Type: call or put
- Strike Price: the agreed-upon price to buy or sell the underlying stock
- Expiration Date: October 18th, 2019
If the strike price or the cost of the shares of XYZ rise above $55 before Oct. 18, then your option is "in the money," which means you'll be able to exercise the option and buy the stock for $55. That also means your option is much more valuable than it was when you bought it, and you can likely sell it for a profit.
What Affects the Price of Options?
In order to make money trading options, you need the price to lean favorably to the option holder.
Intrinsic value is simply the difference between the option’s strike price and the current price of the underlying stock. For example, a call option with a strike price of $40 has a $5 intrinsic value when the underlying stock trades at $45.
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You can exercise the option at any time and pay $40 per share for a stock that everyone else has to buy for $45. You are “in the money,”
On the other hand, let’s say the stock trades at $35 per share. Unfortunately, your option with a $40 strike price has zero intrinsic value. You would suffer a loss if you exercised it. You are “out of the money.”
Time value means that the farther away the expiration date is, the more time the underlying stock has to move in order to make your option profitable.
Options that expire in only a few days carry very little time value because the chances the underlying stock will move enough to make the option profitable is lower. If the expiration is farther away, then there's more time for the stock to rise, so the option is more expensive.
Implied volatility measures the expected volatility of a stock until the expiration date. Implied volatility is derived from several factors that include the strike, expiration, underlying price, and the risk-free interest rate. The higher the volatility, the more likely the underlying security will reach the strike price, which results in a higher price for that option.
For example, an option on a tech stock will likely cost more than an option on a utility stock with the same strike and expiration because tech stocks naturally trade with higher volatility. Higher volatility results in higher extrinsic value and a greater chance to make money trading options.
Strategies to Make Money Trading Options
Now that you know how options work, here are four strategies to spot opportunities to make money with options.
1. Derived Parameters
Derived parameters, or “the Greeks,” describe how the option will perform given changes in the underlying stock over time through the use of mathematical calculations based on data. Different Greek letters calculate the potential gains an option can give you, but it's not necessary to become an expert in them in order to profit from a simple call or put.
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For example, "delta" tells us how the option price moves for each $1 of underlying stock price movement. And "theta" measures how much of an option price falls as time passes. Many brokers provide these parameters through a computerized solution.
Derived parameters may be useful to make money trading options, although a balanced and disciplined options trading strategy is more critical.
2. Strike Prices at or Near the Money
Money Morning recommends looking for strike prices that are near the underlying stock’s price. We also recommend an expiration date within two or three months.
This strategy gives you the biggest bang for the buck without taking on too much risk.
3. Profit from Events
Another strategy to make money trading options is to capitalize on events that will likely affect the share price of a stock.
For example, your research tells you that XYZ company is about to release an excellent earnings report, but Wall Street is bearish on the company. You can buy a call option just ahead of earnings and ride the better-than-expected earnings release to huge gains using the leverage options provided.
Remember, since you invest a much lower dollar amount but benefit just as much as holders of the underlying stock, your percentage gain can soar.
And if you're wrong and earnings disappoint, your downside risk is much lower than for investors owning the stock itself.
4. Analyze Historical Patterns
Stocks often form recognizable patterns on their charts. If you can spot a stock that is about to break out to the upside – or downside – of its historical pattern, you can buy a call – or a put- to take advantage of its predictable performance. Your risk/reward would be similar to trading around earnings.
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But don't stop at just buying calls and puts. You can find even more creative ways to make money from trading options.
Advanced Options Trading Strategies
There are other advanced trading strategies that may be suitable for you, depending on your goals and risk tolerance.
Income Generating Strategy
A covered call is a different way to make money trading options compared to calls and puts.
This income generating strategy is an option for a more conservative investor, which involves selling call options against stocks you already own.
If the stock stays the same or falls in price, the call option you sold will expire worthless, which means you get to keep the entire amount, less commission, you got when you sold the call in the first place.
And if the stock goes up in price, you still make additional profit on the stock – up until the strike price of the option – plus the amount you collected on the option sale. The drawback is that you won't be entitled to the additional gain if the stock price moves above the strike price. The person who bought your option will call it away from you.
Two Option Combination
The most commonly used two-option combination is called a spread, which carries a lower risk than buying a call or a put, while still allowing you to make money trading options.
Let's say you are bullish on a stock. A bull call spread would mean you buy two options with an expiration date over a few months. First, you buy a call option, while simultaneously selling a call option with a slightly higher strike price.
The best part is that the money you receive from the sale of the higher strike call partially offsets the price you had to pay to buy the lower strike call. This is an excellent strategy for when you think a stock will go up modestly in price and your risk is immediately reduced.
Can I Make a Living Trading Options?
Yes, you can make money living trading options.
However, it takes lots of work and dedication to understanding the nuances involved. A trading plan is critical.
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