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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, options can be used to make your trading even safer.
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.
And trading options is one of the best ways to make money in 2020.
But with options, you can make money no matter which way the market moves. You can even make money 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. The good part is that since you put so much less money at risk at the start, your possible dollar amount loss is quite limited.
Big upside potential. Limited downside risk.
But that's just the basic idea.
Today we're going to show you everything you need to know to get started trading options right now, especially as 2020 is shaping up to be a pivotal year for the stock market…
Make Money No Matter What the Stock Market Does in 2020
Stocks have soared since the end of the recession in 2009. This decade-long bull market is now the longest on record. But there are a lot of reasons to expect that next year will be rife with ups and downs.
The Fed just cut interest rates, which often suggests the economy is weakening. And with a somewhat inverted yield curve, pundits are starting to look for signs of a coming recession.
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Of course, the trade battle with China continues to weigh heavily. In early August, the Dow Jones plunged nearly 2,000 points thanks to trade war fallout.
At the same time, the bull market continues to push on.
Economic growth is still good, unemployment is at record lows, and there is no inflation in sight. Money from around the world is pouring into the domestic market in search of returns, keeping a demand floor under our stocks and bonds.
Of course, with the conflicting signals, investors and traders alike aren't sure whether it's time to buy or sell to make the most money.
But by using options, you can profit no matter which direction the market moves in 2020.
Here's how it works…
What Is Options Trading?
Trading options is not much different than trading stocks.
You select the options contract you want, place your buy order and follow its progress on any free quote system online.
And since options give you the right to buy or sell a specific stock, your fortunes are tied to the ups and downs of the underlying stock.
There are a few extra parameters to consider, but the trading concepts are the same: You want to buy an option at a low price and sell it at a higher price.
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The other wrinkle is that you don't have to sell the options to make money. If the option expires "in the money," then you can exercise the option to buy or sell the underlying stock at the agreed upon price.
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.
And to help you hone in on how to use options, we'll dig into the two main forms of options trading, puts and calls.
What Are Puts and Calls in Options Trading?
There are two major 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.
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.
There are two important components of calls and puts.
First, all options have an expiration date, which is the date you can buy or sell the underlying stock (called exercising the option).
You can buy or sell options up until the expiration date.
Second, all options have a "strike price," which is the agreed-upon price you can buy or sell the underlying stock at 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:
- Name: XYZ company is the underlying stock
- Type: call or put
- Strike: the agreed-upon price to buy or sell the underlying stock
- Expiration date: Oct. 18, 2019
If 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.
That's because time is important for the value of an option.
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Options prices are influenced by both intrinsic value and time value.
Intrinsic value is simply the difference between the options strike price and the 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. You can exercise the option at any time and pay $40 per share for a stock that everyone else has to buy for $45.
This is where we get the term "in the money."
Conversely, if the stock trades at $35 per share, your option with a $40 strike has zero intrinsic value. You would suffer a loss if your exercised it.
This type of option is called "out of the money."
The other major component is time value. This is where the magic is. It's where all the fancy options parameters decide the odds that the options will ever become profitable and by how much.
But don't worry. It has a simple explanation. The most important point to know is that the farther away the expiration date is, the more time the underlying stock has to move in order to make your option profitable.
And the more you have to pay for that option.
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.
Knowing these basics is enough to start making money with options right now. But there are other technical indicators that effect options prices.
What Is Implied Volatility in Options Trading?
Not only does an option price depend on the strike price, time until expiration date, and the price of the underlying stock, but also on volatility.
The higher the volatility of the stock, the higher the price of the option. You see, volatile stocks are more likely to have price movements large enough to reach the strike price of the option.
We do not measure this volatility directly but rather derive it from several factors. That's why it is called implied volatility. These factors include the strike, expiration, underlying price, and the risk-free interest rate.
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.
What Else Affects the Price of Options?
Once we understand intrinsic and time values, we need to decide which option is right for us. In order to figure that out, there are many derived parameters available.
These are called "the Greeks." These are parameters named with Greek letters that further describe how the option will perform given changes in the underlying stock over time.
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.
The Greeks are used to 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.
What's more important is to follow an options trading strategy to keep your options trading disciplined and profitable.
How to Make Money Using Options Trading Strategies
Now that you know how options work, let's look at how to spot opportunities to make money using options. Here are three tactics we use at Money Morning to maximize our gains from options trading.
The first options trading strategy we often recommend is to look for strike prices at or near the money, meaning near the same price as the underlying stock's price. And we often look for expirations within two or three months.
These tend to give us the biggest bang for the buck without taking on too much risk.
The second strategy is to use options to profit from events that could 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.
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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.
The third strategy is to look for historical patterns in the stock.
Stocks often form recognizable patterns on their charts, so if you spot one about to break out to the upside – or downside – you can buy a call – or a put – to take advantage. Your risk/reward would be similar to trading around earnings.
But don't stop at just buying calls and puts. You can use options in even more creative ways to profit.
Advanced Options Trading Strategies
There are options for every trader depending on your goals and risk tolerance.
If you are more conservative, you can sell covered calls. With this strategy, you sell call options against stocks you already own.
You can do this to generate income. 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.
Of course, you can get even more creative with options strategies. Some involve buying or selling two, three, or even four options with slightly different parameters. We can leave these exotic combinations to the professionals, but all investors should understand how a two-option combination can lead to profits.
The most commonly used two-option combination is called a spread, and it is another simple way to trade. Although it has a fancy name, it actually carries lower risk than simply buying a call or a put.
Let's say you are bullish on a stock. You buy a call option like we talked about, but you would simultaneously sell 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. Your risk is immediately reduced.
Again, there is no free lunch, and your upside potential is limited. But so is your downside risk!
This is a great strategy for when you think a stock will go up modestly in price.
And by using these strategies, you can make a living from options trading.
Can I Make a Living Trading Options?
Yes, you can make a 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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