What is Options Trading?

When you are trading stocks or currency pairs in the forex market, your trading is very straight forward. In stocks, you are either buying or selling a stock. If you buy a stock and it doesn’t go anywhere, you make no money (assuming there is no dividend on the stock).

When trading options, you can make money if the stock goes up, down or goes absolutely nowhere. Options also allow you to hedge or decrease risk on stocks in your portfolio.

This is just one of the many ways options are a totally different animal vs traditional stock buying/selling.

When you buy or sell an option, you are not trading the underlying directly. You are not actually buying the stock itself, so you are not owning the shares directly. However you are trading their price, direction and value very much the same.

In addition to this unique form of trading, if you buy a stock, you want that stock to go up in value or down in value if you have shorted the stock. However, with options, you can make money if the stock goes up, down or doesn’t move at all which is a very unique property of options.

Options Trading 101

Contract Between Two Parties

When you’re buying or selling options, you’re essentially buying or selling a contract between two parties (the buyer and the seller).

Let’s go through an analogy which will make it easier to understand.

If you own a car in the US, you legally have to have insurance on that car. The insurance policy protects you with certain accidents, liabilities, etc. When you buy insurance, you are buying it from an insurance company who is authorized to sell that insurance policy.

You pay them a monthly ‘premium’ and they offer you coverage. In case you didn’t know it, insurance companies are highly profitable businesses because they are typically selling you insurance at a greater cost than the actual value they most often provide.

Hence the ‘premium’ (i.e. insurance policy) they are selling you is more expensive than it should be.

With options trading, the ‘buyer’ of the option is like the car owner wanting insurance. The ‘seller’ is like the insurance company. Except the only difference is, with options trading, you don’t need to be an insurance company to sell an option, you just need the necessary capital to cover that option.

Thus, if you buy an option, you pay a ‘premium’ (like you do with your car insurance). If you sell an option, you collect that premium from the moment you enter the trade, which is called a ‘credit’ that you receive for selling the option contract.

Now this sounds great as you can (like the insurance company) collect that premium, and thus collect a regular income by selling options. However, you must be able to honor those obligations in the option contract if the counterpart (the buyer) ‘exercises’ the option.

We’ll cover later the process of ‘exercising’ and ‘assigning’ which is a more advanced concept. For now, just make sure to understand that you can now (with options trading) take both sides of the transaction, but you do so as a buyer (payer of premium) or seller (collector of premium) for said option contracts.

Advantages to Trading Options

Below are what I consider to be the main advantages to trading options:

Leverage & Margin – when you trade options, you get more leverage than if you traded the underlying directly because every single option contract controls 100 shares of the stock.

Market Neutral Strategies – if you buy a stock or forex pair, you want that stock/pair to go up in value. You make no money if it goes nowhere in price, and lose money if it goes down.

However when trading options, you can actually make money if the stock or pair goes absolutely nowhere in value. These are called ‘market neutral’ strategies, meaning they make money if the price of the stock/pair goes nowhere.

Pretty cool eh?

Neutralizing Risk – how many times have you bought a stock, the price goes against you, but you still want to hold your position? Probably many…

But what if you wanted to ‘hedge’ your position (i.e. neutralize or reduce) the risk in your trade?

Options are one of the best ways to do that because you can be long a stock and yet buy (or sell) an option which will either a) reduce your downside risk if your trade goes against you, or b) give you money for selling an option against your trade.

Collecting Premium – as mentioned before, if you buy a stock, you do not get ‘paid’ to enter that position. However, with options (particularly selling option contracts) you collect a premium, and thus get ‘paid’ to enter the trade.

Unlimited Upside – there are many options contracts where the upside potential for profit is unlimited. This requires a greater understanding of options contracts, pricing, etc., but there are situations where your potential upside is unlimited.

Fixed Risk/Profit – along with the point above, there are also option contracts you can trade that have fixed risk, along with a fixed amount of profit you can make, no matter how much the stock or pair moves for or against you.

Put/Call Ratio – one of the great things about options is your options broker should give you access to the put/call ratio. This is the ratio of traders buying calls (bullish option trades) vs puts (bearish option trades). This in essence gives you an insight into the order flow and sentiment of a particular stock by seeing the ratio and how those options were traded on that stock.

Making Money With The Price Not Hitting Your Target – yep, you heard that right. Because of a unique feature about options pricing, you can actually make money without the stock price hitting your target on your option (called the ‘strike price’).

Implied Volatility – a concept you will learn about in options is ‘implied volatility’ which is a measurement which reflects the markets ‘view’ that stock XYZ will change over time. Essentially implied volatility is the market’s projection or forecast of a likely movement in the stock price.

Implied volatility usually increases in bearish markets and decreases in bullish ones, but this is not fixed. This gives you an advantage because it gives you a relative ‘insight’ into how much the overall market thinks stock XYZ will move over the life of that option.

Disadvantages to Trading Options

Don’t get to own the actual shares – when you are trading options, you don’t actually own the shares as you’re trading a contract on the shares. Hence any dividend or shareholder access you get by owning the shares are not available when trading options.

Can have unlimited risk – while we mentioned the possibility of having unlimited upside, there are some options that expose you to unlimited risk.

Lesser liquidity – unlike stocks, options trading is definitely less liquid. For the larger and mid cap stocks, you most likely won’t have any issues of finding a buyer or seller for your option trade. However not all stocks have options on them, and some that do have much less options to trade than actual shares.

Spreads – because stocks have greater liquidity, they more often have tighter spreads due to the increased liquidity. Options (having lesser liquidity) thus often have wider spreads.

This is not always the case, but it’s definitely a potential out there for option bid/ask spreads to be wider than the actual stock itself.

Time decay – if I own a stock, and the stock hasn’t hit my stock price, if it takes a day, a week or a month to hit my profit target, I still make the same profit.

However, with options there are times where the longer it takes to hit your profit target, the less money you make. This is called ‘time decay’ which we’ll explore later. Time decay can actually work to your advantage, but it can also be a negative.

Complicated – and lastly, as you might have guessed, because of the increased complexity in trading options, the learning curve can be steeper. Options inherently are more complicated than simply buying/selling stocks or forex pairs.

Option Trading 101

Buying & Selling Options

You can be an option buyer or an option seller. What this means is you can be a call buyer (bullish on stock XYZ) or a call seller (neutral to bearish on stock XYZ). You can also be a put buyer (bearish on stock XYZ) or a put seller (neutral to bullish on stock XYZ).

You can always be an option buyer or seller of option contracts depending upon your view of XYZ stock and where you see the stock going in the future.

Option Premium

All option contracts have a ‘premium’ for those who want to buy it. Just like if you want to buy your car or fire insurance, you are a buyer of car/fire insurance and have to pay the ‘premium’ of the contract to the seller of the insurance. Options are exactly the same as the insurance analogy.

If you want to buy a call on XYZ stock (e.g. you are bullish) then you will have to pay a premium. In essence, you have to pay a cost to buy that call option and contract.

If you are an option seller of the call on XYZ stock (e.g. you are bearish or neutral) then you collect the premium the option buyer will pay for the call option.

Option premiums are paid up front, so if you buy a call or put, you pay up front to enter the trade. The option seller collects the premium up front once they sell the option contract to the option buyer.

Premiums are calculated based upon price of the stock (or underlying), price in relation to strike price (we’ll explain strike prices shortly), length of time for the option contract and volatility.

You don’t have to calculate premium as all brokers will do this for you.

Premiums are priced based on dollars and cents. So if the premium you have to pay to buy XYZ stock is $2.10, then you will have to pay $2.10 x 100 shares (as all option contracts control 100 shares of the stock) which = $210.

If the premium is priced at $.45, then you will pay $.45 x 100 = $45.

If you sell a contract at $2.10, you will receive $210 credit (per option contract). If you sell an option contract for $.45c, then you will receive $45 (per option contract). Hence this is how you understand option pricing and premiums.

The Option Strike Price

All option contracts have a strike price. The strike price is the price the option contract can be bought or sold when exercised.

Only option buyers can ‘exercise’ options. When they do, the option is ‘assigned’ to the option seller.

For call options, the strike price is the price the stock/underlying security can be bought at by the option buyer, whereas for put options, the strike price is the price whereby the security or stock can be sold by the put buyer.

For example, if stock XYZ is currently at $40, and you are wanting to buy a $45 call option on XYZ stock, you need the stock to rise above your $45 strike price by expiration to profit. The strike price is what you can buy the stock at even if it rises above your $45 strike price. This means if XYZ stock closes at $50 by your expiration date, you can buy stock XYZ at your $45 strike price, and profit from the difference between your $45 call strike price and the current price of the stock ($50), thus profiting $5.00 per share.

The Option Expiration

All option contracts have expiration dates. This is a major difference from trading spot forex or stocks. When you buy a stock, there is no date you have to exit the trade. As long as it doesn’t hit your stop loss or take profit, you can remain in the trade indefinitely.

With options, all option contracts have an expiry date, so you have to learn to time your trades and where you think they will be (or can be) by the expiration date of the option.

Traditional option contracts are what we call ‘monthly’ options, meaning they expire at a fixed date for the month which is usually the 3rd Friday of each month.

The key thing to understand about the expiration date is that your option has to hit its price by the expiration date to profit from your option.

For example, if you bought a $50 call on XYZ stock to expire September 18th, and on September 18th at the market close, the price is $49.99, your call will expire worthless since it didn’t achieve its target ($50) by the expiration date.

Hence think of the expiration date as the final date your option contract is valid for and can profit from. If you have an option in profit before the expiration date and you were the option buyer, you can exercise the option for profit before the expiration date.

ATM, ITM & OTM Definitions

Now that we’ve covered the expiration date, it’s time to cover the terms ATM, ITM and OTM.

ATM = At The Money, and it essentially means that the current price of the stock is at the money of your strike price.

ITM = In The Money. This means that the current price of the stock is in the money of your strike price.
OTM = Out of The Money which means the current price of the stock is out of the money of your strike price.

For example, if you buy a call on XYZ at $50, and the stock price is currently around $50, the option would be ‘at the money’.

Using the same example, if you buy a call on XYZ stock at $50, and the stock is anywhere above $50, then the option would be considered ITM or ‘in the money’ because it’s a profitable option (hence ‘in’ the money, or profit).

For OTM (out of the money) options with our same example, if you have a $50 call on XYZ stock and the price of the stock is below $50, then the option would be considered ‘out of the money’ because it’s not profitable, therefore ‘out’ of the money (or profit).

Options P&L Charts/Diagrams

The last key component for understanding options is the option P&L chart. It’s what helps you evaluate the option contract and at what prices the option would be in profit (and by how much) or not.

They are simple tools to help you analyze your option strategy or trade.

Let’s look at the following P&L diagram below and analyze it in detail.

Options P&L Chart

Looking at the chart above, you’ll see an x-axis/line which represents the stock price at expiration. You can see the $30 strike price, $40 strike price, and $50 strike price.

The y-axis/line represents the profit and loss of your option. So anything above the x-axis will be in profit and anything below the x-axis will be in a loss.

Now this chart is what a call option looks like in terms of P&L.

Since the line starts at -$200, it means that you bought the call option on XYZ stock at $40 for $2.00 per contract. In this case, you bought one option contract since your option cost you $200 ($2.00 x 1 contract).

Since you bought the option contract, you’re max loss is what you paid for the option (i.e. $200). No matter what happens to the stock price from here, you cannot lose more than $200.

Now if you notice the red/orange line starts to ascend and crosses the x-axis at $42. This is because you bought the $40 call for $2.00, so you need the price of the stock to climb above $42 to make a profit. The call is at $40 and the cost of the option is $2.00, hence the stock has to climb $2.00 above your $40 call strike price to profit.

The line also ascends up towards infinity, because technically, that is what you can make in terms of profit as the stock rises above $42. Whatever price the stock closes above $42 at expiration is what you will profit.

So if the stock closes at $45, you will profit $5.00 from your $40 strike price minus the cost of the option ($2.00). This means you will profit $3.00 per contract x 100 shares.

For one option contract, that will = $3.00 x 1 contract x 100 shares = $300 profit.

The key points to understand about the option P&L diagrams is the x-axis will always represent the strike price at expiration and the y-axis will represent the profit (if above the x-axis) or loss (if below the x-axis).

In Closing

Make sure to review everything in this article in detail. How well you understand these components will determine how well you can trade options, as these are the primary pieces of the puzzle you need to understand to quantify and fully understand for your option trades.

Be sure to read our article on Calls & Puts next.

Options trading is very unique and often difficult to learn for beginners.

In this free 2-part Options Trading video series, we will give you the foundation and step by step guide on how to trade options, learn option strategies and how you can generate income trading options.

Welcome to our Options Trading Course for Beginners.

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All option strategies are built using calls and puts. Once you fully understand how calls and puts work, you have the foundation to explore all options, strategies and setups going forward, whether they are more complex or not.

All options are calls and puts or variations and combinations of calls and puts, so your ability to get this down is super important, and it will allow you to start making your first option trades.

In this article, we’re going to simplify calls and puts, show you how they work, how you can trade them and why you’d want to trade call and put options.

Call Options

So starting off with calls, a call option can be simply defined as an option that gives the option holder the right, but not the obligation, to buy shares of a stock at an agreed upon price on or before a specific date.

A put is simply the opposite of a call. It gives the option holder the right, but not the obligation, to sell shares of a stock at an agreed upon price on or before a specific date.

Now, I’ve talked about on or before a specific date and I’ve talked about an agreed upon price. What are those? The strike price is the agreed upon price the stock can be bought or sold at. Also, all option contracts have an expiration date.

Unlike buying stock in and of itself, if you want to buy 100 shares of Apple, there’s no expiration date on that. As long as it doesn’t hit your stop loss or take profit, you can hold that position indefinitely. There’s no time that that trade will expire.

However, all options have an expiration date and that’s the specific date that option contracts expire. So these four definitions for calls, puts, strike and expiration date, those are the bare bones that are in every single option contract.

Let’s go through a very simple example of a call and a put.

Let’s say you are going to buy a call on a stock at $50 with what we call 30 DTA or 30 days to expiration. Owning this call option allows you to purchase a stock at $50 per share, which is the strike price, between today and the next 30 days, which is the expiration.

So if the stock goes from $50 to $75, your call option allows you to buy the stock at $50 regardless of the fact that it’s trading at $75 today. That means that you can exercise this call option on the stock, purchase the stock at $50 per share and thus profit $25 per share and you can do this with a lot less margin than buying the stock outright.

Calls and Puts 01

I’ll explain that in terms of margin and leverage and option shortly, but let’s go over a put option to kind of give you the same example. So we’re going to buy a put option on the same stock at the same strike price of $50 with 30 days to expiration.

Owning this put option allows you to sell the stock at the stock price of $50 per share between the time you buy the option and the expiration date or 30 days from now, regardless of where the stock is at.

So if the stock crashes from 50 to $25, then your put option allows you to sell the stock at $50 per share, which is your strike price, even though the stock is at $25 right now, which means you can profit $25 per share.

Calls and Puts 02

Now, the question must be coming into your mind, why would you buy a call or a put option versus trading the stock directly? This is a very good question, there are several reasons to buy calls and puts instead of trading the underlying directly, i.e. the stock.

For example, if you buy a stock at $50 per share and you buy 100 shares, you’re going to have to put up $5,000 in margin if you have a cash account. If you have a margin account, you’ll have to put up $2,500. And if you have a day trading account, which is any account above $25,000, then you can put up $1,250 a margin.

Now, owning this stock at $50 means the stock could technically go to zero, so technically you have $5,000 of risk if the stock goes to zero. This is where a put option comes in. Remember, if you buy a put option on the same stock with a $50 strike price, if the stock price goes down, the put option gains in value while your stock trade loses value.

Think of it like buying insurance on your stock position. The put option will protect your stock trade, even though your stock trade itself is losing value, your put option is gaining value. So it’s like getting insurance or hedging the risk on your long stock position.

Now, what about a call option? Well, you can just flip that scenario. Let’s say you want to sell a stock that you think is going down in price and it’s also currently priced at $50. If you sell 100 shares of that stock at $50, technically the stock can go to infinity, so your risk is unlimited on this short stock trade.

But if you buy a call option, you are hedging your short stock trade because your call option gains in value as the stock goes up. So again, you are buying insurance on this short stock trade. Hence, one of the main reasons to buy and sell options is to protect, hedge or buy insurance on your long or short stock positions.

Another reason to buy calls and puts is leverage. Options have more leverage than buying and selling stocks outright. For example, going back to our long stock trade at $50. If you go long the stock at $50 by buying 100 shares, you have to put up $5,000 in the cash account, $2,500 if you have a margin account and $1,250 if you have a day trading account.

However, with options, you can control 100 shares of the stock for much less. So let’s say a call option on this same stock at $50 with 30 days to expiration costs $2.50. Now, if you remember from earlier, each option contract represents or controls 100 shares of that stock.

So if you buy one option contract for $2.50, times 100 shares equals $250. So you can own a call option contract on the same stock for $250 versus having to put down $5,000 or $2,500 or $1,250 in margin.

That means you get a lot more leverage trading options and therefore you can use that capital to make other trades as well. This is another advantage to buying calls and puts.

Now, let’s talk with you through a couple examples of call and put options and how that works.

Let’s say you own 100 shares of a stock at $50 and you have a downside risk on that stock if it falls.

You decide to buy a put option on that stock for the same $50 strike price at $2.50 or $250 in margin to protect your long position.

If the stock climbs from $50 to $60, you gain $10 per share on your long stock position. This gives you $1,000 profit, which is $10 per share x 100 shares equals $1,000.

But you also bought insurance on this stock trade. You bought a put option, which costs you $250, so your net profit is $750 to protect your long stock position.

This is one example of how you can use options to protect or hedge your stock trades.

Calls and Puts 03

Now, let’s look at that same example with your stock price falling.

So you bought 100 shares of XYZ stock at $50 and you also bought the $50 put option with 30 days to expiration at $2.50, which is $250 of your capital.

Let’s say the stock falls from $50 to $40 per share.

On your long stock trade, you’re losing $10 per share x 100 shares, that’s $1,000 loss. However, you have a long put option that gains in value if the stock falls and that put option allows you to short the stock at $50.

Thus, you can exercise that put or your put option insurance and get $10 per share on that put option, so you lose $1,000 on your short stock trade, but you gain $1,000 on your long put option, which is a net zero loss.

You did pay $250 for this put option and insurance, so instead of losing $1,000 on this trade, you only lose $250, which is much better than taking the full $1,000 loss.

Calls and Puts 04

For every single loss you had on all your trades this year, instead of losing the full amount, the full loss that you took, what if you took anywhere between 25 and 75% less than your full losing position? How much would that help your account?

This is one of the benefits of trading options. It gives you a natural way to protect your trades by giving you that insurance. Now, what if you don’t want to buy insurance on your stock trades or what if you want to trade the stock prices without actually owning the stocks? That is the benefit of trading options.

Now, let’s say you don’t own any shares of a stock, but you want to own shares in the stock or profit from the stock price’s movement. You’re bullish on it, however, the stock is too expensive, say at $300 per share. This is where call options and then option leverage comes in.

Call options, as you recall, gain in value if the stock goes up and they give you better leverage than owning the stock outright.

So to buy 100 shares of a $300 stock, requires $30,000 of margin if you have a cash account. If you have a margin account, you have to put in $15,000 in margin. And if you have a day trading account, you have to put $7,500 down in margin.

But let’s say you don’t have that $7,500 in margin to buy the stock, this is where option leverage comes in. This is where call options come in. You can buy a call option at the $300 strike price with 30 days to expiration. That gives you the right, but not the obligation, to buy 100 shares of that stock at $300 per share anytime between now and the next 30 days.

Now, let’s say this call option costs you $5. That means you have to pay $5 x 100 shares, that’s $500. That’s much better than putting the $7,500 minimum just to own 100 shares of that $300 stock.

Now, let’s examine two scenarios using options. One where the price goes up and another where the price goes down.

In the first example, the stock goes from $300 to $325. You own a 300 call option for $500 or $5. The stock appreciated $25. At 100 shares per option contract, you can now exercise that call option, which means you can buy that stock at $300, even though it’s now at $25 a share. That’s a $2,500 profit. The math is $25 a share x 100 shares, so a profit of $2,500.

However, you did buy the call option for $500, so your net profit on this call option trade is $2,000. If you had bought the stock outright, you would have a $2,500 profit, but you would also have to put up that $7,500 in margin.

Calls and Puts 05

And if you didn’t have the margin to buy the stock, you wouldn’t be able to profit from the stock’s bullish move. That’s where options can allow you to profit from stocks while not having to put up for as much margin.

That’s pretty cool.

Now, in the second scenario, you bought that same call option at the $300 strike price for $5 or $500 in margin. Let’s say the stock price falls to $275. Well, that call option gives you the right, but not the obligation, to buy the stock, so you don’t have to exercise that option and there’s no point in exercising that option, that call option, if the stock price falls.

So if you were long 100 shares of that stock at $300 and it falls to $275, you lose $2,500. However, by buying that call option for $500, you only lost that $500. Hence, options can allow you to buy stocks with greater leverage and also reduce your risk. This is the power of trading options. You can put out much less capital, have less risk, all for the exchange of a small premium. The same goes for put options.

Calls and Puts 06

So, to recap, call options are options that allow you to buy a stock at a set price, which is called the strike price, within a specific timeframe, which is the expiration date, on or before that date.

Put options are the opposite. They allow you to sell a stock at a set price, a strike, within a specific timeframe, the expiration date, on or before that date. To buy a call or put option, you get greater leverage, you have less risk, but you do have to pay a premium.

Now, as we also mentioned, you can use those calls or puts to buy insurance on your long or short stock trades. This gives you the option to hedge or reduce your risk on those same long and short stock trades.

It’s important to understand that even if you think the stock is going up or down, there are certain times where you should buy calls and puts and there are certain times you should not buy those calls and puts.

In closing, calls and puts are the basic building blocks of all options. If you get this down, you understand options and how the basic building blocks of options work.

In this article we’re going to teach you a strategy that you can use to generate income on your stock trading portfolio, called the “covered call strategy“.

The covered call strategy is a strategy you can use to give you a second income on your stock trades, improve your profit potential and generate monthly income.

This simple strategy consists of two components. It’s a combination of a long stock trade and a short call trade.

covered call 02

How the covered call strategy works

Let’s say you are long 100 shares of Apple stock at 100 per share, with the price of Apple let’s say being at $125. You are long-term bullish on Apple. However, you feel the tech sector might be weak for the next few months, and Apple might pull into a range, not appreciate much or perhaps even drift a bit lower.

You don’t want to get rid of your long stock position on Apple, but you think you may not make any money on your stock position for the next few months.

Enter the covered call strategy.

When you buy a call option on a stock, you are bullish on the stock and have the right, but not the obligation, to be long Apple stock at your strike price before the expiration date.

However, when you sell calls, as you do in the cover call strategy, you do collect a premium for selling that option.

Let’s look at a theoretical option chain on Apple for options expiring in 30 days, on June 18th in this example. Looking at the option chain below, you can see the 135 calls are selling for $3.50.

Covered call

With the cover call strategy, since you own at least 100 shares of apple stock already, you can sell calls against those 100 shares. With the $135 calls selling at $3.50, you can collect $350 in premium for each call that you sell.

Since each option contract represents 100 shares of a stock, you can sell one call of Apple for every 100 shares that you own and for each call option that you sell on Apple for $3.50, you collect $350 in premium.

For example, let’s say you own 100 shares of Apple which you bought at $100 with the current stock price of Apple being at $125. You think that Apple is not going to get above $135 before June 18th and you sell the $135 calls with 30 days until expiration, i.e. June 18th.

Let’s go through four different scenarios to see how this strategy plays out.

Scenario 1

In scenario one, Apple goes from $125 to your strike price of $135, exactly on the day of expiration (June 18th).

The $135 call we sold is now at the money. Since the price did not go above the strike price at $135, i.e. that means the option is at the money but not in the money. In extension, this means the option has no value and is worthless to the option buyer and we get to keep the full premium that we received for selling the option which is $350 ($3.50 x 100).

Looking at the profit on this trade, you are still long 100 shares of Apple at $100 and the stock is now trading at $135. That means a profit of $35 per share or $3500 on your long stock trade. On top of this, you also made a second income on this trade by selling the $135 calls.

So you made an additional $350 on that call you sold. This puts your total profit at $3850.

The Covered Call Strategy 01

$3500 on the long stock trade ($35 profit/share x 100 shares) plus $350 in premium that you received from selling the call option.

Had you not sold the $135 call option you would have only walked away with $3500, so by selling this call option, you improved your profit on this trade by an extra 10%.

Imagine if you could increase the profit on every profitable stock trade you took by an additional 10%. How much could this boost your trading performance and trading account on a yearly basis?

Scenario 2

Now let’s look at scenario two, whereby the stock price of Apple rises to $140 by June 18th when our $135 call option expires.

Looking at your profit and loss in this trade, your long stock trade is $40 in profit since you bought the stock at $100 and you also collected $350 in premium for selling the $135 call option.

However, since you sold the call at $135 and the price of the stock now is at $140, the option buyer you sold the call option to has the right to exercise that call option and be long the stock from $135.

That means you made $40 dollars per share on your long stock trade, you collected $350 premium for selling the call option ($3.50 x 100 shares), but you also lost $500 on that short call you sold because the price exceeded your strike price by $5 ($5 x 100 shares).

The Covered Call Strategy 02

Hence, your net profit is $3500 from your long stock position + $350 in premium from selling the call option minus $500 because the stock price went past your strike price of $135 by $5. So your net profit is still $3850, the exact same as if Apple closed at $135.

Hence, when you sell covered calls, you collect the premium from selling those calls, but you also max out your profit at the strike price, in this case $135. Regardless if Apple closes at $140, $145 or $150 at the time of your option expiration date, your profit is still capped at $3850.

This is because while your long stock trade keeps making money, your short calls start losing money above your strike price, in this case $135, and it evens out.

The Covered Call Strategy 02 end

Scenario 3

Now, let’s look at scenario three where the price of apple falls from $127 to $115 by the june 18th expiry and you sold those $135 calls for $3.50 ($350 in premium).

On your long stock trade you made $15 per share or $1500. You also made $350 via the premium you collected for selling the $3.50 call option.. Those calls are now worthless to the buyer because the stock price did not close above $135 at expiration.

So your net profit now is $1500 on your long stock position + $350 in premium from selling the call option, for a total of $1850. If you hadn’t sold the $135 call option, you would only have made $1500 in profit. So selling that covered call improved your profit potential by an additional 23%.

The Covered Call Strategy 03

Again, imagine if on your stock trades, you could collect an extra 23% of your profit. How much would that help your performance?
Now you should start to understand the power of the cover call strategy. Now let’s go through one more scenario to show you the power of this strategy.

Scenario 4

In this scenario, you’re still long 100 shares of Apple at $100 and you sell the $135 call option. But Apple has a big miss on earnings and the stock goes in the pisser, dropping to $98 on June 18th.

This is how your profit and loss works out in this scenario. You lose $2 per share on your long stock position which is a -$200 loss since you own 100 shares. However, since you sold the $135 call option and collected $350 in premium, your net profit on this trade combination is $150.

The Covered Call Strategy 04

Had you not sold the call option you would have banked a -$200 loss, but since you collected $350 in premium for selling the option, you end up with a net profit of $150 instead.

Imagine if on your small losing trades, you actually came out with a net profit. What would that do for your long-term performance over a series of 100 or a 1000 trades?

Conclusion

By now, you should be able to fully understand the power of the covered call strategy. This is one of the many benefits of trading covered calls, because you reduce your risk by collecting that extra premium. If you’d like to learn more on when and when not to use this strategy, check out our Options Bootcamp.

In this video learn how to use covered calls and option strategies to generate income.

Read more

One of the most important questions option traders want to know – is writing options profitable as a trading strategy?

The answer is yes, writing options can be a profitable trading strategy, but it depends upon how you structure the trades. If you write an option without structuring it properly, then you’ll reduce the chances the options you wrote (or sold) will make money. Hence it really depends upon the skills of the option trader.

In this article we’ll explain what an option writer is, how does the writer of call options make money, how does the writer of put options make money, how do option writers lose money, how much money you need to write options, and what is the maximum profit that a call option writer can earn.

Let’s jump in.

What Is an Option Writer?

A trader who is an option writer is someone who sells an option contract in exchange for collecting the premium. Who are the option writers collecting the option premium from? The option buyer who pays the premium.

Anyone who writes options can sell call options, put options, or any combination of options that results in them being a net seller of options.

If you write an option by selling a call option, you get the premium up front for the value of the call you sold. In exchange for collecting the premium, you take on the risks of that call whether its covered or uncovered. The same goes for selling puts.

Hence an option writer is simply a trader who sells (write) the option or a group of options that are collecting net short.

It should be noted anyone can technically buy or sell (write) options assuming they have the permissions from their broker to do so.

What Is an Option Writer?

How Do Option Writers Make Money?

Option writers (who sell options) make money by a) selling options that expire worthless (to the option buyer, thus allowing you to keep the full premium) or b) by closing the option for a partial credit of what you received.

For example, let’s say you sell one call contract on the $SPY (S&P 500 ETF) expiring this Friday at the 430 STR (strike) for $3.50 in premium. Once the trade is fulfilled, you immediately get the $3.50 credit in your account which = $350 (1 contract x 100 shares per contract x $3.50 in premium = $350).

Now if the $SPY never gets above the 430 STR by the time of expiry this Friday, the call you sold expires worthless and you get to keep the full premium. This is the best scenario as you keep the full credit for the option you sold (wrote).

But let’s say the market starts to get close to the 430 STR by Friday and you’re worried it may continue to gain in price and close above 430 by the expiry. Well, you can close the call you sold early for the value of the call at the time you want to close.

If you sold the call for $3.50 in premium and the call is currently worth only $2.00, then you can buy back the call for $2.00 pocketing the difference which is $1.50. This is because you sold it for $3.50 and yet bought it back for $2.00, thus making a $1.50 profit, or $150 per contract.

The advantage of closing it early for a guaranteed profit is that you eliminate the risk (or possibility) the $SPY closes above the 430 STR and is worth more than the $3.50 you sold it for. Hence you avoid a potential future loss by locking in a smaller guaranteed profit. And with American style options (*which most people trade) you can close them any time after you open them. Hence if you’re ever worried your option may become a loss, just close it early for a profit and move onto the next trade.

This is how the writer of a call option makes money.

But how does an option writer of a put make money?

Virtually the same way. Let’s work with another example in Apple stock ($AAPL) which you think will hold above the $150 support level by this Friday. You can (as an option writer) sell a put at the $150 strike expiring this Friday.

Let’s say the value of that put is $2.25. By selling that put, you collect $2.25 in premium or $225 per contract.

Now if the price of Apple closes at or above the 150 STR by the Friday expiration date, you get to keep the full premium of $2.25 or $225 per contract.

But what if the stock price of Apple falls to $151 a few hours before the Friday expiry and you’re worried the stock may fall below the 150 STR?

You can close the put you sold by buying back a put for the current price. Let’s say the current price of that put you originally sold is now worth $1.75 in premium? You can buy back the put for $1.75 in premium and pocket the difference of 50c per contract (or $50 per contract). This allows you to avoid a future loss, close it for a lesser profit and negate the risk of a loss.

Hence the way you make money writing calls is virtually the same way you make money writing puts.

How Do Option Writers Lose Money?

Now that we’ve covered the ways you can make money writing options, its important to cover the ways you can lose money writing options.

Let’s go back to the $SPY call you sold for $3.50 at the 430 STR.

If you remember, you get to keep the full $3.50 credit if the call option expires worthless, which it would if it closed below $430 by expiry.

But what if $SPY starts a bullish trend and is above the $430 STR by the expiry, say at the 433 STR?

Then the call you sold for $3.50 to the buyer would be worth more than the price you sold it for. Let’s say the call is now worth $4.50 at expiry. If the buyer did not exercise it and held it through to expiry, you would have to pay the difference between what you sold it for ($3.50) and what it was worth at expiry ($4.50) which would be a net of -$1.00.

Hence, you’d lose $100 per contract you sold. If the price was $5.00 at expiry, the loss would be $1.50 in premium, or $150 per contract.

Thus, you can lose money at expiry if the contract is worth more than you sold it for.

Another way you can lose money is by closing it early for a loss.

Let’s say it’s one day before the expiry and your 430 STR call that you sold for $3.50 is now worth $4.00 and you’re worried it may continue to go against you?

Well, you can simply close it for the value of the call option now. If it’s worth $4.00, and you sold it for $3.50, then you’d lose the difference of 50c per contract (of $50).

Essentially, there are two ways you can lose money writing options, by a) holding the option till expiry and the option you sold is worth more than you sold it for, thus paying the difference, or b) closing it early and paying the difference between what you sold the option for and the higher value it has when you close it.

There is a third way which has to do with being ‘assigned’ but that is for another article, but you now know the two main ways you can lose money writing options.

How Much Money Do You Need to Write Options

How Much Money Do You Need to Write Options?

Now that we’ve covered using simple examples how option writers can make and lose money selling calls or puts, an important question needs to be addressed of how much money do you need to write options?

The answer is…that depends. There’s no fixed amount of money you need to write an option per se, but you will need at a minimum the margin required to sell an option if the option is not ‘covered’.

What Does ‘Not Covered’ Mean?

When you sell a call, you are selling the call on a particular stock at a particular price (called the ‘strike’) on a particular end date (called the ‘expiry’).

The buyer of your call is buying the same call at the same strike for the same expiry. But the buyer of the option has a ‘choice’ with their option. They can at any time a) close the option for a profit/loss before the expiry, b) hold it till expiry, or c) ‘exercise’ the option.

The latter (exercising) the option allows the buyer of the option to convert their call option in a long share position on the stock.

At what price can they buy the stock with the option? At the strike they bought the call. Hence if they bought the call at $100 and the stock closed at $110 at expiry, and they ‘exercised’ it, by exercising it, it converts their long call option into a long stock position at $100 with them being long 100 shares per contract they bought. If they bought one call, they would be long 100 shares at expiry if they exercised it.

You on the other side of the call (if they exercised it) would be short the stock at the $100 price by 100 shares per contract.

Now if you don’t currently own at least enough shares to cover the call you sold (1 call = 100 shares) then if you don’t own at least 100 shares of the stock at or below the strike price ($100 in this case), then the call is considered ‘naked’ or ‘not covered’.

If, however you already own enough shares to ‘cover’ the call, then when the call you sold is ‘exercised’, your shares will ‘cover’ the call you sold, and will be exchanged 100 shares for the 1 call contract you sold. Thus, by being ‘covered’ in this case, you do not incur any loss if the stock closes above the $100 strike and is exercised.

Now circling back to the amount of money you need to ‘write’ options, if you have enough shares to ‘cover’ the call you sold, then you don’t need any additional margin to write the call. But if you don’t have enough shares to cover it, then you’ll need to put up the necessary margin required for that specific call, which will vary dependent upon the stock price, the value of the option and size of your position. Make sure to check with your brokerage account how much margin they are requiring for writing the call or put.

Hence, there is no fixed answer as to how much money you need to write options as its highly dependent upon the options you are writing, the stock price and the size of the position.

As a general rule, we’d recommend not selling or writing options till you have at least $2K in your account.

Is Option Writing Always Profitable?

While option writing can and often is profitable, especially if you structure the trades correctly and it goes in your favor, there are times writing options will not be profitable.

You’ll need to know what variables can and often do lead to writing options and losing money. A few examples of these variables which can hurt your options writing trades are:

  1. Are the options cheap or expensive relative to their historical volatility?
  2. Is the implied volatility of the option gaining or losing value over the recent time period?
  3. Are there earnings/events coming up which would likely increase the value of the options?

There are many more variables which can affect options pricing and whether the options you are writing/selling will likely make or lose money.

To list all the variables and explain the how/why they can hurt option writers is beyond the scope of this article, but just understand not all options you write will be profitable as many can lose.

But by avoiding the common ways they lose money and structuring the trades in ways they’ll likely make money, you can increase your accuracy and chances of making money consistently writing options.

If you’d like to learn how – make sure to check out our options bootcamp where we explain the ways each strategy can make or lose money, how to maximize the option strategies profitability, and what are the best price action patterns to combine when writing options.

Do 80-90% of Options Expire Worthless?

There is one common myth you’ll hear that 80-90% of all options expire worthless. This myth is not accurate and misstates the actual statistics around options.

There were statistics published by the CBOE (Chicago Board of Options) which stated that only 10% of all options were exercised. But just because only 10% of all options were exercised does not mean the remaining 90% of the options expired worthless.

According to the CBOE, between 55-60% of all option contracts are closed prior to the expiration. This basically means that for every 100 contracts sold, about 55-60 of them will be closed early instead of being held to expiration.

Thus, if 10% of all contracts are exercised, and 55-60% are closed early, that means roughly 30-35% of all contracts expire worthless. Hence it is not accurate to state over 80-90% of all options expire worthless as only 30-35% do.

Now the real question is how many of those 55-60% of options that were closed early were closed for a profit? And what about the 10% that are exercised?

Lamentably, we don’t have those statistics about the 55-60% that are closed early. It’s also important to note not all of the 10% of contracts exercised are done for a profit.

Thus, we simply don’t know the exact details. But now you do know that if someone claims 80-90% of all options expire worthless, that they are not accurate in making this statement.

What Is the Maximum Profit That a Call or Put Option Writer Can Earn

What Is the Maximum Profit That a Call or Put Option Writer Can Earn?

Technically there is no fixed answer for this because the values of calls and puts that are sold are unique to that option. One could sell 10 calls for $150.00 in premium which would be $150 x 10 contracts x 100 shares/contract = $150,000.

Yes, you can do this assuming you have the shares covered or the margin to do so.

The real answer to this question is anyone who writes a call or put option can earn the full credit or value of the option they sold. That is the maximum profit a call or put option writer can earn, but that total profit will depend upon a) the value of the call or put option they are selling and b) the number of contracts they are selling.

Hence, whatever the premium you are selling the call or put option for is the maximum value you can earn on that trade. There is no more money to be made than the premium you collect for selling that option.

To Recap

In this article we have answered the important question of whether option writing is profitable, what is an option writer, how does the writer of call or put options make money, whether options writers lose money, what are ways to make option writing profitable, how much money you need to write options and what is the maximum profit you can make writing options.

There are many reasons to write or sell options which we’ll cover in a later article, but you can’t simply write options and expect to print money. You have to learn the risks and ways writing options can make and lose money.

Once you learn these methods, along with how to ‘structure’ your trade, you can increase your accuracy and profitability in writing options to generate income regularly.

Lots of traders decide to only write or sell options. While we think this approach has some benefits to it, it also has its pitfalls.

If you’d like to learn when to write and when not to write options to generate profits regularly, check out our options bootcamp where I teach you the tips and secrets of when to write, and when not to write options profitably.

What Are Long-Term Equity Anticipation Options?

LEAP options are simply option contracts with expiration dates that are one year or longer in duration. Other than the length of the expiration date being 1 year plus, they are technically and functionally the same as other listed options.

If you remember from our option trading 101 article, an option contract grants the buyer the right (but not the obligation) to buy or sell (dependent upon the option being a call or a put), the underlying asset at a predetermined price (strike) on or before a specific date (expiration).

LEAP Options

If LEAP options are the same functionally as regular options, then why would a trader or long-term investor use LEAP options?

There are several reasons, such as:

  • Long term investors looking to use options to trade a long-term trend
  • To hedge a long or short position in your portfolio
  • To control shares in the underlying while having a lesser margin requirement
  • To have a lesser price sensitivity to changes in the underlying security

Hence, there are several reasons a long-term stock trader or investor should consider LEAP options as an alternative to buying the stock outright.

Now when you compare LEAP options vs short-term options, a few advantages stand out, such as:

  • LEAP options suffer less from Theta decay (time) because they have more time to accomplish their objectives
  • LEAP options act more like the underlying security due to delta being higher vs short term options

However, LEAP options also have some disadvantages vs short-term options, including:

  • Higher premiums
  • Lessor availability (lower volumes)

Thus, when considering to use a LEAP option vs buying the underlying security, it’s important for option traders and investors to consider the pros and cons of LEAP options.

We also mentioned using LEAP options to hedge as they can be an effective tool for doing so. For example, let’s say you own 1000 shares of Microsoft (Nasdaq: MSFT) at the start of the new year, but you’re concerned about an increase in volatility in the stock, and a significant potential pullback in the price of the stock (20% or greater).

LEAP Options 03

Currently, MSFT is trading for $280 per share (as of July 21st, 2021) and you think the stock can lose 20% of its value over the next year and want to protect your stock position in Microsoft, but don’t want to close out your position should it fall 20% or more. This is where you may want to consider a LEAP option (in this case, a put) with an expiration date 1 year out (July 22’).

A 20% decline in the stock would change its price from $280 to $224 per share, thus creating a risk of $56 per share x 1000 shares, so a $56,000 decline in your portfolio.

However, the Jul 22 puts at $280 are pricing at $20.50 (theoretically) which means for $20.50 x 10 option contracts (1 contract = 100 shares, so 10 contracts = 1000 shares), or $20,500, you can own a put option that will gain in value if the price of Microsoft falls over the next year.

Hence for a much lower price, you can hedge (or protect) your long stock position buying put options on MSFT. So, while you will be losing money on your stock position, you’ll be gaining money on your long puts, thus ‘hedging’ your long stock position.
This is one of the many ways long-term investors and option traders can use LEAP options.

Another potential strategy for using LEAP options is to buy index LEAP’s, which will give you exposure to the index while not technically owning any of the stocks in the index.

In Closing

There are many reasons to consider using LEAP options, whether as an investment strategy, to get exposure for less margin, or for hedging, long-term investors and option traders should consider using LEAP options for their portfolio.

LEAP options have been some of my most profitable trades over the last few years (20’, 21’), and I’ll continue to use them both as a trader and long-term investor.

To learn more about calls, puts, and trading options, make sure to check out our option trading 101 article.

Trading options can be utilized alongside your stock trading (or in isolation) to generate income (i.e. selling premium), hedge your risk (long put protection) or by trading volatility (short or long). It is important to note, option trading is without a doubt more complex than buying or selling stocks. Hence its important to get a solid understanding of options before trading them.

Now once you have a solid understand of how to trade options, its important to choose a broker for your option trading. Below we’ve compiled a list of option brokers, with our ratings of each one, alongside listing their pros and cons so you can find the best option broker for you.

Here they are below:

TD Ameritrade

TD-Ameritrade

Rating: 5 Stars
Fees: $0 per options trade, $0.65/contract
Account Minimum: $0
Pros: $0 stock/ETF commissions, a full featured trading platform for all experience levels (both traders/investors), multiple account types, solid trading/investing education & great customer support.
Cons: higher margin rates than other competitors, no crypto trading
Our Quick Take: Out of all the option brokers and trading platforms out there, the TD Ameritrade Think or Swim platform is one of our favorites and the one personally used by Chris Capre (Head of 2ndSkies trading & investing). The simplicity of the option chain, along with tools to help you find and analyze your option trades make this a 5 star in our book. It is our all-around best platform out there for beginner to seasoned option and stock traders, and is also great for active traders alongside long term investors. Overall, it’s the most balanced platform and brokerage out there that really does it all and thus gets our highest rating.

 

WeBull

Webull

Rating: 4.25 Stars
Fees: $0 option commissions, $0 stock fees
Account Minimum: $0
Pros: Excellent/Flexible mobile platform, solid web platform, cheaper margin rates and no account minimums.
Cons: Limited account types, still building its educational resources, some data feeds have monthly fees, and more for active traders.
Our Quick Take: For active traders looking to trade on mobile or web based applications, WeBull has one of the better and more flexible platforms out there (superior to Robinhood in our view). You can also trade a fair amount of crypto offerings (10), forex pairs (10) and loads of stocks. On a platform to platform basis, we find it stronger than Robinhood. For new to intermediate option traders, we find a solid platform, but seasoned pros may want a more sophisticated offering. Overall a solid options broker platform for active traders.

 

Robinhood

Robinhood

Rating: 4.15 Stars
Fees: $0 for options, stocks and ETF’s.
Account Minimum: $0
Pros: Easy to use mobile trading app, fractional shares, crypto offerings and solid education
Cons: No phone customer support (big negative IMO), mobile & web app only, and no IRA accounts.
Our Quick Take: Robinhood is designed to be a simple/easy to use mobile platform for completely new stock and option traders. While we applaud them for ushering in the $0 commissions era, and easy to use mobile platform, they have had many missteps along the way (Gamestop debacle, app outages, still no customer phone support, and gamification tools which can potentially make the app addictive). They do offer fractional shares (a positive in our view), but the mobile or web based app is a bit too simplistic that anyone with any decent trading or investing experience will feel the platform lacks solid tools, charting or features. For completely new stock and option traders, this is the easiest way to go. For anyone else, eventually you will feel the limitations of their platform, technology and customer support.

 

Tastyworks

Tastyworks

Rating: 4 Stars
Fees: $0 for stocks, $1/option contract
Account Minimum: $0
Pros: Built by professional option traders, unique option trading features, solid educational offerings
Cons: Leans towards the active options trader vs long term investor, margin rates are not the best, and not for beginners
Our Quick Take: One of the best option trading platforms out there developed by a team of option traders that really understand the needs of option traders. Hence their technology for trading options is hands down some of the best. They are all about options. However…this is (in our view) not the best option broker or platform for beginners and more suited for active traders. Their pricing is unique wherein you are charged commissions in opening positions and have commissions capped at a per trade maximum. Their margin interest rates are ‘ok’, so not the cheapest, nor the most expensive, but long term investors may not find this platform or option broker their top option and their stock research is lacking. For seasoned option traders who want a platform all about options and trade decent size, this might be your platform.

 

Features we want in our best option brokers

Due to the complexity of options trading in comparison to stock trading, option traders generally require more tools and platform features from their option brokerages. For active option traders, they want better pricing, ease of execution and option screeners, while long term option traders generally are focused on simplicity and commissions.

Best Option Trading Platforms

Below is our list of features we want or look for in our decision process when examining option brokers:

The Platform: Ease of use, the option chain, analytics (in examining potential option traders) and option screeners are what we look for any platform. While more seasoned traders and investors may prefer TD Ameritrade’s Thinkorswim platform or Tastyworks, newer option traders and investors will want to consider the easier option brokers like WeBull and Robinhood.

The platform is a key piece of technology you will use, so make sure it has all the features you want and is easy to use.

Commissions & Fees: simply put, the fees and commissions you pay to take any trade take from your potential profits and add to your losses. Active traders have different needs vs long term investors so make sure you understand your option brokers commissions and fees when it comes to trading options.

Resources & Customer Support: How much educational content does your broker offer? That is an important question for understanding the broker platform and building your knowledge in trading options. A broker that offers more resources means less time you have to spend searching online for the answer, and that matters to us.
On top of this, whether your broker offers customer support or not, and how accessible it is also matters. Its your money parked with a broker, so naturally, you’re going to want answers and support from time to time. How much support and how accessible that support is matters to us, and we believe it should for you as well.

 

What are options?

Simply put, options are contracts between a buyer and a seller, and stock options give traders and investors the right to buy or sell stocks at a predetermined price (strike price) on or before a specific date in the future (expiration date). It’s important to note options give you the right, but not the obligation to buy or sell the stock, hence the word ‘options’ which gives you the option or flexibility to choose to or not.

It is important to understand there are some unique terms used in options trading you should get yourself familiar with. They are:

Call options: an option that gives you the right (but not the obligation) to buy a stock at a certain price on or before the expiration date.

Put options: an option that gives you the right (but not the obligation) to sell a stock at a certain price on or before the expiration date.

Strike price: the option price which gives you the right to buy or sell the stock.

Expiration date: the date at which the option contract between the buyer and the seller expires. Options must be ‘exercised’ on or before this date, or they expire worthless.

Premium: the cost of an option

Contracts: all options are traded as a contract whereby 1 option contract controls 100 shares of that stock.

Buying options: option buyers can buy calls or puts, or any combination of them. The option buyer pays the option premium.

Selling options: option sellers can sell calls or puts (or any combination of them). The option seller receives the option premium the option buyer pays.

To learn more about option trading, check out our options trading 101.

For stock traders that are new to options, one of the most common questions I get is:

Are options safer than trading stocks?

It’s important to note both stock trading and option trading have risks, and while many the risks in trading both of them are the same, some of the risks differ substantially.

In this article, we’re going to explore some key topics, such as:

  • Are options riskier than stocks?
  • Why are stocks riskier than trading options?
  • Are options more profitable than stocks?
  • Why options are better than trading stocks?
  • And should you trade options?

Let’s dive into the listed topics. I’m confident for those of you that read this whole article, you’ll find some major differences between option and stock trading, and why you should look into options.

Are Options Riskier Than Stocks?

The answer to this question is both yes and no, but when done right, options can be less risky than trading stocks?

Why to yes, no, and how can options trading be less risky than stock trading?

As to how trading options can be riskier than stocks, it’s important to understand there are major differences between trading stocks and options.

Trading stocks is like playing checkers – the rules are simple, not that complex, and there’s only a few ways you can move.

Trading options is like playing chess – there are more rules, more ways to move, and more combinations to win.

With trading stocks, you can only make money in two directions, bullish or bearish. But with trading options, you can make money if the market is bullish, bearish, you can make money if the market ranges, you can make money without caring about direction (trading both bullish and bearish), you can make money via time passing, volatility increasing or decreasing, and you can make money via options getting repriced.

This means there are absolutely more ways to make money trading options than simply being bullish or bearish. That’s good for making money and having more strategies, but it also means there are more ways to lose money. Hence, it can be said that in one way, trading options can be ‘riskier’ than trading stocks since there are more ways to lose money (as well as make money).

Hence, it’s important you understand all the ways you can make and lose money trading various option strategies.

With that being said, let’s jump to the next topic.

Are Options Safer Than Stocks 01

Source: Wance Paleri

Why Are Stocks Riskier than Trading Options?

When you trade stocks, you can only buy or sell the stocks, meaning it’s very binary how you make money, you’re either bullish or bearish.

But the problem with these limitations (only being able to buy or sell stocks) is there’s no way to ‘hedge’ or neutralize the risk while maintaining a long or short stock position.

When you trade stocks, if you are bullish and you want to neutralize the risk on your long stock trade, you can only close the position. A stop loss limits the risk, but it doesn’t ‘neutralize’ the risk.

Hence, if you want to keep a long stock position, but the stock is going down, you are stuck with only two options. Keep the position as it declines and lose money on your long stock trade, or close the trade. That’s it!

But with options, you can be long a stock trade and also long or short an option which allows you to neutralize some or potentially all of the risk should the stock decline. This does not require you to close your long stock position, so you can keep it if you’d like.

That’s a major advantage to trading options as it allows you to reduce or neutralize the risk on your long and short stock trades without having to close the stock trade or position.

That’s a major advantage, especially if you’re a long term buy and hold investor. Instead of just watching your long stock portfolio lose money, you can buy or sell options to reduce/neutralize the risk on them, potentially even profiting while the stock market declines.

And that is a major advantage of trading options and stocks versus just trading stocks. Hence, in many ways, trading stocks can be riskier than trading options.

Are Options More Profitable Than Stocks?

It’s important to understand that there are many ways trading options can be more profitable than trading stocks. For example, when you trade stocks, say you buy 100 shares of Apple stock ($AAPL).

For every $1 move the stock goes up, you only make $100 (100 shares x $1 = $100). THAT WILL NEVER CHANGE, no matter how much the stock goes up. It will always be a $100 gain per $1 move up in the stock when you buy those shares.

Hence the amount you make will always be fixed based on the number of shares.

But with options, the amount you make when a position goes in your favor, say when you buy a call option on Apple, can actually increase in profit for every $1 increase in the stock price.

How?

This is because options have what is called a ‘delta’, which is the variable that determines how much your option’s value increases for every $1 move in the stock.

But here’s the secret…when you buy a long call, the delta (assuming it’s less than 1.0) will increase for every $1 move the stock goes in your favor.

This means your option can increase in the amount of profits you make the more and more the stock goes in your favor. It is only until your delta reaches a value of 1.0 that your profits will not increase more for every $1 move the stock goes in your favor.

Hence, if you buy 100 shares of Apple stock and it goes up $10, you can only ever make 100 shares x $10 = $1000. And keep in mind you have to put up a large amount of margin to buy Apple stock.

So if Apple is trading at $150 per share, you’ll have to put up $1500 for your 100 shares of Apple.

But if you buy a call option on Apple for $1.50, you can put up a lot less capital. 1 Call option on Apple for $1.5 = $150 (1 contract controls 100 shares, so 100 shares x 1.50 for the call option = $150). So you can control the same amount of shares in Apple for only $150, which allows you to have more capital to make other profitable trades.

But it gets better. Let’s say this call option on Apple costs $1.50 and the delta for this option is .50, and has a gamma of .05 (gamma = the amount the delta increases per $1 move in the stock).

If Apple stock goes from $150 in price to $151, your $1.50 option is now worth $2.05, or $205. Why $2.05? Because the $1.50 price for the option + the delta (.50) + the gamma (.05) = $1.50 + .55 which = $2.05 with a delta now at .55.

Hence if Apple then increases from $151 to $152, your $2.05 option is now worth $2.65 ($2.05 + .55 delta + .05 gamma = $2.65 or $265 with a new delta of .60).

When Apple goes from $152 to $153, your $2.65 option is now worth $3.30 ($2.65 + 60 delta + .05 gamma = $3.30, or $330.

Hence by trading options, you more than doubled your money ($150 to $330) with only a $3 move in Apple stock. If you had traded only the 100 shares of Apple, your profits would only be $300 on a $1500 investment, which is a 20% return. Hence, you have the potential to make more money trading options with the capital invested than buying an equal size stock position.

That is the power of options – you get better leverage and can make more per $ invested for an equal size stock trade.

Thus, option trading can be more profitable than stock trading.

Are Options Safer Than Stocks 02

Source: Wance Paleri

Why Options Are Better Than Trading Stocks?

Besides the reasons listed above, there are more reasons why trading options are better than trading stocks.

For example, you cannot receive a credit just for buying or selling a stock to start a stock trade. You have to pay money to buy or sell stock shares to initiate a trade.

However, with options, you can ‘sell’ options (like a car insurance company sells car insurance) in exchange for receiving a credit for selling that option.

When you sell an option, that ‘credit’ is immediately applied to your account, which means you can use those profits to make other option trades.

In essence, for taking on the risk of writing (selling) the option, you get a credit into your account. If the option you sell ends up worthless to the buyer (and a lot of them do end up worthless to the option buyer), then you get to keep the full credit.

It’s very much like a car insurance company selling you car insurance, and you not getting into an accident that year. They get to keep the full ‘premium’ of that credit you paid.

On top of this, you can make money by being bullish and bearish on a stock at the same time. Don’t know if the stock is going up or down, but believe it’s going to move a lot soon? You can make an option trade that will profit if you’re right, regardless of whether it moves bullish or bearish.

You can also make money by volatility increasing or decreasing, like it often does before and after earnings.

Simply put, there are way more ways to make money trading options than stocks, hence we think options are better than trading stocks as more ways to make money = more opportunities for profit. This is how option trading can be better than stock trading.

Should You Trade Options?

Now that we’ve listed all the ways you can make money trading options, how you can reduce or neutralize risk trading options, how you can sell options for a credit, and can trade the same size option position for less capital, the question is – should you trade options?

We think the answer is yes, and considering the options market is getting bigger over time, sometimes being larger than the share market for trading stocks, it means that the options market can and often is providing a larger portion of the order flow in the market.

The more order flow the options bring, the more influence they have on the price action. Hence, you could be trading the stock market now, and not even know how the option flows are moving the stock price up and down each and every day.

Hence, this is a major reason why we think you should trade options.

On top of this, when you see stock flows coming in, you have no idea if they are increasing the size of the positions at a particular price or not.

But with options, we can see each day whether the option flows are increasing at a particular price or not. This tells us whether the key support and resistance levels are getting stronger or weaker over time, and where the option traders are positioning their trades.

This gives us vastly more information to find out where the big players are trading, and how we can trade with them.

This is a significant advantage over trading stocks, thus another key reason why we think you should trade options.

Hence, in summary, when you look at all the ways options give you more ways to make money, better leverage than stocks, ways to sell options and get a credit, help reduce or neutralize your risk, and show you more information where the larger players are trading, we think it’s a no brainer that you should be trading options.

It’s important to understand trading options has its risks, and you’ll need to learn them, which is the focus of another article, but when you start to learn how the option market works, its hard to ever see the stock market the same, let alone want to trade in such a binary and limited way to make money in the markets.

I hope you enjoyed this article on how options can be safer than trading stocks and have peaked your interest into trading options.