Options trading lets investors take on leverage without the margin. Each option contract gives you temporary exposure to the price movement of 100 shares. Options traders can profit regardless of how the market moves. Traders can buy puts to profit from downward movements and acquire calls to make money on upward movements. Options trading has risks, but if an investor learns how to navigate them and never takes on excessive risk, options trading can have its place in that investor’s portfolio. This article will reveal whether it can be profitable to trade options and tips to keep in mind when trading options.
What is Options Trading
Options trading involves derivatives that can quickly gain and lose value. Each options contract gives you the right but not the obligation to buy or sell 100 shares of an underlying asset at a predetermined strike price that the trader selects. Calls give the contract holder the choice to buy 100 shares at the strike price, while put options let traders sell 100 shares at the strike price.
Every option has a strike price and expiration date. Understanding these two metrics is vital to profit from options.
The strike price is the price where you have the obligation but not the requirement to buy or sell 100 shares, depending on the type of contract. You must pay a premium to gain the right to buy or sell 100 shares and select an expiration date for your option contract. If the option contract is out of the money on the expiration date, the contract becomes worthless. But if the options contract is in the money, you can exercise the contract. You do not have to wait for the expiration date to exercise your contract if you contact your broker, but most options traders wait it out or exit the position before the option expires.
An expiration date closer to the current date has a lower premium because it increases the buyer’s risk. Opting for a further out expiration date increases the seller’s risk and results in a higher premium. You will also have to pay more for an option with a strike price closer to the current price. The further out-of-the-money (OTM) you go, the less expensive the premium becomes. These far OTM options have the lowest likelihood of becoming profitable, but they represent the greatest potential for returns in the event of a major surprise. It’s more likely that those options expire worthless.
Types of Options Trading
Every options trading strategy revolves around two types of options contracts: calls and puts. Understanding how these derivatives work can help you profit from options trading during bullish and bearish market cycles.
Put Option and Its Profitability
Put options can be profitable if you buy them before a market correction. Puts gain value when a stock’s price falls. If you buy shares of a company at $100 per share and the stock falls 20% on a bad earnings report, you could make a nice profit from your put option. But events like earnings have higher implied volatility, which means you will need a more dramatic swing in your direction to make a profit. A put will lose value if the stock price rises or stays the same.
Call Option and Its Profitability
Do you believe a bull market or short-term rebound is on the way? Call options reward traders who predict an underlying asset will gain value. You can profit from call options when a stock is on the rise. If you pay a $2 premium for a 105 strike price, and the stock rises to $110 at expiration, you would have made $300. The $2 premium and the 105 strike price give you a $107 per share break-even price. Exiting the option when the stock rises to $110 per share secures a $3 profit per share.
6 Tips for Higher Chances of Profitable Option Trading
Are you wondering whether it’s possible for you to make a profit with options trading? While there’s no guarantee, these tips will increase your probability of success.
Trade Liquid Options
When your option rises to an acceptable level for your exit, liquidity suddenly becomes important. Liquidity is the easy flow of trades. An option with more liquid will have its order executed without any issues. Illiquid options have fewer traders, and your option order may remain pending for several minutes, even if you set your selling price to the midpoint.
Create an Entry and Exit Plan
An entry point is the price you purchase an option. You can select a strike price and expiration date for a derivative that aligns with your risk tolerance. It’s easier to set an entry price without emotions getting in the way, but the exit plan can get filled with emotions. The exit plan reflects conditions that would result in you selling a security. Some traders limit themselves to a 20% loss per trade or realize their gains after being up 30% on a single trade.
Options have fickle valuations that can move significantly within 24 hours. It’s possible to see an options trade up 30% to start the day only to see the contract lose half of its value by the end of the day. An exit plan reduces the likelihood of staying in a trade too long and seeing your contract become worthless. Creating an exit plan before you put down capital helps you realize more of your gains instead of seeing your gains turn into losses.
Maximize Probability
Every option has a probability of becoming profitable. You can’t guarantee profitability, but selecting options with strike prices near the market price increases your likelihood of making a profit. You can also sell far out-of-the-money options through covered calls and cash-secured puts. Because these options are more likely to expire worthless, they increase the seller’s likelihood of realizing a profit. Some options traders also use bull and bear spreads to minimize risk and increase the likelihood of making a return on their investment.
Know What to Do When Assigned
If you sell options, you may get assigned. Options traders who sell covered calls may have to sell 100 shares at the strike price, while cash-secured put sellers may have to buy 100 shares at the agreed-upon strike price. The best options traders know what they will do upon getting assigned. Traders who get assigned for a covered call can immediately sell a cash-secured put with the same strike price to realize additional profits. If the cash-secured put gets assigned, you make a profit equal to the call and put premiums while still having 100 shares.
The strategy is different for people who get assigned 100 shares. These traders can proceed to sell a covered call, following the previous strategy in reverse. This strategy is known as the options trading wheel. Traders who use the options trading wheel collect premiums from each trade and lower their cost basis on the stock. You can switch stocks when doing this strategy instead of only using the options wheel for a single stock. It may become necessary to do this if a stock rises substantially while you have a covered call for it.
Consider Index Options
Index options are a great way to get started because they mimic the market. Index funds don’t have very dramatic movements compared to individual investments, but they can still swing 1% to 2% in either direction on some days. Index funds have expiration dates on Mondays, Wednesdays and Fridays, while most options only expire on Fridays. Index funds can provide greater peace of mind than using options for individual securities and increase your odds of profitability. These contracts won’t swing as dramatically during earnings compared to an option contract tied to a stock that reports earnings this week.
Be Open to New Strategies
You can profit from the options trading strategies mentioned, but a trader should always expand their horizons. Incorporating multiple options trading strategies helps you tap into the upside under any market conditions. You can explore multiple options trading strategies, such as covered calls and straddles, but you can also explore new ways to conduct research. Traders can use fundamental and technical analysis to build a thesis and become more confident in their investments.
It’s Possible to Profit from Options Trading
Options trading has quicker movement than traditional stock trading. Contracts can rise or fall in value substantially over short periods of time. It’s possible to profit from options trading. Every trader should consider their risk tolerance and financial objectives to determine whether options trading makes sense for their portfolios.
Frequently Asked Questions
Are options more profitable than stocks?
Options can be more profitable than stocks, but they are also riskier. Know your exit plan before getting into an options contract.
Is options trading good for beginners?
Beginners would be better off trading stocks first and getting comfortable with how these securities work. Options trading is optimal for intermediate traders.
Are options better than futures?
Options can be less risky than futures because you are not obligated to buy or sell the securities. Options are usually the better choice.
About Marc Guberti
Marc Guberti is an investing writer passionate about helping people learn more about money management, investing and finance. He has more than 10 years of writing experience focused on finance and digital marketing. His work has been published in U.S. News & World Report, USA Today, InvestorPlace and other publications.