The markets are significant for economic growth, and they operate with the help of the activity of the traders. The traders provide valuable services for the market and, at the same time, can earn profit. Options trading enables potential profit even during volatility, irrespective of the market's direction.
Hence, many traders opt for options trading, as such trading requires a less financial commitment. As a result, options trading is less risky than trading with stock. If you are interested to learn more about how options trading make money, keep reading this article.
Options Trading Profitability - How Options Trading Make Money
The options traders can earn profit either by being option buyers or options traders. Call option buyers will make a profit when the price of the underlying stock rises above the strike price before its expiration date.
The amount of profit the trader earns depends on the difference between the underlying stock's price and the option strike price at the expiration date. On the other hand, call option writers make a profit when the underlying stock stays below the strike price.
When they write a put option, the trader then profits if the price of the underlying stock stays above the strike price. The profitability for option writers is limited to the premium received for writing the option.
Guide to Options Trading
When we talk about options trading, we refer to the process of buying and selling two types of options, known as calls and puts. The options are financial instruments and a type of derivative security, given their value is derived from the underlying asset, which is often a stock.
Buying a call option
A call option gives the contract owner an option but not the requirement to purchase a specific underlying stock at a predetermined price within a certain time period. The option buyer pays a ‘premium’ per share to the option seller.
It is known that the options contract represents 100 shares of the specific underlying stock. It is important to mention that as a trader, you don’t have to own the stock in order to purchase or sell a call. If you are expecting the underlying stock’s price to increase, you can buy a call option. In contrast, if you expect the price to decrease or stay the same, you can sell an option.
Buying calls allows traders to earn a great profit by paying a relatively small amount of money upfront. When the price of the underlying stock rises above the strike price, the option is then considered to be ‘in the money.’ In such a case, as a buyer of the option, you can call the option from the seller and hold or sell it before the expiration date to gain profit.
Selling a call option
While the option buyer has the right to exercise the option, the option seller has an obligation to sell the stock at a specific strike price. Traders selling a call option expect the underlying stock price to stay the same or decrease.
That said, if the underlying stock trades above the strike price, the option is then ‘in the money’ and is exercised. The seller of the call will then have to deliver the underlying stock at the strike price and earn a profit.
In case the underlying stock remains the same or decreases, typically, the option is not exercised, and the call seller then keeps the premium.
The difference between buying and selling an option
A very significant thing to mention when it comes to options trading is that there is a difference between buying and selling options. Time decay plays a significant role in options trading and is beneficial for the option's writer but works against the option buyer.
Also, the buyer of the option can earn a substantial profit if the option trading works out in his favor. This is because the price of the underlying stock can rise significantly above the strike price. Hence, option buyers have great profit potential.
Correspondingly, the option sellers receive a smaller limited profit that is tied to the premium. However, option sellers receive earnings from the premium upfront and can receive the full amount no matter whether the option expires out of the money.
Buying and selling put options
Another way to earn a profit when trading options is to buy a put. The put options increase in value as the price of the underlying stock decreases. Buying a put comes with high reward potential and low risk.
It gives you the right to sell a stock at a certain strike price at any time before a specific date. To get this right, the buyer pays the seller an amount called ‘a premium’.
By buying a put option, you hedge against a potential decrease in the share price and the downside risk in your portfolio. The put option is in the money once the price of the stock goes below the strike price at expiration.
When the premium paid for a put is less than the difference between the strike price and the price of the underlying stock at the time of expiration, you have made a profit as the put's owner.
When the price of the stock rises above the strike price at expiration, the put is then considered to be out of the money and expires worthless. In this case, the put seller keeps the premium they received for the option.
Implementing Options Trading Strategies
If you are wondering how options trading make money, it is significant to be familiar with all of the trading strategies. They can help you decide which options to trade and what decisions to make in order to minimize potential loss and maximize profit.
The trading strategies you will use depend on whether you are bullish or bearish on the underlying stock and the volatility of the market. Let’s take a look at the options trading strategies you can implement to earn a profit while trading.
Bullish option strategies
The bullish options strategies are strategies to use when you expect an increase in the price of the asset.
- Bull call spread
- Bull put spread
- Synthetic call
- Bull butterfly spread
- Bull condor spread
- Bull call ladder spread
- Married put
Bearish option strategies
These are the strategies to use when you anticipate the price of the underlying stock to move downwards.
- Bear call spread
- Bear put spread
- Strip
- Synthetic put
- Bear butterfly spread
- Bear iron condor spread
- Protective collar (bearish to neutral)
Neutral options strategies
Such strategies are applied when you are not sure whether the underlying asset's price will rise or fall.
- Long straddle
- Short straddle
- Long butterfly
- Short butterfly
- Long iron condor
- Short iron condor
- Covered call
- Call ratio back spread (neutral to bullish)
How to Start Trading Options
In order to start trading, you need to open an options trading account and choose which options you would like to buy or sell. The next step is to predict the option strike price and determine the time frame of the trade, as each option contract has an expiration date which indicates the last date when you can exercise the option.
What to consider when trading options
As an options trader, there are several factors to consider when trading options. They include entry and exit trade points, market volatility and how and when to implement the right trading strategy.
This type of trading enables traders to buy or sell a stock depending on the movement of the market. When a trader believes that a particular stock will rise or fall in price, they can use options to their advantage and earn profit.
However, traders cannot just buy or sell a call and wait for the price of the underlying stock to increase to earn a profit, as there are a lot of factors that influence the outcome of the trade.
Aside from when to enter and exit a trade and which strategy to use, as an options trader, you need to determine how much you anticipate the price of the underlying stock to change and be aware of how volatile the stock’s price was in the past.
More About Options Trading Profitability
As mentioned, there is a possibility to earn a lot of money when trading options, but there is a risk involved as well. For this reason, it is important for every trader to work on their trading skills and practice and study as much as possible about this type of trading.
While no one can predict the movement of the stock’s price with certainty, making an educated guess after researching more about a company which stock you plan on purchasing is very beneficial for success.
Equally important is to use tools and trading charts to help you determine the movements of the market and be able to make the right decisions on time. When trading options, it is vital to have a trading plan and stick to it instead of trading with emotion.
Determining the trade type
Options trading can be very profitable, but success depends on several factors, including how you structure the trades. If you are wondering whether to become an option seller or buyer, there is no answer that applies to all traders.
That said, if you are looking to make big profits from one trade, you should go for buying options. However, if you are satisfied with making small profits multiple times, then you can consider selling options.
Trading profitably in options successfully is a process that requires a lot of patience, extensive education, careful research, skill, and discipline. Profits from options trading do not come simply, so you need to give your time and effort to earn profit.
Difference between stock and options trading
The primary difference between purchasing a stock and an options contract is that when you purchase stocks, you get a piece of ownership in a company, whereas options contracts give you the right to either buy or sell the stock at a certain date at a specific date.
When a trader invests in a stock, they expect that the value of the company will increase, and as a result, the stock’s market value will also increase over time. Then, when the price of the stock increases more than its price when you purchase the stock, you can then sell the stock in order to earn a profit.
On the other hand, when you are trading options, you are investing short-term, as all contracts have expiration dates. For this type of trading, you need to determine the direction of the stock price, how much the underlying stock will fluctuate, and when you would like the option contract to expire.
Benefits and Risks of Trading Options
Now that you know how options trading make money, let’s take a look at the benefits and risks that come with trading options.
Advantages
One of the main advantages of trading options is the ability to earn a profit when investing short-term. You can also implement suitable options trading strategies to help you generate money even when the market goes sideways.
By using options as a hedge, traders can also protect their investments by trading options. When used the right way, options are considered to be less risky than equities and can bring the trader high potential earnings.
As a trader, you can use specific option trading strategies to earn potential profit regardless of the movement of the market. The options trading market is flexible, so there are various ways you can approach a trade.
Disadvantages
Options trading requires trading skills, knowledge, and experience and involves risks. Hence, in case of making improper moves, the trader can experience heavy losses, which is the main disadvantage regarding options trading. With this in mind, investing only the amount of money you are comfortable losing is recommended.
Managing Risk
When it comes to successfully trading options, knowing how to manage risks is crucial. The reason for this is to earn a profit but minimize the risk you can experience during the trading process.
A very important thing to keep in mind is that different options and strategies come with different levels of risk. Here is an example to learn more about how to manage risk and whether you should buy or sell an option.
Options trading example
You are considering buying 10 options contracts, each with a price of $0.70. As mentioned, each contract has 100 shares of the underlying asset, meaning the contracts will cost you around $700.
If you buy the contracts, the maximum loss you can experience is $700, and the profit is (theoretically) limitless. However, the probability that the trade is profitable is not very high and depends on the implied volatility of the call option.
On the contrary, if you make a decision to sell an option, the maximum profit you can get is limited to the premium, while the loss possibility is (theoretically) unlimited.
However, these are only general applications and can vary depending on the situation and the market. Also, implementing the right trading strategy can alter the odds and help you earn a profit either way.
Become a Successful Trader
Now that you are familiar with how options trading makes money, you can start trading to get significant returns. As mentioned above, options trading is a relatively complex process that requires trading skills and extensive knowledge.
To help you out when trading, you can use a trading service such as FoolProof, which gives you at least three alerts during the week regarding significant option trades, helping you make the right trading decisions.
For only $97 per month, you receive a thorough trading plan from Wall Street experienced traders who guide you through the whole process, from the basics to using advanced trading strategies and earning a profit.
Conclusion
That concludes our article on how options trading make money. Options trading has become increasingly popular among beginners and experienced traders as it allows them to earn profit by investing a small amount of money.
Trading skills and risk tolerance are key aspects when it comes to trading options successfully. Equally important is implementing the right trading strategies that will help you make the right moves and decisions and gain significant returns.
To assist on your path to profit, you can also use trading services which will help you stay on the right side of the market and minimize the risk but maximize the profit.