Thursday, November 14th, 2019

Three Ways to Make Money with Options


A few years ago we noted that there are several kinds of options trading. Depending on why you choose to trade options there are various options trading strategies. In the end the point of trading options is either to hedge risk on money that you have already made or to make money with a new trade. Here we discuss three ways to make money with options.

Avoiding a Loss

Avoiding a very likely loss is in fact one of three ways to make money with options. A common use of put options is when a person has purchased a stock and watched the price climb to excellent profits. The investor believes that the stock will continue to rise but he wants to protect his profits in case of an unexpected correction in the stock price. What he does is buy puts on the stock. This gives him the right to sell the stock at the strike price, the current high price, even if the stock price falls. If, in fact he sees a correction he will then execute the contract and sell the stock. He will then buy the stock again at the current lower price and pocket his profits.

Locking in an Opportunity

A common use of call contracts in options trading is to lock in a low price for a stock that you believe will go up in price. This is the next of our three ways to make money with options. A call option gives the trader the right to buy a stock at a set price up until expiration of the options contract. He is under no obligation to do so and will only execute the contract if doing so is profitable. Let us say that XYZ Corporation sells for $100 a share and that a $102 call option on XYZ sells for $1 a share. Since options contracts are traded in batches of 100 this option costs $100 for the right to buy XYZ Corporation at $102 a share any time until the contract expires. This contract only has value because the market believes that there is a good chance that the stock price will go up in the next weeks or months. If the trader is right in his assessment the stock price will go up. Let us say it goes up to $110 a share. The trader can execute the contract and buy 100 shares at the contract price of $102 a share and then sell at the market price of $110 a share. This is an $8 a share profit or $800 on 100 shares. The profit minus fees and commissions is $800 minus $100 which is $700. That is a seven fold return on invested capital. This brings up the leverage that options offer.

Options Leverage

The last of the three ways to make money with options is to take advantage of the leverage that options trading offers. In the example of XYZ Corporation we could have purchased the stock at $100 a share and sold at $110 a share instead of buying a call option. However, then we would have tied up $10,000 in trading capital and taken the risk that the stock price could go down and lose hundreds of dollars. When the stock in our hypothetical example went up in price we made $1,000 which was a ten percent return on investment. On the other hand when we bought a call option we only invested $100 in the trade which was the limit to our potential losses and gained a seven fold return on investment. This is the leverage of options trading.

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