Last Updated on 17 November, 2020 by Samuelsson
Are you a stock trader, futures trader, or someone who is just starting out in the financial market but want to know if options trading can make you rich? In this article, we will like to help you answer that question and explain how to use options to your benefit.
Options can make you rich if you know how to take advantage of the various options trading strategies in different market conditions. You can use options to manage risk, diversify your portfolio, or most commonly, take advantage of any perceived opportunity in the market.
While options may be the right trading vehicle for you, you need to understand what options are, how they work, and the various strategies for trading them.
What Are Options?
Options are derivative contracts in which the buyer has the right to buy or sell the underlying asset at the specified strike price, on or before the expiration date. There are two types of options:
- Call options
- Put options
A call option gives the buyer the right to purchase the underlying asset, while a put option offers the buyer the right to sell the asset.
How Options Work
Being a standardized contract, options trade on an options exchange, such as the Chicago Board of Options Exchange. A trader can buy or sell a contract on the exchange, and the clearinghouse of the exchange serves as the middleman, connecting the options sellers with the buyers.
A buyer can choose whether or not to exercise his right to buy or sell the underlying asset. But a seller of the contract is obligated to exchange the underlying asset anytime the buyer wishes to exercise the contract, on or before expiration. For this obligation, a seller gets a premium on the contract.
There are two types of options contracts:
- Put options
- Call option
A put option gives the buyer the right to sell the underlying whereas a call option gives the buyer the right to buy the underlying.
Options Trading Strategies
There are many different options trading strategies. While some are basic, others are very complex. Here, we will discuss the most basic ones.
Long Call Strategy
A long call refers to buying a call option. Here, the trader buys a call contract with the expectation that the price of the underlying asset will rise well above the strike price before the contract expires.
For example, let’s say a stock is selling at $29 per share, and a call with six months expiration and a strike price of $30 is selling at $100 per contract (a contract = 100 shares). A trader that buys this contract will be expecting the stock to rise well above the $30 strike price before exercising his right to buy the stock. At $31, he is barely at breakeven (strike price + premium), but anything above that, he is making money.
Theoretically, there is no limit to the amount of profit the trader can make; if the stock continues to rise, the trader makes more money. On the other hand, the contract can expire worthless if the stock price remains below the strike price at expiration. But the $100 premium is the maximum the trader can lose.
A long call strategy can be used as an alternative to buying a stock outright when you expect the stock to rise significantly because the downside risk is limited to the premium while the profit potential is unlimited. In addition, it gives you the leverage to buy more shares since the premium is cheaper than the cost of buying the shares outright.
Short Call Strategy
In this strategy, a trader sells a call option. A trader in this position is betting that the price of the asset will remain below the strike price. If the price stays below the strike price, the seller pockets the call premium without any issues, but if the price rises above the strike price, he must sell the asset to the call buyer at the strike price whenever the buyer chooses to exercise the option on, or before expiration.
Depending on whether this call seller already has the asset before selling the contract, a short call can be a naked call or covered call. In a naked call (uncovered call), the trader sells a call contract without owning the underlying asset. If the price rises above the strike price, he must buy the asset at the current market price and sell to the call buyer at the strike price. So there’s an unlimited risk of losses, while the profit is limited to the call premium collected.
In a covered call, the seller has a long position in the asset before selling the call contract. So the risk of buying the asset at market price when the call buyer exercises the contract is removed. However, the profit is limited to the call premium. He can’t make any money if the asset price is rising because he must sell to the call buyer at the strike price. And if the asset price is falling, he can lose all the money he used to purchase the asset, assuming the price gets to zero.
Long Put Strategy
This is a strategy where a trader buys a put option. The trader, here, is expecting the price of the asset to fall significantly below the strike price. A put option can be bought for speculative reasons or to hedge a long position in the underlying asset.
A trader, with a bearish outlook, can buy a put option, instead of shorting the asset directly. Here, the trader has no prior long position in the asset. For instance, say a stock is trading at $26 per share, and its put option with six months expiration and a strike price of $25 is selling at $100 per contract. A trader can buy the put option with the expectation that the price will fall significantly. The more the stock’s price falls, the more he can make, until the price get to zero (stocks can’t fall below $0). If the price rises, he can only lose the $100 premium, no matter how high the price gets.
On the other hand, an investor could also use a long put to hedge his long position on the underlying asset. In this case, the long put is called a protective put or married put. For example, assuming an investor who is long 100 shares of the stock at $26, is afraid that the price may fall significantly in the coming months. He can buy the put option to limit his losses — in this case, to $200 at most (The Put Premium + 100 shares x ($26-$25)). So, even if the stock goes down to $0, the maximum he can lose is $200.
Short Put Strategy
Here, a trader sells a put contract. The trader is expecting the price of the asset to remain above the strike price till expiration so that he can enjoy the premium as his profit — the maximum he can gain. If the asset’s price falls below the strike price on or before expiration, the put buyer can force him to buy the asset at the strike price, no matter how low it has fallen. So the loss can be very huge, as the price can potentially fall to $0.
A short put can be naked or covered. It is a naked put (uncovered put) if the seller wasn’t initially short in the underlying asset before selling the put option. In this case, when he is forced to buy the asset at the strike price (well above the current market price), he can hold the asset and hopes that the price goes back above the purchase price. He can also sell at the market value and bear all the loss.
In a covered put, the seller was initially short in the asset before selling the put option. So when the put buyer forces him to buy the asset, he would only be offsetting his initial short position in the asset, thereby limiting the risk of holding on to a depreciating asset.
Options can make you rich if you know how to take advantage of the various option strategies in different market conditions. You can use options to manage risk, diversify your portfolio, or take advantage of any opportunity you see in the market.