In a nutshell, options are a financial instrument that you can use for several different reasons, including protection against expected moves in an underlying instrument, leverage, earning additional cash from your existing investments, and many others. Are trading options a good way to make money? In short, yes, trading options can make you money.
The obvious next question then is, how?
In the event you have cash but not a lot of buying power, you can use all of your cash to buy calls on your favorite growth stock with the expectation that it will skyrocket before your options expire, perhaps after an upcoming earnings report.
If you buy an option contract, you get 100 shares of the underlying stock, which means you get to control more shares of your favorite growth stock than if you bought it individually.
When your chosen stock soars, sell your options to make a considerable profit.
In addition, there are also other ways to go about it. When it seems no one else is aware that a company is likely to go bankrupt, then you can buy puts. Sell the puts and pocket your winnings when the underlying stock reaches zero (or close to it). You can choose to use your buying power to sell a lot of naked puts on a company whose stock price you expect to be at or above the put’s strike price at expiration, or you can use it to buy long-term bonds.
As the underlying stock becomes more volatile, you will be able to sell your puts for more money and make a more significant profit. Utilize your total buying power to take home the most from each trade.
There’s a thing all these strategies have in common: They’re more like gambling than trading. You can’t assume something is safe simply because it’s possible. The odds of going broke trading options are higher than those of getting rich. Since there are a lot of risks involved in trading options, the Securities and Exchange Commission has rules in place that require investors to meet specific qualifications. The goal is to make sure you have enough experience with investing and trading to make good choices when considering your options.
Is this to say that you cannot get prosperous with options? Absolutely not. Nevertheless, options trading is not likely to make you rich fast or efficiently unless you’re fortunate. But luck is not an aspect of responsible trading in stocks or options. The word “quickly” is also not encouraging. It won’t happen unless you change your mindset and put a lot of time and effort into your trading.
Three tips that should help you succeed
When thinking about the question in the title, you should really be asking, how do I remove luck from my option trading? Alternatively, how do I reduce risk?
Throw out that crystal ball and learn something new. Put your skills to the test and study with plenty of research. Ultimately, no one can predict an equity’s price movement with 100% accuracy. But you can make an educated guess about the price direction and the ceiling or floor of a stock. To trade successfully, you need to understand the company in which you intend to invest, and that requires a lot of time and effort.
It is possible to make educated predictions about a company’s stock price differently, but understanding the company is a prerequisite for any strategy. Is there a product and a competitive landscape? What is its position in the market? Is it strong or weak? Has it created a competitive moat that discourages new players from entering? Do significant risks exist? Are the leaders investing in the company or simply holding it together?
Looking ahead is the next step. As a trader, you might use charts to forecast price movements, so you might study and learn chart patterns and how they relate to the industry in which your chosen equity is traded. How has the stock moved based on past events, such as earnings? Even though past performance is no guarantee of future success, many automated trading programs are based on chart patterns and price movements so that the charts can affect a stock’s price. It might be more relevant to shorter-term options strategies since this effect is likely more pronounced for short-term or event-driven movements.
Fundamental analysis is used by other traders to guide their future expectations. Get familiar with quarterly financial statements. Having at minimum a basic understanding of such matters as a company’s free cash flow, debt, margins, etc., does not require you to be a CPA. The idea is to determine the intrinsic value of a company reasonably accurately. The question is, what is a fair price, or value, for the stock of the company? The price of a stock can be influenced by several factors, such as sentiment, news stories, and so on, but setting a fair value gives you a way to construct some soft guardrails.
Based on your acceptable risk level, you can use an appropriate options strategy once you have a fair-value price. Instead of relying on a “hot tip” from a friend or hyped-up website, make reasonable estimates. (This is not to suggest that you need to do all the research and charting yourself; there are many reputable websites with knowledgeable analysts discussing charting and fundamentals, as well as tools to help you with both.)
Secondly, you should understand risk, both in general terms for options trading and also in terms of each specific trade you engage in. Each option strategy has a different risk profile. It would help if you avoided naked puts unless you are very confident in your exit strategy.
At the end of each contract, you will be liable for whatever 100 shares cost at the strike price, minus any premium you received when you sold the contract. You lose the entire investment if the stock reaches zero. When you make a long call, your risk is no more than the premium you pay for it, so don’t spend more than you can afford to lose. Understand the risks associated with the strategies you use.
Taking a risk involves more than simply how much you stand to lose and the likelihood of losing that much. These are examples of positional risk, but portfolio risk also needs to be taken into account.
You often have to use your account’s margin to execute options strategies, including selling naked options. Rather than attempt to calculate buying power, suffice it to say that you might face a margin call if you overextend your buying power and the market turns against your positions.
In this situation, your stocks will often be sold out from under you at a time when you are at your most vulnerable, such as during a correction. Use caution when applying buying power because your entire portfolio is potentially at risk. Stick to a small percentage of your overall options, trading for naked (short) options.
Don’t trade on emotions; have a plan and follow it. Mastering this aspect is likely the most difficult. Know your exit point in advance. It is okay to adjust your fair-value estimates for longer-term options with changing conditions. If you are in an unfavorable position for a day or a week, or a month, don’t panic.
If you have done your research, you should be confident in your price expectation since most options strategies can be extended. A few bad positions should not affect your overall performance if you manage and spread out the risk in the long run.
Don’t forget to be patient. Options positions have a set expiration date. One of the factors in your plan is choosing that date. It is part of your research. Make sure you don’t change your plan midstream unless you have very good, rational reasons for doing so. It would be best not to become overwhelmed or depressed because the position is not going as you planned.
It is not necessary for you to constantly check multi-month positions. Simply check in every few days. Give your positions time to work, and when you make a mistake, learn from it and use your fresh perspective in the future. You’ll gain experience over time and have fewer failed positions.
How Do Put Options Work?
A put option (or “put”) gives the option buyer the right, but not the obligation, to sell at a predetermined price a specified amount of underlying security within a specified timeframe. A strike price is a predetermined price at which the buyer of the put option can sell the underlying security.
Various underlying assets are used in put options, such as stocks, currencies, bonds, commodities, futures, and indexes. This approach contrasts with a call option, which gives the holder the right to buy the underlying security at a specified price when the option expires.
What about fundamental analysis?
An analysis of related economic and financial factors determines the intrinsic value of a specific security through fundamental analysis (FA). An analyst studies macroeconomic issues such as the state of the economy and industry conditions and microeconomic issues like management effectiveness to determine whether a security will grow or decline in value.
Ultimately, the goal is to arrive at a number that can be compared with the current price of a security to determine whether it is undervalued or overvalued.
Stock analysis based on fundamentals is considered in contrast to technical analysis, which utilizes data sources such as price and volume to forecast the direction of prices.
What is an expiration date?
The expiry dates of options vary. For example, you could purchase a call option on a stock that expires in April or another that expires in July. As there is a shorter time to execute options with less than 30 days remaining, they will begin losing value rapidly. Options chains are organized from strike to symbol, last to change, bid to ask, volume to open interest in the following order.
Like the underlying stock, each option contract has its own symbol. Different expiration dates are assigned to different options contracts for the same stock.
What is fluctuation?
Premiums for options constantly fluctuate as the price of the underlying stock changes. This volatility impacts the possibility of a profitable option. Stocks with little volatility and a strike price far from the market price have a low probability of being profitable at expiration. Low premiums or costs indicate that there is little chance that the option will be profitable.
As a result, if a contract has a higher likelihood of being profitable, the premiums will be higher.
An option’s price is affected by other factors, such as the remaining time on an option contract and how far into the future the expiration date is.
The premium will decrease as the options contract approaches its expiration, for example, as an investor has less time to profit.
Alternatively, options with more extended periods to expiry have more chances for the stock price to move beyond the strike and become profitable. Due to this, options with a longer remaining time have a higher premium.
What is trader flexibility?
Traders should consider experimenting from time to time in order to remain flexible. One way to minimize risk might be by using options. Traders can learn a great deal by experimenting (within reason). They may also reduce emotional influence after the experience.
Traders should also evaluate their own performance periodically. The trader should also consider how they prepared for the session, how up-to-date they are on the markets, and how their education progresses. Performing periodic assessments can help traders correct mistakes, change bad habits, and enhance overall performance.
As you can see, you can absolutely make money trading options. But it does require some research, discipline, and a focus on risk. If you are happy with risk, have money you can lose, and know-how to research the markets, it is well worth investigating options.