Americans have become much more knowledgeable about the stock market in comparison to where they were 30 years ago. A lot of American investors own either a 401-K account, Individual Retirement Account (IRA) or an individual investment account. While that gives people reason to pay attention to and learn about stock prices, it doesn’t educate people about alternative ways to make money playing the market.
Introducing Stock Options
Most Americans cannot afford to purchase 100 shares of IBM at $143 a share. That’s a whopping $14,300 plus broker fees. However, stock option prices provide an affordable way to play stocks like IBM without a huge financial investment.
Options by definition are an option to buy (Call Option) or sell (Put Option) 100 shares of an underlying stock. Call options would be purchased in anticipation of the underlying stock going up while put options would be purchased in anticipation of the stock’s price going down.
Stocks options are available on options exchanges for a great many of the most prominent stocks. Each option carries a predetermined buy or sell price, called a “strike” price. It also comes with an expiration date that falls on the third Friday of a given month. The expiration date is the last day the buyer can exercise their or sell their option. Each underlying stock may have as many as a dozen strike prices spread out over as long as six to twelve months, one month at a time.
When purchasing a stock option, the investor must decide which option they wish to play. This is an important decision because options carry premiums that are paid to the options sellers, who are also referred to as option “writers.” Two things will influence the amount of premium the buyer has to pay.
The first determinant would be the expiration date. The further out the expiration date will increase the amount of the premium. The second determinant with be the strike price in relation to the actual stock price. The closer the strike price sits in relation to the stock price increases the premium.
With the basics related to stock option on the table, it’s time to discuss how to make money trading options.
How to Make Money Trading options
While there’s several ways of making money trading options, the following discussion only addresses two of them.
- Without owning any stock, you can trade options – If you have conviction about which way a stock is going to move in the short-term, you can buy options on that stock in anticipation of selling those options at a higher price, creating a profit. Of course, there’s risk involved should you be wrong about where the stock price is headed. The good news is your losses will never exceed the amount you paid for the options, plus you always have until expiration date to sell your options and regain a portion of your losses.
Let’s look at a practical example: IBM sits at $143. You believe it’s going higher in the short-term. You decide to buy three IBM $145 calls with an expiration date of November 15, 2019. The price for each option is $4.50 a share or $450 an option, total cost of $1,350 plus broker fee. Note: The premium you paid was effectively $6.50 per share because the stock price would have to rise to $149.50 as a break-even point with IBM’s stock sitting at $143. If the stock price goes to $153, your $145 call options would probably go to approximate $9 a share or $900 an option. You could sell your three options prior to expiration date for a total of $2,700 minus broker fee. In the end, you net profit would be approximately $1,300.
- Playing Options as a Hedge – If you own underlying stock, you could actually write an option and collect premium. That premium is extra income.
Using the same example, you decide to write or sell the three IBM $145 call options. The buyer pays you $450 per option less commission. If IBM’s stock price doesn’t exceed $145 by expiration date, you keep the entire premium and the stock. You could actually repeat the process for another month and secure more premiums. If the stock price goes to $153, you have to sell 300 share to buy at $145, but you keep the $1,350 option monies, giving you a sales basis of $149 a share. Still not bad.
These are but two ways to make money trading options. If interested, you should read more and speak with your broker or experienced stock traders.