Earning Money with Options

Using Options Efficiently

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 I recently came across this innocent sounding question: "Can anyone make money consistently when trading options?"

I don't know if the person who posted this question is an investor who is considering the use of options, or whether this comes from a frustrated options trader who has been losing money. 

Th problem with questions of this type is that they serve no purpose. It is equivalent to asking: "Is eating food good for you?"

The answer to both questions is yes -- most of the time. You need food to survive. If you get most of your meals at a fast-food restaurant, then that is far from being good for you. In fact it can be harmful to your health. However, when the alternative is to eat nothing at all, then even McDonald's becomes  healthy in comparison.

When it comes to trading options, it is not the use of option strategies that turns an investor into an investing wizard. Options are simply an investing tool, and tools are instruments that make it easier or more efficient to complete a task. If you are someone who owns stocks that underperform the general stock market, then using options can provide slightly improved results. But if you are looking for a miraculous change in your profitability, then options will prove to be a disappointment.


How do Options Help Investors Achieve their Goals?
Options make it possible to adopt risk-reducing strategies that are just not available without options. Another way to look at it is that options allow investors to tweak their holdings to accomplish some specific goals and to reduce or eliminate specific risk.

For example, an investor can write covered calls in an attempt to collect extra cash (similar to collecting dividends).

In return for that 'extra' income, the investor accepts a limit on just how much money he/she can earn by owning the stock. In other words, the covered call writer says to the call buyer: "Pay me a negotiated cash premium now, and in return, I promise to sell the stock to you at a negotiated price (the strike price) for a limited period of time.

That strike price represents my maximum selling price for the stock. So if the stock price runs much higher, you get all the profit above that strike price."

Another example for the conservative investor is to own a collar. That protects the value of his/her holdings by establishing both a minimum and maximum sale price for the stock. This is accomplished by owning a put option, which provides a guarantee that you can always sell your shares at the minimum price, or higher and simultaneously writing a covered call (which sets the maximum sale price). This strategy allows the investor to earn some money when the stock price increases, but protects him/her from a large loss.

Any investor can adopt a variety of strategies that meet a specific stock market expectation. For example, the typical bullish investor may buy stock, index funds, or ETFs. The results are straightforward. If your stock or fund moves higher, then you earn a profit. The bullish options trader has alternatives.

  • If very bullish, buy in-the-money call options (75 to 85 Delta) instead of stock. Be sure to buy only one  option for each 100 shares that you would have bought if buying stock. This serves two purposes. First, it allows you to earn money on a rally and it limits losses if you were wrong in your expectations for the stock price.
  • If you want a high probability of earning a profit, and if willing to accept a limited profit, then sell out-of-the-money put spreads. This strategy returns a profit even when the stock price does not increase. And it may earn a profit on a small decline. 
  • If you have a feel for where the stock price is headed (this is very difficult to get right), you can buy a call spread. For example, if you anticipate that a $53 stock will move near $60 per share over the next three months, buy a call option struck at $50 and sell the call option struck at $60. By selling the $60 call option, you collect a premium, reducing the cost of the investment. 
  • If you believe that the stock price will be stagnant for a couple of months, but rally thereafter, you can buy a calendar spread. Sell the two-month option (expecting it to lose most, or all of its value as expiration arrives) and buy a three- or four-month option with the same strike price. Once your short option disappears (it expires worthless or you cover it at a low price), you will own the longer-term option and will make some good money if and when you have successfully timed the market.

     

    Please remember that an option's primary purpose (at least in my opinion) – is to allow hedging, or risk reduction.

    It is not an option strategy that makes money. It is the investor and his/her decisions, strategy selection, and risk management techniques that determine your success. However, options are useful tools that allow you to own a position that meets your expectations for the stock market. 

    Yes you can make money with options.  But no one is going to hand it to you.  As with anything else in life, it requires an effort to learn how options work and it takes discipline to manage risk.