Are you interested in making money with stock options? If so, you’re not alone. Traders from around the globe look to stock options to generate cash flows, sustain an income, and hedge risk.
In this blog article, we’ll cover the basics of stock options and how they can help you achieve your financial goals.
A stock option is a derivatives product that provides the holder the opportunity—but not an obligation—to buy or sell a stock at a specified price on a forthcoming date in time. The flexibility enables both speculators and hedgers to participate in the market.
Stock options have several unique foundational elements:
Strike price: A stock option’s strike price is the expected price of the stock at a point in time. It is the basis for contract valuation and determines whether or not an option is exercised.
Contract quantity: The contract quantity is the number of shares allocated to the contract holder. One contract is worth 100 shares of stock.
Premium: An option premium is the price paid to secure the contract’s rights.
Expiration: All options contracts have an expiration date when they are no longer tradable.
Stock options come in two types: calls and puts. Here’s a brief look at each:
Calls: A call option gives the holder the right to buy a stock at an agreed-upon price on a future date. Call options anticipate an appreciation of stock price.
Puts: A put option gives the holder the right to sell a stock at an agreed-upon price on a future date. Put options are profitable when a stock’s price falls.
Making money with stock options relies on call and put functionality. If a trader is bullish on a stock, then a call option is purchased; if bearish, a put is purchased.
In the live market, traders use two methods to make money with stock options: buying and selling. For most traders, these concepts are intuitive. However, buying and selling options contracts is a unique undertaking.
Buying: When you buy an options contract, you are taking a long (call) or short (put) position in the market. The trade becomes profitable or “in-the-money” when price rises above strike (call) or falls below strike (put). Theoretically, the profit potential is unlimited and the only risk is the premium paid for the contract.
Selling: Selling or “writing” options contracts occurs when a trader collects a premium in return for honoring the terms of the options contract. When you write a contract, you collect a premium and assume the put or call option. Your risk is unlimited because you’re responsible for compensating contract holders for in-the-money positions at expiry.
Let’s take a look at an example of making money with stock options. Assume that Trader A thinks Netflix (NFLX) is due for a springtime rally above $300. To get in on the action, Trader A buys two July calls of NFLX with a strike of $300 for a $1 premium. Here’s what this means:
Trader A has the right to buy 200 shares of NFLX for $300 per share in July.
Trader A pays a premium of $200 for this right ($1 ✕ 200 shares).
If price rises above the $300 strike at expiry, Trader A profits from the difference. So, if NFLX trades at $310, Trader A makes a profit of $1,800 [(200 shares ✕ $10 per share) − $200].
If NFLX’s price doesn’t exceed $300 at expiry, the contract expires worthless.
If Trader A decided to write an NFLX contract with a strike of $300, the opposite of the above scenario would be true. A premium of $200 would be realized, but a liability would be assumed for a market price above $300 at expiry. If NFLX stock fell beneath $300 at July expiration, the contract would expire worthless and a $200 profit would be realized.
As you can see, the leverage of stock options multiplies profit potential multifold while reducing capital outlays. Trader A would need $60,000 to purchase 200 shares of NFLX, whereas only $200 was needed for the options contract.
However, options contracts do come with risks. Contracts are subject not only to market risk but also to the impact of time decay. Although stock options do have some key advantages, they certainly aren’t risk-free.
If you’re an aspiring options trader, be sure to check out CME Group’s free course “Options Strategies.” In it, you’ll learn a variety of options trading techniques, including covered calls, married puts, and many more. Before you ever buy a call or write a put, boost your options IQ with “Options Strategies.”