The trade of standardized derivatives has gained popularity in recent years. For the first half of 2018, the Financial Information Association (FIA) reported the total number of traded futures and options contracts measured 14.9 billion, up 19.7% year-over-year. Of this figure, options accounted for 42% of the action. If nothing else, options are a premier means of participating in the equities, currency, and futures markets.
Options strategies are as diverse as the product offerings themselves. Butterflies, straddles, and spreads are few ways that individuals make money trading options. As with any product or strategy, suitability varies from trader to trader. While not for everyone, options can be a sound way of pursuing almost any financial goal in the marketplace.
Options 101: Composition and Risk
An options contract is an agreement to execute a transaction in a specified product, on a predetermined date, at a set price. Options are financial derivatives, meaning their value is related to that of an underlying asset. Stocks, currencies, and futures contracts frequently serve as the basis for this line of products.
In order to make money trading options, it’s important to first get up-to-speed on the basics:
- Types of contracts: Options come in two basic types: calls and puts. Each may be bought or sold, either to take a position in a market or generate income. If a trader buys a call or put, then a long or short position has been effectively opened at market. In the event the trader decides to sell a call or put, then revenue is realized from the premium.
- Strike price: The price at which each contract may be exercised is referred to as the strike price. As the market fluctuates above and below strike, the contract gains or loses value relative to the position taken.
- Risks: The most attractive part of options is that there are many alternatives for addressing risk. When buying a call or put, the only risk assumed is the premium paid for the contract. On the other hand, selling options entails being exposed to a potentially unlimited downside. This liability is typically managed through covering the open position.
Valuing options contracts is a complex undertaking, often resembling rocket science. Factors such as time decay, asset volatility, and institutional hedging can influence pricing models greatly. Of course, as with other products, you don’t have to be an expert in asset pricing to make money trading options. All that is needed is a viable strategy and the discipline to follow it religiously. Sounds easy, right?
How to Make Money Trading Options
There’s no holy grail for profiting in the options markets. The basic tenets of successful trading apply ― align risk and reward consistently within the structure of a comprehensive plan.
However, there are strategies unique to options that are solid jumping-off points for your foray into the market. Here are a few common ways people make money trading options:
- Straddles: A straddle is a neutral strategy designed to capitalize on a directional move in price. When executing a straddle, both a call and put with the same strike price and expiration date are purchased. As the market deviates from strike, profits are gained. In practice, a straddle offers the trader unlimited upside potential while only being out the premium.
- Spreads: A spread trade is the simultaneous buying and selling of put/call options. It’s a net-value strategy, meaning that offsetting positions are taken to limit risk while attempting to lock in a stable profit. In options, the sky’s the limit when it comes to spread trading. Calendar, bull, bear, vertical and diagonal strategies are only the tip of the iceberg.
- Selling calls/puts: Selling call or put options is one way to generate instant revenue in the options markets. When a trader sells options, the premium is realized as profit in return for assumption of the contract’s liability. While revenue is instant, risk is essentially unlimited if left unchecked. This was the case in fall of 2018 with the meltdown of optionsellers.com. A “rogue wave” in the natural gas markets destroyed uncovered short calls, costing the firm its equity — north of $150 million.
In the traditional sense, options function much like futures do. If you’re an active trader, then some of the strategies above may be worth looking into.
Getting Started with Options
Options can be a complex arena, featuring a vast array of trading and investment alternatives. If you want to make money trading options, then seeking advice and guidance from a market professional before jumping in with both feet is a good idea. For a crash-course in all things options, check out the online resources available courtesy of Daniels Trading.