If you are a beginner investor you may have heard of options trading but may not have fully understood it. You may be wondering how exactly can you make money trading options?
As a beginner investor myself, I can tell you that it is much easier than you think. And I, personally, wish I had started trading options sooner.
Trading options has been around since the 1920s. And millions of people have used options trading to supplement their income, decrease their investment risks, and/or quit their day jobs.
Options trading can be quite lucrative if you know what you are doing. Once you learn the basics, you can begin employing simple strategies and start making money immediately.
Today, we'll go over exactly how you can start making money with these simple options strategies.
What are options?
Options are contracts that give the buyer the right to buy or sell stocks at an agreed upon price, quantity, and time frame. There are two types of options: calls and puts.
Call options give the buyer the option to buy the stocks at a discounted price while put options give the buyer the option to sell their stock at a premium.
For a more in-depth look at options and other strategies check out this complete beginner's guide. We talk about how to use calls and puts, go over key terminology, and discuss 7 reasons why people trade options.
I even cover some advanced topics, such as the Greeks, for those who are curious.
Can you Make Money Trading Options?
Of course you can!! There are hundreds of thousands of people who are making money trading options as we speak.
Some are just doing it to supplement their income while others have even been able to make it their full time career.
The real question is not can you make money trading options but how. There are 3 different ways you can make money trading options.
- By Selling (or Writing) Options
- By Buying Options
- By Combining the Two (Spreads)
We'll take a look at each of these methods in more detail below.
How to Make Money Selling Options
Selling options is perhaps the easiest way that you can make money trading options. It is what I did when I was first starting out.
There are two ways you can make money selling options: by selling calls or selling puts. One thing to note about selling options is that your maximum profit is capped at the premium you receive.
Selling Put Options
Selling, or writing, a put option is when you promise to buy someone's shares at a specified strike price should the value of those shares go below it.
So, you are providing insurance to this person that they will not lose more than the agreed upon price.
Because of the risk involved and because the person wants to minimize their potential losses, they will pay you a premium. That's cash in your pocket. Immediately.
Easy peasy lemon squeezy.
It may be easy to collect that premium but be aware that should the stock's price go below the agreed upon strike price, you are obligated to purchase the shares. So have your money ready!
The only way to get out of this is to buy back the option before the expiration date which could cost you a pretty penny.
However, should the stock's price be above the strike price at expiration, it will expire worthless and you get to keep all of your premium.
Selling Call Options
When you sell a call option, you are giving the buyer the right to purchase your shares at an agreed upon strike price.
Should the market value of the shares go higher than this, the buyer can now buy the shares at a discount. A definite perk.
Because of this, the buyer pays you an option premium. And just like when selling puts, you receive this money immediately. All that's left to do is wait.
Should the price of the shares never go above the strike price, the option will expire worthless and you get to keep the entire premium.
However, should the price be higher than the strike price at expiration you will be obligated to sell your shares at the agreed upon price.
The only way to get out of this is to buy back the call option before the expiration date. This, unfortunately, will cost you money to do. And it just may be more money than you received with the premium.
Pro-Tip: You do not have to wait until expiration to profit from trading stocks! Lock in your profits by buying back or selling the option. Note: This means you will lose out on some of the gains.
The Risks in Selling Options
Selling options may be the easiest way to make money trading options but it is also the riskiest. There is a huge downside potential when selling options as there is no limit to how much you can lose.
When Selling Puts
When selling puts, the risk is that the stock you are required to purchase falls to $0 after you buy them. This means your total loss is your purchase price minus the premium you received times the total number of shares purchased.
Example
You sell 1 put contract (100 shares) of XYZ Corp with a strike price of $44 for $1. You receive the $100 premium ($1 x 100 shares). When you sold the contract, XYZ Corp had been trading at $45.
However, at expiration XYZ Corp. is trading at $43. So the buyers exercises his right to sell at $44 and your purchase XYZ stock for a total of $4,400.
In the example above, should XYZ Corp go bankrupt and its stock price drops to $0, you would lose your entire investment of $4400. This results in a total loss of $4,300.
When Selling Calls
When selling covered calls (meaning you own the stock), the risk you have is losing out on the gains of owning the stock. This is because you would be required to sell them at a discount should the buyer exercise the option.
Your losses get substantially worst when you sell uncovered calls. Selling uncovered calls means you don't actually own the stock you are selling a call option for.
Therefore, should you be required to sell the stocks you must first purchase them at the much higher price. Then sell them at the agreed upon lower price.
Your total loss would be the difference between two minus the premium you received and plus all the transaction fees.
Note: This is about the same loss you'd have if you decided to buy back the option contract instead of selling your stock.
Remember, selling options have a limit on how much money you can make but your losses are limitless.
How to Make Money Buying Options
Another way you can make money trading options is by buying them. You make money buying options only if the underlying asset (stock, index fund, etc.) makes big moves in the direction you predicted.
As with selling options, there are two ways you can make money - by buying call options or buying put options.
Buying Put Options
There are only a few reasons why you would buy a put option. One, is if you believe that the stock's price will go down. And, two, is if you want to protect the stock you own, in case the market drops significantly.
As this post is about making money, we are mainly concerned with the first reason. So if you are pretty sure a particular stock's price will drop significantly in the future, you should buy a put option.
If you do and your prediction is correct, you can then sell that option back on the open market and make a good profit.
How exactly does this work?
Well, as the price of the stock decreases, the value of your put option increases. And if, at expiration, the price of the stock is well below the strike price of your option, the value of your option will be quite a bit higher than when you purchased it.
Thus, by selling it, you would have essentially bought low and sold high.
Note: The value of the option would be at least equal to the difference between the strike price and the market value price.
Of course, you can sell your option at anytime to lock in the profits.
Buying a Call Option
When you buy a call option, the assumption is that the price of the stock is going to go up. Otherwise, there would be no profit to be gained.
Buying a call option gives you the right to purchase stock at a discount. So if you buy a call option for a certain time period and the stock's price goes up within that time frame, you have two options.
You could purchase the stock yourself at a discount. Or you could sell that right to someone else and make the profit that way. If done on expiration, the profit will be essentially the same either way you choose.
But should the stock's value continue to increase then buying the stocks at a discount would've been the better option. Hindsight is 20/20.
As always you can lock in your profits early and take the risk of losing money off the table. But, this, of course, takes away your potential to get more later.
The Risks in Buying Options
Buying options are much less risky than selling options as the maximum amount you could use is limited to the amount you paid to buy the option.
Therefore, if you are just starting out trading options, this is, generally, the recommended way to go.
Although, quietly, I prefer selling options as you can receive money immediately. But this is much riskier and I have definitely lost money selling options.
Buying options are a lot less risky than selling options as your losses are capped at the premium you pay. The potential for profit, however, is limitless!
How to Make Money With Simple Spreads
If you are new to the options game, you may not know what spreads are. Spreads are when you execute two trades (buying and selling) of the same underlying asset with different strike prices or expiration dates.
Spreads are nice because they limit your losses. However, spreads also limit your gains. But as they say, going for a sure thing is better than gambling!
With many spreads, you can calculate exactly how much you could gain and exactly how much you could lose for a given scenario.
Check out a diagram of a spread below.
This happens to be an example of a Bull Call Spread but with such a graph you can see exactly how much you can profit from a trade and how much you can lose.
Let's take a look at some of the simple spread strategies you can start using even as a beginner.
There are three categories of options spreads:
- Vertical Spreads
- Horizontal (or Calendar) Spreads
- Diagonal Spreads
Spreads are a lot less risky then trading options individually. They limit your losses but also your gains.
Vertical Spreads
This category of spreads involve buying 2 or more call options or put options for the same asset with the same expiration date, but different strike prices.
Bull Spreads
If you think that the stock market is going to go up, you may want to consider doing a bull spread. These spreads make money when the stock's price goes up.
You can do a Bull Call Spread (buying and selling call options) or a Bull Put Spread (buying and selling put options).
Bull Call Spread
To enter into a vertical bull call spread, you would need to buy and sell call options for the same stock with the same expiration date. The option you buy should be the one with the lower strike price.
This is usually at-the-money. While the option that you sell, should be at the higher strike price. The bull call spread is a debit spread. Meaning, you must pay money to enter into this position.
This is because, the option that you buy is more valuable (because of its lower strike price) then the option you sell. So, you will end up paying a higher premium than you receive.
This spread makes money if the stock's price increases. It makes its maximum if the stock price is above the higher strike price at expiration.
Your maximum loss will occur if the stock's price is below the lower strike price.
Enter your text here...
Maximum Profit: (Spread width - total premium paid) x 100
Maximum Loss: Total premium paid
Breakeven Price: Lower Strike Price + Premium paid
Bull Put Spreads
Like the bull call spread, you would also enter this trade if you believe the stock's price is going to go up. Unlike the bull call spread, this spread is a credit spread meaning you receive money when you make this trade.
To enter into this trade, you must buy a put option at the lower strike price and sell a put option at a higher strike price.
As this is a credit spread, you make your money up front. And you maximize your profits if the stock price closes above the higher strike price ensuring that the put option you sold expires worthless.
Maximum Profit: Premium Received - Premium Paid
Maximum Loss: (Spread Width - Net Credit Received) x 100 shares
Breakeven Price: Higher strike price - Net Credit Received
*Net Credit Received = max profit
Bull Spreads Summary Table
Bull Call Spread | Bull Put Spread |
|---|---|
Debit | Credit |
Buy call at lower strike price; Sell call at higher strike price | Buy put at lower strike price; Sell put at higher strike price |
Max Profit Scenario: Stock price above the higher strike price | Max Profit Scenario: Stock price above the higher strike price |
Bear Spreads
If you think that the stock market or more specifically a stock's price is going to go down, you would enter into a bear spread trade. This trade makes money when the stock's price decreases.
As with the bull spreads, there are bear call spreads and bear put spreads.
Bear Call Spread
To enter in this trade, you will need to buy calls at the higher strike price and sell calls at the lower strike price. With this trade, you make money up front since the call with the lower strike price is more valuable. So it is a credit spread.
Maximum profits can be had when the stock's price is below the lower strike price at the expiration date.
Maximum Profit: Premium Received - Premium paid
Maximum Loss: (Spread Width - Net Credit Received ) x 100
Breakeven Price: Lower Strike Price + Net Credit Received
Bear Put Spread
To enter into a bear put spread, you would need to buy a put with the higher strike price and sell a put with the lower strike price.
Because you are buying the put option with the higher strike (and, therefore, more value), this spread is a debit spread. So it will cost you to enter into this trade.
To gain maximum profits with this spread, you need the stock's price to drop below the lower strike price.
Maximum Profit: Spread Width - Net Amount Paid
Maximum Loss: Net Amount Paid
Breakeven Price: Higher Strike Price - Net Amount Paid
Bear Spreads Summary Table
Bear Call Spread | Bear Put Spread |
|---|---|
Credit | Debit |
Buy call option at higher strike price; Sell call at lower strike price | Buy put option at higher strike price; Sell put at lower strike price |
Max Profit Scenario: Stock price drops below lower strike price | Max Profit Scenario: Stock price drops below lower strike price |
Horizontal Spreads
Calendar, or horizontal spreads, get their name from how they appear on an options chain. They involve buying and selling call or put options for the same asset at the same strike price but for different expirations dates.
By buying options with different expiration dates, you take advantage of time decay to make money on the spread.
The shorter term option will decay faster than the longer term option. So buy making more in the decay of the shorter term option than you lose with the longer term option, you make money.
Also, you may want to consider doing horizontal spreads if you want to take advantage of the implied volatility of the market for different expiration dates as well.
Though, ideally, you will want the stock's price to remain around your strike price throughout this spread.
I would say Calendar spreads are typically going to be a debit spread as buying the longer term option will usually cost more. However, a reverse calendar spread would most likely be a credit spread.
Entering a Calendar Spread
To enter into a trade, you would buy the option that has the farther expiration date and sell the option with the closer expiration date.
Theoretically, the trader profits when the volatility increases over time and loses if the volatility decreases over time. But there is a catch to this which we will get into later.
You can enter into a reverse calendar spread if you believe that the volatility will decrease in the future. That way, you would, theoretically, profit when it does.
You can do horizontal spreads with calls or puts. Call horizontal spreads offer more protection for if the stock goes up in value while put horizontal spreads offer more protection when the value goes down.
Ways to Profit With Calendar Spreads
We've talked a lot about volatility but there are two ways you can profit using a calendar spread:
1) The implied volatility increases
2) The passage of time
Increased Volatility
As the volatility of the stock increases over time, the value of the longer term option increases as well. More volatility equals higher options prices.
Thus, if the implied volatility goes up, you will make a profit using the calendar spread.
However, this is not always true. An increase in volatility can sometimes make you lose money instead of making money.
For instance, if the volatility of the stock increase more in the short term than the long term, you will lose money.
Furthermore, any dramatic increase in volatility of the stock will probably shift the price of the stock dramatically thereby making it unlikely that you will profit from this scenario.
Thus, using calendar spreads to profit from the volatility of the market may not be the best option.
Passage of Time
With any options trade, the passage of time results in a decrease in value of your options. For calendar spreads, it can actually be profitable.
This is because as time passes the option you sold loses value faster than the option you bought. And as long as the stock's price remains close to the strike price, you can make money on your spread.
Because you can profit when the stock's price remains relatively unchanged, calendar spreads are perfect for markets that are moving sideways.
**It's not the prettiest graph but just to give you an idea of the profit/loss graph of a horizontal spread. The max profit is when the stock's price is close to the strike price.
Once your sold option expire you can sell another options and keep rolling your horizontal spread!
Diagonal Spreads
This category of spreads involves buying/selling call or put options for the same underlying asset but at different strike prices and expiration dates.
So you would buy and sell two call options or two put options with varying strikes and expirations.
The diagonal spread is a combination of a vertical and a horizontal spread. And is it typically bought with a 1:1 ratio (i.e. the same number of bought calls to sold calls).
These spreads can be credit or debit spreads varying on a case by case basis. But typically, if you are buying the option that is farther out, it will be a debit spread. Whereas, if you buy the closer option, it will most likely be a credit spread.
But with so many ways you can do a diagonal spread, nothing is really set in stone.
All this variability makes the diagonal spread a wee bit more complicated than the others. So we won't get into this one too much as it is a not so simple spread.
Suffice it to say that diagonals spreads are very flexible and can be arranged a number of ways depending on whether you think the stock will go up or down.
The profit potential of diagonal spreads can be estimated based on the spread width and the amount paid to enter the trade but with all the variables it is only an estimate.
Check out your options with the table below:
Call Diagonal Spreads | Put Diagonal Spreads | ||
|---|---|---|---|
Long (Bullish) | Short (Bearish) | Long (Bearish) | Short (Bullish) |
Sell Near Buy Far | Buy Near Sell Far | Sell Near Buy Far | Buy Near Sell Far |
Sell Higher Buy Lower | Buy Higher Sell Lower | Sell Lower Buy Higher | Buy Lower Sell Higher |
Why do Diagonal Spreads?
The problem you may find with doing vertical spreads is that once you finish one you have to set up another one and another and another. This can lead to a lot of transactions which means a lot more fees.
For calendar spreads, buying the option that is farther out is more expensive then selling the nearer option and will limit your profitability. To combat this, you can simply buy the option at a strike that is further out of the money.
This will decrease the purchase price for that option and so will increase your profit potential. It will also give you a vertical spread and the potential to profit from a change in the stock's price.
In this way, diagonal spreads can really link the best of both worlds. You can take advantage of price changes of the stock and still get the benefit of time decay.
As with horizontal spreads, you have the option to keep "rolling" the short options from one expiration date to the next. That means once the first expires you can simply purchase another to keep you spread going.
Conversely, you could just close the spread out when the nearer option expires.
Note: Tastytrades advises you not to enter a debit trade that costs more than 75% of the spread width.
**Not the prettiest of graphs but just to give you an idea of some example profit/loss graphs of diagonal spreads.
Note: There are much more variations than these. And profits and losses will vary drastically.
Diagonal spreads can give you the best of both worlds!
Trade Options With a Money Making Plan
Decide now how you want to do options. Which strategy do you want to use to make money? Simple calls and puts? Spreads?
If you are going to sell options, do you prefer selling 10% out-of-the-money options or 5% in-the-money options. Will you exit your trade when you have made 20, 30, or 50% of your max profit potential?
When will you cut your losses?
Don't worry too much about whatever decision you make now as you can always change later.
The point is that having a plan helps you to make the right decisions for you when you are trading. Make the decisions now so that you can minimize your risks and ensure profitability later.
Additionally, once you enter a trade, you may want to consider setting a stop loss order, to limit the amount of money you lose, and a stop limit order, take your profit early.
How Much Money Do You Need to Make Money Trading Options?
Believe it or not, you technically don't need any money to start making money trading options. This is because in writing options you get paid the premium immediately without actually putting in any money of your own.
However, most brokerages won't allow you to start trading options unless you have some money in your brokerage account to start.
And if you are a beginner, you will most likely be required to have enough to cover the purchase of assets should that become necessary.
This is best as writing uncovered calls or puts can put you at great risk of losing lots and lots of money. And that is most definitely not what we are going for here.
Overall, I'd say, to get started, having as little as $1,000 in your brokerage account is sufficient to start making some money. I started with about $4,000 and I was able to make a couple hundred a month just selling puts.
You can start trading with as little as $1000 in your account!
All in All
It is actually quite easy to start making money trading options. The thing you have to remember is that it is also quite easy to lose a lot of money as well.
That's why implementing certain strategies, such as having your money making plan in place or using spreads, to reduce your risk is important.
If you are just starting out, make sure you take some time to really learn the basics before jumping in. Start slow and small.
The world of trading options can be fun, exciting, and very profitable if you know what you are doing. Have fun! And looking forward to hearing your success stories!
Happy Investing!
*DISCLAIMER: The Information provided in this post is simply the opinions of the blogger and is given in the spirit of educational fun. It is not investment advice. Trading options is risky and not to be taken lightly. Please do your own research and decide what is right for you before investing in or trading any asset. If necessary, seek the help of a certified professional in discussing your options.