Due to their capability for large losses, stock options have earned themselves a bad reputation. Over the years, they have become the boogieman of investing due to this perceived risk. It’s true, you may experience very large losses in options… if you misuse them. I follow a strategy where it is impossible (yes, impossible) to lose money. By exclusively selling options for certain stocks at a specific price point, the downsides are virtually zero. Warren Buffett has used this strategy for years. Using these guidelines, you can make money trading options, too.
The Basics of Options
An option is a contract to buy or sell an underlying asset on or before a certain date (expiration date) for a specific price (strike price). There are two options–calls and puts–and each of these can be either bought or sold for a small fee (premium).
In the case of stock options, the underlying asset is 100 shares of a certain stock. These options can be traded separately from the stocks themselves by buying (going long) or selling (going short).
If you’re confused, don’t worry, it gets easier from here. Use the below table for a quick overview of option definitions.
A long call gives the owner the right to purchase the underlying at the strike price. Say, for instance, that AT&T (T) is trading at $30. A long call with a strike price of $29 would be able to buy 100 shares of AT&T stock for $29. This would result in a payoff of $1 per share.
There are two strategies to buying options: insurance and speculation. To explain the insurance strategy, say AT&T is still trading at $30. If you’d like to ensure that you can sell your shares in a month for no less than $29, buy a $29 put with an expiration date one month from now. This will cost you a little, but it’ll guarantee that you can sell your stocks for at least $29 down the road. The goal of the insurance strategy is to protect your assets.
The goal of the speculative strategy is to make money on the changing price of the options themselves. If you believe a stock is going up, you can buy a call with the hopes of selling it later for a higher price.
Buying speculative options is the way people get rich fast. Due to the small investment, people can buy tens or hundreds of options at a time. On a volatile stock, the value of an option can double in a matter of days. Unfortunately, this means the value of an option can also drop by 50% in the same time. This is the risk that comes with buying speculative options.
Speculating with options can be profitable for some, but it also comes with a lot of risk. The method I use won’t make you rich fast, but it’ll guarantee a positive return.
How to Make Money Trading Options: The Winning Strategy
I make money trading options by utilizing two strategies: cash-covered puts and covered calls. Let’s look at these one at a time:
For explanation sake, say you’ve been following a company called “ABC Company” that you really like. The price of ABC finally drops to a level you’d like to buy. You could buy the stock straight up, or you could sell a put at your target price instead.
For example: your target price to buy ABC is $7. After a while, ABC finally drops into this range. Instead of just buying 100 shares of ABC, you could sell a put with a $7 strike price. This strategy enables you to buy at your target price while also taking home the premium. You’re getting paid to buy stocks you were going to buy anyway!
If the price never gets below your strike price, you can repeat this same strategy. You can do this over and over until the put finally expires in-the-money (in the case of a put, an option is “in-the-money” when the price of the stock is below the strike price).
This strategy requires you have enough cash on hand to cover the purchase. Since the chosen strike price is $7 and each option is for 100 shares, 1 short put would require $700 on hand.
Say you already own 100 shares of ABC Company, and the price of ABC is nearing your target sell price. You could just sell your position, and that’s fine. If you’d like to make a little extra on this trade, short a call for ABC with a strike price at your target. This allows you to sell out of your position and make extra money for doing so.
Here’s the scenario: you own 100 shares of ABC and the price is currently $13.75. If your target sell price for ABC is $14, you could receive a premium for selling a call with a $14 strike. If the premium for this example is $0.20 and the stock price ends at exactly $14 on the expiration date, you effectively sold your shares for $14.20 each. On 100 shares, you just made an extra $20. That’s $20 in your pocket for selling a position you were going to sell out of anyway.
And what if the price never reaches $14? Well, you can sell another call and receive another premium until the option expires in-the-money (“in-the-money” for a call means the price of a stock is above the strike price).
For this strategy, you will need at least 100 shares of the stock you are selling the call against.
The Argument Against
Opponents of this strategy say you are missing out on further stock moves. What if you sell a put on ABC with a $7 strike and the price drops to $6 at expiration? Opponents say that you would be overpaying for the stock by $1 then. Same logic applies to the call. If you sell a $14 call and the price goes to $15, they say you would miss out on the $1 gain.
If you have a $7 cash-covered put on ABC and the price at expiration is $6, it is true that you would have to still pay $7 for those shares. The opponents’ argument, however, assumes that you could predict this difference. This thinking is fundamentally flawed.
Yes, you miss out on the $1 per share, but the same would happen without the option. If your strategy is to purchase ABC at $7, you would do it. The stock could then drop to $6, and you would be in the same position as the option seller. Actually, you would be in a worse position than the option seller because you would miss out on the premium income.
When you use options only at the right prices for the right stocks, you end up winning in the end. Follow your strategy and leverage options for your benefit.
I’ve taken many college and CFA classes on options, and they all say trading options is risky. If you speculate with option pricing, I agree. Options are extremely risky in that circumstance.
As Matthew McConaughey’s character said in Wolf of Wall Street, “Nobody knows if a stock is going to go up, down, sideways or in circles.” This is true in the short-term. When you speculate with options, you’re gambling. If you stick to the above strategy, you too can make money trading options.
For more information on the world’s greatest investor’s philosophy, check out 7 Principles of Investing Like Warren Buffett.
Check out How to Invest in the Stock Market – A Beginner’s Guide for more information on getting started.
DISCLAIMER: Investing is an inherently risky operation. Past performance is not a guarantee of future returns. All information presented is for educational purposes only and should not be taken as investing advice.