Options traders can profit by being an option buyer or an option writer. Options allow for potential profit during both volatile times, and when the market is quiet or less volatile. This is possible because the prices of assets like stocks, currencies, and commodities are always moving, and no matter what the market conditions are there is an option strategy that can take advantage of it.
Basics of Option Profitability
A call option buyer stands to make a profit if the underlying asset, let's say a stock, rises above the strike price before expiry. A put option buyer makes a profit if the price falls below the strike price before expiration. The exact amount of profit depends on the difference between the stock price and the option strike price at expiration or when the option position is closed.
A call option writer stands to make a profit if the underlying stock stays below the strike price. After writing a put option, the trader profits if the price stays above the strike price. A option writer's profitability is limited to the premium they receive for writing the option (which is the option buyer's cost). Option writers are also called option sellers.
Option Buying Versus Writing
An option buyer can make a substantial return on investment if the option trade works out. This is because a stock price can move significantly beyond the strike price.
An option writer makes a comparatively smaller return if the option trade is profitable. This is because the writer's return is limited to the premium, no matter how much the stock moves. So why write options? Because the odds are typically overwhelmingly on the side of the option writer. A study in the late 1990s, by the Chicago Mercantile Exchange (CME), found that a little over 75% of all options held to expiration expired worthless.
This study excludes option positions that were closed out or exercised prior to expiration. Even so, for every option contract that was in the money (ITM) at expiration, there were three that were out of the money (OTM) and therefore worthless is a pretty telling statistic.
Evaluating Risk Tolerance
Here’s a simple test to evaluate your risk tolerance in order to determine whether you are better off being an option buyer or an option writer. Let’s say you can buy or write 10 call option contracts, with the price of each call at $0.50. Each contract typically has 100 shares as the underlying asset, so 10 contracts would cost $500 ($0.50 x 100 x 10 contracts).
If you buy 10 call option contracts, you pay $500 and that is the maximum loss that you can incur. However, your potential profit is theoretically limitless. So what’s the catch? The probability of the trade being profitable is not very high. While this probability depends on implied volatility of the call option and the period of time remaining to expiration, let’s say it 25%.
On the other hand, if you write 10 call option contracts, your maximum profit is the amount of the premium income, or $500, while your loss is theoretically unlimited. However, the odds of the option trade being profitable are very much in your favor, at 75%.
So would you risk $500, knowing that you have a 75% chance of losing your investment and a 25% chance of making a profit? Or would you prefer to make a maximum of $500, knowing that you have a 75% chance of keeping the entire amount or part of it, but have a 25% chance of the trade being a losing one?
The answer to those questions will give you an idea of your risk tolerance and whether you are better off being an option buyer or option writer.
It is important to keep in mind that these are the general statistics that apply to all options, but at certain times it may be more beneficial to be an option writer or a buyer in a specific asset. Applying the right strategy at the right time could alter these odds significantly.
Risk/Reward Payoff of Basic Option Strategies
Buying a call: This is the most basic option strategy. It is a relatively low risk strategy, since the maximum loss is restricted to the premium paid to buy the call, while the maximum reward is potentially limitless. Although, as stated earlier, the odds of the trade being very profitable are typically fairly low. "Low risk" assumes that the total cost of the option represents a very small percentage of the trader's capital. Risking all capital on a single call option would make it a very risky trade because all the money could be lost if the option expires worthless.
Buying a put: This is another strategy with relatively low risk but potentially high reward if the trade works out. Buying puts is a viable alternative to the riskier strategy of short selling the underlying asset. Puts can also be bought to hedge downside risk in a portfolio. But because equity indices typically trend higher over time, which means that stocks on average tend to advance more often than they decline, the risk/reward profile of the put buyer is slightly less favorable than that of a call buyer.
Writing a put: Put writing is a favored strategy of advanced option traders, since in the worst-case scenario, the stock is assigned to the put writer (they have to buy the stock), while the best-case scenario is that the writer retains the full amount of the option premium. The biggest risk of put writing is that the writer may end up paying too much for a stock if it subsequently tanks. The risk/reward profile of put writing is more unfavorable than that of put or call buying, since the maximum reward equals the premium received, but the maximum loss is much higher. That said, as discussed before, the probability of being able to make a profit is higher.
Writing a call: Call writing comes in two forms, covered and naked. Covered call writing is another favorite strategy of intermediate to advanced option traders, and is generally used to generate extra income from a portfolio. It involves writing calls on stocks held within the portfolio. Uncovered or naked call writing is the exclusive province of risk-tolerant, sophisticated option traders, as it has a risk profile similar to that of a short sale in a stock. The maximum reward in call writing is equal to the premium received. The biggest risk with a covered call strategy is that the underlying stock will be “called away.” With naked call writing, the maximum loss is theoretically unlimited, just as it is with a short sale.
Reasons to Trade Options
Investors and traders undertake option trading either to hedge open positions (for example, buying puts to hedge a long position, or buying calls to hedge a short position), or to speculate on likely price movements of an underlying asset.
The biggest benefit of using options is that of leverage. For example, say an investor has $900 to use on a trade, and desires the most “bang for buck.” The investor is bullish in the short term on XYZ Inc.. Assume XYZ is trading at $90. Our investor can therefore buy a maximum of 10 shares of XYZ. XYZ also has three-month calls with a strike price of $95 available for a cost $3. Instead of buying the shares, the investor instead buys three call option contracts. Buying three call options all costs $900 (3 contracts x 100 shares x $3).
Shortly before the call options expire, suppose XYZ is trading at $103 and the calls are trading at $8, at which point the investor sells the calls. Here’s how the return on investment stacks up in each case.
- Outright purchase of XYZ shares at $90: Profit = $13 per share x 10 shares = $130 = 14.4% return ($130 / $900).
- Purchase of three $95 call option contracts: Profit = $8 x 100 x 3 contracts = $2,400 minus premium paid of $900 = $1500 = 166.7% return ($1,500 / $900).
Of course, the risk with buying the calls rather than the shares is that if XYZ had not traded above $95 by option expiration, the calls would have expired worthless and all $900 would be lost. In fact, XYZ had to trade at $98 ($95 strike price + $3 premium paid), or about 9% higher from its price when the calls were purchased, for the trade just to breakeven.
These scenarios assume that the trader held till expiration. That is not required with American options. At any time before expiry the trader could have sold the option to lock in a profit. Or, if it looked the stock was not going to move above the strike price, they could sell the option for its remaining time value in order to reduce the loss. For example, the trader paid $3 for the options, but as time passes, if the stock price remains below the strike price, those options may drop to $1. The trader could sell the three contracts for $1, receiving $300 of the original $900 back and avoiding a total loss.
The investor could also choose to exercise the call options rather than selling them to book profits/losses, but exercising the calls would require the investor to come up with a substantial sum of money to buy the number of shares their contracts represent. In the case above, that would require buying 300 shares at $95.
Selecting the Right Option to Trade
Here are some broad guidelines that should help you decide which types of options to trade.
- Bullish or bearish: Are you bullish or bearish on the stock, sector, or the broad market that you wish to trade? If so, are you rampantly, moderately, or just a tad bullish/bearish? Making this determination will help you decide which option strategy to use, what strike price to use and what expiration to go for. Let’s say you are rampantly bullish on hypothetical stock ZYX, a technology stock that is trading at $46.
- Volatility: Is the market calm or quite volatile? How about Stock ZYX? If the implied volatility for ZYX is not very high (say 20%), then it may be a good idea to buy calls on the stock, since such calls could be relatively cheap.
- Strike Price and Expiration: As you are rampantly bullish on ZYX, you should be comfortable with buying out of the money calls. Assume you do not want to spend more than $0.50 per call option, and have a choice of going for two-month calls with a strike price of $49 available for $0.50, or three-month calls with a strike price of $50 available for $0.47. You decide to go with the latter, since you believe the slightly higher strike price is more than offset by the extra month to expiration.
What if you were only slightly bullish on ZYX, and its implied volatility of 45% was three times that of the overall market? In this case, you could consider writing near-term puts to capture premium income, rather than buying calls as in the earlier instance.
Option Trading Tips
- As an option buyer, your objective should be to purchase options with the longest possible expiration, in order to give your trade time to work out. Conversely, when you are writing options, go for the shortest possible expiration in order to limit your liability.
- Trying to balance the point above, when buying options, purchasing the cheapest possible ones may improve your chances of a profitable trade. Implied volatility of such cheap options is likely to be quite low, and while this suggests that the odds of a successful trade are minimal, it is possible that implied volatility and hence the option are underpriced. So, if the trade does work out, the potential profit can be huge. Buying options with a lower level of implied volatility may be preferable to buying those with a very high level of implied volatility, because of the risk of a higher loss (higher premium paid) if the trade does not work out.
- There is a trade-off between strike prices and option expirations, as the earlier example demonstrated. An analysis of support and resistance levels, as well as key upcoming events (such as an earnings release) is useful in determining which strike price and expiration to use.
- Understand the sector to which the stock belongs. For example, biotech stocks often trade with binary outcomes when clinical trial results of a major drug are announced. Deeply out of the money calls or puts can be purchased to trade on these outcomes, depending on whether one is bullish or bearish on the stock. Obviously, it would be extremely risky to write calls or puts on biotech stocks around such events, unless the level of implied volatility is so high that the premium income earned compensates for this risk. By the same token, it makes little sense to buy deeply out of the money calls or puts on low-volatility sectors like utilities and telecoms.
- Use options to trade one-off events such as corporate restructurings and spin-offs, and recurring events like earnings releases. Stocks can exhibit very volatile behavior around such events, giving the savvy options trader an opportunity to cash in. For instance, buying cheap out of the money calls prior to the earnings report on a stock that has been in a pronounced slump, can be a profitable strategy if it manages to beat lowered expectations and subsequently surges.
The Bottom Line
Investors with a lower risk appetite should stick to basic strategies like call or put buying, while more advanced strategies like put writing and call writing should only be used by sophisticated investors with adequate risk tolerance. As option strategies can be tailored to match one’s unique risk tolerance and return requirement, they provide many paths to profitability.