Earn money with options: 4 strategies
Options are interesting securities with which you can make good money. Before you can really invest in options, it is important to know how to select options and how profits and losses are determined. We also discuss some strategies that you can apply to make money with options.
Options are financial derivatives that give you the option, but not the obligation, to buy or sell an underlying security at a specified price. An option may relate to a share, for example.
- A call option allows you to buy the underlying share at a set price.
- A put option allows you to sell the underlying stock at a set price.
Options always have an expiry date. The option expires after that date: if the option is worthless at that moment, you lose the entire deposit.
If you use the options wisely, you can earn a lot of money with them. However, it is important to mention that options are riskier than the average investment: you can easily lose your entire deposit when you invest in options. For this reason, you should first practise investing in options first.
There are two ways in which you can invest in options: you can buy options or you can actively trade the price movement of an option.
At DEGIRO, you can buy options at low fees. Buying options is attractive when you want to exercise them for instance. Use the button below to open a free account at DEGIRO:
You may also choose to actively trade the price movement of options. At Plus500 you can speculate on both the rise and fall of option prices. When the prospects of an option deteriorate, the price may fall. Use the button below to try trading CFD Options for free with a demo at Plus500:
Trading in options is mainly strategic in nature. You should try to predict how the price of the underlying asset will develop and in what timeframe this development will take place. By predicting this, you can pick an option that suits your prediction.
Before selecting an option, it is important to determine whether you expect the price to rise or fall further. Also take a look at the volatility of the underlying asset: with a high volatility, there is a bigger chance that a high or a low value will be reached before the expiry date. Finally, don’t forget to look at the expiry date and assess whether the option will be of value before this time.
When you are more certain about a rising or declining trend on an option, you can choose an option with an expiry date which is less far in the future and which is further out of the money. This way you can optimize the amount you earn by trading options.
Some examples of option trading
If, for example, you think that the Philips share that is quoted today at $18 will be quoted at $20 within three weeks, you take a call option with an exercise price of £ 20and an expiry period of one month.
However, if you think that the stock is going to fall to $16 within four months, you take a put option on the stock with strike price $16 and an expiration time of four months.
You should select options based on your predictions. Bear in mind that the party writing the options apparently thinks that exactly the opposite will happen. In the end, of course, only one party can be right: investing in options is a zero-sum game.
Before you can make money with options, you need to understand how profits and losses in options work. Options expire on the third Friday of every month. An option is in the money when executing the option earns you a profit. This is the case for a call option at an execution price of $20 and with a premium of $1 when the price rises above $21. After paying the premium, you make a profit by immediately selling the share at a higher price.
Selling an option before the expiry date
When you are in the money with your option at the end of the period, you can exchange it for stocks. You then buy the stocks against a lower price than the current price. However, it is easier and cheaper (you pay less transaction costs) to sell the option before the expiry date.
Depending on the intrinsic value and the expected value, you will be able to receive a certain amount for your option. The actual profit you make can always be calculated by subtracting the premium paid from the profit received.
If you have paid $1 premium for your option, and you can now sell it for $2, your profit will be $1 per option. Your return is then 100%.
You can also lose
If an option is out of the money at the expiry date, it is worthless. You can then let the option expire and no further action is required. The loss consists of the premium you paid.
See in more detail how profits and losses are structured in the article on investing in options.
How can you write options?
Besides buying an option, it is also possible to write an option. When you buy an option, you receive a right, but when you write an option, you enter into an obligation. You have to sell the security (call option) or buy it (put option) at a certain value. In exchange for this obligation, you receive a certain premium from the buyer of the contract; this premium is your profit.
If you write out an option, you will earn money when you don’t have to execute the contract. Therefore, write out an option with characteristics of which you think they will not come true. The more favourable the conditions for the buyer of the option, the higher the premium you will eventually receive. So be on the edge of your prediction, that way you will earn more.
Once you have written an option, you can close it early by trading it on the stock exchange. Writing a position requires a certain margin with your broker, so you can deliver the securities at the promised price. After the expiry date, the buyer of the option can oblige you to deliver the securities.
In the last part of the article we will look at which strategies you can use to make the most money with options. This way you will know how to achieve a good result responsibly.
It may be wise to combine options investments with the underlying asset. By buying shares, you ensure that you cover the risks. It is then possible to use options to achieve a better return on your portfolio.
To achieve this, you can write a call option on stocks you already own. Suppose you have 100 stocks with a value of $10, and you do not expect a rise in the future. You can then use options to still achieve a return on your shares. By writing a call option, you receive a premium on your stocks.
In this example, you write an option with a premium of $70, committing yourself to deliver 100 shares at a price of $11 with an expiry date of the third Friday of the following month. Because you own the stocks, delivering the shares will never be a problem.
An advantage of this construction is that you obtain a guaranteed return of $70 whereas otherwise you might not obtain any return at all. However, if the share price rises above $11, the buyer of the option will probably exercise it. Therefore, you cannot profit from sharp price increases during this period.
Roll over: Continue with this tactic
It could be that the stock has risen slightly to $10.50. This also gives you a positive return on your shares. At the same time, the buyer of the option will not exercise it as there would be a negative return. So, in this scenario, you profit twice! Next, there are several ways to make more money with the options.
The first option is to sell your shares. You will then have a price gain of $0.50 per stock and on top of that, you will have received the extra premium of $70. In this way you have increased your return thanks to the options.
It is also possible to roll over the position. You then write out an option again for which you will receive a premium. Of course, you then always run the risk that the price of the share drops considerably, causing you to experience price losses, or that the price actually rises and you have to deliver the stocks. Regardless of what happens, you are guaranteed to receive the premium.
Finally, you can also hold on to the stocks and not issue options. This is the best decision if you expect the shares to rise further.
You can write a put option to buy stocks at a lower price. Let’s assume you are interested in a share trading at $10. You write a put option at the price of $11 and receive $70 in premiums. You now have the obligation to buy 100 stocks at the price of $11 at the end of the expiry date. The premiums that you receive can be used as a discount so that you can buy the shares cheaper later on.
If the price rises dramatically within the period, and you buy the shares too late, you will miss out on this huge increase in price. However, the put option is not executed, so you do have the premium as profit. If the price falls sharply, you will have to deliver the shares. By doing so, you make a loss. However, if you had bought the shares immediately, you would also have suffered this loss. Thanks to the premium, your loss is now lower.
Strategy 3: Protecting your portfolio
You can also use options to further protect your share portfolio. You can use put options to ensure that you can sell the shares that you own at a certain price, guaranteed. In this way, you actually protect your shares against a sharp fall. Of course, you do pay a premium for this, which can reduce your return. You can read more about options as insurance in this article.
Strategy 4: Make money with active trading
You can also use options to actively trade the underlying asset. For this, you need to make predictions about the future price development of the underlying share. However, there are other factors that influence the value of an option. Think for example of the volatility of the market and the time that remains until the expiry date. Therefore, make sure you read up on all these factors before you start actively trading options!
How can you earn more money (in theory) with options?
If you use options wisely, you can make more money than when you buy shares. This is the case because you can use leverage with options. This means that you can open a larger investment position with a smaller amount of money. As a result, your potential profit (but also your potential loss) is higher.
You only pay a premium for an option. That premium can be $1 and that option can relate to a share of $20. If you were to buy the share with $100, you can only buy 5 of them. However, you can buy multiple call options at the price of $1.
Of course, with an option, there is a chance that you will lose the entire deposit. If the option does not generate a profit, the option remains out of the money. When the call option in the example is at $22, the share price has to rise to a value above $23 to have a favourable result.
Speculating in options can therefore be very attractive, but you have to know what you are doing.
Buy or write options?
For most investors, it is smarter to buy options. When you buy an option, your risk is limited to the premium you pay. At the same time, your positive result is theoretically unlimited.
However, when you write options, your profit is limited: you never receive more than the premium you pay. At the same time, your loss is theoretically unlimited. Nevertheless, many people write out options: according to research, more than 75% of the option contracts end up being worthless. When you really know what you are doing, you can earn a lot of money with writing options.
Writing options is risky: at most brokers, you can only write covered options. This means that you write options on shares that you already own.
When do you make money with a call option?
You make money with a call option if the underlying security increases in value. How much money you make depends on the difference between the premium you pay and the profit you make.
When do you make money with a put option?
You make money with a put option if the underlying security falls in value. How much money you lose depends on the difference between the premium you pay and the profit you make.
Before you start investing in options, it is important to determine your risk tolerance. Options are high-risk investment products. If you prefer lower risk, you are better off investing in individual stocks.
Investing in call options is slightly less risky than investing in put options. This is because shares tend to rise over the long term. This is logical when you consider that the general production within an economy is only increasing. Buying a put option can be a less risky alternative to a short position, as you have no obligation when you buy options.
When you want to write options, put options are the least risky. The biggest risk you run is that you pay too much for a share when it crashes. When you write a call option, your theoretical loss is unlimited when you do this uncovered. We also call this writing an option naked. Therefore, this is not advisable for most private investors.
You can further limit your risks by setting up option spreads. You then combine different types of options.
Also read this
- What is an option – here you can read in detail how options work.
- How options investing works – find out how to invest in call options and put options.