Option trading offers the investor an opportunity to profit in one of two basic ways — by being an option buyer, or by being an option writer or seller. While some investors have the misconception that option trading can only be profitable during periods of high volatility , the reality is that options can be profitably traded even during periods of low volatility.

Options trading can be profitable — under the right circumstances — because the prices of assets like stocks, currencies and commodities are always dynamic and never static, thanks to the continuous process of price discovery in financial markets. See Investopedia's tutorial on " Options Basics.

Don't know your puts from your calls? That's what Investopedia's videos are for! Watch Call Option Basics and Put Option Basics. Conversely, an option writer stands to make a profit if the underlying stock stays below the strike price if a call option has been written , or stays above the strike price if a put option has been written before expiration. The exact amount of profit depends on a the difference between the stock price and the option strike price at expiration or when the option position is closed, and b the amount of premium paid by the option buyer or collected by the option writer.

Read more about how options are priced. An option buyer can make a substantial return on investment if the option trade works out.

An option writer makes a comparatively smaller return if the option trade is profitable, which begs the question — why bother writing options? Because the odds are typically overwhelmingly on the side of the option writer. For more on this study, see " Do Option Sellers Have A Trading Edge?

Of course, this excludes option positions that were closed out or exercised prior to expiration. But even so, the fact that 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. However, your potential profit is theoretically limitless. The probability of the trade being profitable is not very high. The answer to that question will give you an idea of your risk tolerance and whether you are better off being an option buyer or option writer.

This is the most basic option strategy imaginable. 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.

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 , while 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 a put buyer is slightly less favorable than that of a call buyer.

Read more about the difference between short selling and put options. Put writing is a favored strategy of advanced option traders, since in the worst-case scenario, the stock is assigned to the put writer, 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.

Call writing comes in two forms — covered and uncovered or 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 a call or calls on stocks held within the portfolio. But 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.

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.

Instead of buying the shares, the investor instead buys three call option contracts again ignoring commissions. The investor can choose to exercise the call options, rather than selling them to book profits, but exercising the calls would require the investor to come up with a substantial sum of money.

If the investor cannot or does not do so, then he or she would forgo additional gains made by Apple shares after the options expire. In this case, you could consider writing near-term puts to capture premium income, rather than buying calls as in the earlier instance.

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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. The author did not own any of the securities mentioned in this article at the time of publication. Dictionary Term Of The Day.

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This Mistake Could Cost You Guides Stock Basics Economics Basics Options Basics Exam Prep Series 7 Exam CFA Level 1 Series 65 Exam. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. The Basics of Options Profitability By Elvis Picardo, CFA Share. 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 or bearish? Making this determination will help you decide which option strategy to use, what strike price to use and what expiration to go for.

Is the market becalmed or quite volatile? How about Stock XYZ? Strike Price and Expiration: As you are rampantly bullish on XYZ, you should be comfortable with buying out of the money calls.

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. Some 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. 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 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.

What Is the Maximum Loss That Could Occur for a Purchaser of a Call Option? | Finance - Zacks

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. Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.

Buying Calls - Series 4 | Investopedia

Trading options is not easy and should only be done under the guidance of a professional. Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons. Futures contracts are available for all sorts of financial products, from equity indexes to precious metals.

Trading options based on futures means buying call or put options based on the direction Learn the top three risks and how they can affect you on either side of an options trade. Learn more about stock options, including some basic terminology and the source of profits. A brief overview of how to profit from using put options in your portfolio.

Learn how this simple options contract can work for you, even when your stock isn't. While writing a covered call option is less risky than writing a naked call option, the strategy is not entirely riskfree. Learn how aspects of an underlying security such as stock price and potential for fluctuations in that price, affect the Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered Learn a couple of popular options trading strategies that can be used by investors seeking to enhance their profits from Learn what a call option is, what determines a buyer and seller of an option, and what the difference between a right and An expense ratio is determined through an annual A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies.

A period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all A legal agreement created by the courts between two parties who did not have a previous obligation to each other.

A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over No thanks, I prefer not making money.

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