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.
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Basics of option profitability
An option buyer stands to make a profit if the underlying asset – let’s say a stock, to keep it simple – rises above the strike price (for a call) or falls below the strike price (for a put) before expiration of the option contract. 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).
Options buyers vs. option sellers
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. A study in the late 1990s by the Chicago Mercantile Exchange (CME) found that a little over 75% of all options held to expiration at the CME expired worthless.
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.
Evaluating your 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 call 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 big score? 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 that question will give you an idea of your risk tolerance and whether you are better off being an option buyer or option writer.
Risk-reward payoff of basic option strategies
While calls and puts can be combined in various permutations to form sophisticated option strategies, let’s evaluate the risk-reward of the four most basic strategies –
Buying a call: 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).
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, 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.
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, 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.
Writing a call: 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. 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.
Why 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 invest, and desires the most “bang for the buck.” The investor is very bullish in the short term on, for example, Apple – which we assume is trading at $90 – and can therefore buy a maximum of 10 shares of Apple (we exclude commissions for simplicity). Apple also has three-month calls with a strike price of $95 available for $3. Instead of buying the shares, the investor instead buys three call option contracts (again ignoring commissions).
Shortly before the call options expire, suppose Apple 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 Apple shares: Profit = $13 from ($103 - $90) x 10 shares = $130 = 14.4% return ($130 / $900)
- Purchase of 3 call option contracts: Profit = $8 x 100 x 3 contracts = $2,400 minus premium paid $900 = 166.7% return from ($2,400 - $900) / $900)
Of course, the risk with buying the calls rather than the shares is that if Apple had not traded above $95 by option expiration, the calls would have expired worthless. In fact, Apple would have had to trade at $98 (i.e. $95 strike price + $3 premium paid), or about 9% higher from its price when the calls were purchased, merely for the trade to break even.
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.
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. Let’s say you are rampantly bullish on hypothetical Stock XYZ, a technology stock that is trading at $46.
- Volatility: Is the market becalmed or quite volatile? How about Stock XYZ? If the implied volatility for XYZ 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 XYZ, 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 XYZ, 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.
- 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.
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.
Disclosure: The author did not own any of the securities mentioned in this article at the time of publication.