If you’re new to options, you may want to read this article on option trading basics. It will give you a good understanding of a couple of basic option trading strategies. It does so by taking you through an example of purchasing a call and then selling a call for the following month as “insurance”.
If you’re of the opinion that the market is bullish (going to go up) then one position to consider could be a long call.
This is done by buying a call option with a lot of time value.
You may consider XYZ stock is going to rise over the next couple of months so you purchase a call with say three months expiry date.
Your maximum risk or loss is what you paid for the option and this will happen if the stock doesn’t go above the strike price and what you paid for the option.
So if you paid 2.00 for an at the money twenty dollars option you need the stock to be twenty-two dollars at expiry to break even. Anything less and you have incurred a loss.
If you’re correct and the stock does go up as you predicted according to your trading plan entry strategy your profit’s how ever much the stock goes up above the option price you paid.
So in this case if the stock were to be twenty-four dollars at expiry you have a 2.00 profit.
The difference between the at the money price you bought the option being twenty dollars and the expiry price being twenty-four dollars less the money two dollars you paid for the option.
This is 100% return on your money from one strategy.
If you actually owned the stock and it went up the same amount your profit would be 20%.
Always remember there will be brokerage fees to be taken into consideration when trading.
If you wish to reduce your risk and potentially increase you profit you may wish to sell a call against the option you have purchased.
In this example you have paid 2.00 for the 20.00 option with three months time value. You can consider selling an option for say 22.00 for the following month for which we’ll assume you’re paid 1.00.
If at expiry the following month the stock has not reached 22.00 you keep the option premium you have been paid and still own the option you bought which then only owes you 1.00 as the premium you received repays half what you paid for the initial option.
If you are exercised ( the stock goes to say 22.50) you keep the premium you were paid and you receive the difference between what you bought the option for and what you sold it for in this example 2.00.
So if that were the case you have only made 50% return on you money in a month, only 50% for one month.
The amount the stock went up covers what you initially paid for the option, the premium you received for selling an option is your profit.
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