How to Make Money Trading Options

Options are financial contracts deriving value from an underlying asset (e.g., stock, ETF, commodity). They offer opportunities to generate income or manage risk. Options provide leverage, allowing small capital to control a larger asset position. This flexibility makes them attractive for various trading objectives.

Understanding Options Fundamentals

Understanding options fundamentals is essential. An option grants the holder the right (not obligation) to buy or sell an underlying asset at a predetermined price by a specific date. This right is acquired by paying a premium to the seller (“writer”). Options are contracts with specific terms, not asset ownership. Its value links directly to the underlying asset’s price.

Options are either call or put. A call option grants the holder the right to buy the underlying asset at a specified strike price before or on an expiration date. The seller must sell the asset at the strike price if the buyer exercises this right. Call buyers anticipate an increase in the underlying asset’s price.

A put option grants the holder the right to sell the underlying asset at a specified strike price before or on an expiration date. The seller must buy the asset at the strike price if the buyer exercises this right. Investors purchase puts when they expect the underlying asset’s price to decrease.

The “strike price” is the predetermined price for buying or selling the underlying asset if exercised. The “expiration date” is the final day an option can be exercised; it becomes worthless if not exercised or closed. The “premium” is the price paid by the option buyer to the seller for contract rights, quoted per share and paid upfront.

An option’s status (“in-the-money,” “at-the-money,” or “out-of-the-money”) depends on its strike price relative to the underlying asset’s current market price. For a call, it is in-the-money if the asset’s price is above the strike, yielding immediate profit upon exercise. It is at-the-money when prices are equal; out-of-the-money if the asset’s price is below the strike, resulting in a loss.

For a put, the classification reverses. It is in-the-money if the underlying asset’s price is below the strike, allowing profitable exercise. It is at-the-money when prices are equal; out-of-the-money if the asset’s price is above the strike, making exercise unprofitable.

The option buyer (“holder”) pays the premium for rights. The seller (“writer”) receives the premium for the obligation to fulfill the contract if exercised. Both have distinct risk/reward profiles based on option type and market outlook.

Common Options Trading Strategies

Buying call or put options are straightforward strategies. Traders choose these based on a clear directional view of the underlying asset’s future price.

If an individual believes an underlying asset’s price will increase, they might buy a call option. This strategy, a long call, reflects a bullish outlook. Profit potential is theoretically unlimited, as the asset’s price can rise indefinitely. Maximum loss for the buyer is limited to the premium paid, the only upfront cost.

For example, buying a call option at a $50 strike for $2 per share. If the stock rises to $55, the profit is $3 per share ($300 per 100-share contract). If the stock stays below $50, the option expires worthless, and the $200 premium is lost.

If an individual believes an underlying asset’s price will decrease, they might buy a put option. This strategy, a long put, reflects a bearish outlook. Profit potential is substantial if the asset’s price drops significantly, with maximum profit if the asset falls to zero. Like buying a call, maximum loss for the buyer is limited to the premium paid.

Similarly, buying a put option at a $100 strike for $3 per share. If the stock falls to $90, the profit is $7 per share ($700 per 100-share contract). If the stock rises to $105, the option expires worthless, and the $300 premium is lost.

Options profits are treated as capital gains for tax purposes, like gains from selling stocks. Short-term capital gains (held less than one year) are taxed at ordinary income rates. Long-term capital gains (held over one year) are taxed at lower preferential rates. Losses can offset other capital gains and, to a limited extent, ordinary income, subject to IRS rules.

Factors Influencing Options Profitability

The underlying asset’s price movement is a primary determinant of an option’s profitability, but other dynamic factors also influence its premium and potential for profit or loss. These factors constantly adjust an option’s value, even if the underlying asset’s price remains unchanged.

The underlying asset’s price is the most direct factor. An increase in its price increases call option value and decreases put option value. Conversely, a decrease boosts put option value while diminishing call option value. This correlation forms the basis of options trading strategies.

Time decay, or Theta, describes the rate at which an option’s extrinsic value erodes as it nears expiration. Options are wasting assets; their value diminishes over time, especially closer to expiration. For buyers, time decay works against them, as the premium decreases daily. Sellers benefit from time decay, as it contributes to the option expiring worthless, allowing them to keep the premium.

Volatility, or Vega, measures expected future fluctuations in the underlying asset’s price. Higher implied volatility leads to higher option premiums due to a greater probability of a significant move. This uncertainty translates into a higher contract price. Conversely, lower implied volatility results in lower premiums.

High volatility means an option buyer might pay more, potentially reducing profit or increasing loss if the expected price movement doesn’t occur. Conversely, an option seller might receive a higher premium during high volatility. These factors interact to determine an option’s premium.

Beginning Your Options Trading Journey

Options trading requires establishing accounts and gaining approval. These ensure individuals understand risks and meet financial suitability criteria.

First, open a brokerage account offering options trading. Most major online brokerages provide this service. The application asks for personal information, financial details, and investment experience, helping the brokerage assess suitability.

After opening a general investment account, a separate application for options trading approval is required. Brokerages categorize approval into “levels” based on strategy complexity and risk. Basic buying of calls and puts falls under Level 1 or 2, with less stringent criteria than advanced strategies like selling uncovered options. The approval process involves questions about investment objectives, trading experience, income, net worth, and risk tolerance. FINRA Rule 2360 details the broker-dealer approval process.

Once approved, fund the brokerage account. Common methods include Automated Clearing House (ACH) transfers from a bank account (1-3 business days). Wire transfers offer faster availability (usually within one business day) but may incur a fee. Some brokerages also accept checks or transfers from other accounts.

Placing an options order involves logging into the brokerage’s trading platform. Select the underlying asset, then choose the option type (call or put), strike price, and expiration date from the options chain.

After selecting the contract, the trader specifies the quantity (one contract represents 100 shares of the underlying asset). Choose an order type (e.g., market or limit order). Reviewing order details, including total premium and fees, is an important final check before submitting.