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Know Your Options

Did you know that in spite of all the volatility in the markets as of late (or maybe partly because of it), the growth in options trading has continued to rise?

In fact, for the last seven years in a row, the volume of options contracts traded has steadily increased with last year setting an all-time high.

More and more people are now including options in their investments as a smart way to get ahead of the market.

And it's easy to see why.

Advantages

Most people know that options afford the investor many advantages, not the least of which is a guaranteed limited risk when buying calls and puts.

And you can also get a great deal of leverage while using only a fraction of the money you would normally have to put up to get into the actual stocks themselves.

But those are just some of the advantages of options.

Flexibility

The real advantage with options is the opportunity to make money if a stock goes up, down and, depending on your strategy, even sideways.

In fact, with some strategies you can even be wrong on the underlying stock's direction and still profit. Simply identifying a range is all you need to win.

This flexibility gives the options investor the opportunity to profit in virtually any market condition – even when you're unsure what the market will do.

Easier Than You Think

Even though the popularity of options has soared, they are still not as well known or understood as stocks.

But it's all a lot easier than you might think.

1.) Are You Bullish?

If you believe the price of a stock will go up, you can buy a call option on it and make money as it goes higher.

The option buyer gets a guaranteed limited risk, which is limited to the purchase price (or premium) plus any applicable commissions and fees.

Essentially, at expiration, your profit is the difference between where the stock price is and your option's strike price.

Example:

Let's say a stock was trading at $50.

You buy a $45 call option with a premium of $6.50, i.e., $650.

At expiration, the stock has shot up to $65.

Your $45 call would now be $20 in-the-money, making it worth $2,000.

So the option is worth $2,000.
You paid $650.
That's a gain of $1,350.
All on just a $650 investment.

Worst case scenario: if the stock at expiration closed below your option's strike price of $45, you could lose the entire $650. But even if the price went down to $0, you could never lose any more than that. Whereas with a stock, you'd be on the hook for it all.

2.) Are You Bearish?

If you believe the price of a stock will go down, you can buy a put option on it and make money as the price goes lower.

Once again, the option buyer gets a guaranteed limited risk, which is limited to the purchase price (or premium) plus any applicable commissions and fees.

At expiration, your profit is the difference between where the stock price is and your option's strike price.

Example:

Let's say a stock was trading at $60.

You buy a $65 put option with a premium of $7.00, i.e., $700.

At expiration, the stock has dropped to $40.

Your $65 put would now be $25 in-the-money, making it worth $2,500.

So the option is worth $2,500.
You paid $700.
That's a gain of $1,800.
All on just a $700 investment.

Worst case scenario: if the stock at expiration closed above your strike price of $65, you could lose what you paid for the option. But even if the stock went against you even more, you could never lose any more than that.

3.) Expecting a Big Move, But Not Sure Which Way?

A straddle is a way to make money when you're not sure which way the market will go, but you believe something big will happen in either direction.

With a straddle, you're buying both a call and a put at the same time, with the same strike price, and the same expiration date.

For example, let's say it's earnings season and you expect a big move to occur, either up or down, based on whether the company reports a positive surprise or a negative surprise. Or maybe the charts are suggesting a big breakout could be getting ready to take place in one direction or another.

With this strategy you can make money in either direction without having to worry about whether you guessed correctly or not.

Example:

Let's say a stock was trading at $100 a few days before their earnings announcement.

You buy the front month $100 strike call for $150.
And you buy the front month $100 strike put also for $150.

That's a cost of $300 (not including transactions costs) to put on the trade.

Now let's say the stock shoots up $15 as a result of a positive earnings surprise.

The call option is now worth $1,500.
The put option is worth $0.
You paid $300.
That's a profit of $1,200.
All on just a $300 investment.

The best part with this strategy is if the stock had posted a negative surprise and it dropped -$15 instead, you would have been just as profitable. The only difference is that the put would have been the profitable side and the call would have been the loser. (But so what, because you didn't care which way it went, you just expected something big to happen in one direction or the other.)

Worst case scenario: at expiration, if nothing big ever happens, you would have lost the entire $300.

4.) Expecting a Stock to Fall (or at Least Not Go Much Higher)?

Writing calls can be profitable in mildly bullish markets, sideways markets and bearish markets.

Buying a call option gives you the right but not the obligation to purchase 100 shares of a stock at a certain price within a certain period of time. The price you pay for the option, let's say $500 for example, is called the premium.

If you write an option, you're collecting that premium. Someone else is buying the right to own 100 shares of a stock at a certain price within a certain period of time. And that premium is paid to you.

If that stock goes down and the option expires worthless, the buyer of the option loses -$500, but the writer of the option makes $500.

Example:

Let's say a stock was at $70.

For whatever reason, you determined the stock would go down or at least not go much higher.

Let's also say that you wrote an $80 call for a premium of $5.00, i.e., $500. That means your account would be credited $500.

If at expiration, the stock is at or below the strike price of $80, you'd keep the entire premium of $500.

Even though the stock didn't go down like you thought, but instead went even higher -- $10 higher in this example -- as long as it stayed below your strike price of $80 by expiration, you'd still profit by the full $500 you collected.

Thought the stock was going down.
Instead it went up.
Still made money: $500.
Pretty exciting.

In fact, at expiration, the stock could literally be above the strike price of $80, plus an amount commensurate with what the writer collected for the premium, and still not lose any money. (In this case, the stock could literally be at $85 at expiration and you still wouldn't have lost anything.)

Worst case scenario: if the stock went up past the strike price plus the amount collected in premium, then you'd start losing on the trade. And for every $1 above that level, you'd lose $100.

But if the stock looks like it's breaking out above your price level, you can simply buy that option back to limit your loss, or depending on where you are in the trade, lock in a partial gain.

5.) Think a Stock Will Go Up, But You'd Like To Buy It at a Lower Price, Yet Still Make Money Even If You Never Get In?

Writing put options is a great way to make money if the market goes up, sideways and even down (to a limited extent).

This is also a way to potentially get into a stock that you'd like to own at a much cheaper price, and get paid while you wait, even if you never get the stock.

As you know, if you buy a put option, you're buying the right to sell a stock at a certain price within a certain period of time. The buyer pays a premium for this right. He has a limited risk – which is limited to the price he paid for the option.

However, the writer is taking the other side. He has to buy the stock if it's put to him at a certain price within a certain period of time. And for this 'risk', the writer collects a premium.

Example:

Let's say a stock was at $50.

And you decided to write a $40 put option, collecting a premium of $4.00, i.e., $400. (Not to mention, looking forward to potentially getting a chance to own that stock a full $10 cheaper than where it's trading at.)

If at expiration, the stock is trading anywhere above your strike price of $40 or higher, you'd keep the entire premium of $400. You may not have gotten that stock, but you still got paid for your wait.

Thought the stock would go up, but didn't want to buy it at that price.
Wanted it to go down to buy at a lower price.
Never does.
You still made $400.

If at expiration, the stock price is at $40, the buyer of the option could exercise it and you'd now be obligated to buy that stock for $40 a share, which means you've now got that stock at the price you wanted – plus your $400 premium.

Didn't want the stock at $50.
Wished it would go down so you could get it at $40.
Finally does and you get your stock.
Plus $400.

But even if the stock fell to $36 (i.e., down to your strike price plus an amount commensurate with the premium collected -- this would be your breakeven point), you still wouldn't lose anything.

Worst case scenario: the stock would have to fall below $36 to even begin to lose on the trade. And for every $1 below that level, you'd lose $100 due to the stock you now own.

Of course, if you changed your mind, or if you thought the stock could fall below your strike price and even your breakeven point, you could buy the option back at any time, thus cutting your loss or locking in your gain and ending the trade right there, without having to even bother with the stock.

Options give the investor numerous ways to make money in the market. Up, down or sideways, decide to make success your only option.

You can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

And be sure to check out our Zacks Options Trader.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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