The Basics of Options Profitability

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Options traders can profit by being an option buyer or an option writer. Options allow for potential profit during both volatile times, regardless of which direction the market is moving. This is possible because options can be traded in anticipation of market appreciation or depreciation. As long as the prices of assets like stocks, currencies, and commodities are moving, there is an options strategy that can take advantage of it.

Key Takeaways

  • Options contracts and strategies using them have defined profit and loss—P&L—profiles for understanding how much money you stand to make or lose.
  • When you sell an option, the most you can profit is the price of the premium collected, but often there is unlimited downside potential.
  • When you purchase an option, your upside can be unlimited and the most you can lose is the cost of the options premium.
  • Depending on the options strategy employed, an individual stands to profit from any number of market conditions from bull and bear to sideways markets.
  • Options spreads tend to cap both potential profits as well as losses.

Basics of Option Profitability

A call option buyer stands to make a profit if the underlying asset, let’s say a stock, rises above the strike price before expiry. A put option buyer makes a profit if the price falls below the strike price before the expiration. The exact amount of profit depends on the difference between the stock price and the option strike price at expiration or when the option position is closed. 

A call option writer stands to make a profit if the underlying stock stays below the strike price. After writing a put option, the trader profits if the price stays above the strike price. An option writer’s profitability is limited to the premium they receive for writing the option (which is the option buyer’s cost). Option writers are also called option sellers. 

Option Buying vs. Writing

There are fundamental differences between buying and writing options. An option buyer has the right to exercise the option, while the option writer must exercise the option. Time decay benefits the option writer and works against an option buyer.

An option buyer can make a substantial return on investment if the option trade works out. This is because a stock price can move significantly beyond the strike price. For this reason, option buyers often have greater (even unlimited) profit potential. Alternatively, option writers have comparatively limited profit potential that is tied to the premiums received.

An option writer makes a comparatively smaller return if the option trade is profitable. This is because the writer’s return is limited to the premium, no matter how much the stock moves. So why write options? Option writers receive upfront premium earnings, may collect the full premium amount regardless of whether the option expires out of the money, and can trade out of liquid options.

Evaluating Risk Tolerance

Here’s a simple test to evaluate your risk tolerance 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 the implied volatility of the call option and the period of time remaining to expiration, let’s say it is 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 options 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 profit? 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 those questions will give you an idea of your risk tolerance and whether you are better off being an option buyer or option writer.

It is important to keep in mind that these are the general statistics that apply to all options, but at certain times it may be more beneficial to be an option writer or a buyer of a specific asset. Applying the right strategy at the right time could alter these odds significantly. 

The Securities and Exchange Commission recognizes risks involved in trading options and encourages traders to educate themselves about the various types of options and how basic options strategies work.

Option Strategies Risk/Reward

While calls and puts can be combined in various permutations to form sophisticated options strategies, let’s evaluate the risk/reward of the four most basic strategies.

Buying a Call

This is the most basic option strategy. 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. “Low risk” assumes that the total cost of the option represents a very small percentage of the trader’s capital. Risking all capital on a single call option would make it a very risky trade because all the money could be lost if the option expires worthless.

Buying a Put

This is another strategy with relatively low risk but the potentially high reward if the trade works out. Buying puts is a viable alternative to the riskier strategy of short selling the underlying asset. 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 the put buyer is slightly less favorable than that of a call buyer.

Writing a Put

Put writing is a favored strategy of advanced options traders since, in the worst-case scenario, the stock is assigned to the put writer (they have to buy the stock), 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. That said, as discussed before, the probability of being able to make a profit is higher.

Writing a Call

Call writing comes in two forms, covered and 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 calls on stocks held within the portfolio. Uncovered or naked call writing is the exclusive province of risk-tolerant, sophisticated options traders, as it has a risk profile similar to that of a short sale in 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.

Options Spreads

Often times, traders or investors will combine options using a spread strategy, buying one or more options to sell one or more different options. Spreading will offset the premium paid because the sold option premium will net against the options premium purchased. Moreover, the risk and return profiles of a spread will cap out the potential profit or loss. Spreads can be created to take advantage of nearly any anticipated price action, and can range from the simple to the complex. As with individual options, any spread strategy can be either bought or sold.

Reasons to 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 use on a particular trade and desires the most bang-for-the-buck. The investor is bullish in the short term on XYZ Inc. So, assume XYZ is trading at $90. Our investor can buy a maximum of 10 shares of XYZ. However, XYZ also has three-month calls available with a strike price of $95 for a cost of $3. Now, instead of buying the shares, the investor buys three call option contracts. Buying three call options will cost $900 (3 contracts x 100 shares x $3).

Shortly before the call options expire, suppose XYZ 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 XYZ shares at $90: Profit = $13 per share x 10 shares = $130 = 14.4% return ($130 / $900).
  • Purchase of three $95 call option contracts: Profit = $8 x 100 x 3 contracts = $2,400 minus premium paid of  $900 = $1500 = 166.7% return ($1,500 / $900).

Of course, the risk with buying the calls rather than the shares is that if XYZ had not traded above $95 by option expiration, the calls would have expired worthless and all $900 would be lost. XYZ had to trade at $98 ($95 strike price + $3 premium paid), or about 9% higher from its price when the calls were purchased, for the trade just to break even. When the broker’s cost to place the trade is also added to the equation, to be profitable, the stock would need to trade even higher.

These scenarios assume that the trader held till expiration. That is not required with American options. At any time before expiry, the trader could have sold the option to lock in a profit. Or, if it looked like the stock was not going to move above the strike price, they could sell the option for its remaining time value to reduce the loss. For example, the trader paid $3 for the options, but as time passes, if the stock price remains below the strike price, those options may drop to $1. The trader could sell the three contracts for $1, receiving $300 of the original $900 back and avoiding a total loss.

The investor could also choose to exercise the call options rather than selling them to book profits/losses, but exercising the calls would require the investor to come up with a substantial sum of money to buy the number of shares their contracts represent. In the case above, that would require buying 300 shares at $95.

Many private investment firms enter into options contracts. As of March 31, 2022, Berkshire Hathaway held six open contracts with an aggregate fair value liability of $121 million and an aggregate notional value of $2.6 billion.

Selecting the Right Option

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/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 ZYX, a technology stock that is trading at $46.

Volatility

Is the market calm or quite volatile? How about Stock ZYX? If the implied volatility for ZYX 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 ZYX, 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 ZYX, 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.

Option Trading Tips

As an option buyer, your objective should be to purchase options with the longest possible expiration, to give your trade time to work out. Conversely, when you are writing options, go for the shortest possible expiration to limit your liability.

Trying to balance the point above, when buying options, purchasing the cheapest possible ones may improve your chances of a profitable trade. The 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, the option may be 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 (higher premium paid) if the trade does not work out.

There is a trade-off between strike prices and options 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. 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, allowing the savvy options tradertrader an opportunity to cash in. For instance, buying cheap out-of-the-money calls before 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.

How Do Options Work in Trading?

Options traders speculate on the future direction of the overall stock market or securities of individual companies. Instead of outright purchasing shares, options contracts can give you the right but not obligation to execute a trade at a given price. In return for paying an upfront premium for the contract, options trading is often used to scale returns at the risk of scaling losses.

What Are the 4 Types of Options?

The four basic types of option positions are buying a call, selling a call, buying a put, and selling a put. A call is the right to buy a security at a given price. Therefore, a trader can buy a call if it wishes to own the ability to buy at a certain price. A put is the right to sell a security at a given price. Therefore, a trader can buy a put if it wishes to own the ability to sell at a certain price. On the other side of the trade is the option writer who collects an upfront premium for entering into the contract and selling the option.

When Should You Buy Options?

Options are most useful to capitalize on volatile markets. It doesn’t matter which direction the market is going; all option traders need is price movement in one direction or the other. In general, it’s usually best to enter into an option position when you expect market volatility to increase and best to exist an option position when you expect market volatility to decrease. This is because low price movement is not beneficial for an options contract (especially if the option is current out of the money).

How Do Call Options Make Money?

A call option writer makes money from the premium they received for writing the contract and entering into the position. This premium is the price the buyer paid to enter into the agreement.

A call option buyer makes money if the price of the security remains above the strike price of the option. This gives the call option buyer the right to buy shares at a price lower than the market price.

Can I Sell Options Immediately?

Options contracts can often be bought and sold during normal market hours through a broker on many regulated exchanges. As long as the market is open, you can usually buy an option and sell it the next day (assuming the market is also open the following day).

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.