How to trade options for a living


Trading options for a living provides a good opportunity to make a lot of money and have a relatively flexible life, not bound by the nine to five grind. But there is also significant risk. Depending on your starting capital, experience, risk tolerance and the strategies you pursue, you can aim for very high annual returns, in the hundreds of percent or more, but typically 15 to 50 percent is a more realistic goal. This article provided an overview of the knowledge required to trade options, the major risks, the differing approaches, and a realistic appraisal of the reward potential. Read on to learn how to trade options for a living.

Things You'll Need

  • Thorough knowledge of stocks, options, and how markets work
  • Brokerage account allowing all types of option strategies
  • Modern computer with at least 512MB of RAM
  • High-speed Internet connection
  • Software for record keeping such as Excel
  • The first and most important thing to look at when thinking about trading for a living is how much capital you have to work with. Whether you trade stocks, commodities, currencies or options, you should have at least $50,000 that you can operate with. If you can manage to secure another stable income while you're trading, this capital requirement wouldn't need to be so high, but it's imperative to realize you'll have losing trades, and you have to somehow be able to accept and control them while still paying the bills. The next thing you need is a plan. This will incorporate whether you intend to use a speculative or strategic approach to the business, how much you'd like to realistically make, how much you're willing to risk in total, and how much you're willing to risk on each individual trade.

  • Option contracts are derivatives--they derive their value from underlying instruments. These instruments can be stocks, commodities, or indexes, it doesn't really matter. Options will fluctuate in price principally based upon the price movement of the underlying instrument. There are other factors such as time to expiration, distance from the strike price, and volatility, but the main driver of option price change--what you'd usually be betting on--are price changes in the underlying instrument. Therefore, before you begin trading options, it's vital you develop an understanding of the underlying instruments and the markets they trade in, whether that's stocks, commodities, or indexes. For example, before trading stock options, it's vital you understand what moves stock prices, and it's even better if you have some experience trading stocks directly.

  • Understand that there are two types of options: puts and calls. In the case of stock options, one contract typically controls 100 shares of the underlying stock. Call options give buyers the right--but not the obligation--to purchase 100 shares for every contact owned at the strike price--the strike price being the price at which the buyer is willing to own shares. This right exists until the option expires. Put options are just the reverse. They give buyers the right--but not the obligation--to sell 100 shares for every contract acquired at the strike price. It’s important to remember that for every buyer, you have a seller--and, you can be an option seller yourself. Sellers have terms that are almost the mirror opposite of buyers. The seller of a call has the obligation to deliver, or sell, 100 shares of the underlying stock to the buyer at the strike price, at anytime before expiration. Conversely, the put seller has the obligation to accept assignment--as in, purchase--100 shares of stock for every put he sold at the strike price. A good, general rule of thumb is, buyers of calls and sellers of puts are bullish--they think the underlying stock will go up--whereas buyers of puts and sellers of calls are bearish, thinking the stock will go down.

  • Unlike stocks, which could theoretically exist forever, options are a wasting asset with a finite lifetime. They are grouped into strike prices in a monthly series. Each series of options has a monthly expiration date, which is typically the third Friday of every month. For example, April series options would expire on the third Friday of April, and May series options would expire on the third Friday of May. At expiration, options that are out-of-the-money (OTM) expire worthless, while those that expire in-the-money (ITM) by more than $0.05, in the case of stock options, are automatically exercised. Exercise, for call buyers, means they'll have to buy the underlying stock at the strike price--100 shares for every contract they own--while for call sellers exercise means they'll have to deliver, or sell, 100 shares at the strike price. Put buyers would have to sell 100 shares for every put they own at the strike price, while put sellers would have to accept assignment--meaning, purchase--100 shares at the strike price. Whether an option is in-the-money or out-of-the-money is contingent upon where the stock price is in relation to the option strike price. For calls, if the stock price is above the strike price of the option, the option contract is in-the-money. For example, a call with a strike price of 50 would be in-the-money if the stock was at 55. Conversely, the same option would be out-of-the-money if the stock was at 45. Puts, again, work in reverse. A put with a strike of 50 would be out-of-the-money with the stock at 55, but in-the-money with the stock at 45. It seems confusing at first, but after working with it for a few weeks it'll become second nature.

  • Once you've got a firm command of the rules specific to options, as well as a thorough understanding of the main drivers and dynamics of the underlying market you'll be trading, you can formulate and execute your broader options trading plan. From a strategic perspective, there are really two types of option trader: the speculator and the strategist. The speculator, who is often an option buyer--of either puts or calls--typically only bets on the price of the underlying. If he's smart, he'll pay attention to other factors like strike price, time to expiration, and volatility, but nonetheless, his main bet is on what the price of the underlying instrument is going to do. If he's bullish, he'll buy calls. If he's bearish, he'll buy puts. The strategist tries to make herself a little bit more independent of price. She'll use a variety of option strategies--combinations, straddles, strangles, things like butterfly spreads, credit spreads, or plain old selling, especially of puts--to attempt to give herself a probabilistic advantage. Price is still very important to her, but by way of her more intricate strategies, she tries to dull its impact a bit.

  • Keep in mind that there's a yin-yang sort of balance to options trading. Every benefit has a cost. The advantage to being a speculator--who is almost always an option buyer--is that you have limited risk and an unlimited reward. Somebody buying one stock option contract at $3--which would be an outlay of $300, because you're controlling 100 shares of the underlying at $3--can only lose that $300, plus a token brokerage commission. The profits are theoretically unlimited. For trades that go well with short-term options, a typical return is 75 percent to 250 percent, but in certain cases you can make 1,000 percent or even 10,000 percent. That would turn a $300 investment into $30,000, possibly overnight, something that is almost impossible to do with almost any other kind of investment. The drawback is, such huge profits are extremely rare. Most options expire worthless. And while you're holding an option that you've purchased, time value is always moving against you--which is only natural since eventually the contract will expire, and expire worthless if it's out-of-the-money. Anybody would be weary of buying something that's going to evaporate in a few weeks or months, so price steadily moves against you, even if the underlying stock stays flat. You need your underlying equity to make a relatively big move in the right direction to counter this time value erosion.

  • Know that the strategist is often on the other side of the speculator's trade. Not always, of course. Once you get into more advanced options trading techniques, you'll see plenty of strategies that don't involve selling options. But about 60 to 70 percent of option strategies involve selling in some manner. The advantage you have as an option seller is that probabilities are typically on your side, and you can often forecast your income with greater regularity than a speculator can. Because time value erodes an option's price, a buyer loses a little bit everyday, while a seller makes a little bit everyday. And the option that expires worthless is money in the bank for the seller. Like the $300 example above. Somebody sold that speculator the option, and if it expires worthless, they'll bank the full $300 he loses. The drawback is what happens when the improbable occurs. A merger, an acquisition, an unexpectedly terrible or fantastic earnings report--all those things will radically shake the price of the underlying stock, and thus the option, and could usher in massive losses for the seller. Like that improbable 10,000% move from the example above. Just as the buyer would have made $30,000 for having only risked $300, the seller would have lost an equal amount even though she only sought to make $300. There are strategies she could have used to reduce her risk, but the basic essence of option selling is that magnitude is against you. Your risk to reward ratio is typically 5-1 to 10-1, even on careful strategies, meaning that for every $300 you make, you're risking $1,500 to $3,000.

  • Remember that there is no hard and fast rule that says somebody has to either be a strategist or a speculator. There are opportunities for buying, selling and strategizing that anyone can exploit at almost any time. But most people who trade options full-time eventually settle into what's comfortable for them and do that full-time. They either rely more on a speculative approach, attempting to time price movements of stocks, indexes or other instruments, and use the leverage of purchased options to generate large percentage returns for comparatively little risk, or they become strategists, looking for smaller, more consistent returns, and bet that they'll be able to avoid disasters like getting on the wrong side of a very improbable 10,000 percent move. Typically, speculators are willing to be wrong more often--as much as six to seven times out of 10--in return for the large amount they make when they're right, while strategists like to be right much more often, have a more regular income and will in turn sacrifice larger gains. They realize they're not going to become a millionaire in a few months--as a buyer could theoretically become if he bagged a very improbable multi-thousand percent trade--but figure it's better to have a high chance of returning 2 to 4 percent a month and control risk as best they can, than accept the high attrition rate of option buying in hopes of landing a big score.

  • Never forget that in trading options for a living, there are really no absolutes. A speculator uses a lot of strategy, and a strategist, no matter how much he or she may try to hedge out price risk, is still, to one degree or another, speculating. You can't make anything without some degree of risk. A good speculator will seek to be right on four to six out of ten trades, and make at least $1.5 to $2 on every winner for $1 that he sacrifices on his losers. So, even without a dramatic 10,000 percent return, he would still make 15 to 30 percent per annum, depending on the amount of risk he takes. And then if he can hit a few of the high-percentage returns on top of the moderately successful regular trading, his returns could really skyrocket. The seller, in turn, seeks to be right at least seven out of 10 times--and would prefer ten of 10. For every $1 she makes, she would try to limit her loss potential to $1, but in the event of a freak price move by the underlying, she could lose significantly more. In a good year she too could make 15 to 30 percent, or maybe even close to 50 or 100 percent, but the latter is really more the ideal than the reality. Even if she could make a return as high as 10 percent a month for several months--which would entail significant risk--sustaining such a rate of return throughout the year is very unlikely. All this again goes back to why it's good to have a relatively large pool of capital to work with, because a 15 percent return--which would in many years triple what a mutual or index fund would give you--still only returns $7,500 in a year on a $50,000 account.

Promoted By Zergnet



You May Also Like

Related Searches

Read Article

3 Day-to-Night Outfits for the Work Week

Is DIY in your DNA? Become part of our maker community.
Submit Your Work!