Using options trading as an income strategy

Trading stock options is similar to trading the actual stock. You can effectively profit from both scenarios, but when options trading, your initial cost is a lot less.

When you buy an option you are effectively buying time.

Confused?

When you buy an option, you are buying the right (but not the obligation) to purchase, or sell a particular stock for a set price, within a set time frame. You are not buying the actual stock, you are buying time in which you could purchase the stock if you wished.

There are two types of options.......

CALL OPTIONS give you the right to buy the shares if you wish to.

PUT OPTIONS give you the right to sell the shares if you wish to.

All options have an expiry date. You can exercise your right to buy or sell shares at any time up until and including this date. After that the option is worthless.

All options have a strike price, or set price that cannot change throughout the life of the option contract. This is the price at which you can buy or sell the shares.

So how do you earn money, or income when buying options?

When options trading, you only buy the option to sell it later for a profit.

To earn money on a call option, firstly you would have a bullish view, that is you think the share price will go up.

Lets say it is March and XYZ shares are trading at $ 20 each. We could buy a $ 22 May call option to purchase 100 XYZ shares for $ 275

At any time before expiry (May) of our option we could exercise our right to buy 100 XYZ shares at $ 22 each. This means we have 2 months in which the share price could rise above $ 22.

Once our call is in the money (share price is above our strike price of $ 22) we could exercise our option to purchase the shares.

If the share price was trading at $ 30 then our profit would be...........

$ 3000 (on sell price $ 30 x 100) -
$ 2200 (purchase price $ 22 x 100) -
$ 275 (cost of option)

= $ 525

But didn't I say your cost when options trading would be less than trading the actual stock?

Here's the power! As the price of the stock rises then so too does the value of our options. Rather than exercising our right to buy the stock, we can SELL OUR OPTIONS to someone else for a profit. The only money we need to trade this way is the $ 275 we would pay for our options in the beginning.

You can also earn money when the share price goes down.

You would trade Put options if you have a bearish view, or you thought that prices would go down. As the share price falls, the value of the put option increases. You could then sell the put option for a profit!

You cannot profit from a falling share price when you own the shares outright.

The maximium potential loss for an options trader is limited to the amount they initially paid for their option contract. With the right strategies and money management rules in place, the potential loss can be much less than this.

Before I started options trading, I met a lot of negativity from relatives and friends who believed options was an easy way to lose money and far too risky.

I have come to learn that buying a car is a much easier way to lose money. When you buy a car you are guaranteed to incur a loss as it will depreciate in value, yet do people react the same way when you show them your new wheels?

ANY purchase or investment will have a risk factor associated if you don't know what you are doing. This is why I would only recommend someone consider options trading after completing the right educational avenues and using sound money management rules.