The popularity of options has increased tremendously in the past few years. With brokerage apps such as ThinkorSwim, Robinhood and Tastyworks, the popularity of options has grown considerably just in 2020 alone.
Contrary to popular misconception, options are not riskier than stocks. Reducing risk in the markets is why options were developed.
Not knowing what you are doing with options, however, can increase your risk. Options are easy to use but you need to educate yourself about options investing.
The first thing to know is that calls and puts are two sides to the same coin. Calls are generally bullish while puts are generally bearish (if you are buying).
Your only profit is when there is an increase for calls and decrease for puts. A more strategic way of investing is by selling, rather than buying, calls and puts.
There are pros and cons to any investment strategy. But the first and foremost reason is that option selling gives a 3:1 ratio in favor of selling rather than buying.
The stock market can move one of three ways: up, down, or sideways. With buying options you can only take advantage in one direction.
Profitable in three directions
However, selling options means you can be profitable if the option goes up, goes down a little, or sideways for puts.
Or down, up a little, or sideways for calls. Notice that this is the inverse of the buying strategy. That’s because calls and puts are the inverse of each other and selling and buying are the inverse of the inverse.
Secondly, when buying an option the price of the underlying has to exceed the strike price plus the amount paid to profit.
For example, you paid $1 for the put option for an underlying strike price of $20. It needs to fall to $18.99 before you start to profit.
Conversely, if you were to sell that same put you profit if the stock increases, stays about the same, or drops less than the $1 received.
Even if the price drops below the $18.99 mark you can still profit. You can sell covered calls on the shares put to you at a strike equal to or greater than the price you paid for the shares.
More ways to make money
Thirdly, time value, called “theta,” decays the price as time passes.
When you sell an option, you have the right, but not the obligation to sell shares (calls) or buy shares (puts) for a given time period.
As time passes the contract price reduces each day, whether you are selling or buying. When you are buying, you want it to increase.
This is so you can sell it later for a higher price or exercise your position.
Yet the price is always decreasing due to the passage of time (theta). If the stock’s price effectively trends sideways, the seller benefits because it will eventually go to zero and he or she keeps all the premium the buyer paid.