So far we have discussed Understanding Options and Using Options as Insurance, in here we’ll look at how we can use options to increase our profits.

Previously we looked at how we can use options as an “insurance” policy to limit our losses, but options can also be used to increase our profits. Please note that options are complicated and potentially risky investment vehicles, consult with a professional financial adviser before making decisions.

In order to make a profit with options you’ll have to sell an option and collect the premium, you can sell a Put option or a Call option depending on how you feel about the markets.

Sell a Put Option

If you feel optimistic about the markets and believe that over the life of the option the price of the stock will not fall below the strike price then sell a Put option. Remember a put option gives the buyer the right to sell their stocks at the strike price and will give you the obligation to buy the stock at the strike price if the buyer exercises their rights. When you sell the option contract you will collect the premium and if the option is not exercised the premium will be your profit, if it is exercised than you will have to purchase the stocks at the strike price.

Example:

You believe the stock of company ABC which is currently trading at $16, will not fall below $12 over the next 12 months, so you sell a Put option for ABC with a strike price of $12, expiring in 12 months for $1.5. You collect $150/contract. If the buyer does not exercise the option the $150 will be your profit. If the buyer does exercise the option than you’ll have to pay $1200/contract you have sold, regardless of market price.

Sell Call Option

On the other hand if you are a little more pessimistic and believe that the price of ABC will not go above $18 over the next 12 months you can sell a Call Option. Remember a Call option gives the owner the right to purchase the stock at the strike price and will give you the obligation to sell the stock at the strike price should the buyer exercise the right.

Naked Call: When you sell a call option and do not own the stock it is called a Naked Call. This strategy is risky because if the price of ABC rises above the strike price ($18 in our example) than you will have to buy it at the market price and sell it below that price. If ABC is trading at $20 and one option contract is exercised you will have to buy 100 shares of ABC for total of $2000 and sell them at $1800, you loose $200. You received $150 for selling the option and lost $200 for a net loss of $50, NOT INLCUDING COMMISSION.

Covered Call: Covered call option is when you sell an option and actually own the underlying security. You sell one call option for ABC but already own 100 shares so if the option is exercised you do not have to purchase the stock at market price you just sell yours. This can be good or bad depending on how much you bought the stocks for. If you bought them below the strike price you will still make money, if you bought it above strike price but below current market price you will loose but not as much as you could have, and if your purchase price was above the current market value well you are out of luck.

What Do I Think?

As I have said before options are complicated and risky strategies and should only be attempted after fully understanding them. Selling call options can be dangerous since you are taking on an obligation and will have to deliver when exercised, I think there are better investment strategies that regular investors can use to attain their goals.

What are your thoughts on selling options? Any interesting stories to share?