Trading OptionsTrading options offers an opportunity to make extra income. An option is the right, not the obligation, to buy or sell a given asset on or before a particular expiration date. Options are an ambitious and risky way to invest. Generally, its not something amateurs should get involved in and the risk of losing large sums of money is real. That being said, trading options may be useful for some investors to generate income, if they are willing to assume the risks. In this article we'll describe a particular way of trading options, known as a "call". Trading options can involve stocks. A stock option is basically a gamble that the price of a given stock will go up or down by a given date. As such its not an investment per se, rather its a bet you can profit from movements in the stock price. One nice aspect about it is that you can even profit from downward movements in share prices. The first item of business when trading options is to select a strike price. When buying a call, this is the price above which you expect the price of the stock to rise. Let's say that you're interested in Apple, and its trading at $200 a share. Well Apple just announced the release of the iPad, and you expect it to sell well and when it does you think Apple stock will go up. You can look up available stock options by ticker. When you do this, you find that the strike prices available range from $180 to $220. You expect the price to zoom up to $250 a share, so you buy the option for $220. Each option contract has a price per share, called the premium. In this case the premium is cheap, its around 50 cents a share. Smaller strike prices are more likely to be exceeded so they cost more, up to $13 a share. Each option contract is for 100 shares. So if you opt for the $220 strike, its 50 cents a share or $50 to buy one contract. If the actual share price exceeds the strike price, you're "in the money" by the difference. So let's say the share price goes to $240. For the option to be worth anything, the stock price has to exceed the strike. Otherwise the option is worthless. In this example, you're in the money because $240 a share is higher than the $220 strike price. So the intrinsic value is up $240-$220 = $20 a share. For 100 shares, that's $2,000. When the stock price exceeds the strike, you have the option to buy the 100 shares at the strike price. If you exercise the option, this is a great deal because you are able to buy the stock for less than the current market value. So while it would cost someone $240 x 100 = $24,000 to buy the 100 shares of Apple stock, since you bought the options contract with a $220 strike, you could buy the shares for $22,000 and save $2,000. But what's neat about options is you don't have to actually buy the shares. You can make money by "trading out". In that case, you would get the intrinsic value plus a "time value" which represents the possibility of the option increasing in value. Time value is often calculated by some complicated formula. Lets say for our hypothetical example its $1 a share. At $240 a share we already calculated the intrinsic value to be $240 - $220 = $20 per share. We add the time value to this to get a total of $21 a share. For 100 shares, that's 100 x $21 = $2100, which is the value of the options contract. If we trade out we make $2100 on a $50 investment. Of course the share price may not exceed the strike. In that case, the option is worthless. So if the expiration date rolls around and Apple is trading at $215 a share, if we picked the $220 strike price we're out of luck. We lose the money we used to buy the options contract, which in this case is $50. Prices of options contracts vary, so they aren't always this favorable. But you can see why trading options can be enticing. In this example, we invested $50 that we might lose in its entirety- but there's a good chance we can make some good money. If the stock did jump to $240 (not all that unreasonable at the time of writing), we'd walk away with roughly $2,000 profit. Let's look at another example. Let's say we pick the strike price of $210 for Apple. The ask for this option, which at the time of writing is trading under the ticker .AJLBV is $1.30. So the options contract will cost $1.30 x 100 shares = $130. It expires in 20 days. Let's say just before the end of the 20 days the share price jumps to $215. Then we're in the money $215 - $210 = $5 a share, or $5 x 100 shares = $500. We can trade out, and make $500 - $130 = $370. Not a bad profit for a short 20 day time period. So you see how options offer the possibility of generating some income. You can buy options contracts to expire within the month, and if you're lucky and made careful bets, you can make some bit of income. Of course if the strike was $210 and instead as the option expires the share price drops to $195 a share, well the option contract is worthless and you lose your $130 initial investment.
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