1. Money

Where is the Money in Options Trading?

By October 20, 2008

Time and time again, options traders are told that making short options trades (i.e. selling options) is very risky, while making long options trades (i.e. buying options) is the only safe way to trade options. Is this good advice which will help you save money, or is this bad advice which will prevent you from making any money?

Before I answer this question, I need to warn you that understanding this will require some knowledge of options and options trading. If you are not yet familiar with options, the description of options markets, and how options are traded articles, will provide the necessary background information so that you can understand the following discussion.

Short Options Are Risky, but Profitable

Short options trades are considered risky because they have a limited profit potential (i.e. limited reward) but an unlimited loss potential (i.e. unlimited risk). For example, a short call trade (selling a single call option) can only make the option's premium in profit regardless of how far the underlying market's price decreases, but can lose an unlimited amount if the underlying market's price increases significantly. So far, it appears as though the advice given above is correct, however, this is only half of the story.

The other half of the story is that there are two possible outcomes for an option (it can expire in profit, or it can expire worthless), but three ways that the two outcomes can be reached (the underlying market can move upwards, sideways, or downwards). With most markets (futures, stocks, currencies, etc.), the market moving sideways does not result in either a profit or a loss, but with options, the market moving sideways does result in a profit or a loss. As there are two profit / loss outcomes, but three ways that the market can move, there must either be two ways of making a profit, or two ways of making a loss (three items distributed over two groups equals two in one group and one in the other). It is this uneven distribution that weights the profit of options trading in favour of either long or short options trades.

Which Options Trades Have the Advantage?

In order to know which options trades have the advantage, it is necessary to know which options trades are long and which options trades are short. The article about long and short options trades lists each possible options trade and explains whether the trade is a long trade or a short trade. Once this is understood, the article about options profit and loss explains how the underlying market's movement makes each options trade profitable and unprofitable, and answers the original question (where is the money in options trading?). If you are an options trader (or are considering trading options), this information is vital to your success. While it will not guarantee that you make money trading options, it will certainly make a big difference in the right direction.

Comments
November 21, 2008 at 11:58 am
(1) Alexander Chong says:

Yes, what Adam said is right. Selling options is very risky because it will cause unlimited loss if the market direction goes against you. Buying options is safer because if the market direction goes against you, you only loss the amount of money that you have used to buy the options. It will not cause unlimited loss.

May 1, 2009 at 11:57 am
(2) Gator Fan says:

You forgot about the time decay in options. Don’t know which way the stock will turn, but decay in the time value of option is certain. Design strategy to take advantage of that.

May 11, 2012 at 5:05 pm
(3) Arty says:

You can read all these ideas and “directions” about how to make money trading options, but it’s all B.S. Fundamentals and technicals are all voodoo economics. It’s no different than picking a horse race, a ball game or even playing the roulette wheel. No one, I repeat, NO ONE can predict where a stock or option is headed. You pays yo money and yo takes yo chances. It’s as simple as that. Options are fun if you don’t lose all your cash. I played that game for 7 years and only lost $5,000 so I think I was lucky. Very lucky. I’d like to see Adam’s brokerage account for the last few years. That’s what tells it all – not anecdotes. Sorry if I burst your bubble, but if you have some money you can afford to lose and do your homework, you will have fun when you win, which is highly unlikely, and you might break even – possiblly even make a few hundred bucks or a couple of grand after YEARS of trading options but don’t look for too much more than that.

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