Ever wondered how traders make money from Options even when the stock price is moving downwards or sideways? In this guide, we show you how to profit from stocks using call and put options, without having to own the underlying shares.
You won’t want to miss this because we’ll make sure that this is one of the simplest guides that you’ve seen thus far, packed with case studies and actionable insights on how to deploy the strategy immediately in the stock market today.
What Is a Stock Option?
A stock option is a financial contract between two parties that gives the buyer the right, but not the obligation, to buy or sell a specified amount of stock at a pre-agreed price within a set time frame. The two main types of stock options are call and put options.
Key Components of Stock Options
There are a few key terminologies that you will need to get familiar with in the options world.
- Underlying Asset: The stock that the option derives its value from
- Strike Price: The pre-agreed upon price where the owner can buy/sell the underlying security
- Expiration Date: The date at which the option expires and becomes worthless if not exercised
- Premium: The price paid by the option buyer to the option seller for the right to buy or sell the stock
Two Types of Options: Calls and Puts
Call Option Definition and Analogy
A call option gives the buyer the right to buy a specific quantity of the underlying stock at the strike price before the expiration date. If the stock price rises above the strike price before expiration, the call option holder can exercise their right to buy the stock at the lower strike price, potentially making a profit.
Let’s use an analogy. Imagine you're interested in a bike, but you don’t want to commit to purchasing it just yet. So, you decide to rent an option to buy the bike instead.
You rent the option to buy the bike at a set price of $100, valid for a specific period, let's say a month. During this time, the bike's market price rose to $150. You still have the right to buy it at $100, even though it's now worth $150.
Put Option Definition and Analogy
A put option is the opposite. It gives the buyer the right to sell a specific quantity of the underlying stock at the strike price before the expiration date. If the stock price falls below the strike price before expiration, the put option holder can exercise their right to sell the stock at the higher strike price, potentially profiting from the price decline.
Back to our bike analogy.
This time, you choose to rent the option to sell the bike at a set price of $100, valid for a one-month period. During this time, the bike's market price fell to $80. You still have the right to sell the bike at $100, even though it's now only worth $80.
In both cases, you pay a fee upfront to rent this option. If you decide not to exercise your option before it expires, you lose the fee you paid, similar to forfeiting a rental deposit.
Call Options Explained with Examples
A call option contract gives the buyer the right to buy 100 shares of a stock at a specific strike price on/before the expiration date.
Buying Call Options: Example
For example: MSFT Jul 26 400 Call at $10
Here, MSFT represents the underlying stock, which is the ticker symbol for Microsoft. The option expires on 26 July, at a strike price of $400, and the premium that the buyer has to pay upfront is $10, for each contract. And since one contract is 100 shares, the total premium paid would be $1,000.
From the diagram, you can see that the losses of this call option would be limited to the premium paid, which is $1,000. The break-even upon expiration would be the strike price ($400) plus the premium ($10) you paid, i.e. when Microsoft is anywhere above $410 per share. As you can see, the right tail of the payout diagram is uncapped - which suggests that there is unlimited upside to this option position.
When going long on call options, traders are bullish. They want the stock price to go up so that they can profit from buying at the lower strike price.
Buying Call Options versus Buying Stocks
Buying a call option instead of the stock itself gives us the potential for higher returns with lower initial capital outlay. Call options allow investors to leverage their investment, meaning they can control a larger position in the underlying stock with a smaller upfront cost.
Additionally, call options limit potential losses to the premium paid, whereas buying the stock directly exposes the investor to the full downside risk of the stock price.
To illustrate this with a numerical breakdown:
Disadvantages of Buying Call Options
- Time Decay: Also known as theta decay. Call options lose value as time passes, especially as they get closer to their expiration date. This can eat away potential profits, especially if the price movement is gradual.
- Market Volatility: The price of options is affected by how much the market moves. If volatility decreases after you buy a call option, its value can drop even if the stock price stays the same.
- Higher Break-Even Point: Call options have a higher break-even point because you paid a premium upfront to buy them. This means the stock price needs to rise significantly above the strike price for you to make a profit after factoring in the premium.
Selling Call Options: Example
Till now, we’ve been discussing the perspective of a buyer of call options. On the flipside, you can choose to be a seller of call options instead.
Selling a call option means you take on the obligation to sell a specified quantity of the underlying stock at a pre-agreed price if the option buyer chooses to exercise their right to buy.
Using the same example: MSFT Jul 26 400 Call at $10
By 26 July, if MSFT goes below the strike price of $400, the contract will expire worthless and the call option seller will be able to keep the entire premium of $10. However, if MSFT goes above $400, the call option seller is obligated to sell their shares to the buyer at $400.
Payout Diagram of a Short Call Option
From the diagram, you can see that the profit of this call option would be limited to the premium received, which is $1,000. The break-even upon expiration would be the strike price ($400) plus the premium ($10) you paid, i.e. when Microsoft is anywhere below $410 per share. As you can see, the right tail of the payout diagram is uncapped - which suggests that there is unlimited downside to this option position.
When going short on call options, traders are bearish. They want the stock price to go down or sideways so that they can profit from keeping the premiums that they received initially.
How to Profit from Selling Call Options
Investors and traders may sell call options for any of these reasons:
- Generate income by collecting premiums upfront. Compared to buying call options, selling an option gives an immediate payout. This can be useful for generating cash when stock prices are not expected to rally.
- Profit from a neutral or bearish market outlook. In a flat or slightly down market, the stock is unlikely to be called away. As long as the stock price remains below the strike price, the option expires worthless, and the seller pockets the premium.
- Increase the returns from selling stocks. Investors may wish to sell their existing stock holdings but find the current price too cheap. By selling a call option, they can sell the stock if the price goes above the call’s strike, and earn the premium as a bonus on their sale.
Disadvantages of Selling Call Options
- Limited upside potential. As you can see from the payout diagram above, in the event that the stock price rallies, call option sellers will miss out on the potential gains in share price. Their profit is capped to the premium they’ve collected.
- Unlimited risk. Unlike buying call options, selling call options exposes you to potentially unlimited losses if the stock price rises greatly above the strike price.
- Assignment risk. There is always a possibility that the option buyer will exercise their right to buy the stock, forcing the seller to sell shares at the strike price. This can happen at any time before the option expiration date and may result in unwanted transactions or missed opportunities if the stock price moves unfavorably.
Put Options Explained with Examples
A put option is like insurance for your stocks, giving you the right to sell them at a pre-agreed price within a specified time frame. If the stock's price falls below that price, you can still sell it at the higher pre-fixed price, potentially limiting your losses.
Buying Put Options: Example
For example: AAPL Aug 30 170 Put at $4
In this example, AAPL represents the underlying stock, which is the ticker symbol for Apple Inc. The option expires on 30 August at a strike price of $170, and the premium that the buyer has to pay upfront is $4 for every contract. And since one contract is 100 shares, the total premium paid would be $400.
From the diagram, you can see that the losses of this put option would be limited to the premium paid, which is $400. The break-even upon expiration would be the strike price ($170) less the premium ($4) you paid, i.e. when Apple is anywhere below $166 per share.
When going long on put options, traders are bearish. They want the stock price to go down so that they can profit from selling at the higher strike price.
Buying Put Options versus Short-Selling Stocks
Buying a put option instead of shorting the stock itself offers the potential for higher returns with less initial capital outlay. Put options allow investors to leverage their investment, meaning they can control a larger position in the underlying stock with a smaller upfront cost. Furthermore, you will save the interest that you pay when you maintain a short position over a period of time.
Additionally, put options limit potential losses to the premium paid, whereas shorting the stock exposes the trader to unlimited downside risk as the stock price can go up infinitely.
To illustrate this with a numerical breakdown:
Selling Put Options: Example
We’ve discussed the perspective of a buyer of put options. On the other hand, you can choose to be a seller of put options instead.
Selling a put option means you take on the obligation to buy a specified quantity of the underlying stock at a pre-agreed price (the strike price) if the option buyer chooses to exercise their right to sell.
Using the same example: AAPL Aug 30 170 Put at $4
The profitable scenario for the seller of this put option is come
By 30 August, if AAPL is above the strike price of $170, the contract will expire worthless and the put option seller will be able to keep the entire premium of $4. But if AAPL falls below $170, the put option seller is obligated to buy the stock at $170.
Payout Diagram of a Short Put Option
From the diagram, you can see that the profit of this put option would be limited to the premium received, which is $400. The break-even upon expiration would be the strike price ($170) plus the premium ($4) you received, i.e. when Apple is anywhere above $174 per share.
When going short on put options, traders are bullish. They want the stock price to go up or sideways so that they can profit from keeping the premiums that they received initially.
How to Profit from Selling Put Options
Investors and traders may sell put options for any of these reasons:
- Generate income by collecting premiums upfront. This can be useful for generating extra cash in sideways or uptrending markets when stock prices are not expected to decline greatly.
- Profit from a neutral or bullish market outlook. As long as the stock price remains above the strike price, the option expires worthless, and the seller keeps the premium.
- Buy stocks at a discount. When investors don’t mind owning certain stocks but find the current price too expensive, they can choose to sell put options and collect premiums while waiting for the share price to fall.
Disadvantages of Selling Put Options
- Limited upside potential. As you can see from the payout diagram above, the put option seller’s gains are capped to the premium they received.
- Unlimited risk. Selling put options exposes you to potentially unlimited losses if the stock price falls significantly below the strike price.
- Assignment risk. There is always a possibility that the option buyer will exercise their right to sell the stock, forcing the seller to buy shares at the strike price. Therefore, it’d be wise for traders to only sell put options on fundamentally good stocks that they are comfortable to own. .
A Better Way to Trade Options: Buying and Selling a Call at the Same Time
Many beginner options traders like to buy call options due to the lure of unlimited upside. The plan sounds easy enough — the stock price moves quickly in your desired direction, you make money.
But for this approach to be profitable, not only do you have to get the direction right, it has to move significantly enough from your strike price, and it has to be done within a specific time period. If any of these three criteria are not met, you might sit on a losing trade.
See, when you purchase a single option (one leg), you expose your trade to expensive premiums, time decay and falling volatility. For a smarter way to counter these risks, you can use the BCS options strategy that deploys two option legs.
With this strategy, you’re able to reap the profit potential of purchasing a call, while at the same time mitigate the time decay element. Furthermore, this strategy ensures a much lower breakeven point compared to buying a call option outright, making the trade more cost-effective.
Resources for Further Learning
You're in luck! The BCS options strategy is one of the core strategies we cover in our Options Waverider™ Membership.
The first step is believing you can fully commit to trading firmly. And the next step will be to get a solid foundation of your knowledge. 
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