option

When Should You Buy an Option to Make a Profit

Options are powerful tools for generating income, hedging risk, and speculating on future market behavior. However, no matter your strategy or financial objectives, options come in only two types: buy (call) and sell (put). Let’s take a look at a few instances when buy options may provide potentially lucrative trading opportunities.

Options 101: The Buy-Sell Dichotomy

An option contract gives the holder a right, but not a duty, to buy or sell a quantity of an asset at a specified price by a forthcoming date in time. In reality, sell and buy options serve very different purposes. Here’s a quick breakdown of essential functionality.

Buy

When you buy an option, you pay a premium for the right to buy or sell an asset quantity at the contract’s strike price by an expiration date. Buying a call gives you the right to purchase an asset at the contract’s strike price; buying a put provides the right to sell at strike. Accordingly, profits grow as price rises above call strikes and when price falls beneath put strikes.

Sell

When you sell an option, you immediately receive a premium in return for pledging to buy or sell at contract expiration. Gains are realized from call or put contracts that expire out of the money.

If selling options can generate instant revenue, then when are buy options a good idea? Here are a few times when purchasing puts or calls can be profitable.

Bullish Bias

As in conventional stock trading, purchasing call options can be an ideal way of buying low and selling high. Given a bullish bias, buying calls is one way of getting in on uptrends or implementing buy-and-hold investment strategies.

For instance, assume that Erin the options trader believes that the S&P 500 is undervalued at $3,250.00 on New Year’s Eve 2020. On Jan. 4, 2021, Erin buys one contract of December 2021 E-mini S&P 500 calls with a strike price of $3,500.00. If the December 2021 E-mini S&Ps trend north of $3,500.00 by expiration, Erin will profit from the call option.

Bearish Bias

Having a bearish bias toward the market reflects the belief that prices are going to fall over a given period. To profit from the decline in value, a trader can buy put options to benefit from a lagging market or asset class.

Assume that Erin decides that the outcome of the 2020 U.S. presidential election is likely to weigh on U.S. equities for the coming year. Accordingly, Erin believes the S&P 500 is overvalued at $3,250.00 on New Year’s Eve 2020. To get in on the action, Erin buys December 2021 E-mini S&P 500 puts with a strike price of $3,000.00 on Jan. 4, 2021. If the December 2021 E-mini S&Ps fall beneath $3,000.00, Erin will profit from the market downturn.

Expiration and Time Decay

For a majority of traders, profits realized from buy options are related to the avoidance expiration and time decay. It’s important to remember that options contracts have a finite shelf life. They can—and often do—expire worthless.

Each option contract is assigned an expiration date, on which it ceases to be traded. If the contract is out of the money on this day, then the contract expires worthless. So it stands to reason that as a contract approaches expiry, its value decreases. This phenomenon is known as time decay.

With time decay in mind, engaging buy options for profit is best done well ahead of expiry. Although the premiums are typically more expensive, the probability of success is significantly higher the further out from contract expiration. No matter whether your market view is bullish or bearish, having enough time to capitalize on a correct opinion is critical if you want to make money trading options.

Credit: Daniels Trading

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