Options trading has become increasingly popular with investors for two primary reasons. First, traders can make large profits in the options market without needing significant capital to start. Second, through options, traders can access large amounts of stock for a period of time without needing tens of thousands of dollars or more to purchase a corresponding amount of shares. Both traits allow for the potential of large gains.
Puts and Calls
An essential element to making big profits with options is starting with the basic concept of knowing the difference between put and call options. Puts are the options a trader buys when he is bearish on a stock. As the stock falls, the puts increase in value. Calls are the options contracts a trader buys when he thinks the stock is going higher. If that assessment is correct, the calls increase in value as the underlying stock price rises.
While it is not a guarantee of profits, trading stock options for potentially big gains around the time of major news pertaining to the underlying stock is a frequently used and easy tactic for even beginning investors to employ. Obviously, unscheduled events do happen, but investors can use sources such as Yahoo Finance and company investor relations websites to find out when the next earnings report is. Options traders frequently trade around earnings announcements. Another tactic to consider is trading options leading up to drug approval announcements by the FDA. The FDA has a calendar that traders can use to be prepared for the news.
Find Buyout Candidates
Another way some traders make significant options profits is to buy call options on takeover targets. However, there are some moving parts with this strategy that make it challenging. First, options are time-limited, meaning American options expire on the third Friday of every month. Second, this strategy is also risky because rumors often fuel takeover chatter. If the rumor does not turn into a legitimate takeover announcement, traders can lose money on options that were purchased in anticipation of a deal happening.
The biggest problem options buyers face is being correct about the direction the underlying stock will move in during the time frame of the purchased options. One way some traders deal with that situation is to execute a trade known as a straddle, which entails buying both a put and call at the same strike price with the same expiration. For example, if a trader thinks XYZ Corp. is poised to make a large, near-term move and stock is currently trading at $50, he could buy the $50 calls and puts to put on a straddle. If that big move happens, either the puts or the calls will lose value, but the profitable part of the trade can more than cover the losing side.
Todd Shriber is a financial writer who started covering financial markets in 2000. He worked for three years with Bloomberg News and specializes in analysis of stocks, sectors and exchange-traded funds. Shriber has a Bachelor of Science in broadcast journalism from Texas Christian University.