Options and options on futures are called derivatives. These are contracts to buy or sell specific commodities (in the case of futures) or stocks (in the case of options) at a predetermined price on or before a predetermined date. Derivatives give the holder the right, but not the obligation, to buy (or sell) the underlying stock or commodity at a preset "strike price" on or before a preset "expiration date". Stocks are traded on stock market exchanges, and derivatives are similarly traded on derivative exchanges.
Nibble Like A Mouse
If a mouse grabs a piece of cheese on a mouse trap, it'll set off the trap. However, if it just nibbles little pieces at a time, it might get some food and get away safely. Similarly, many traders, especially beginners, try to make a killing in the market, but finding that one big deal that makes a fortune is almost impossible. A better way is to nibble like a mouse. Make a little bit of money at a time, but do it consistently. This will reduce your risk, and over time, profits will accumulate. Use the strategy of "writing covered call options" will generate small profits consistently every month or two. The technique involves purchasing shares of stock (in increments of 100 shares) of companies whose stock price you believe will not increase greatly in the near future. You write (sell) a call option giving someone the right, but not the obligation, to purchase the stock from you at a preset price on or before a preset expiration date. You set the price higher than the price you paid for the stock. Your bet is that the stock will either remain about the same or not rise significantly above the strike price before the expiration date. You receive money (a premium) for selling this right, and you get to keep that premium no matter what happens, which could typically be about $75 to $150. At expiration, if the stock price has not gone above the strike price, the option most likely will expire worthless, and you get to keep your stock. Repeat the process, and again make premium money, over and over, a little money each month.
A Bull Call Spread
When a trader is very bullish on a stock in the near term, he might buy a call option. There is no limit to how much money could be made by buying a call. But, if the trader is only mildly bullish on a stock, he has a better chance of making a profit by employing a "bull call spread". Using this spread technique, a call option is purchased with a lower strike price than the current stock price. At the same time, a call option is sold (written) with a higher strike price. A premium is received for selling the call, and this money will pay for some of the cost of buying the call, acting as a "hedge," lowering risk. This strategy is also hedged by the fact that the purchased call with a lower strike price protects the trader in the event the stock price goes up above the strike price of his written call option, in which case he would have to sell shares of stock at that higher price. A profit typically will be made once the underlying stock price rises higher than the strike price of the higher written call, as both options will expire "in the money". A broker can execute a bull call spread (both the buying of a call and selling a call) as a single unit.
Profit Regardless Of Market Direction
Suppose a stock (and possibly the market as a whole) is in a volatile period. You are watching a stock that you believe is subject to volatility, and expect it's price will move in the near future, but you don't want to bet on which direction that price will go. You can utilize a strategy that will be "market neutral" and has the potential to make a profit whether the stock price goes up or down. This strategy requires buying both a call and a put option. Suppose the XYZ company is trading around $25. The closest available strike price is $25. Buy a call with a $25 strike price and simultaneously buy a put with the same strike price. Both options should have the same expiration date. A profit will be made once the stock price rises or falls enough to pay for the purchase of the two options.
