It’s one thing to invest in stocks, it’s another to trade them.  Trading implies a shorter time frame.  Investing means looking for price appreciation.  Dividends play an important part to many investors.  Most traders have never received a dividend, nor do they miss them.

Investors are willing to tie up most of their money.  Their gains are the product of appreciation and time.  They look for better than average returns to maximize their investments.  As well as selecting plays, traders manage money.  They tie up as small an amount as possible.  Their gains are the product of repeatability and speed.

An option’s limited time frame match better to the trader mentality.  Most option traders have a much smaller time horizon than the long term buy and hold investors.  Trading options adds leverage to the mix.  Options fit perfectly to the trader time and money management mentality.

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To trade successfully, option buyers need to be right and right on time.  Buying options resembles betting on direction.  Buy Calls on bullish expectations.  Buy Puts on bearish expectations.

Options cost money, their premium pays for the potential stock price movement.  Potentially up for Calls, potentially down for Puts.  You need big fast price moves to make any money trading options.  If a stock doesn’t move far or fast enough, you will lose money.

If you buy the right option, the stock may only need to move a little before being profitable.  Buy the wrong option, the stock will need to move farther and/or faster to make a profit.  Playing the right stock may heal any wounds caused by picking the wrong option.

Option buyers have rights which if the option is as little as 1 penny in the money get exercised automatically.  The seller, also known as writer, has an obligation.  Call options give the right to buy stock and the obligation to sell.  Put options give the right to sell stock and the obligation to buy.

If we buy Calls on bullish expectations, why not sell them on bearish expectations?  If we buy Puts on bearish expectations, why not sell them when bullish?  Remember, until the option is closed, there can be no profit.

If we sell a Call option we are obligating ourselves to deliver stock at the strike price anytime until the option expires.  For that obligation we collect a premium.  If we already own the stock, it’s known as a Covered Call.  Our obligation to deliver is covered, guaranteed by the fact we already own the stock.  Our broker should put a lien against our stock.  They won’t let us sell it to anyone else.  In the end, they are responsible.  When you think about it, they are covered.

The profit in Covered Calls potentially comes two ways, from the premium collected and from any appreciation in the stock’s price.  Like long term investors, Covered Call writer’s gains come from appreciation and time.  Only, not from the multiplication of time on a return, but from the decay of time’s value on options.

Selling an uncovered, or naked, Call is the riskiest of all option strategies.  The seller, or writer, of uncovered calls is obligated to sell stock they don’t own.  If the price skyrockets, their losses take off.

Selling Put options obligates the writer to buy the stock at a set price for a specific period of time.  Think of a Put option as an insurance policy.  The buyer of the policy pays the insurance company a premium, for that premium they can insure against loss.  Unlike naked Calls, which have unlimited risk, uncovered Puts maximum risk is if the stock becomes bankrupt.

Put selling profits comes from two sources.  Time’s passage deflates the value of options.  Time passing is truly the only guarantee in life.  When you buy them, they decay on you.  When you sell them, they decay on you.  The other profit doesn’t come from appreciation, but the lack of depreciation.  If buying Puts is a bet the stock will go down, selling Puts is not a bet it will go up but a bet it won’t go down.

Selling Covered Calls and selling Naked Puts have the same risk curve, but not the same reward curve.  Our example will be a $20 stock, one position will be buying the stock and selling the $20 Covered Call.  The other position will be selling the $20 Naked Put.

Buying the stock for $20 and selling the $20 Covered Call gives no room for appreciation, the only profit comes from the premium collected.  The only Profit from selling a $20 Put would be the premium.

In either case, if the stock were to go above $20, you would not own the stock.  The Call buyer would call you out on the Covered Call.  The Put buyer would have their option expire worthless.  If the stock closed below $20 before option expiration, either position would end up owning stock.  The Call Buyer wouldn’t exercise.  The Put buyer would force the Put seller to buy the stock.

A great strategy combining both would be to initially sell a Put Option – I prefer selling a Weekly Put Option.  If the Put Option expires worthless then you get to keep the premium and repeat for the next week.  If the Put gets exercised you end up with the stock and then the next step is to sell a Call – resulting in a Covered Call.  Let me know what you think!

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