Option is a right to buy or sell a financial asset like stock at a specific price. For example when you buy stock option to buy stock ABC at $50, you can buy the stock at $50 even though it is $60. That means you can get $10 profit from that option. You can buy stock ABC at $50 using the option and sell it at current market price at $60. The right to buy stock at a specific price is called call option and the right to sell stock at a specific price is called put option. In this article I will show you how to make money with call option strategy.
Using option you can get high return in just a short time. I’ll show you a call option example making profit. Stock ABC is currently trading at $50. The call option is $5. You want to buy 1 call contract for 100 * $5 = $500. This position is also called long call options. If the stock goes to $55, your option will at least worth $10. So that is ($10-$5)/$5 = 100% profit. The stock it self only has 10% profit.
First you need to find companies which stock you want to buy. The best way for this is by using value investing. It is used by the third richest man on earth, Warren Buffet. The strategy is finding good healthy company which is undervalued. Healthy company means they have good profit margin and low debt. You can check if they have high debt from it’s debt to equity ratio. If the ratio is above 1, it means the company has high debt. Company with low debt has the ability to expand their business by borrowing more money.
Next step you need to check if it is undervalued or not by looking at its P/E ratio. The ratio compare stock price with its earning per share. Your goal is to look for companies with low P/E. You should remember that low P/E does not always mean it is undervalued. Low P/E also means it is a poor company and nobody is buying the stock, thus the P/E is low. So you must use P/E ratio with other ratios like profit margin and debt to equity ratio.
Once you know which company is good, then it’s time to buy the companies call option several months before expiration. If you think the stock will rise in four months then buy call option which has five months before expiration. This is because you need to sell your call option before the last month. When option only has 30 days to expire, it will lose its value very fast. So it is better to sell your option before you lose your money very fast.
Before you buy, you need to check if it recently has high volatility. High volatility means it will be more expensive than usual because it is riskier. You should sell your option when it has high volatility and not buying it. You can check this by looking at its Bollinger band. Wide Bollinger band means it has high volatility recently.
Now, you should know which call option to buy. Next, it’s time to learn when to close your position or sell your call option. There are 3 reasons why you want to do that:
- You want to take profit. When you have reached your profit target, it’s time to sell your call option. Before you buy your option, you should know how much profit you want to have. Once it reaches the target then it’s time to sell. I believe we should lock our profit with option, because you are racing with time. Don’t be greedy. Once you get your 100% target, don’t wait it to reach 200% profit. It could happen but you could also lose your profit. I also use technical analysis on the stock. So when the stock is overbought, I will sell it.
- You want to cut loss. I usually cut my loss when it reaches over 50%. You might think this too much, that’s why you should use your own cut loss level. Different people have different preference. I think 50% is quite normal because 10% loss in option could happen very fast.
- Bad news coming that affects the company’s future profit. When bad news coming that makes your price target unlikely to happen, it’s time to sell your option. With limited option life, you don’t have too much time to wait the company to improve its ability to make profit.
One thing you should remember is always sell your call option 30 days before expiration. I have previously talked about it above, but I want to say it again because it is important. During the last 30 days before it expire, option will lose it’s time value very fast each day.
Besides buying call options, we can also make money by writing call options. A good strategy for selling call option is covered call. You should have a stock in hand first then you can write call option to generate income. Call option trading is dangerous if you do not have stock to cover your option.