Direction, Magnitude, and Time
Many of the option strategies that we’ll discuss expect the underlying to move in a particular direction and actually need that move to occur in order to be profitable. From that point of view option traders might be no different than stock traders. Buyers of a stock expect the stock to move higher, in fact they require the stock to move higher if they’re going to make a profit (ignoring dividends). If the stock moves higher from their purchase price, then they’ve got a profit even if the profit is unrealized (meaning they haven’t sold their stock yet to lock in or “realize” that profit). Likewise, if traders sell a stock short, then they expect the stock to move lower and need it to do so if they’re going to make a profit.
For example, if XYZ is at $50 and we think it’s going to rally, we might buy 100 shares of the stock. If we buy the stock and XYZ moves to $60 we’ve made a $10 profit. It’s not quite that straightforward for traders using options. If we think XYZ is going to rally, we might buy a 60 call. Like stock traders, we need XYZ to appreciate in order to make money. If XYZ falls, then the stock traders will have lost money. For option traders, if XYZ falls and our option expires worthless, then we’ve lost money—we’ll have lost the amount we paid for our call option.
What if the price of XYZ doesn’t change? This is where the outcomes diverge for stock traders and option traders. Stock traders experience no loss, other than an ...