This is another ELI5 style explainer of how I trade options. I’ll go through covered calls and call credit spreads in this one. Let’s jump straight into the explanation.

Imagine I have a stock worth $100. It’s not going up or down, just sitting there and using up my $100. I could put this $100 somewhere else, and it’ll generate good returns. But you know what? Maybe I don’t want to sell this stock for tax reasons. I want to keep this dead stock and still make a living out of it. I happen to meet you at that moment and tell you about the stock. You have reasons to think it might go up, but you don’t want to use up your $100 in buying it. There’s a chance it will go up, but it’s not THAT big of an opportunity to justify using $100. You have better places to use that money right now but still want to take a chance on this stock. So I make you a deal. Give me $2 right now, and come back to me any time for the next 30 days. I’ll sell the stock to you for $120. I won’t care if the stock price is $500 in the market; I’ll give it to you for $120. Just $2 for taking this chance. Sounds like a fair deal?

You may or may not take the deal, but I can always find people to take these types of deals, people who buy call options. In this case, I’ll assume you took the deal. For you, it’s an excellent gamble. You get to use your $100 in better places but still take a chance on this stock for just $2.

What’s in it for me? Well, most of the time, the stock never ends up rising, the month goes by, and I keep the $2. I’ll cut a new deal with someone after that, the cycle repeats. I control variables like the deal price ($2), the strike price ($120) and the deal expiration(30 days). The odds are in my favour, and if they’re not, I don’t do the deal. The stock could sleep there at $100, and I’ll still keep making a $2 profit every month giving out promises to people. This deal is called a covered call.

How about optimizing this trade? In most cases, no one asks me for the stock; the price doesn’t shoot up that much. If people aren’t going to ask me for the stock most of the time, do I need to have it at all? Just keep earning $2 every month by giving out promises like these. I don’t need to own the stock to make this deal. What can go wrong?

Let’s stick with the same example where I promised to give the stock to you for $120, and I don’t even have it. I kept the $2, thinking you’ll never ask me for that stock. Maybe the price hits $250, and you choose to exercise your option. Since I don’t have the stock, I’ll have to buy it brand new for $250 from the open market and give it to you for $120. I’ll lose $130 in this process! All this for $2 every month?

In real life, I’ll buy another call option at $130 stock price for a $1 fee. So I’ll have a way to get the stock for $130 no matter what. When you come to me to get the stock, I’ll use my option to get it at $130 and give it to you for $120. Max loss = $10 (difference) - $2 (you gave me earlier) + $1 (had to use this for the $130 call option) = $9. I lose $9 in the worst case and gain $1 in the best case. You know how the calculation goes from the previous blog post. I only make this trade if there’s a positive expected outcome, probability-wise. There’s no woo-woo magic here; this is math and statistics. The deal I explained in this paragraph is called a call credit spread.