I’ve been learning and trading options for a couple of years now. It was virtual back when I didn’t have the money to do it. Now, I have some savings enough to make small trades. In this post, I explain the essence of how I make all my options trades. If you understand options, here’s the one-line answer: I do credit spreads. If you’re not familiar, there’s a more intuitive explanation in this post.

Imagine you have a stock worth $100 and are worried about the market crashing. I come in with an offer to protect your stock. For a $2 fee, I promise to buy your stock for $90 whenever you want to sell it, regardless of the market price. This “insurance” stays valid for a month. If the market crashes or the stock price dips below 90, you can choose to claim your insurance and sell that stock to me for $90. It’s is a fair exchange; I get $2, and you get the security that your stock is safe for a month from market crashes. You’ll lose $10 at most if something terrible happens.

A month has passed, and the stock has been performing well, staying above $100. The deal has now expired, I keep the $2 fee you gave me, and you’ll need to buy a new contract from me. That is how I make money; it’s like insurance but for stocks. I take a fee from people to buy their stocks in case something goes wrong. Here are some reasons why my $2 price can increase:

  • The stock is riskier than others; maybe they have an earnings announcement next week. Perhaps it’s a company known to dip down, so I charge more money to account for the risk.
  • You need insurance for longer than 30 days. Longer duration = more price.
  • The entire stock market is crazy and volatile. Every stock is more likely to dip, which means I charge higher to provide insurance.

Most of the time, nothing happens to the stock, and I pocket the commission. It’s similar to how insurance companies make money. In reality, I don’t go to individual people asking them to buy this insurance; there are formal contracts for this called “options.” This whole deal is called a put credit spread.

You might say, what if the market crashes and I have to pay up that $90? To tackle that, I need to use that $2 fee you gave me. I’ll use $1 to get another insurance for myself at $80. So in the worse case, I have to buy your stock for $90 but still recover $80 from my other insurance. I only lose $10 when the market crashes. Here are two scenarios:

  • Case 1 - Everything stays fine - This is what happens most of the time; I keep my $1 profit.
  • Case 2 - Market goes down - You want to claim your insurance in this scenario, I’ll lose $9 in the process. +$2 (your money) - $1 for buying backup insurance - $10 loss

Let’s assume these are the probabilities of Case 1 and 2 happening:

  • Case 1 - 95% chance of getting $1
  • Case 2 - 5% chance of losing $9

Expected outcome = (0.95 x $1) + (0.05 x (-$9)) = +$0.50

As you can see, I’m more likely to have a profit compared to a loss, based on the calculation. In real life, I have access to all four variables, which helps me structure my trade. I don’t need to know IF your stock will dip below $90; I only need to know the likelihood of that event. I earn money as long as the stock stays above $90. I can do another type of trade to make money if the stock remains below $120. I’m not going to describe that in much detail. I can combine those two kinds of trades and have a trade where I earn money as long as the stock stays between $90 and $120 for a month. I don’t care about the exact price it has, which means I don’t need to stare at the charts so hard. I do this at scale, and it’s a lot more complex than it looks here. I hope this gives you a better idea of how I structure my trades. As I said, this is not a magic lottery or some hidden secret; it’s cold hard statistics as you dig deeper. Options are the fastest way to lose money; read ten books on the topic before trying them.