Here's How Much Money You'll Make

The world of options has dozens of strategies to complement your stock investment positions. So which strategy is best for you? That's a subject far broader than this simple article can tackle in its entirety, but we can start with some basics.

By now, you'll be familiar with the two basic option types (calls and puts). You should also recall that there are always two sides to a transaction -- the buyer and seller -- each of whom will be seeking to do specific things with their positions. Now, let's try to tie these concepts together and lay out the profit and losses from four basic option strategies.

Strategy 1: The long (buy) call
Imagine that you think Yum! Brands' (NYSE:YUM) recession-friendly food offerings will remain all the rage, and you consider its $34 stock price a tasty treat. But you're looking to leverage your expected upside via call options.

You can pick up a call option for $4.30, giving you the right to buy the purveyor of KFC, Pizza Hut, and Taco Bell for $35 until the third week of January 2012. That means you'd pay $430 (remember that options are sold in contracts for 100 shares) for that right. How much do you stand to gain -- or lose?

The loss part is easy. No matter how far Yum! falls between today and expiry, our risk of loss on the calls is capped at the $430 per contract we're investing. If the market gets crushed, there's blood in the streets, dogs and cats are marrying each other, and Yum! heads for $20 -- no problem. A bad situation, perhaps, for those who simply buy the shares outright and would prospectively sit on a near-$1,500 loss (per hundred shares), but less bitter for a call buyer.

On the other hand, there's (theoretically) no limit to how high Yum! can rise before expiry. And any rise in the stock price will be paralleled with a rise in the price of the call:

Note that, though the call strikes at $35, the option buyer doesn't actually make a profit until the stock goes above $39.30 (the cost of the option plus the strike price). Also note that if the option expires when the stock price is between the break-even price and the strike price, the option buyer is still better off exercising, since some of the loss taken on the initial call buy can be recouped.

Strategy 2: The long (buy) put
We can similarly show a risk profile for any option position. Perhaps we're bearish on Wells Fargo's (NYSE:WFC) prospects at $26.40, and seek to profit by buying a put option.

The January 2011 $25 strike puts currently tip the scales at $4.45. So if "Buffett's favorite bank" continues to shrug off the financial malaise and heads (and stays) north of $25 by expiration, our maximum loss per contract is $445. Our maximum profit would occur if Wells went bankrupt before our option expiry (don't hold your breath) and the stock went to zero.

Strategy 3: The short (sell) call
What about the other side of the trade? Somebody is always selling the options that the counterparties are buying. The profit payouts of the option writers are the mirror opposites of those of the option buyers. So while a call buyer has a capped downside risk and unlimited upside, the call writer has a capped profit potential and an unlimited downside risk (hmm ... that doesn't sound like much fun).

Consider the damage you could have inflicted on yourself if you'd decided that rapid riser SXC Health Solutions (NASDAQ:SXCI) was overvalued earlier this year at $25 and sold calls against it (it's over $50 now), or if you'd sold calls earlier this year, when it looked like General Electric's (NYSE:GE) finance division might do it in (big, stodgy GE has nearly tripled since).

It's arguably for that reason that selling calls as a stand-alone trade is termed "being naked" -- as in, that's how you feel if the stock doesn't cooperate and keeps going up. Still, if you felt that Bank of Nova Scotia (NYSE:BNS), flirting with its 52-week high, had suitably weathered the financial storm and was unlikely to continue its meteoric recovery, you could sell a March $50 call for $1.25 and hope for the best.

Those who go short calls are generally down on the stock's prospects, at least until expiration. In isolation, those who go naked short calls are playing with fire with that potential unlimited downside.

Strategy 4: The short (sell) put
Finally, the short put mirrors the profit and loss profile of the long put. It's generally employed by those who are at least tepidly bullish on the underlying stock -- they hope the stock price either stays above the strike, so they can bank the cash received from selling the put after it expires, or they're looking to become owners of the stock at an effective price of the strike less the option-writing premium received.

The maximum potential profit is equal to the money received up front, while the maximum loss occurs if the stock goes to zero. The March $60 puts, currently fetching $6.10, might be attractive for someone who believes that Research In Motion (NASDAQ:RIMM) is approximately fairly valued, and wishes to sell those shares either to generate extra income, or with an eye toward gaining a cheaper price on buying shares.

The Foolish bottom line
Options can be a valuable tool to help you make money in up, down, and flat markets. But as with any tool, it's important to make sure you understand them so you can use them effectively. If you're interested in learning how to use options appropriately in your own portfolio, check out what's going on at Motley Fool Options -- just enter your email in the box below for more information.