Here's How Much Money You'll Make

The world of options has dozens of strategies to compliment 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 ($2 Meal Deals!?) will remain all the rage, and you consider its $50 stock price a tasty treat. But you're looking to leverage your expected upside via call options. You can pick up a call option giving you the right to buy the taco/fried chicken/pizza purveyor for $50 until the third week of January 2013 for $7.40, meaning you'd pay $740 (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 the company falls between today and expiry, our risk of loss on the calls is capped at the $740 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! drops to $30 -- no problem. A bad situation, perhaps, for those who simply buy shares outright and would prospectively sit on a $2,000 loss (per hundred shares), but less bitter for a call buyer. On the other hand, there's (theoretically) no limit to how high Yum!'s shares 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 $50, the option buyer doesn't actually make a profit until the stock goes above $57.40 (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
One of Yum!'s smaller, less nimble competitors, Jack in the Box (Nasdaq: JACK) just turned in the latest in a string of weak quarters. And while the headline results were bad, some of the behind-the-scenes numbers were worse. Cash flow from operations fell nearly 60% year-over-year, margins that should be increasing as the company moves to franchise an ever-greater portion of their stores are moving in precisely the opposite direction, and their pension plans remain woefully underfunded while sucking back gobs of cash. Even after the recent fall, I'm bearish on Jack without major changes at the restaurateur. An investor seeking to profit from this view could consider buying a put option. The June 2011 $20 puts currently tip the scales at $2.00. So if Jack manages to stay above $20 by expiration (or perhaps finds a private equity saviour as did competitors Burger King and CKE Restaurants), our maximum loss per contract is $200. Our maximum profit would occur if the company went bankrupt before option expiration.

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 Green Mountain Coffee Roasters (Nasdaq: GMCR) was doomed to plunge from $30 following September's revelation that the SEC was investigating its accounting and had sold calls against it. Revelation that the inquiry is nearly done, and with little material impact, bumped the shares up some 20%, which would have seriously cratered the profits from your written calls.

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 goes up instead. 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 2011 $55 call for $1.70 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 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 upfront, while the maximum loss occurs if the stock goes to zero. The March $35 puts, currently fetching $1.95, might be attractive for someone who believes that UnitedHealthGroup (NYSE: UNH) is approximately fairly valued given the expectations for lower profits in the next fiscal year due to the impacts of health-care reform, and wishes to sell them to either 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 more, just enter your email in the box below to get a free report from Motley Fool Options and find out more about our strategies.