For those who are not familiar how actually options work, it may be a little bit confusing in the beginning. Options actually share a lot of same characteristics like insurance policies, which most people should be able to understand. We will get a clearer picture of how literally options work by checking through the features that options and insurance policies have.  

For an insurance policy, the policy is actually a contract between the purchaser and the underwriter of the insurance policy. Underwriter of the insurance policy is the company, whose sells the policy. Whereas; option is a contract between the option buyer and seller when there is an initial transaction taking place. Stated in the contract, option buyer has the right to buy an amount of stock from the seller at an agree price within a specific period of time; whereas, seller has to obligate to sell an amount of stock to the buyer at an agree price within a specific period of time.  This agreed price is called strike price.  

For insurance policy, purchaser pays a premium to the insurance underwriter. The probability payout is influenced by a number of factors, which the premium is dependent. Premium will be charged higher if the risk payout is higher. Whereas for option; purchaser of the option contract pays premium to the writer of the option. A number of factors, which will affect the overall likelihood of a particular stock price being reached, will also affect the amount that needed to be paid as a premium. When the premium for the option is higher, the likelihood of a stock price can reached also higher. 

In term of time period, the validity of the insurance policy is within a specific length of time. The passing of time works in favour to the insurance underwriter but against to the purchaser of the insurance policy. For option, it works exactly same as the insurance policy, that is option contract is valid within a specific length of time. When the time passes, it does not favour to the option buyer but favour to option writer.  

Upfront is the risk for the purchaser of the insurance contract. The policy is paid by the premium. The insurance underwriter risk is open-ended depending on the terms that are insured. In options trading, the options buyer risk is also known as upfront. The option is paid by the premium. Here are the differences between insurance policy and the option. The option buyer can gain more than premium that he or she has paid for the option but not less than the premium. On the other hand, option writer has open-ended risk potential, which may cause unlimited loss.  

In term of payout, if there is any event that has been stated in the insurance policy has occurred, the payout from the insurance company will be a lot more than the original premium paid. If the market direction favours the option buyer, then he or she has unlimited profit potential. The option buyer may make a lot of money, which is many times more than the premium that he or she has been paid. 

My pal was a normally a mild-mannered sort – very reflective, always weighing the consequences rationally before acting. In short, a logical thinker.

Imagine my dismay when that one phrase, “trading options”, triggered this unprecedented tirade. You’d think I’d insulted his family or something even worse.

After a few seconds had passed, I realized the reason for my friend’s outburst. He, like so many other investors, had only lost money trading options.

Why? Because he’d never discovered the number one option trading secret: 3 out of 4 options expire worthless. You read that correctly, when you trade options as a buyer, you have a 25% chance of making money, and a 75% chance of losing money.

This is why professional traders and investors favor the option strategy of selling options, rather than buying them, in hopes that the trade will go their way.

“Wait a minute. How can all of those options just expire worthless? I’ve seen ads for 100’s of option strategies and trading systems on the internet. They can’t all be losing money.”

I had to smirk. Now I really had him thinking. He knew that I hadn’t yet told him the big “secret behind the secret”, but he couldn’t quite put his finger on it.

“I have one word for you, my doubting friend”, I said,…”Time”. “When you become an option seller, you have time working FOR you, instead of against you. The reason is simple – as puts and calls get closer and closer to their expiration date, they lose their time value, due to “time decay”, or theta, the Greek letter that option traders use to denote the % of change in time value of an option.”

This is true of any option, no matter if you’re buying or selling call options or put options, or using a covered call strategy. It’s one of the big secrets of options investing that doesn’t get written about too often.

Because of the power of time decay, you can actually guess wrong about the direction of the market, or a stock, and you’ll still make money selling a call option or put option, as opposed to the buyers on the other side of the trade, who not only have to guess the stock’s future price movement correctly, but must do it BEFORE the option expiration date.

This helps to explain why even conservative investors use the covered call strategy, which is widely considered one of the most conservative option trading strategies around.

To sell covered calls, you must own at least 100 shares of the underlying equity, since each call contract corresponds to 100 shares of the underlying stock.

This is a tool you can use to hedge your portfolio, and lower your risk, by receiving “call premium” money, which lowers your break-even cost basis.

Selling covered calls is a short-to-mid-term option strategy you can use to double and triple your yields on new stock purchases, and/or to earn more income from your existing portfolio.