Options Trading Strategies

by Beth Gaston Moon | April 12, 2012 2:23 pm

OptionsTradingBasics logo Options Trading Strategies[1]Options Trading Strategies: Buying Call Options

Buying a call option —or making a “long call” trade— is a simple and straightforward strategy for taking advantage of an upside move or trend. It is also probably the most basic and most popular of all option strategies. Once you purchase a call option (also called “establishing a long position”), you can:

• Sell it.
• Exercise your right to buy the stock at the strike price on or before expiration.
• Let it expire.

HOW TO TRADE OPTIONS:
- What Are Options?[2]
- What Are Options Contracts?[3]
- Price of Options[4]
- How to Read Options Symbols[5]
- How to Price Options[6]
- How to Read Options Quotes[7]
- Understanding Options Risk[8]
- Common Mistakes to Avoid[9]
- Options Trading Strategies[10]
- Choosing an Options Broker[11]

A call option gives you the right, but not the obligation, to buy the stock (or “call” it away from its owner) at the option’s strike price for a set period of time (until your options will expire and are no longer valid).

Typically, the main reason for buying a call option is because you believe the underlying stock will appreciate before expiration to more than the strike price plus the premium you paid for the option. The goal is to be able to turn around and sell the call at a higher price than what you paid for it.

The maximum amount you can lose with a long call is the initial cost of the trade (the premium paid), plus commissions, but the upside potential is unlimited. However, because options are a wasting asset, time will work against you. So be sure to give yourself enough time to be right.

Options Trading Strategies: Buying Put Options

Investors occasionally want to capture profits on the down side, and buying put options is a great way to do so. This strategy allows you to capture profits from a down move the same way you capture money on calls from an up move. Many people also use this strategy for hedges on stocks they already own if they expect some short-term downside in the shares.

When you purchase a put option, it gives you the right (but, not the obligation) to sell (or “put” to someone else) a stock at the specified price for a set time period (when your options will expire and no longer be valid).

For many traders, buying puts on stocks they believe are headed lower can carry less risk than shorting the stock and can also provide greater liquidity and leverage. Many stocks that are expected to decline are heavily shorted. Because of this, it’s difficult to borrow the shares (especially on a short-them basis).

On the other hand, buying a put is generally easier and doesn’t require you to borrow anything. If the stock moves against you and heads higher, your loss is limited to the premium paid if you buy a put. If you’re short the stock, your loss is potentially unlimited as the stock rallies. Gains for a put option are theoretically unlimited down to the zero mark if the underlying stock loses ground.

Options Trading Strategies:  Covered Calls

Covered calls are often one of the first option strategies an investor will try when first getting started with options. Typically, investor will already own shares of the underlying stock and will sell an out-of-the-money call to collect premium. The investor collects a premium for selling the call and is protected (or “covered”) in case the option is called away because the shares are available to be delivered if needed, without an additional cash outlay.

One main reason investors employ this strategy is to generate additional income on the position with the hope that the option expires worthless (i.e., does not become in-the-money by expiration). In this scenario, the investor keeps both the credit collected and the shares of the underlying. Another reason is to “lock in” some existing gains

The maximum potential gain for a covered call is the difference between the purchased stock price and the call strike price plus any credit collected for selling the call. The best-case scenario for a covered call is for the stock to finish right at the sold call strike. The maximum loss, should the stock experience a plunge all the way to zero, is the purchase price of the strike minus the call premium collected. Of course, if an investor saw his stock spiraling toward zero, he would probably opt to close the position long before this time.

Options Trading Strategies:  Cash-Secured Puts

A cash-secured put strategy consists of a sold put option, typically one that is out-of-the-money (that is, the strike price is below the current stock price). The “cash-secured” part is a safety net for the investor and his broker, as enough cash is kept on hand to buy the shares in case of assignment.

Investors will often sell puts and secure them with cash when they have a moderately bullish outlook on a stock. Rather than buy the stock outright, they sell the put and collect a small premium while “waiting” for that stock to decline to a more palatable buy-in point.

If we exclude the possibility of acquiring the stock, the maximum profit is the premium collected for selling the put. The maximum loss is unlimited down to zero (which is why many brokers make you earmark cash for the purpose of buying the stock if it’s “put” to you). Breakeven for a short put strategy is the strike price of the sold put less the premium paid.

Options Trading Strategies:  Credit Spreads

Option spreads are another way relatively novice options traders can begin to explore this new family of derivatives. The most basic credit and debit spreads combine two puts or calls to yield a net credit (or debit) and create a strategy that offers both limited reward and limited risk. There are four types of basic spreads: credit spreads (bear call spreads and bull put spreads) and debit spreads (bull call spreads and bear put spreads). As their names imply, credit spreads are opened when the trader sells a spread and collects a credit; debit spreads are created when an investor buys a spread, paying a debit to do so.

In all of the types of spreads below, the options purchased/sold are on the same underlying security and in the same expiration month.

Bear Call Spreads

A bear call spread consists of one sold call and a further-from-the-money call that is purchased. Because the sold call is more expensive than the purchased, the trader collects an initial premium when the trade is executed and then hopes to keep some (if not all) of this credit when the options expire. A bear call spread may also be referred to as a short call spread or a vertical call credit spread.

The risk/reward profile of the strategy can vary depending on the “moneyness” of the options selected (whether they are already out-of-the-money when the trade is executed or in-the-money, requiring a sharper downside move in the underlying). Out-of-the-money options will naturally be cheaper, and therefore the initial credit collected will be smaller. Traders accept this smaller premium in exchange for lower risk, as out-of-the-money options are more likely to expire worthless.

Maximum loss, should the underlying stock be trading above the long call strike, is the difference in strike prices less the premium paid. For example, if a trader sells a $32.50 call and buys a $35 call, collecting a credit of 90 cents, the maximum loss on a move above $35 is $1.60. The maximum potential profit is limited to the credit collected if the stock is trading below the short call strike at expiration. Breakeven is the strike of the purchased put plus the net credit collected (in the above example, $35.90).

Bull Put Spreads

These are a moderately bullish to neutral strategy for which the seller collects premium, a credit, when opening the trade. Typically speaking, and depending on whether the spread traded is in-, at-, or out-of-the-money, a bull put spread seller wants the stock to hold its current level (or advance modestly). Because a credit is collected at the time of the trade’s inception, the ideal scenario is for both puts to expire worthless. For this to happen, the stock must be trading above the higher strike price at expiration.

Unlike a more aggressive bullish play (such as a long call), gains are limited to the credit collected. But risk is also capped at a set amount, no matter what happens to the underlying stock. Maximum loss is just the difference in strike prices less the initial credit. Breakeven is the higher strike price less this credit.

While traders are not going to collect 300% returns through credit spreads, they can be one way for traders to steadily collect modest credits. This is especially true when volatility levels are high and options can be sold for a reasonable premium.

Options Trading Strategies: Debit Spreads

Bull Call Spreads

The bull call spread is a moderately bullish strategy for investors projecting modest upside (or at least no downside) in the underlying stock, ETF or index. The two-legged vertical spread combines the same number of long (purchased) closer-to-the-money calls and short (sold) farther-from-the-money calls. The investor pays a debit to open this type of spread.

The strategy is more conservative than a straight long call purchase, as the sold higher-strike call helps offset both the cost and the risk of the purchased lower-strike call.

A bull call spread’s maximum risk is simply the debit paid at the time of the trade (plus commissions). The maximum loss is endured if the shares are trading below the long call strike, at which point, both options expire worthless. Maximum potential profit for a bull call spread is the difference between strike prices less the debit paid. Breakeven is the long strike plus the debit paid. Above this level, the spread begins to earn money.

Bear Put Spreads

Investors employ this options strategy by buying one put and simultaneously selling another lower-strike put, paying a debit for the transaction. An investor might use this strategy if he expects moderate downside in the underlying stock but wants to offset the cost of a long put.

Maximum loss — suffered if the underlying stock is trading above the long put strike at expiration — is limited to the debit paid. The maximum potential profit is capped at the difference between the sold and purchased strike prices less this premium (and is achieved if the underlying is trading south of the short put). Breakeven is the strike of the purchased put minus the net debit paid.

Okay, now you’ve learned the basics and may be itching to try your hand at virtual options trading. It’s time to select a broker if you don’t already have one.

Endnotes:
  1. [Image]: http://investorplace.com/how-to-trade-options-options-trading-basics/
  2. What Are Options?: http://investorplace.com/2012/04/what-are-options/
  3. What Are Options Contracts?: http://investorplace.com/2012/04/what-are-options-contracts/
  4. Price of Options: http://investorplace.com/2012/04/price-of-options/
  5. How to Read Options Symbols: http://investorplace.com/2012/04/how-to-read-options-symbols/
  6. How to Price Options: http://investorplace.com/2012/04/how-to-price-options/
  7. How to Read Options Quotes: http://investorplace.com/2012/04/how-to-read-options-quotes/
  8. Understanding Options Risk: http://investorplace.com/2012/04/understanding-options-risk/
  9. Common Mistakes to Avoid: http://investorplace.com/2012/04/common-mistakes-to-avoid-when-trading-options/
  10. Options Trading Strategies: http://investorplace.com/2012/04/options-trading-strategies/
  11. Choosing an Options Broker: http://investorplace.com/2012/04/choosing-an-options-broker/

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