Options trading strategies range from basic to complex. The many creative and even snarky names for them (like one-legged, multi-legged, long strangle, and iron condor spread) are reminiscent of the moves Daniel Laruso undertakes in the Karate Kid.
But from the simple to the complicated these options trading strategies all have underlying basic concepts in common and are made up of simple calls and puts.
In this article, we’ll review a few basics about options, discuss how to trade options, and examine three basic strategies.
What Are Options?
Let’s begin at the beginning and establish, or revisit as the case may be, some basic facts.
Options are essentially derivative contracts. Derivative is a word that scares off many investors. But think of a derivative this way: It simply derives its value from another asset. So your options contract is tied to another asset and will increase or decrease in value based on that underlying asset. In the case of stock options, the underlying asset is a stock.
The buyers of these contracts pay the seller a premium to be able to buy or sell an underlying security at a predetermined price before a predetermined expiry date.
If the stock market doesn’t cooperate with the buyer’s expectations for the underlying security, the buyer will allow the option to expire worthless.
2 Types of Options: Calls and Puts
Depending on whether the options contract purchaser is securing the right to buy or sell the underlying security, that purchaser will be buying one of two types of options: a call option or a put option.
When purchasing a call option, the investor buys the right to purchase an underlying asset in the future at a predetermined price. This preset price is called the strike price, or the exercise price.
A put option, on the other hand, gives the buyer the right to sell an underlying asset in the future at a predetermined strike price.
Options Trading Strategies
Once investors understand the basics of call and put options, the natural progression is to begin designing options trading strategies that can vary from simply buying or selling a single option to constructing complex trades that have multiple moving parts.
Using this basic understanding, investors can work toward maximizing the return on their investment from a particular stock’s movement. Today’s investors are becoming very attracted to options trading because they’ve realized they will only spend a fraction of the price of the underlying security, so there is significant gain potential.
To get started, be sure to understand:
- The various strategies that are available
- Which strategy works best for a particular situation
- The pertinent risks and rewards
The three basic strategies below use one option in the trade. These are your “one-legged” strategies.
Although one-legged trading strategies are on the simpler side of the spectrum, be aware that in no way does that imply they are risk-free.
The Long Call
With a long call strategy, you buy a call option and “go long.” With this strategy, you’re betting that the underlying shares of stock will increase in value by the expiration date of the option.
Best for: Bullish traders who are confident about a stock, index fund, or ETF but would like to limit their risk exposure and avoid purchasing the actual security itself.
For example, let’s say XYZ stock is trading at $100 per share. You find a call option with a strike price of $100 with a premium of $10, and the expiration is in six months. Options contracts typically come in 100 share bundles, so your cash outlay here is the $10 premium times 100 shares, which is $1,000.
Risk/Reward: Your loss is capped at $1,000 because the worst-case scenario is that the stock price never appreciates over $100. But whether the stock ends up at $99 or tanks to $50, your loss can’t be more than the premium of $1,000.
Your upside, however, has no limit. As you watch the stock price for the next six months, you can determine when to exercise the option to buy. The payoff profile on this long call example is as follows:
|Stock Price||Gross Profit||Less Premium||Net Profit/Loss|
As you can see from the table above, to recover your premium and turn a profit, that underlying stock will need to appreciate by more than $10 in the next six months.
The Long Put
With a long put strategy, you’re betting that a stock’s price will decline below the strike price by the expiration date. And your bet in this case is the premium.
Best For: Bearish investors predicting that the underlying company is facing potential trouble within the near future but don’t want to get involved with short selling stock.
Short selling stock means the investor “borrows” stock, betting that the market price will decrease. The investor then sells these borrowed shares to buyers at market price, hoping that the price will dip before these borrowed shares must be returned. The investor can then buy them back at the lower price. However, short selling involves unlimited risk since a stock’s price can rise indefinitely and the investor is obligated to repurchase and return those shares.
Let’s walk through an example of a long put. XYZ stock is trading at $100 per share. You purchase a put on 100 shares of XYZ for $10 per share at a strike price of $100 per share, with an expiration of six months. Your cash outlay is the premium of $1,000 (100 shares times $10 premium per share).
Risk/Reward: The put enables you to sell XYZ at $100 when the price dips. So even if the price never falls, or even if the price increases, you simply let the option expire. Your downside risk is capped since you are essentially only risking the premium of $1,000. The reward, on the other hand, is determined by how far the stock price falls.
The payoff profile on this long put example is as follows:
|Stock Price||Gross Profit||Less Premium||Net Profit/Loss|
|$100 (or over)||$0||$1,000||($1,000)|
As you can see in this example, to recover your premium and turn a profit, that underlying stock will need to decrease by more than $10 in the next six months.
The Short Put
With a short put, the investor sells a put option. You are essentially doing the opposite of a long put.
Best For: Investors who think the stock price will either stay flat or rise in the period between now and the expiration date.
The buyer of the put, of course, is expecting the stock price to dip. But if your hunch is correct and the stock price stays flat or the price rises, the put expires worthless, and you keep the buyer’s premium.
For example, let’s say XYZ stock is trading at $100 per share, and you are able to sell a put option for 100 shares with a strike price of $100 per share and an expiration date of six months. The premium is $10 per share.
You sell the put option for $1,000 (100 shares times $10 premium per share).
Risk/Reward: The risk for the investor with a short put is that the seller is forced to buy the stock at the strike price and take a significant loss if the stock moves down in price. The potential losses are capped at $10,000 (100 shares times strike price of $100 per share). The maximum reward an investor will see with the short put, however, is the premium paid by the buyer, or $1,000 in this example.
Are You Ready for Options Trading?
Even the most experienced options traders began with a simple option trade. But before you dive in, you must understand the market and realize that past performance does not necessarily drive future performance.
Be sure you understand the market risks and volatility surrounding the option strategy and the underlying security, and know how much you can afford to lose. Obtaining investment advice is never a bad idea.
Taking the First Step
Now that you’ve got the basics of options trading and three strategies under your belt, it’s time to consider taking action.
While options trading might seem risky, it could be an effective way to accelerate the success of your retirement portfolio. The best way investors can set themselves up for success is to keep learning about options and get some hands-on experience for yourself.
Subscribe to Investors Alley’s “Options Floor Trader PRO” and find out how to make your first options trade.