Many beginning traders have little trouble understanding the risk/reward characteristics of options but often have difficulty deciding which strike prices to use.
Whether those strike prices are “in the money,” “at the money” or “out of the money” will affect how big the underlying move needs to be to reach profitability, and also determines whether the trade can be profitable if the underlying stock remains unchanged.
The tables below help illustrate how to properly structure a long or short option trade to match your level of bullishness or bearishness.
For example, if you are extremely bullish, you may want to consider out-of-the-money (OTM) long calls or in-the-money (ITM) short puts. Keep in mind, both generally require a bullish move of extreme magnitude in the underlying stock in order to reach profitability.
If you’re slightly bullish, you may want to try ITM long calls or OTM short puts, the latter of which can sometimes be profitable with no movement in the underlying stock.
If you are extremely bearish, you may want to consider out-of-the-money long puts or in-the-money short calls. Both generally require a bearish move of extreme magnitude in the underlying stock in order to reach profitability.
If you’re slightly bearish, ITM long puts or OTM short calls will likely be your best bet. And keep in mind that out-of-the-money short calls can sometimes be profitable with no movement in the underlying stock.
Risk vs. Reward
As with most option strategies, the greater the move needed in the underlying st! ock, the higher the profit potential, but also the less likely a profit will be made.
In the case of OTM short puts and OTM short calls, because profitability is possible with no movement in the underlying stock, the potential profit will likely be very small.
However, the risk on these trades is extremely high, which is why I don’t recommend uncovered calls or puts. The use of credit spreads is a safer alternative while generally providing only slightly less profit potential. Credit spreads involve the simultaneous purchase and sale of option contracts of the same class (puts or calls) on the same underlying security.
Randy Frederick is Director of Derivatives at the Schwab Center for Financial Research. To learn more about him, read his bio.
This article originally appeared on The Options Insider Web site.
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