Once you understand the basics of options — including terminology, rights and obligations, open interest, pricing, sentiment and expiration cycles — it’s time to put that knowledge to work by examining some basic option strategies and how they can be used.
For simplicity’s sake, we’ll use equities as the underlying instrument in this discussion, but keep in mind that the underlying instrument can also be an exchange-traded fund (ETF) or even an index.
Remember that you can take a bullish or bearish position using either long/short calls or long/short puts.
Long Calls
Perhaps the simplest option strategy to understand (though not necessarily the easiest with which to make a profit) may be the long call trade, which you can use if you believe the underlying stock will rise.
Buying a call gives you the right (but not the obligation) to buy the underlying stock at the strike price at any time up until the option expires.
If the price of the underlying stock rises higher than the strike price, exercising the option allows you to “call” away the stock from the option seller for less than its market value.
A long call trade is often the first option strategy investors use when they decide to venture into trading options. Unfortunately, long calls can often be difficult to trade profitably.
A long call option is a bullish strategy, but unlike a long stock trade, you generally have to be right about more than just the direction of the underlying stock to be profitable. Remember, the price of an option is based on many components, including whether it’s a put or call option, the strike price of the option and the amount of time until it expires.
To profit on a long call trade, you’ll typically need to be right about the direction of the underlying stock price movement and the magnitude it moves in that direction, as well as how long it takes to make the move. Occasionally, you can be profitable if you’re right on two of these three items, but direction alone is almost never enough.
Before you decide to enter any option position, it’s important to do some simple calculations to find the maximum gain, maximum loss and break-even points.
Here is an example of these calculations for a long call trade (assuming the position is held until expiration) and a profit-and-loss graph:
Long 1 XYZ Jan 50 call at $3
Maximum gain = unlimited
Maximum loss = $3 (premium paid)
Breakeven = $53 (strike + premium)
Note: Chart depicts strategy at expiration.
As you can see, while the maximum potential loss on a long call trade is the price paid for the option, the upside profit potential is theoretically unlimited.
Remember that, because the option has a limited lifespan, the underlying stock will need to drop enough to offset the cost of the option, the erosion in time value and possibly even changes in volatility.
These factors work against the owner of a long call or put, resulting in a much more difficult profit-and-loss scenario than you might think.
Long Puts
When you believe the underlying stock will fall, buying a put gives you the right (but not the obligation) to sell the underlying stock at the strike price any time up until the option expires.
If the underlying stock falls below the strike price, exercising the option allows you to “put” the stock to the option seller for more than its market value. Like long calls, long put trades can be difficult to trade profitably.
A long put option is a bearish strategy, but unlike shorting a stock, you generally have to be right about more than just the direction of the underlying stock in order to be profitable.
As with long calls, you’ll typically need to be right about the direction of the stock price, the magnitude of the change and the time frame. Occasionally, getting two of these three items right is enough to be profitable, but direction alone is almost never enough.
Before you decide to enter a long put trade, be sure to find the maximum gain, maximum loss and break-even points.
Long 1 XYZ Jan 50 put at $3
Maximum gain = $47 (strike � premium)
Maximum loss = $3 (premium paid)
Breakeven = $47 (strike � premium)
As you can see, while the maximum potential loss on a long put trade is the price paid for the option, the profit potential (as the stock price falls) is significant.
Short Calls
Selling a call — also called a short call — allows you to receive the premium up front, but creates an obligation to sell the underlying stock at the strike price at any time up until the option expires. Using this strategy, you receive income if the underlying stock stays below the strike price or falls below the strike price.
If you don’t own the underlying stock, such options are called naked or uncovered calls.
Although I wouldn’t recommend the use of short naked calls — and they are particularly inappropriate for inexperienced option traders or traders without substantial risk capital — I think it’s helpful to illustrate how selling a naked call creates a profit-and-loss scenario that is exactly the opposite of a long call.
Short 1 XYZ Jan 50 call at $3
Maximum gain = $3 (premium received)
Maximum loss = unlimited
Breakeven = $53 (strike + premium)
A naked call trade is an extremely risky position because, while the profit (if the stock drops in price) is limited to the premium received at the time the option is sold, the upside risk is unlimited.
If the stock goes up you may be forced to buy it at the market price and deliver it to the option buyer at the lower strike price. And the higher that stock moves, the greater your loss.
To enter an uncovered call trade, you’ll need the highest option approval level available at your broker (Level 3), and substantial funds available to meet the high margin requirements of this strategy.
Short Puts
Selling a put — also called a short put — allows you to receive the premium up front, but creates an obligation to buy the underlying stock at the strike price at any time before option expires.
With this strategy, you receive income if the underlying stock stays above the strike price or rises above the strike price.
If you haven’t also shorted the underlying stock, such options are called naked puts or uncovered puts.
Although a short (naked) put is not quite as risky as a short (naked) call, this is still not a strategy for inexperienced option traders or traders without substantial risk capital.
Selling a put creates a profit-and-loss scenario that is exactly the opposite of long put.
Short 1 XYZ Jan 50 put at $3
Maximum gain = $3 (premium received)
Maximum loss = $47 (strike � premium)
Breakeven = $47 (strike � premium)
As you can see, while the maximum potential loss on a long put trade is the price paid for the option, the profit potential (as the stock drops in price) is significant.
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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