Options trading strategies cover across the spectrum from basic “one-legged” trading to more exotic “multi-legged” creatures. However, what all strategies share is that they’re all based on two types of fundamental options which are calls and puts. (If you don’t know all about these concepts, make sure to understand the basic concepts about options and follow an options alert service.)
The best approach for novices is to stick with the basics. The following strategies for trading options are specifically designed for novices and can be described as “one-legged,” which means they only have one option to trade.
Note: Simple does not mean safe, just that the strategies listed below are simpler than the more complex multi-legged strategies.
The long call
Long call refers to an option strategy in which you purchase the option to call also known as “go for it.” This simple strategy is a bet that the stock you are buying will surpass the strike price at the time of expiration.
Example: XYZ stock trades at $50 per share. calls with $50 is offered at $5 and expires within six months. The contract is for 100 shares that’s why the call will cost $500. That’s the $5 premium multiplied by 100. Here’s the payoff report for one long-term call contract.
|Stock price at expiration||Profit from Long Calls|
Potential upside/downside: If a call is timed correctly it is possible to gain upside from an extended call is theoretically unlimited up to the point of expiration, as long as the price rises. Even if the price moves in the wrong direction, traders usually can recover a portion of the price when they sell the call prior expiration. The negative is a total loss of the amount paid for the call, which in this case is $500. instance.
What is the benefit of using it? If you’re not worried about losing all the money it can be a means to bet on a rising stock and earn a higher profits than when you own it directly. It is also an opportunity to minimize the chance of owning an individual stock. For instance, some investors may opt to use a long-call instead of owning a similar amount of shares since it offers them an the potential for upside, while also limiting their risk to the cost of the call against the greater expense of owning stock in the event that they are concerned that a stock could decline in the meantime.
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The long put
The long put is comparable to the long-call, but you’re betting on the decline of a stock instead of its rise. Investors buy an option to put on the price will fall below the strike price before the time it expires.
Example: XYZ stock trades at $50 per share. Moreover, put with $50 is $5 and has expiration within six months. The put will cost $500. $5 premium multiplied by 100 shares. Here’s the payout profile for the long-term put.
|Stock price at expiration||Profits from Long Puts|
Potential upside/downside: A long put is most valuable when the stock is trading at the price of $0, therefore its maximum value is strike price x 100 times the amount of options. In this case, it’s $5,000. If the stock does rise it is possible to offer the option to sell and usually keep a portion of premium so long as they have time before the expiration date. The most serious risk is the reduction in the price which is $500 in this case.
What is the reason to you should use it: A long put can be used to bet on a company’s decline, provided you are able to accept the possibility of losing the entire cost. If the stock is in a decline the traders can earn more from owning put options as opposed to short-selling the stock. Some investors might opt for the long put to reduce the risk of losing money, as compared to short-selling, in which the risk is unlimited because the price of a stock could remain rising for an indefinite time and the stock is not subject to expiration date.
The short put
A short put can be described as a variant to the longer put by selling put or “going short.” The strategy is that the price will remain at a level or even rise to the expiration date, with the put becoming worthless and the seller taking the entire cost. Similar to the long call the short put could be a chance to profit from an increase in the price of a stock however, with significant distinctions.
Example: XYZ stock trades at $50 per share. puts with $50 could be purchased for $5 and have expiration within six months. The put is offered for sale at $500, which is the $5 premium divided by 100 shares. The payoff pattern of a short put is precisely the opposite of that of the long put.
|Stock price at expiration||Profits from short put|
Potential upside and downside: While the long call is a bet on a substantial rise in the price of a stock while a short put an investment that is more moderate and returns less. While the long put can yield multiples of the initial investment, the highest return for short put is the premium, which is $500, which the buyer gets in the beginning.
If the stock remains above or stays over the strike value, the buyer gets the entire price. If the stock is under the strike value at the time of expiration the seller of the put must purchase the stock at the strike price and suffers the loss. The most severe downside is when the stock drops to zero per share. In this case the short put would be unable to sell the strike price x 100 times the number of contracts, which is $5,000.
What is the reason for it? Short puts are often used by investors to earn income, and sell the premium to investors who are betting the price of a stock will drop. As with insurance sales put sellers are looking to sell the premium so that they do not be forced to pay for it. However, investors should consider selling puts with caution, as they’re liable to buy shares in the event that the price falls below the strike value at expiration. A declining stock could take away any premiums earned from selling put.
Some investors utilize short puts to bet on the increase in the value of a stock, particularly because the trade doesn’t require upfront investment. However, the upside of this strategy is limited, as opposed to the long call, and it has a greater risk of losing money when the stock declines.
Investors can also utilize short puts to obtain a higher purchase price for an expensive stock by selling them with a lower strike price, if they’d like to purchase the stock. For instance, if XYZ stock trading at $50, an investor can offer a put with an average strike price of $40 at $2 and then:
- If the stock falls below the strike price at expiration then the seller of the put is given the shares and the premium offsets the price of purchase. The buyer pays $38 per share for stock or the $40 strike price, minus the $2 premium that was already received.
- If the price is above the strike when it expires The put seller gets the money and is able to try this strategy again.
The covered call
The covered call begins to look fancy due to two components. The investor first needs to have the stock in question before selling an option for the deal. For a the buyer will give all the gains over what the price of strike. This method ensures that the price will remain flat or only a little down until expirationtime, which allows the call buyer to keep the premium and hold the stock.
If the price of the stock is lower than the strike when the call expires the call seller holds the shares and may issue another covered call. If the price rises above the strike price, the buyer must hand over the shares to the buyer on the call, then sell those shares for the price of strike.
A crucial point to remember: for every hundred shares, an investor is able to sell only one call. Otherwise the investor would in the market for “naked” calls, and have the risk of losing money that is not capped in the event that the stock price rose. However, covered calls can transform an unattractive option strategynaked calls into a safe and feasible option and is a popular choice by investors who are looking to earn income.
Example: XYZ stock trades at $50 per share. the call with 50 strikes could be purchased for $5, with an expiration date of six months. In all, the call is offered at $500, which is the $5 premium multiplied by 100 shares. The buyer buys or has 100 shares XYZ.
|Stock price at expiration||Profits from Call||Profit from Stocks||Total profit|
Potential upside and downside: The highest upside for the called-for call covered is its price or $500 in the event that the stock is at or is just less than the strike value upon the time of expiration. If the price rises above that price at which it was struck, the option gets more expensive, reducing the stock’s gains and limiting upside. Since upside is limited and call sellers could be unable to make a profit on stock that they would otherwise have earned because they didn’t set up a covered call, however they do not lose any capital. In the meantime, the possible negative is a complete loss in the value of the stock which is less than the $500 premium which is $4,500.
What is the reason to use it? A covered call has become a popular choice for investors seeking to generate profits with a low risk, with the expectation that the stock will remain in a flat or slight down until the expiration date of the option.
Investors can also make use of covered calls to get an improved price to sell the stock by selling calls for a more attractive strike price at which they’d be content to offer the stock. In the example above, with XYZ stock trading at $50, a buyer could offer a call with 60-$60 strike at $2. Then:
- If the stock price rises above the strike price at expiration, the call seller is required to offer the shares at strike prices including the premium as an added bonus. The investor will receive $62 per share of the shares either the strike price of $60 or the price, plus the premium of $2 already paid.
- If the price is below the strike by the time it expires The call seller gets the cash and is able to test another time to use the same strategy.
The couple put
As with the covered call it is slightly more sophisticated option than the basic options trade. It is a combination of an extended put and the stock in question, “marrying” the two. For every hundred shares in stock the buyer purchases one put. This method allows investors to hold onto stocks for eventual growth while also securing the position in the event that the stock drops. It is similar to purchasing insurance, which involves paying a cost to safeguard against a loss of the value of the asset.
Example: XYZ stock trades at $50 per share. Moreover, the put with $50 strikes is $5 and has expiration within six months. In all, the put is $500, which is the premium of $5 x 100 shares. The investor already has 100 shares XYZ.
|Stock price at expiration||Profit of Put||Profits from stocks||Total profit|
Potential upside or downside The upside will depend on the price of the stock or down. If the put that was married allowed the investor to keep holding an asset that was rising and the gain was possible to be infinite, less the value of the put. The put will pay off in the event that the stock drops, usually compensating the losses on the stock less the premium. This puts the risk of losing at $500. The investor protects against losses and holds the shares for the possibility of appreciation following expiration.
What’s the reason? It’s an investment hedge. Investors can use a married put when they’re hoping for ongoing growth in their stocks or want to protect gains they’ve achieved while waiting for further.