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Options are one of the most exciting areas of the investing world because of their potential for huge gains. But to get started, you’ll want to know what options strategies are available, when they’re best suited to particular situations and what the risks and rewards are.
Options
strategies come in a variety of flavors, but they’re all based on the two
fundamental options: calls and puts. From these basics, investors can create a
range of strategies that maximize the payout from a stock’s movement and savvy
investors pick the strategy that’s best for how they expect the stock to
perform.
Options
trading strategies to consider
1. The
long put
2. The
long call
3. The
short put
4. The
covered call
5. The
married put
6. The
long straddle
7. The
long strangle
1. The long put
Best to use when: The long put is a useful strategy when you expect the stock to decline and you want to earn a large upside. Traders will earn a significantly better return on their investment than by short selling the stock, so a long put could be a good substitute for shorting the stock directly. The long put also limits the short seller’s loss to the premium, while shorting the stock exposes the trader to uncapped losses.
Example of the long put: Reliance stock trades at $100 per share, and puts with a $100 strike price are available for $10 with an expiration in six months. One put costs $1,000 (one contract * 100 shares * the $10 premium).
Here’s the return at each stock price, including the cost to set up the position.
|
Stock price at expiration |
Long put’s profit |
|
$130 |
-$1,000 |
|
$120 |
-$1,000 |
|
$110 |
-$1,000 |
|
$100 |
-$1,000 |
|
$90 |
$0 |
|
$80 |
$1,000 |
|
$70 |
$2,000 |
Risk/reward: The long put can pay off significantly if the stock moves below the strike price before the option expires. In this example, the maximum return is 10 times the original investment, or $10,000. In general, the maximum value of the long put equals the total value of stock underlying the trade (the number of contracts * 100 * the strike price).
The risk for this potential upside is a complete loss of the premium paid for the put. But if the stock moves higher, making the put less valuable, traders often can salvage some of the value by selling the put, as long as it has substantial time to expiration.
2. The long call
With the long call, the trader buys a call expecting the stock to be above the strike price before expiration.
Best to use when: The long call is much like the long put, but it pays out when the stock rises. So if you’re expecting the stock to move higher, the long call is the way to go. The long call can earn a much higher percentage return than owning the stock directly.
Because the trader’s downside is limited to the option’s premium, the long call also could be a good strategy if the stock has the potential to move much higher but has the potential to move much lower too. If the stock falls, the option’s limited loss could be less than owning the stock directly.
Example of the long call: Reliance stock trades at $100 per share, and calls with a $100 strike price are available for $10 with an expiration in six months. One call costs $1,000 (one contract * 100 shares * the $10 premium).
Here’s the profit at each stock price, including the cost to set up the position.
|
Stock
price at expiration |
Long
call’s profit |
|
$130 |
$2,000 |
|
$120 |
$1,000 |
|
$110 |
$0 |
|
$100 |
-$1,000 |
|
$90 |
-$1,000 |
|
$80 |
-$1,000 |
|
$70 |
-$1,000 |
Risk/reward: The long call has uncapped upside as the stock moves higher, and that’s why this strategy can be a home run. If a stock rises, you can make many times your investment.
Like the long put, the risk here is that the investor could lose all of the premium paid for the call. However, if the stock moves lower — making the call less valuable — traders often can save some of the value by selling the call, as long as it has substantial time remaining to expiration.
3. The short put
In a short put, the trader sells a put expecting the stock to be higher than the strike price by expiration. This is similar to selling insurance against the stock falling below the strike price.
Best to
use when: There are two good situations for the short put.
- If
the trader expects the stock to be above the strike price at expiration,
the short put is a way to generate income by pocketing the premium.
- The
trader can use the short put to achieve a more attractive buy price on the
underlying stock. If the stock doesn’t move below the strike price, the
trader keeps the premium and can execute the strategy again. If the stock
falls below the strike, the trader buys the stock at a discount to the
strike price, using the premium to reduce the net price paid.
Example of the short put: Reliance stock trades at $100 per share, and puts with a $100 strike price are available for $10 with an expiration in six months. One put generates a total premium of $1,000 (one contract * 100 shares * $10 premium).
Here’s the profit at each price, including the cost to set up the position.
|
Stock
price at expiration |
Short
put’s profit |
|
$130 |
$1,000 |
|
$120 |
$1,000 |
|
$110 |
$1,000 |
|
$100 |
$1,000 |
|
$90 |
$0 |
|
$80 |
-$1,000 |
|
$70 |
-$2,000 |
Risk/reward: The short put’s maximum payoff is the premium received by the trader. The stock might fall well below the strike price, but all the short put earns is the premium. The maximum payoff occurs anywhere above the strike price.
The downside for the short put can be substantial, and the trader can be forced to add money in order to close out the trade if there’s not enough to purchase the stock at the strike price. The maximum downside occurs when the stock goes to zero. In this example, the put would lose $10,000 (100 shares * the $100 stock * the one contract), though the investor would still have the $1,000 premium. Short puts can be risky with limited upside.
