In our last article we have described the basics of ?Option Pricing and Option Greeks?. You can get through the Article by Clicking Here
Every investor or trader new to stock market know that buying something now and selling it later at a higher price is the path to profits. But what about managing the risk? Is there any instrument available to make profit while managing the downside risk?
Whether you are a trader or an investor, your objective should be to make money with the minimum acceptable level of risk. Options are the instruments available to you, if you use it in a proper way you can minimize your risk with possibility of getting quick profit. One of the major difficulties for new options traders arises because they do not really understand how to use options to accomplish their financial goals.
Let?s understand the basics of Option Strategies:
Puts and Calls form the basic building blocks of all option trading strategies.
There are four basic option positions:
- Long Call options (buying Call options)
- Short Call options (selling/writing Call options)
- Long Put options (buying Put options)
- Short Put options (selling/writing Put options)
Simple Option Trading Strategies
# Buying Call Options: Buying a call option ?or making a ?long call? trade? is a simple and straightforward strategy for taking advantage of an upside move or trend. It is also probably the most basic and most popular of all option strategies. Once you purchase a call options (also called ?establishing a long position?), you can:
- Sell it.
- Exercise your right to buy the stock at the strike price on or before expiration.
- Let it expire.
Typically, the main reason for buying a call option is because you believe the underlying stock will appreciate before expiration to more than the strike price plus the premium you paid for the option. The goal is to be able to turn around and sell the call at a higher price than what you paid for it.
The maximum amount you can lose with a long call is the initial cost of the trade (the premium paid), plus commissions, but the upside potential is unlimited. However, because options are a wasting asset, time will work against you. So be sure to give yourself enough time to be right.
When to Use: Investor is very bullish on the stock / index.
Risk: Limited to the Premium. (Maximum loss if market expires at or below the option strike price).
Reward: Unlimited
Breakeven: Strike Price + Premium
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# Selling Call Options: When you buy a Call you are hoping that the underlying stock / index would rise. When you expect the underlying stock / index to fall you do the opposite. When an investor is very bearish about a stock/ index and expects the prices to fall, he can sell Call options. This position offers limited profit potential and the possibility of large losses on big advances in underlying prices. Although easy to execute it is a risky strategy since the seller of the Call is exposed to unlimited risk.
When to use: Investor is very aggressive and he is very bearish about the stock / index.
Risk: Unlimited
Reward: Limited to the amount of premium
Break-even Point: Strike Price + Premium
# Buying Put Options: Investors occasionally want to capture profits on the down side, and buying put options is a great way to do so. This strategy allows you to capture profits from a down move the same way you capture money on calls from an up move. Many people also use this strategy for hedges on stocks they already own if they expect some short-term downside in the shares.
When to use: Investor is bearish about the stock / index.
Risk: Limited to the amount of Premium paid. (Maximum loss if stock / index expires at or above the option strike price).
Reward: Unlimited
Break-even Point: Stock Price – Premium
# Selling Put Options: Writing a Put is opposite of buying a Put. An investor buys Put when he is bearish on a stock. An investor Sells Put when he is Bullish about the stock ? expects the stock price to rise or stay sideways at the minimum. When you sell a Put, you earn a Premium (from the buyer of the Put). You have sold someone the right to sell you the stock at the strike price. If the stock price increases beyond the strike price, the short put position will make a profit for the seller by the amount of the premium, since the buyer will not exercise the Put option and the Put seller can retain the Premium (which is his maximum profit). But, if the stock price decreases below the strike price, by more than the amount of the premium, the Put seller will lose money. The potential loss being unlimited (until the stock price fall to zero).
When to Use: Investor is very Bullish on the stock / index. The main idea is to make a short term income.
Risk: Put Strike Price ? Put Premium.
Reward: Limited to the amount of Premium received.
Breakeven: Put Strike Price – Premium
# Covered Calls: Covered calls are often one of the first option strategies an investor will try when first getting started with options. Typically, investor will already own shares of the underlying stock and will collects a premium for selling the call and is protected (or ?covered?) in case the option is called away because the shares are available to be delivered if needed, without an additional cash outlay.
This strategy is used to generate extra income from existing holdings in the cash market?with the hope that the option expires worthless (i.e., does not become in-the-money by expiration). In this scenario, the investor keeps both the credit collected and the shares of the underlying. Another reason is to ?lock in? some existing gains.
The maximum potential gain for a covered call is the difference between the purchased stock price and the call strike price plus any credit collected for selling the call. The best-case scenario for a covered call is for the stock to finish right at the sold call strike. The maximum loss, should the stock experience a plunge all the way to zero, is the purchase price of the strike minus the call premium collected. Of course, if an investor saw his stock spiraling toward zero, he would probably opt to close the position long before this time.
When to Use: This is often employed when an investor has a short-term neutral to moderately bullish view on the stock he holds.
Risk: If the stock price falls to zero, the investors loses the entire value of the stock but retain the premium, since the call will not be exercised against him. So maximum risk = Stock Price Paid ? Call Premium.
Upside capped at the Strike price plus the premium received. So if the stock price rises beyond the strike price investor (call seller) gives up all the gains on the stock.
Reward: Limited to (Call Strike Price ? Stock Price Paid) + Premium Received
Breakeven: Stock Price Paid ? Premium Received
# Covered Put: This strategy is opposite to a Covered Call. A Covered Call is a neutral to bullish strategy, whereas a Covered Put is a neutral to Bearish strategy. You do this strategy when you feel the price of a stock / index is going to remain range bound or move down. Covered Put writing involves a short in a stock / index along with a short Put on the options on the stock / index.
The Put that is sold is generally an OTM Put. The investor shorts a stock because he is bearish about it, but does not mind buying it back once the price reaches (falls to) a target price. This target price is the price at which the investor shorts the Put (Put strike price). Selling a Put means, buying the stock at the strike price if exercised (Strategy no. 2). If the stock falls below the Put strike, the investor will be exercised and will have to buy the stock at the strike price (which is anyway his target price to repurchase the stock). The investor makes a profit because he has shorted the stock and purchasing it at the strike price simply closes the short stock position at a profit. And the investor keeps the Premium on the Put sold. The investor is covered here because he shorted the stock in the first place.
If the stock price does not change, the investor gets to keep the Premium. He can use this strategy as an income in a neutral market.
When to Use: If the investor is of the view that the markets are moderately bearish.
Risk: Unlimited if the price of the stock rises substantially
Reward: Maximum is (Sale Price of the Stock ? Strike Price) + Put Premium
Breakeven: Sale Price of Stock + Put Premium
Hedging with Spreads
Options are often used in combination with other options (i.e. buy one and sell another). You can construct positions that earn money when your expectations come true. The number of possible combinations is large. Spreads have limited risk and limited rewards. However, in exchange for accepting limited profits, spread trading comes with its own rewards, such as an enhanced probability of earning money. The somewhat conservative investor has a big advantage when able to own positions that come with a decent potential profit and a high probability of earning that profit. Stock traders have nothing similar to option spreads.
We will discuss detail about the most major options spreads in our next article. Stay tuned with us?