Beginners Guide To Options Strategies

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Beginners Guide To Options Strategies

The two main types of option strategies are call options and put options. Here’s a quick rundown of how to earn from utilizing these options in your portfolio.

Key Takeaways

  • There are various basic options strategies for novices that give a reasonably simple framework and plain profit & loss results.
  • Buying options may be used to hedge against risk or to speculate with little risk on the downside.
  • Writing covered options might bring additional revenue while posing no risk.
  • More intricate combination and spread tactics are possible, but they may need a deeper grasp of options trading.

Puts And Calls

A call option gives an investor the right, but not the duty, to buy a stock at a certain price. This is known as the striking price or exercise price. A put option gives an investor the right, but not the responsibility, to sell a stock at a certain price. This is also known as the striking price or exercise price. Other essential contract conditions include the contract size, which is typically 100 shares per contract for stocks. The expiry date indicates when the option will expire or mature. The contract style, which might take two forms, is also crucial. An investor may exercise an American option at any time before the maturity date. Only on the expiry date may European options be exercised.

Writing Call Options for Income

Purchasing a call option is equivalent to going long or benefitting on an increase in the stock price. An investor may short or write a call option, just like a stock, and get the premium. If the stock price increases over the exercise price, the call writer is obligated to sell the shares to the call option holder.

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Shorting call options means wagering that the stock price will stay below the exercise price for the duration of the option. As long as this occurs, the investor receives revenue from the strategy in addition to the premium.

Three Ways to Profit Using Call Options

Combining One Call with Another Option

Consider combining a call option with an option for income to develop a more complex strategy and illustrate the usage of call options in practice. A bull call spread is a strategy that comprises of purchasing, or going long on, a call option and combining it with a short strategy of writing the same number of calls with a higher strike price. The goal in this situation is to benefit from a tight trading range.

Assume a stock trades at $10, a call is acquired at $15, and a call is placed at $20 for a premium of $0.04 per contract. This is based on a single contract for $4 in premium income, or $0.04 per 100 shares. Regardless of the circumstances, the investor will retain the premium income. If the stock stays between $15 and $20, the investor keeps the premium income as well as the gains from the long call position. The long call option is worthless below $15. Over $20, the investor retains the $4 premium income as well as the $5 profit from the long call option, but loses any gain above $20 since the stock will be called away due to the short position.

Writing Put Options for Income

Purchasing a put option is akin to selling a stock short, or benefitting on a drop in the stock price. An investor may, however, short or sell a put option, getting the option premium if the stock continues above the strike price. If the stock falls below the strike price, the put writer is obligated to acquire the shares from the put option holder (since it is effectively “put” to the writer). This happens again if the stock price falls below the exercise price.

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When an investor writes put options, he or she is wagering that the stock price will continue above the exercise price for the duration of the option. As long as this occurs, the investor obtains revenue from the approach in addition to the premium.

Combining One Put with Another Option

Consider pairing a put option with a call option to develop a more complex strategy and illustrate the usage of put options in practice. A straddle is a strategy that involves purchasing a put option and going long on a call option. In this situation, the investor is betting that the stock will make a substantial move, either up or down.

Assume a stock is now trading at $11. The straddle strategy is extremely simple, consisting of buying both the put and call options at a strike price of $11. Two long options with the same expiry date are acquired, and a profit is made if the stock goes up or down by more than the cost of purchasing both options.

Assume XYZ just traded at $11 per share. For a total cost of $0.35, a call option costs $0.20 and a put option costs $0.15. In this scenario, the stock must rise above $11.35 to pay off the call option and fall below $10.65 to pay off the put option.

The Bottom Line

These straightforward call and put option strategies may be used with a wide range of more complex positions to create profits while limiting risk.

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