Options are a type of financial agreement that grants those who buy them (known as option holders) the ability to purchase or sell a financial asset at a chosen price on a future date. These buyers pay a fee called a premium to the sellers for this privilege. If the market conditions are not favorable, option holders can choose to let the option expire without using it, ensuring that their potential losses are limited to the premium paid. Alternatively, if the market moves in a way that makes the option more valuable, it can be used effectively.
Options are categorized into “call” and “put” contracts. A call option lets the buyer acquire the right to buy the underlying asset at a pre-agreed price in the future. On the other hand, a put option grants the buyer the right to sell the underlying asset at the pre-agreed price in the future.
Now, let’s explore some basic strategies that beginner investors can employ using call or put options to control their risk. The first two strategies involve using options to make a cautious bet on market direction, while limiting potential losses. The remaining strategies focus on hedging techniques that provide protection for existing investment positions.
- Options trading might seem too risky or complicated for new investors, causing them to avoid it.
- Simple options strategies exist that can aid inexperienced investors in safeguarding against losses and mitigating market risks.
- Here, we explore four of these strategies: long calls, long puts, covered calls, protective puts, and straddles.
- Since options trading can be intricate, make sure to grasp the potential dangers and benefits before getting started.
Buying Calls (Long Calls)
For people wanting to predict where the market is heading, trading options has its benefits. If you believe an asset’s price will go up, you can purchase a call option with less money compared to buying the actual asset. Even if the price goes down, your potential losses are confined to the option’s cost and won’t go beyond that. This could be a preferred strategy for traders who:
- If you feel positive or confident about a specific stock, exchange traded fund (ETF), or index and want to reduce risk.
- If you wish to use borrowed funds to make the most of increasing prices.
Options can be seen as tools that provide leverage. This means traders can increase their potential profits by using less money compared to directly trading the actual asset. For example, instead of investing $10,000 to buy 100 shares of a $100 stock, you might only need around $2,000 to buy an options contract with a strike price set somewhat higher than the current market price.
Fact: A standard equity option contract on a stock controls 100 shares of the underlying security.
Imagine a trader has $5,000 to invest in Apple (AAPL), which is priced at about $165 per share. With this money, they can buy 30 shares for $4,950. Now, let’s say the stock’s price goes up by 10% to $181.50 within a month. In this case, their investment will grow to $5,445, resulting in a profit of $495 or 10% of their initial investment.
Now, let’s consider an alternative scenario. A call option for AAPL with a strike price of $165 that expires in about a month costs $5.50 per share or $550 per contract. With their available funds, the trader can buy nine of these options for $4,950. Since each option controls 100 shares, they are essentially making a deal for 900 shares. If the stock price increases by 10% to $181.50 by the time the option expires, the option will be “in the money” and worth $16.50 per share (given the $181.50 to $165 strike), totaling $14,850 for the 900 shares. This results in a profit of $9,990, which is 200% of the initial investment. This is a much larger return compared to directly trading the stock itself, showcasing the leverage provided by options.
When using a long call strategy, the most a trader can lose is the premium they paid for the option. On the upside, the potential profit is limitless because the option’s value rises as the underlying asset’s price goes up until the option expires, and there’s no theoretical cap on how high the value can go.
Buying Puts (Long Puts)
When a call option provides the holder with the ability to buy the underlying asset at a fixed price before the contract ends, a put option offers the holder the chance to sell the underlying asset at a predetermined price. This approach is favored by traders who:
- If you feel negative about a certain stock, ETF, or index, yet wish to manage risk more cautiously than with short-selling.
- If you aim to benefit from declining prices by using borrowed funds for greater potential gains.
A put option operates in the complete opposite manner compared to a call option. A put option becomes more valuable when the price of the underlying asset goes down. While short-selling also enables traders to gain from price drops, it comes with an open-ended risk because prices could theoretically rise without limit. On the other hand, with a put option, if the underlying asset ends up higher than the option’s designated price, the option just becomes worthless and expires.
Imagine you believe a stock’s price will go down from $60 to $50 or even lower due to poor earnings. But you’re not comfortable with the risk of short-selling the stock in case you’re mistaken. Instead, you have the option to buy a $50 put for a fee of $2.00. If the stock doesn’t dip below $50, or if it even rises, your maximum loss will be the $2.00 premium you paid.
However, if your prediction is accurate and the stock indeed falls to $45, you could earn $3 ($50 minus $45, minus the $2 premium).
The most you can lose with a long put is the amount you paid for the option. The highest profit you can make is limited because the underlying price can’t go below zero. However, just like a long call option, a long put option magnifies the trader’s potential return.
Different from the long call or long put, a covered call is a tactic used on top of an already held long position in the underlying asset. It’s like selling an upside call that matches the size of the existing position. Through this approach, the person writing the covered call gains income from the option premium, but also puts a cap on how much the underlying position can gain. This is a favored choice for traders who:
- Anticipate either no alteration or a small rise in the underlying asset’s price, aiming to gather the entire option premium.
- Are ready to trade off some potential for gains on the upside in return for a degree of safeguard against downturns.
A covered call strategy means purchasing 100 shares of the main asset and then selling a call option for those shares. When the call is sold, the trader receives the premium, which reduces the overall cost of the shares and offers a bit of protection against losses. In exchange, by selling the option, the trader commits to selling the underlying shares at the option’s set price, which sets a limit on potential gains.
Imagine a trader buys 1,000 shares of BP (BP) at $44 per share and at the same time sells 10 call options (one for every 100 shares) with a strike price of $46 and an expiration of one month, costing $0.25 per share or $25 per contract, totaling $250 for all 10 contracts. This $0.25 premium reduces the share cost to $43.75, meaning any decrease in the underlying price to this level will be counterbalanced by the premium from the option, offering a level of protection against losses.
Should the share price go above $46 before the option’s expiration, the short call option will be exercised, causing the trader to sell the stock at the option’s strike price. In this scenario, the trader will make a profit of $2.25 per share ($46 strike price – $43.75 cost basis).
However, this example implies that the trader doesn’t expect BP to surpass $46 or drop significantly below $44 in the next month. As long as the shares don’t climb above $46 and get called away before the options expire, the trader can retain the premium and continue selling calls against the shares if desired.
If the stock’s price goes higher than the strike price before the option expires, the short call option can be activated. This means the trader must sell the underlying shares at the strike price, even if it’s lower than the current market price. To compensate for this risk, a covered call strategy offers a safeguard against potential losses through the premium collected when selling the call option.
A protective put strategy involves buying a put option to cover an existing position in the main asset. This strategy sets a bottom limit below which you won’t incur more losses. Naturally, you’ll need to pay for the option’s cost. This approach functions somewhat like an insurance policy to guard against losses. This is a preferred tactic for traders who already possess the underlying asset and want protection against potential declines.
In essence, a protective put is a long put, as we discussed earlier. However, the main goal here is safeguarding against downward moves, rather than trying to make gains from such moves. If a trader holds shares with a generally positive outlook for the long term but wants to hedge against short-term drops, they might opt for a protective put.
If the underlying asset’s price goes up and is higher than the put’s designated price when the option matures, the option becomes worthless, and the trader loses the premium paid. Still, they retain the advantage of the increased underlying price. On the flip side, if the underlying price decreases, the trader’s portfolio position loses value, but this decline is largely offset by the gain from the put option. In this way, the approach acts much like an insurance strategy.
The trader has the option to choose a strike price lower than the present price. This decision would lower the premium cost, but it would also decrease the amount of protection against potential declines. This concept is akin to having a deductible in an insurance plan. To illustrate, let’s say an investor purchases 1,000 shares of Coca-Cola (KO) at $44 each and seeks to safeguard their investment from unfavorable price shifts in the coming two months. The following put options are accessible:
|Protective Put Examples
|June 2018 options
The information in the table demonstrates that the expense of safeguarding the investment goes up as the level of protection increases. For instance, if the trader aims to shield their investment from any price decrease, they can purchase 10 put options at the strike price of $44 for $1.23 per share, which totals to $123 per contract. The complete expense would be $1,230. Yet, if the trader is open to accepting a certain degree of risk, they can opt for a less expensive out-of-the-money (OTM) option like the $40 put. In this instance, the cost of the option position would be significantly lower at only $200.
If the underlying price remains steady or goes up, the potential loss will be restricted to the option premium, which is like a payment for protection. But if the underlying price goes down, the capital loss will be counterbalanced by a rise in the option’s value, and it will be limited to the disparity between the initial stock price and the strike price, plus the option premium. In the earlier example, with the strike price at $40, the maximum loss is limited to $4.20 per share ($44 – $40 + $0.20).
When you buy a straddle, you can benefit from upcoming market fluctuations without needing to predict whether the price will rise or fall—it’s a win either way.
In this strategy, an investor purchases a call option and a put option with matching strike prices and expiration dates on the same underlying asset. Since it involves getting two options at the current market price, it’s pricier compared to certain other approaches.
Imagine someone who predicts that a specific stock will go through significant price swings after an earnings announcement on January 15. Currently, the stock is priced at $100.
To set up a straddle, this investor buys both a $5 put option and a $5 call option, both with a $100 strike price and an expiration date of January 30. The total cost for these options is $10. The trader would earn a profit if the underlying security’s price is either above $110 (which is the strike price plus the option cost) or below $90 (which is the strike price minus the option cost) when the options expire.
With a long straddle, your potential loss is capped at the amount you invested in it. However, because it consists of two options, the cost is higher compared to buying a single call or put option. On the upside, the maximum potential gain is unlimited in theory. On the downside, it’s limited by the strike price. For instance, if you have a $20 straddle and the stock price drops to zero, your maximum potential gain would be $20.
Some Basic Other Options Strategies
The approaches mentioned here are simple and can be used by most beginners in trading or investing. Still, there are more intricate strategies beyond just purchasing calls or puts. Although we delve into many of these methods in other sections, here’s a quick rundown of a few other fundamental options positions suitable for those who feel at ease with the ones we’ve talked about earlier:
Here are some more strategies that expand on the concepts we’ve discussed before:
- Married Put Strategy: This approach resembles a protective put. It means buying an at-the-money put option to cover an existing long position in the stock. In a way, it’s like using a call option (sometimes known as a synthetic call).
- Protective Collar Strategy: In a protective collar, an investor who holds a long position in the underlying asset buys an out-of-the-money put option (for downside protection). Simultaneously, they write an out-of-the-money call option (for upside potential) for the same stock.
- Long Strangle Strategy: Similar to the straddle, a long strangle involves buying an out-of-the-money call option and a put option simultaneously. Both options have the same expiration date but different strike prices. The put’s strike price should be below the call’s. This strategy requires the stock to move either significantly up or down to be profitable. While it demands a smaller premium than a straddle, it also necessitates a movement in either direction.
- Vertical Spreads: A vertical spread entails buying and selling options of the same type and expiration but at varying strike prices. These spreads can be created as bull or bear spreads, which profit from a market rise or fall, respectively. Spreads are more cost-effective than long calls or puts since you also receive a premium from the option you sold. However, this also limits your potential gain to the range between the strikes.
Advantages and Disadvantages of Trading Options
Purchasing options offers a major advantage: the potential for significant gains while restricting losses to the option’s cost. Yet, this can also be a downside, as options expire worthless if the stock doesn’t move enough to make them valuable. This means that purchasing many out-of-the-money options can become expensive.
Options are beneficial for leveraging and managing risk. For instance, an optimistic investor with $1,000 to invest might gain more by using that amount to buy call options on a company, rather than spending the same on the company’s shares. This way, call options provide a means to leverage their investment by boosting their buying ability. Conversely, if an investor already has exposure to a company and wants to decrease it, they could manage risk by selling put options against that company.
The chief drawback of options contracts is their complexity and challenging pricing. This is why options are often seen as more advanced and suitable mainly for experienced investors. In recent times, they’ve grown popular among retail investors. However, because of the potential for significant returns or losses, investors should be completely aware of the potential outcomes before getting involved in options. Neglecting this caution can result in substantial losses.
Selling options also carries substantial risk, as you face the possibility of unlimited losses while your profits are capped at the premium received for the option.
What Are the Levels of Options Trading?
- Level 1: Covered calls and protective puts, for investors who already have the underlying asset.
- Level 2: Long calls and puts, which also encompass straddles and strangles.
- Level 3: Options spreads, where you buy one or more options and simultaneously sell one or more different options of the same underlying asset.
- Level 4: Selling (writing) naked options, indicating unhedged positions and carrying the risk of unlimited losses.