Options trading involves buying and selling put and call options to better tailor your investing strategy to your beliefs about what is going to happen to the value of a security in the future.
Unfortunately, options trading is pretty heavy on jargon (and, frankly, quite tricky to understand if you’re not in that world already). Therefore, it can be difficult for a beginner to really get into it and start making money.
This post first explains some of the terms that financial traders like to use when referring to these instruments and then runs through the best options trading strategies available.
Options Jargon
Put options give the owner the right to sell a stock at a predetermined price by an expiration time.
Call options give the owner the right to buy a stock at a predetermined price with a fixed expiration time.
Neither owner has an obligation to buy or sell the stock when they hold the option. However, in each case, the counterparty must buy or sell. For instance, for a put option, the owner does not have to sell if the price goes below the strike price, but the counterparty (the entity holding the underlying securities) must buy at that price.
Similarly, for a call option, the owner does not have to buy the security at the set price, but the owner of the underlying shares must sell if the option owner exercises their rights. The “strike price” is another term for this “set price.”
Options have three components: the expiration date, the strike price, and the premium. The premium is the amount the option buyer must pay the owner of the stocks to accept the terms of the option.
We will refer to these concepts repeatedly throughout this article, so if you don’t quite understand something, return to this section.
Best Options Strategies
In this section, we explore the best options strategies out there, from simple to complex.
Long Call
Investors consider the long call to be the most basic options strategy available, making it great for beginners. This option gives the owner the right to buy a security by a certain expiration date at the strike price (the predetermined price).
The way it works is simple. An investor approaches someone who owns, say, 100 shares in a company and asks them to accept the terms of the long call option. If the counterparty agrees, then they must agree to sell the stock at the strike price on the predetermined date.
Investors who purchase long calls tend to be bullish. They believe that the underlying market price of a security will rise above the strike price by the expiration date, compensating them for the premium.
The great thing about long calls is that they limit your losses. If the price of a security falls, you don’t have to exercise your option rights.
Example
Suppose you create an option that requires an Apple share owner to sell you 100 shares at $1,500 each on November 1, 2022. The owner charges a premium of $100 per share to hold them for you until that date.
If you believe that the real price of Apple shares will be $1,600 or more by that date, you might want to consider buying the option.
Now, suppose that the underlying value of Apple shares is $1,700 on November 1. Exercising your option rights, you can buy 100 Apple shares for $150,000 and then sell them on the open market for $170,000. The option premium was $10,000, generating a net profit of $10,000.
If Apple stock falls below the strike price, the option expires and becomes worthless.
Long Put
The long put works in reverse. This option gives you the right to sell a stock you own at the strike price on a predetermined date. You do not have to sell if you don’t want to, but the counterparty must buy at the agreed strike price on the date the option comes due.
Investors who use long puts tend to be bearish. They believe that the underlying market price of a security will fall below the strike price by the expiration date. The more the stock price falls below the strike price, the higher the profit. Unlike long calls which can have unlimited profits, long put profits are capped by the fact that most securities prices can’t fall below zero.
Example
Suppose a stock is trading at $10 and the strike price is $10. A counterparty offers a premium of $1 per share for the option and you buy 100 shares for a total cost of $100.
If the price goes above the strike price of $10 per share, the investor does not exercise their put option and it expires. If the price falls below $10 per share, then the investor earns extra money.
Say, for instance, the underlying price falls to $5. In this situation, the investor can sell the shares to the counterpart for $1,000 and then use that money to buy shares at the new, lower price.
Covered Call
Like long calls, choosing covered calls usually means that a trader is bullish on a particular stock. It is a popular option because it reduces the risk of being long on a stock but generates income at the same time. The downside is that you need to be willing to sell your shares at a fixed price in the future.
To perform this strategy, you need to buy an underlying asset as you would normally and then issue a call option for those shares. You must then sell the shares at the strike price to a counterparty. If the value of the underlying security falls in value, you will lose money on the stocks. However, you will earn a premium. If stocks rise in value, you will gain on the stocks but that will be offset exactly by short call losses.
Investors typically use this strategy when they think a share price will rise or stay roughly the same and want to make money from the premium.
Example
Suppose that a stock is trading at $10 per share with a strike price of $10 with a premium of $1 per share. You want to trade 100 shares, so the shares you acquire cost $1,000 and you make $100 by selling the call option.
The breakeven point is $9 per share since a one-dollar fall in the value of 100 shares is offset by the $100 premium. If the share value falls below that, you’ll lose money when you come to sell the shares.
Above $10, your profit is capped at $100. That’s because increases in the share price are exactly offset by the counterparty’s call option. If the price goes up to $20 by the expiration date, you simply sell shares at the higher price and then pass the profit over to the call option owner.
Short Put
The short put is the inverse of the long put. Here, instead of buying a put, you are selling one. Traders use this option when they believe that an underlying security will go above the strike price by the expiration date, while the counterparty believes that it will fall.
When you sell the put option, the counterparty compensates you with a premium. You earn the premium if the price of the security goes above the strike price, and you earn less if it goes below. If the price of the underlying security falls significantly, you will lose money.
Example
Suppose that a stock is trading at $10 per share and you agree on a strike price of $10 at the expiration date. The cost of the option is $1 per share and the counterparty agrees to buy a contract for 100 shares, costing $100.
If the price of the stock is $10 or more at expiration, then the option expires and the counterparty does not exercise its right to buy from you at that price. However, if the price falls below $10, they can make a profit, and you will start to lose money.
Between $10 and $9, losses will be offset by the premium. Below $9, you will make real losses.
Protective Put
The protective put lets you hedge against the downside risk of going long on a security, but in a more comprehensive way than a regular long call. Here, you buy the underlying stock, but combine it with a put. This action hedges your position against downside risk, preventing you from losing money if the stock starts to decline. Hence, protective puts are best for traders who are tentatively optimistic about a security but still see significant downside risk.
The nice thing about the protective put (sometimes called the “married put”), is that there is a limited downside and potentially unlimited upside. However, you will need to pay the premium, so expected returns will fall.
Example
Suppose you buy the usual 100 stocks for $10 per share and agree on a put strike price with a counterparty of $10 and a $1 per share premium. The 100 shares cost you $1,000 and the put option costs you $100.
If the price of the shares rises to, say, $20, you can sell them for $2,000, making a $1,000 gross profit and $900 net profit after paying the put premium. If the share price drops to $0 by the expiration date, you can exercise your put option to sell the shares at the strike price, getting $900 back, compensating you for most of the loss.
Long Straddle
A long straddle is an options trading strategy that traders use if they are neither bullish nor bearish on a particular security. It gives them the option to buy a stock at price A or sell it at price A. The idea is to make money on a stock, regardless of whether it goes up or down.
Traders generally prefer this strategy for highly volatile securities. Wild price swings earn profits on both legs of the trade. Unfortunately, long straddles don’t come cheap because traders must buy both a call and a put at a single strike price.
Example
Suppose you agree on a strike price of $10 for a call option and a put option at strike price A. You hold 100 hypothetical shares and each counterparty charges 1 per share, implying a total premium of $200.
If the price says the same at $10, you lose the $200, equal to the premium. However, if the price rises to $12 by the expiration date, you can buy shares for $10 each for a total of $1,000 from counterparty A and sell them in the open market for $1,200, breaking even. If prices rise to $13 per share, you make a $100 profit, and so on.
Likewise, if the price falls to $8 per share, you can claim your put option. You can sell your shares for $1,000 at the strike price agreed with counterparty B and then use the money to buy more shares than before at the market price. If the price of shares falls to $7, you can sell your shares above the market price for a nice profit.
In this example, traders profit when the underlying security goes below $8 or above $12. (Please note that long straddles don’t have to be symmetrical).
Long Strangle
A long strangle is the same as a long straddle, except you choose different strike prices for both your call and put. Put another way, there is a gap between the price at which you have a right to sell to counterparty A and the price at which you have a right to buy from counterparty B.
As with a long straddle, the goal of this strategy is to make a profit if the price rises or falls by a certain amount. The benefit of separating the call and put strike prices is that it reduces the cost of the trade since the options you buy will be out of the money. The downside is that you’ll need bigger swings in the underlying security price to make a profit.
Example
Suppose you agree on a call option strike price with counterparty A of $12 and a put option strike price with counterparty B of $8. The value of the underlying stock is $10 right now. You buy 100 shares and pay counterparties A and B $1 per share for a total premium of $200.
If the price is between $8 and $12 at the expiration date, both call and put options are out of the money and you take a loss of $200 – the price of the premium.
If the underlying price is $12 or above, you can exercise your call option. Here, counterparty A agrees to pay you $12 per share which you can then sell into the market for a profit. With an underlying price between $12 and $14 per share, you will offset some of the cost of the premium, but not all. And with a profit over $14 per share, you will make a pure profit.
If the price is $8 or below, you can exercise your put option. Here, counterparty B must sell shares for $8 per share, and you can then buy back the shares at a lower value.
Collar
The collar option strategy is a way to cap both gains and losses for a particular security. Traders buy a put option to hedge against the downside and sell a call option to make a premium profit on the upside. In other words, running a collar is the same as combining a covered call and protective put.
Traders like the collar because the covered call pays for the protective put. However, there is a cost: profits are capped at the call strike price.
Example
To start a collar, you must buy a security. Let’s say you purchase 100 stocks at $10 each. You then buy a put with counterparty A, setting the strike price at $8, and offer a call to counterparty B, setting a strike price of $12. You pay counterparty A $1 per share for the put and receive $1 per share from counterparty B for the covered call, leaving your net premium at $0 for the trade.
Suppose that the price of the security falls to $8 or less. Here, counterparty A is obligated to pay you $8 per share, capping your losses. In this example, you still lose money, but not much.
Likewise, if the price of the underlying stock rises to $12 or more, you must sell stock to counterparty B at the agreed strike price of $12. They can then take those shares and sell them into the market to make a profit. The profit you make is on selling the shares for a higher amount. If you sell 100 shares you bought at $10 per share for $12 per share, you will make a $200 profit. If the market price for the shares is $20, you must still sell them for $12, meaning that you can miss opportunities.
Long Put Spread
With a long put spread, you sell a put at a strike price agreed with counterparty A and buy a put at the strike price agreed with counterparty B.
The long put spread is essentially the inverse of the collar. This time, you make a limited profit if the price falls, and a limited loss if the price rises.
Traders view the long put spread as an alternative to the long put. As with the collar, the net premium can be zero. You sell a put to counterparty A and buy a put from counterparty B. Traders like to use this strategy when they want to neutralize the downside volatility of a stock. However, as before, you limit the upside.
Example
Suppose you buy 100 shares at $10 for a total of $1,000. You agree on a strike price of $8 per share for the put option you sell to counterparty A and a strike price of $12 per share for the put option you buy from counterparty B. As before, the premium per share for buying and selling put options is $1 so they cancel out.
If the price falls below $8, counterparty A does not claim the option and you earn a profit. If the price is between $8 and $12, counterparty A will claim, eating into your premium. If the price rises above $12, you can claim your put option, limiting the losses owed to counterparty A.
Short Call Spread
The short call spread is similar to the long put spread except, this time, you’re selling a call to counterparty A for a lower strike price, and buying a call from counterparty B for a higher strike price. Traders typically see this option as an alternative to the short call.
There is also symmetry in the calls. With a short call spread, you sell an expensive call to counterparty A and buy a cheaper call from counterparty B. If the stock goes up, you earn modest, limited profits. If it goes down, you suffer larger limited losses.
Example
Suppose you buy 100 shares at $10 each. You then sell a call to counterparty A for $0.5 per share for a total of $50 and buy a call from counterparty B at $1 per share for $150 for a net premium of $100. You agree on a strike price of $8 for the call option you sell to counterparty A and a strike price of $12 for the call option you buy from counterparty B.
If the price of the stock falls below the strike price for counterparty A, they do not claim the option, and it expires, leaving you with the premium. However, if the price goes above $8, profits start to fall and eventually go negative. However, they are capped by the second strike price with counterparty B at -$150.
People typically associate options trading with high-risk trading. However, as we have seen, many options actually lower risk and reward.
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