Many options trading strategies can help investors gain an advantage in portfolio protection and return enhancement. We are going to venture into the top 5 strategies for beginners.
We’ll take a look at the setup and the risk profiles for each strategy, as well as factors to consider when evaluating risk and the objectives of each strategy.
Options Terminology
To navigate the world of options we need to know a few common terms that are used when taking on this activity:
Exercise: The right to execute the options contract, that is to sell or buy the underlying stock.
Strike: This is the price that the option contract establishes for the exchange of the stock if the option is exercised.
Expiry: The last day when the option contract can be exercised.
Premium: The amount of money exchanged when buying or selling the options contract.
Volatility: The percentage change in the underlying stock price over a specific period.
In the money (ITM): This means the strike price is below the market price for a call or above the market price for a put.
Out of the Money (OTM): This refers to the opposite of the above: the strike price is above the stock price for a call, and vice versa for a put.
At the Money (ATM): In this case, the strike price is equal to the stock price.
Long Call Strategy
The long call trade is one of the simplest but most effective options trading strategies when comparing the risk/reward ratio. A call option gives you the right, but not the obligation, to buy the underlying stock at a set price, amount, and for a specific future date.
Long Call Setup
When you believe the price of a stock is likely to rise and volatility is going to increase, you can buy a call option. Usually, the idea is to gain the right to buy the stock at a price that is OTM. This allows the buyer to pay a relatively small premium.
Options contracts come with inbuilt leverage. Meaning the exposure gained is high for a relatively small sum compared to buying the stock outright. A standard options contract is for 100 shares of the underlying stock.
So, buying 1 contract allows you to gain exposure to 100 shares of the underlying stock. Let’s say the stock price is $100, and the options premium on a call is $0.50 with a strike at $105, you can buy the option for $50.
Whereas buying the underlying stock would cost you $10,000. You don’t have to wait until the stock price goes above $105 to cash in on profits. If the market price goes to $104, your options contract will be worth much more than the initial premium paid.
Depending on market volatility, the price of the option, or premium, may have doubled or even tripled. At this point, an investor may decide to simply sell the option and cash in on the profit. The chart above shows the profit and loss profile of a long call strategy.
Long Put Strategy
A put option gives the buyer the right, but not the obligation, to sell the underlying stock at a predetermined price, amount, and date. The strategy can be used to take a bearish view on a stock, without the complications of short selling.
This strategy is also useful to investors who are long the underlying stock and believe the stock price may go down.
Long Put Setup
Buying a put in this case is like buying insurance against a drop in the market price of the stock. If the stock price falls, you can sell the shares to the buyer of the put, allowing you to offset the losses.
You may also buy a put on the broader market, such as a put option on the S&P 500. This strategy may be useful when you believe in the long-term fundamentals of the stocks you are holding.
However, you may believe that the broader market is about to experience an increase in downside volatility. The increase in volatility would also impact the prices of the stocks in your portfolio.
The chart above shows the profit and loss profile of a long put options strategy.
Covered Call Strategy
This is one of the slightly more complex options trading strategies but can be effective in enhancing returns in a sideways cycle. Investors who believe in the forward valuations of their stocks can hold the stocks and cash in on some revenue.
Covered Call Setup
The covered call consists of selling calls on stocks you already own. Here the investor believes there will be a decrease in volatility. The price of the underlying stock will remain unchanged over the duration of the options contract.
If that is the case, the call options contract will expire worthless, and the options seller will cash in on the full premium. At the same time, if the stock rises the options seller’s return will be limited to the stock price increase plus the premium.
The chart above shows the profit and loss profile of a covered call strategy, with a stock price of 100, a premium of 5, and a strike of 105. You can see that if the price of the stock remains unchanged the call seller receives the full premium.
If the market price of the underlying stock rises to 5, then the call seller will receive the return from the initial stock price plus the premium. If the stock price falls, the losses on the stock price are offset by the premium.
Long Straddle Strategy
This is one of the more complex options trading strategies, that beginners can still use when they expect a sharp increase in volatility. The strategy consists of buying a call and a put on the same stock and expiry date.
Straddle Setup
The straddle strategy uses the same strike for the call and put, which is at-the-money. The ATM strike makes this strategy expensive. However, small increases in volatility can lead to substantial gains in the value of the options.
A variation of the straddle is the strangle, which uses strikes for the call and the put that are OTM. This setup requires a larger move in the price of the underlying stock to make a profit but is much cheaper to enter.
The strategy aims to be profitable when the market moves independently of the direction. Since the options buyer is long of both a put and a call, if the market price of the stock moves substantially the buyer can make a profit.
Of course, if the market fails to move up or down sufficiently the options will expire worthless. The chart above shows the profit and loss profile of straddle and strangle strategies.
Bull Call Strategy
This strategy consists of buying a call with a strike closer to ATM and selling a call with a higher strike. This one looks simple compared to the Straddle, but it’s actually one of the more sophisticated options trading strategies.
Bull Call Setup
For this strategy to be profitable the buyer needs the market price of the stock to rise. Maximum profit is reached when the spot price reaches or exceeds the higher strike. For example, you buy a call option at $5 and simultaneously sell a call option at $2.
The $5 call option has a strike at 100 and the $2 call option has a strike of 110. Your maximum profit is $7. That is the difference between the two strikes and the net cost of the strategy, which is $3.
The chart above shows the profit and risk profile of a call bull strategy. As you can see, the profit is limited by the strike of the shorted call, while the maximum loss is limited by the net cost of this options trading strategy.
Conclusion
Learning about the various options trading strategies can seem daunting. However, carefully studying the mechanisms of options and how their profit and loss profiles work can add value to your portfolio returns.
Not all strategies are suitable for every investor. You should consider your risk tolerance and your investment goals when analyzing a possible options trading strategy. Buying options carries the benefit of limiting losses while selling options opens you to the possibility of unquantified losses.
