October 14, 2017

Options Trading Strategies

Read more about Options Trading

Bears, bulls, calls, and puts can make your head spin. Options trading does have the tendency to get overwhelming. But breaking it down can help you understand the strategies.

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Start with getting a good understanding of calls and puts. After you grasp those terms, consider some of the more strategies below.

Write a Covered Call

The covered call is often one of the first options brokers allow. Here's how it works:

  1. You buy the stock at the current market price.
  2. You write a call on the asset. The call you write should equal the shares you bought. Remember, you must work in increments of 100.

This popular option works when you are neutral regarding a stock's position. In other words, you aren't bullish or bearish. You're aiming to make a little extra money. Since you write the call, you sell it. You'll collect the premium and keep it. It doesn't matter if the buyer executes the contract or not.

This is a strategy investors use for the short-term. They make a quick profit on the premium collected. If the stock does increase dramatically, though, their profits are limited.

Here's an example:

You buy 100 shares of ABC stock for $50. You pay $5,000 out of your own pocket. You now own the shares. At the same time, you write one call for $60 with a 60-day expiration and a $2 premium.

If at expiration, ABC stock is still worth $50, the contract expires and is worthless. You keep the premium paid of $200. You also still own the stock. You are free to keep it or sell it. If you do sell, you still walk away with your $200 profit (the premium minus commissions).

On the other hand, if ABC stock rises to $65, the buyer would execute the contract. You must sell your shares for $60 rather than $65. Your profits were capped because your forecast was off. You would make $10/share or $1,000 plus the $200 premium.

Writing a call helps you leverage your losses. You won't lose as much in the end had you bought a stock outright. If the stock does drop, the premium you get back makes up some of the loss. If the stock plummets, it's not likely that the premium will fully offset the loss, though.

Keep in mind that writing a call does limit your profits. It puts a cap on what you can make. It's basically like taking out an insurance policy with a cap.

Bullish: If you are "bullish," it means you think a stock price might increase.
Bearish: If you are "bearish," it means you think a stock price might decrease.

Buy a Protective Put

Another way to protect your investment is with a protective put.

Here's how it works:

  1. You buy the stock at the current market price.
  2. You buy the protective put at some point down the road for the same number of shares.

Many investors use this strategy when there is a sudden spike in a stock's price. They already own the stock but aren't ready to sell. With a protective put, they can limit their losses.

Here's an example:

You buy 100 shares of ABC stock at $50/share. You pay $5,000 for the shares. A few months down the road, the market price increases to $60/share. You feel bullish about the stock. You don't want to sell just yet. But you also don't want to lose your earnings thus far.

At this time, you buy a put with a strike price of $55 and an expiration of 3 months. You pay a $3 premium for the option. You've now put out $5,300 for the stock and the option. But you're protecting some of your unrealized gains. So far, you've made $10 per share. But, unless you sell now, you won't realize those gains. Buying the put helps you keep some of those gains - your profit - if the price plummets.

If, however, ABC stock increases like you thought, you have no cap on your profits. The put expires worthless. You take in the profits by selling your stock at the current market price. Your hope is that it gets high enough to cover the extra $3/share you paid for the protective put.

Buy a Married Put

This isn't about romance - in fact, a married put more closely resembles a prenuptial agreement than a marriage. It's almost identical to a protective put except for one factor. You don't already own the stock. Instead, you buy the stock and the put at the same time.

Here's how it works:

  1. You buy 100 shares or shares in multiples of 100 of the stock.
  2. On the same day, you buy a put for the identical amount of shares you bought.

It might seem odd to buy a put on the day you buy a stock. Why buy the stock at all if you know it will fall? It's not that you are feeling bearish about the stock. It's all about limiting your losses. It's much like investing in a prenuptial agreement. You don't buy the policy because you KNOW you will have a divorce. You buy it in case you do, to protect the investments you've made. It's the same situation when buying a married put. You protect yourself in the case of a loss.

Here's an example:

On March 1st, you buy 100 shares of ABC stock for $50/share. At the same time, you buy a put with a $45 strike price and 3-month expiration. You pay a $1 premium for the option. You tell your broker you want this to be a "married" deal. This way, if you exercise the put, your broker will use the stock shares you already own.

If in 3 months, the stock price falls to $40, you'd cut your losses in half. Rather than losing $10/share, you'd lose only $5/share plus the premium of the option.

You don't buy a married put because you think a stock will tank. Instead, most investors use this strategy right before an earnings report is released. There could be one of two outcomes - the stock could skyrocket or plummet. If you are unsure about what to expect, you can protect your losses with a married put.

Sell a Cash-Secured Naked Put

Selling a naked put means you must buy the stock if the buyer executes the contract. That's a big risk. If you sell a cash-secured naked put, though, you protect yourself. Here's how:

  1. You stock your brokerage account with enough cash to buy 100 shares of the desired stock.
  2. You don't buy the stock yet.
  3. You write a naked put for the stock at your desired "buy price." This is the strike price.
  4. If and when the buyer executes the put, you then have the cash to buy it at the intended price.

This strategy benefits you in 2 ways. First, you may get to own the stock shares at the price you wanted. At the time of selling the put, you think the stock price will fall temporarily. If it does, you are in luck. Overall, you are bullish on the stock and hope that the value will increase quickly. You have the cash in your brokerage account to buy the stock at the lower price. Second, you get to keep the premium paid for selling the put. This can give you a return on your investment right away.

Here's an example:

You feel bullish about ABC stock. Rather than buying it outright, you stock your brokerage account with enough cash to buy the stock at your desired price. You then sell a naked put for the stock for this price. Let's say ABC stock currently sells for $50/share. You only want to pay $47/share, though. You write the put for $47/share for 3 months with a $3 premium.

You immediately gain $300 per contract. You then promise to buy the stock if/when it falls to $47 per share. Keep in mind, though, you are required to execute this purchase even if the stock falls below $47. That's a risk you take. You must have at least $4,700 in your brokerage account to conduct the transaction.

If after 3 months, ABC stock closes at a price higher than $47, the put expires worthless. You keep the $300/contract and walk away. You can sell another put on the stock or choose another investment.

If after 3 months, ABC stock closes at $47 or lower, though, you then own the stock. It's at this point that you hope your bullish strategy works and the stock price increases.

Collar Strategy

Using the collar strategy means you take both sides of the equation. First, you own the stock. Then, you sell a call and buy a put at the same time. Let's look at what this means:

  • Sell a call: When you sell a call, you have the OBLIGATION to sell a stock at the strike price
  • Buy a put: When you buy a put, you have the RIGHT to sell a stock at the strike price

When you conduct both transactions at the same time, it's like an insurance policy. You offset the cost of buying the put by selling the call. Here's how it works:

  1. You buy a put for the intended strike price.
  2. You sell a call for a strike price that is higher than the strike price on the put.

Investors use this strategy to make premiums on the covered calls. They own the stock and think the stock price will either stay the same or drop. If this is the case, they keep the premium. If, however, the price increases, the buyer of the call will execute the contract. You must then sell your shares for the strike price, which is lower than the market price.

By buying a put, the investor protects both sides of the equation. If the price does drop, the investor can execute the put contract. This means he can sell at the higher price, thus limiting his losses.

Here's an example:

ABC stock currently trades for $50. You buy 100 shares for $5,000. You then use the collar strategy. You buy a put with a strike price of $45 expiring in 3 months. You pay a $2 premium or $200. At the same time, you sell a call with a strike price of $55 expiring in 3 months. You make a $3 premium or $300.

Overall, you paid $5,000 for the stock. You also paid a $200 premium for the put and made a $300 premium for the call. Your total cost so far is $4,900. You've already made $100 on the deal.

If at expiration, the stock price increased to $60, the buyer of the call would execute the contract. He would buy the shares from you for $55/share. You'd make $5/share plus the $100 premium. Overall, you'd make $600.

If things went the other way at expiration, though, you'd have a different story. Let's say the price dropped to $42. Without any protection, that's a paper loss of $800.

But, with the put, you have the right to sell at $45/share. That's still a $500 loss, but with the $100 net profit on the premium, you lose only $400. You cut your losses in half.

The collar puts a hold on the stock in both directions. It allows investors to make a little money on the premiums while protecting them against major losses.

Vertical Spread

As the name suggests, this strategy helps spread the risk thinner. The vertical spread strategy means you buy and sell a call or put at the same time. Everything about the call or put is identical with the exception of the strike price.

You can have a bull call spread or a bull put spread.

In a bull call spread, you think the underlying stock's price will increase. Here's an example:

ABC stock currently trades for $40/share. You think it will increase in the next month, though. You enter a bull call spread. You buy a 30-day call for $38/share, paying a $200 premium. You sell a 30-day call for $43/share for a $100 premium. The total investment costs you $100 so far.

If ABC stock closes at $44 at the end of the 30 days, both options close in the money. You have the right to buy the stock at $38/share because you bought a call with a strike price of $38. You then have the obligation to sell the stock at $43/share because you sold a call with a strike price of $43. You walk away with a profit of $5/share, or $500. Your net profit equals $400 because of the $100 cost between the premiums.

Now, if ABC stock closed at $37, neither option would be in the money. You wouldn't execute your option to buy the stock at $38 as that would cost you $100 more. The buyer of the call also wouldn't execute his right to buy at $43/share, as that's $5 more than the market value. You'd minimize your loss at $100 for the transaction.

In a bull put spread, you also think the stock's price will increase. This strategy helps minimize your losses. Here's an example:

ABC stock currently trades for $40/share. You buy a put for $38 with an expiration of 30 days. It cost you a $100 premium. At the same time, you wrote a put for $43 with an expiration of 30 days. You made a $300 premium. You instantly make a $200 profit.

Now, it all depends on how the stock reacts. If the market price closes higher than both strike prices at expiration, both options retire worthless. You walk away with the $200 profit.

If the market price falls below both strike prices, though, the contracts get executed. Let's say the market price fell to $35. You execute your right to sell for $38/share with your put. The buyer of your put will likely execute their right to sell the stock to you at $43/share. It looks like you made $3/share when you sold the shares. However, you lost $5/share when you were required to buy shares at $43 rather than $38.

Overall, you would lose $300, which is the $5/share loss minus the $200 profit you made.

Both the bull call and bull put have limited profits and limited losses.

The Bottom Line

We recommend you use one strategy at a time. Options trading can be profitable when done right. It can be financially destructive when done wrong. Implementing one options strategy in your portfolio at a time lets you get your feet wet. See firsthand how options work and what you stand to gain or lose, and over time you'll be ready to try another strategy.

Don't forget to shop for the right broker. You want someone who will work closely with you and walk you through your first few options trades.

Write to Kim P at support@creditdonkey.com. Follow us on Twitter and Facebook for our latest posts.

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