Options are one of the more favored options for traders because they can be traded at a rapid pace, making (or losing) lots of money quickly. Options strategies can vary from relatively simple to extremely complex that include a wide range of payouts, and even bizarre names. (Iron condor, anyone?) No matter how complex, the majority of options strategies are built on two fundamental types of options: call and put. Below are five of the most popular options and a breakdown of their rewards and risks and the times when a trader might leverage them for their next investment. While these strategies are fairly simple, they can earn traders a lot of money, but they’re not completely risk-free. Here are a few guidelines about the basics of call options and put options before we dive into the details.
In this strategy, the trader invests in a call called “going long” a call — and expects the price of the stock to surpass the strike price prior to the time of expiration. The upside on this trade is not limited and traders could make a lot more than their initial investment if the price of the stock rises. Example: Stock X is trading at $20 per share. calls with a strike price of $20, and an expiration date of four months, is traded at $1. The contract cost $100 which is one call * $1 = 100 shares represented per contract.
Reward/risk In this scenario the trader is able to break even at $21 per share, or the strike price plus the $1 premium paid. If the price is above 20 dollars, an option will increase to $100 for each dollar the stock gains. The option expires when the stock is at strike price but not below. The upside on a long call is theoretically unlimited. If the price continues to increase prior to expiration, the call could continue to rise and vice versa. This is why long calls are one of the most sought-after ways to bet on an increasing price of stocks. The drawback of a long call is the loss of your investment, $100 in this instance. If the stock closes below the strike price and the call is not canceled, it will become without value and you’ll be left with nothing.
When to use It: A long call is an excellent option if you are expecting the stock to rise significantly before the option’s expiration. If the stock rises only one percent above the strike value, the option could still be worth the investment but it might not return the premium paid making you an unintentional loss.
Calls that are covered
A covered call is a process of selling the option of a call (“going short”) however with twists. The trader will sell an option, but they also purchase the stock that underlies the option, which is 100 shares for every call sold. Being a stock owner turns a potentially risky trade -called the short call- into a relatively safe trade that could generate earnings. The market expects the price to be lower than the strike price upon expiration. If the stock is priced above that price at expiration, the seller must sell the stock to a buy-out buyer for the amount of strike.
Example: Stock X is trading for $20 per share. calls with a strike value of $20 and expiration in four months is priced at $1. The contract pays a premium of $100 or the equivalent of one call * 1 * 100 shares represented by each contract. The trader purchases 100 stock shares for $2000 and sells one call to receive $100.
Risk/reward: In this example the trader has a break-even point for $19 per shares which is the strike value minus the $1 premium paid. Below $19 the trader will be losing money, since the stock would be unable to make money, far more compensating one cent of the premium. When the price is exactly $20, the trader would maintain the full price and hang onto the stock. Beyond $20, the profit is limited to $100. Although the short call will lose $100 for every dollar increase above $20, it’s totally compensated by the gain of the stock which leaves the trader with the original $100 as the total gain. The upside on an covered call limited to the premium received, regardless of how high the price of the stock rises. You can’t make any greater than this, however you may lose more. Any gain that you otherwise could have earned from the increase in the price of the stock is negated through the shorter call.The negative is a total loss on your investment in the stock should the stock fall to zero, minus the premium paid. The covered call can leave you vulnerable to a large loss, if the stock is down. For instance, in our case, if the stock declined to zero, your total loss could be one hundred dollars. When to use it: A covered call can be a good strategy to generate income when you already have the stock but don’t expect the stock to rise substantially in the near-term. So the strategy can transform the assets you already have into a source of cash. The covered call is very popular with investors older than their age and who require the income, and it can be useful in accounts that are tax-advantaged in which you would otherwise have to pay taxes on the amount of premium as well as capital gains if the stock is referred to as.
In this strategy, the trader purchases a put that is referred to as “going long” a put — and expects the stock price to be lower than the strike price at expiration. The benefits of this trade can be multiples of the initial investment if the stock falls significantly. Example: Stock X is trading for $20 per share. Similarly, puts with a strike of $20 and expiration in 4 months is currently trading at $1. The contract is priced at $100, which is one contract * $1 = 100 shares represented per contract.
Reward/risk: In this instance, the put is in break even when the stock is closed at option expiration at $19 per share, which is the strike value less the $1 premium that was paid. The put is priced below $19 and increases by $100 per dollar loss in the stock. Above $20, the puts expires and is worthless, and the trader loses the entire premium of $100.The upside of a long put is almost as good as that of a long-call since the gains can be multiples of the cost. However, a company’s stock could never go below zero, limiting the upside, whereas a long call can theoretically have unlimited potential upside. Long puts are another simple and well-known method of betting on the decline of a particular stock. Additionally, they’re more secure than shorting a stock. The risk associated with a long put is that it is only the price of the premium, which is $100 here. If the stock closes above the strike price at expiration of your option the put becomes meaningless and you’ll lose your investment. When to utilize the option:A longer put can be the best option when you anticipate the stock to fall significantly before the option expires. If the stock drops only marginally below the strike price, the option will be in the money, however, it could not pay back the premium which you have paid, leaving you with the risk of a net loss.
This method is the reverse from the traditional long put, however, the trader here sells puts — which is referred to as “going short” a put and hopes for the stock price to exceed the strike price when it expires. In exchange for the sale of a put the buyer receives a cash premium which is the largest amount an option that is short can yield. If the stock is trading below the strike price upon expiration time, the buyer is required to buy it at its strike price. Example: Stock X is trading at $20 per share. Similarly, the put with a strike value of $20 with an expiration time of four months, is currently trading at $1. The contract is liable for a premium of $100, which is one contract * $1 * 100 shares represented by the contract.
When should you apply the option: A short put is a suitable strategy when you expect the stock to close at the strike price or above when the option expires. The price must be above or equal to the strike price in order for the option to run out of value, letting you keep all the money you paid for it.
Your broker should make sure that you have enough capital in your account to buy the stock if it’s put to you. A lot of traders have sufficient cash to purchase the stock when the put is finished in the money. It is possible to close out the option position prior to expiration to take the net loss without needing to purchase the stock at the time of expiration.
This strategy is like the long put with a twist. The trader holds the underlying stock and buys a put. This is a hedged trade where the trader believes that the stock will rise but also wants “insurance” in the event that the stock does fall. If the stock does fall the long put is able to offset the fall. Example: Stock X is trading for $20 per share, and an option that has a strike price of $20 with an expiration time of four months is trading at $1. The contract costs $100, or one contract * $1 * 100 shares represented per contract. The trader buys 100 shares for $2000 and purchases a put for $100.