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Options Trading Strategies: Everything You Need to Know About Put and Calls

[Editor's Note: I've seen firsthand over the years just how little people understand about options. That's why we had Michael create an exclusive investor's guide for you called "The Power of Options." The best part is we are giving it to every single subscriber for free. To access your free investors guide,click here. In the story below Michaels explains various options trading strategies...]

By , Money Morning •

There are hundreds of option trading strategies. And they can be vastly different in terms of tactics and desired outcome.

Covered calls are very conservative, for example, while uncovered or "naked" calls are high-risk. How you select them depends on your risk tolerance and comfort level with different degrees of exposure.

But in fact, there are really only a few basic strategies, and everything else is built on these in some form.

At Money Map Press, we use eight general strategies (and "families" of strategies). These will cover most of the approaches you are likely to see and to take in your own trading.

But I do want to mention something first.

This same huge range of possible strategic designs is what makes the options market so interesting, challenging, profitable... and also nice and risky.

Are you surprised by my characterization of risk as "nice?"

Well, "risk" and "opportunity" are really the same thing, and every option trader needs to accept this.

If you want to go fast and get some serious movement, well, you have to climb on board the rollercoaster first, even if it scares you a little bit. Okay, here we go.

Today we'll take a deeper look at four of the eight options strategies we use on a routine basis.

Long Calls

The long call is a cinch. You simply buy a call - often for as little as 5% of the value of the 100 shares it controls.

You wait for the underlying to rise in value, which is what you're betting on. And then you either sell the call (at a profit) or exercise it.

Now, as attractive as the long call may be at first glance, it is not easy to make money consistently. It's a matter of time, timing, and proximity, and almost never a matter of price only.

Let me explain that.

Time describes the endless dilemma of the long call trade. You want to find the cheapest long call you can, knowing that you need to build profits, not just above the strike, but far enough above to cover your cost, too. So the more expensive the call, the further the price needs to move. At the same time, focusing on cheap calls will leave you with very little time for the call to appreciate.

Timing is the key to creating profitability in long call positions. If you are going to pick calls at random, you'll lose more often than you'll win. But if you know how to time your trade, your odds of profiting go way up. All ETFs, and indexes go through predictable cycles. The time to buy calls is right when the underlying is at the bottom of a cycle. This is where the chances of reversal and upward movement are highest, whether you seek a five-day turnaround or a two-month turnaround. Whatever your timeframe, timing is key.

Proximity is the third decision point in picking a long call. The distance between the price of the underlying and the option's strike is what determines not only current premium price, but how responsive that price is going to be to movement in the underlying. When the two are far apart, you cannot expect a lot of point-for-point reaction, even in the money. The extrinsic value (implied volatility) will dampen reaction due to the distance.

In other words, the further away from the strike, the less the underlying price matters in terms of option premium. This is especially true for deep OTM options. The way the market prices options, the less chance that price will catch up to strike, the less faith there is in even strong price movement.

Long Puts

Just like the long call, trading long puts involves the three issues of time, timing, and proximity.
The only difference is, it's a play on the underlying falling in value. Buying puts at the top of the cyclical swing - even very short-term ones - improves timing and presents opportunities to take profits, often in only a matter of days.

Short (Covered) Calls

The covered call is one of the most popular strategies - the "rock star" of options.
Now, it may be a rock star, but it is generally thought of as a conservative strategy. That's because, when properly designed, a covered call generates profits no matter how the stock price moves.
(Are you starting to see the beauty of options?)

It consists of owning 100 shares and selling one call against those shares.
It's for a trader who believes the stock price will go down. The short position is "covered" in the sense that, if the call is exercised, the stock is called away, but you don't lose (even though the stock's value will be higher than the strike). The idea is that the assurance of known profits from the covered call is worth the occasional lost opportunity.

You have to be cautious in how you set up the covered call to make sure that you "program" net gains no matter what.

Here's the idea: With the covered call, you create a "cushion" with the premium you receive, so that your breakeven is below your original cost per share.
For example, if you sell a call and get three points, that moves your breakeven down to three points below your cost. That is the initial benefit to selling covered calls. But it does not address the larger market risk of having long stock. If the price falls below your strike, you lose. The short call is not a culprit in this scenario. In fact, the call reduces your exposure. But it does not eliminate the market risk, and that's the point I want you to keep in mind.

On the upside, you face a different risk - that the underlying price could move well above the strike, meaning the call will be exercised, and your shares called away at the strike.
Since the market price would be higher at this point, it creates a loss - the difference between the fixed strike and the underlying current value. Is this potential loss acceptable to you, or not? If not, then you should not write covered calls. But realistically, it's unusual for the underlying price to soar so far above the strike. Most of the time, the short call is going to expire worthless, or can be closed at a profit, or can be rolled forward. Yet even if none of these can occur, you can exercise the call at any time before expiration.

To ensure the greatest success in writing covered calls, follow these guidelines:

  1. Focus on very short-term contracts. Returns on short-term calls are better than on longer-term ones, because time value declines at an accelerated rate. If you sell covered calls that expire in one to two months, you can maximize your annualized return (we covered that term in Chapter 2). Even though you get more cash premium selling longer-term contracts, you make more in the end with short-term ones. You are better off writing six two-month calls than one 12-month short call. Another reason to avoid longer-term covered calls is that they keep you and your cash tied up that much longer. Anything can happen, but in the market, the longer you remain exposed, the greater the risk.
  2. Buy the right strikes. The ideal short call is going to be slightly out of the money. This is where the premium is at its best. Far OTM calls are going to have dismal premium in comparison, especially for soon-to-expire contracts. An ITM premium will be higher, but more likely to get exercised. Slightly OTM is the way to go.
  3. Remember, exercise can happen at any time. The most likely day of exercise is on the last trading day for any ITM option. The second most likely date is going to be on or right before the ex-dividend date. Traders exercise to become stockholder of record and get the current quarter's dividend. So if you want to avoid early exercise, stay away from covered calls on stocks with ex-dividend in the current month. Or, as long as they are ATM or ITM, you probably don't have to worry.
  4. Open profitable positions. Pick strikes above your basis in the underlying so that you get a capital gain, and not a capital loss, when exercise occurs. This is often overlooked, but it is essential. Now, there is an exception: You can sell covered calls below your basis, so long as premium is rich enough and exceeds the loss. For example, you buy stock at $37 per share. The 40 call is not attractive, but the 35 call can be sold at 5. If the call is exercised, you will lose two points in the stock, but the net outcome is a three-point profit.
  5. Remember the underlying. Another easily overlooked aspect of covered call selling is the stock, ETF, or index you select. You're going to find the most attractive premiums in the most volatile underlying. Lower premiums are symptoms of low-volatility issues. This is yet another balancing act. High-volatility underlying issues are higher-risk, so if you buy shares solely to write covered calls, you expose yourself to higher market risk - a problem that can easily offset the benefits of the covered call.

You can also "cover" a short call by offsetting it with a later-expiring long call, or with a call that expires at the same time, but at a higher strike. However, these forms of cover are difficult to make practical. The cost element net of outcomes will usually be negative.

A lot of people wonder if you can create a "covered put" in the same way as a covered call. No. Here's why: If you have shorted stock, a short put protects you to a degree, in the event the stock price rises, it's kind of like insurance.

But on a practical level, a long call provides better protection because it will offset loss in the stock all the way up. A put protects you only to the extent of the premium you receive. And if the stock declines as short sellers want, the short put is at risk of exercise. So, realistically, all short puts are uncovered.

And the bigger risk is going to be found in the uncovered, or "naked" call.

When you sell a call naked (without owning 100 shares of stock), you face a bigger risk. In theory, a stock's value could rise indefinitely. But at exercise, you have to satisfy exercise at the strike price. So, for example, if you sell an uncovered 30 call, and the stock then skyrockets to $90 per share, your loss is $6,000 (minus whatever premium you got for selling the call). Of course, it's pretty unusual for stock prices to rise so dramatically. But it could happen. And therein lies the risk.

Every short put is uncovered, unless you offset it with a later-expiring long put. However, the risk is much smaller. Can you guess why?

Even in the very worst-case scenario, a stock's value cannot fall below zero. So risk is quantified as the difference between the strike and zero. Actual risk is much less, of course. The true risk to an uncovered put is the difference between the strike and tangible book value per share (again, less the premium received). Realistically, a stock is very unlikely to fall lower than its tangible book value.

The risk, in all short options, is exercise. For covered call writing, exercise can be desirable since it produces a net yield. But for other covered call writers, as well as virtually every uncovered option writer, exercise is not desirable. It can be delayed or avoided by rolling forward. (See the sidebar for more.)

You can also take the covered call up a notch - creating even more profit in exchange for somewhat higher risks - with a ratio write. This is just a covered call involving more calls than you cover with shares. For example, if you own 200 shares and sell three calls, you set up a 3:2 ratio write. The market risk is greater, but so is the premium income - by 50%. For this reason, many covered call writers like the ratio write, and accept the risk.

You can address the risk, somewhat, too. If the underlying begins moving up, you can partially close the ratio write to eliminate risk. Or you can roll forward one or more of the short positions. Given the fast decline in time value, there is a reasonable chance that the premium value of the calls is going to fall enough to wipe out the risk. Close the extra leg of the shorts and take a small profit.

An even better variety is the variable ratio write. The risks with this one are very small compared to the straightforward covered call - which makes it a desirable expansion of the strategy. The "variable" portion refers to the strike. You set up the ratio, but use two different strikes.

For example, say you bought 300 shares of stock at $38 per share, and today's market value is $39. You can set up a variable ratio write by selling two 40 calls and two 42.50 calls. Now your premium income is increased, but your risk is not that much higher, because all of the calls are OTM. If the stock price rises to $40, you have no immediate market risk, because the higher strike is still OTM. But if the price continues to rise and approaches the $42.50 threshold, you can close or roll forward one or both of the higher-strike calls.

Short puts

Remember, with the call, you offset the exercise risk by owning 100 shares of underlying for each call sold. When you sell a short put, however, you cannot cover the position in the same way.

But uncovered puts are not as risky as uncovered calls. That's because the underlying price cannot fall indefinitely, though the price can rise indefinitely (at least in theory). So in the worst case, your risk with the short put is the difference between the strike price and zero. (The price can't go negative.) However, the true maximum risk is the difference between strike and tangible book value per share.

A couple of rules here.

First, focus on puts expiring within one month. That will help you maximize your profit potential. Time value is going to evaporate very quickly, so even if the stock price falls below the strike, you can often close the short put at a profit ITM. You can also roll forward the short put. However, the likelihood of expiring worthless is quite high, so the short put, like the covered call, is a potential cash cow.

Second, the risk here is exercise, in which case you have to buy shares at the strike, which will be above market value. So if you are going to write short puts, make sure you consider the strike a good price for the underlying. Be realistic about the potential of exercise at any time. And be willing to either hold onto shares or develop a strategy for offsetting the paper loss.

In my next article I'll cover insurance puts, leap options, spreads and straddles.

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