trading strategies Options Trading Strategies One of the reasons trading options is so powerful is they give you the ability to tailor a strategy to nearly any situation. Once you learn the basics of how to trade options, you’ll want to start utilizing these more advanced strategies to help you make money, protect your portfolio, or even generate income. Options strategies can often sound complicated. But don’t let the number of strategies or their technical names fool you. Every options strategy involves using either a call, a put, or both. That’s it. Every strategy is simply a different combination of buying and selling calls and puts to help you make money when a stock moves in the direction you want it to. We’ll start by going over the basics and the building blocks of every strategy: calls and puts. Once you’ve got the basics of buying and selling calls and puts down, it’s just a matter of tailoring them to the stock you’re trading. It’s that simple. Buying Calls Buying calls is the most popular options trade. It’s a bullish strategy that helps you profit when the share price of a stock goes higher. A call option gives you the right to buy a stock at an agreed-upon price. You can either exercise the option to buy the stock at that price, sell the option to someone else, or let it expire worthless. The price of a call option rises alongside the share price of the stock. Options traders hope to buy the contract, see the price of the stock rise, and either sell the contract for a profit or exercise the contract and buy the stock below market value. Buying calls is a simple strategy, but there are many factors that go into the price of an option and your ability to profit from it. Make sure to read our guide to making the best options trades to hone your strategy. Buying Puts Buying puts works similarly to buying options, except puts are a bearish strategy and you want to see the stock price drop. Puts give you the right to sell a stock at an agreed upon price. You can exercise the option, sell the put option, or let it expire worthless. Because a put gives you the right to sell a stock at a contracted price, the lower the price of the stock goes, the more valuable your put option is. You have the ability to sell a stock for an above-market price. That means the more the stock drops, the more the put can be worth. Selling Calls An option contract is between two people, which means you need both a buyer of the contract and someone who writes, or sells, the contract. We’ve already covered what that looks like for the buyer of the contract. But you can also be the one who writes the contract. When you buy the call option contract, you’re buying the right to buy the stock at the contract price. The person who wrote the contract is the one you’ll be buying it from. Since buying a call is a bullish strategy – you want the stock price to go up – selling a call is a bearish strategy, and you want the price to go down. When you sell a call contract, a buyer pays you a fee for it, called a premium, which you get to keep no matter what happens next. If the stock never rises above the strike price, the premium is your profit. If the stock does rise above the strike price and the option is executed, then you’re obligated to sell the stock at the strike price. If you don’t already own the stock, then you’ll have to buy it at market price, which could mean a potential infinite loss. This is called writing a naked call, and we don’t recommend doing it due to that level of risk. Writing covered calls, on the other hand, can be a very useful strategy. Covered Calls If you already own at least 100 shares of the stock and you’d be willing to sell it at the right price, then writing calls can be a profitable strategy. When you write a call option contract using a stock you already own, it’s called a covered call. Your risk is covered by the stocks in your portfolio, so you don’t have to buy them on the open market. That means you can collect the premium from the sale of the contracts until the stock rises to the strike price. You can sell contracts weekly, monthly, or longer depending on the expiration date you choose, letting you earn income on a stock you plan to sell. The main risk is the stock shoots dramatically higher, forcing you to sell it at a below-market price. But if you have a price target in mind where you’d sell the shares anyway, this is a great strategy for earning extra income. Selling Puts Selling put options is more of a bullish strategy. Similar to selling calls, you’re on the other end of the put contract someone is buying. So if the stock drops below the strike price, you’re potentially obligated to buy shares of the stock at the strike price. If the stock never goes below the strike price, then you keep the premium paid for the contract as profit. The risk here is if the stock tanks – say, something disastrous happens to the company – you’d be on the hook for buying shares at an above-market price. But when done right, selling puts can be part of an income strategy or a long-term bullish strategy. Here’s one way to do it. Cash-Secured Puts One of the best strategies for selling put options is cash-secured puts. If there’s a stock you’d love to own, but you think is too expensive right now, you can sell puts on the stock at the strike price you’d be willing to pay for the stock. Think of it as naming your own discount. Then you add the cash to your account it would take to buy enough shares of the stock to cover your contract (one contract is 100 shares). This means you’re ready to buy the stock if it hits your share price and don’t have to worry about a margin call or freeing up funds in a hurry. If the stock falls to your strike price and the contract is executed, great. You got the stock you loved at the price you wanted to pay, plus, someone paid you for the opportunity. If the stock doesn’t fall to your strike price, you collect the premium as profit. And you can keep doing this until the stock falls to your strike price or rises high enough that you aren’t able to sell puts at your preferred strike price anymore. Collar Now that you’ve got the basics of buying and selling calls and puts down, we can start to combine these trades to build tailored strategies. The first strategy we’ll talk about is called the collar. The options collar is a bullish trade to use on a stock you already own at least 100 shares of. You want to use a collar when you like the stock, but worry it has downside risk. Maybe you own a high-flying tech stock that just surged higher after an earnings report. You’re not ready to sell, but you know the stock could come back down on some negative news. By now, you already know simply buying a put option on the stock is one strategy to protect yourself from a share price drop, but the collar goes one step farther. The first step to a collar is to buy that put option. The second step is to sell a call option with a similar expiration date. Ideally, you’d choose a strike price at a price you’d sell the stock anyway. The premium from selling the call option helps offset the cost of buying the put option. That means you’re hedged at very little expense. The downside to the collar is if the stock shoots even higher, then it will act just like a covered call: You’ll have to sell your shares at a below-market price. But for the right investor with the right stock, this is a great strategy to hedge your risk, even if it limits your potential upside. Spreads Spreads are similar to a collar but involve buying and selling either a call or a put at the same time. Here’s how you can use spreads depending on your situation. Bull Call Spread A bull call spread, like its name, is a bullish strategy using two call options. In this strategy, you buy one call option and sell another call option at the same time. You want to use this strategy when you’re bullish on a stock, but want to limit your risk. First, buy a call on the stock you expect will go up. Second, sell a call for a higher strike price with a similar expiration date. The sale of the second call option will help cover the cost of buying the first option. That will limit your risk. But it will also cap your upside potential if the stock soars above the strike price of the options you sold. Bear Put Spread The bear put spread works the same way, but for when you’re bearish on a stock. First, buy a put on a stock you expect will fall. Second, sell a put at a lower strike price with a similar expiration date. If the stock’s price drops below the put you bought but stays higher than the put you sold, you’ll profit the difference between the cost of the two contracts. Similar to the bull call spread, your profit potential is limited as well, even if the stock price continues to drop. Your risk is reduced here too. The put you sell will help pay for the put you buy. And if the contract on the put you sold is executed, the put you bought will cover it. Straddles and Strangles Straddles and strangles let you profit off a stock’s movement, even if you don’t know whether the stock will go up or down. However, these are more advanced strategies and can come with more costs, and more risks. Long Straddle The long straddle is a simple way to profit from potential movement in a stock price. First, buy a call at the money on the stock. Second, but a put at the money with the same expiration date. If you’ve been following along, you’ll see the problem with the long straddle right away: It’s going to be a costly trade. Buying at-the-money options is more expensive than buying out-of-the-money options. And buying two at-the-money options is doubly so. That means you need a pretty big swing in the stock price for this one to make money. The good news is you own both a call and a put. If the stock surges higher, your call will make you money. If the stock swings lower, your put will make you money. But if the stock stays flat, you’ll lose the cost of the contracts. Short Straddle A short straddle works just the opposite way. You want the stock to stay flat here. Be warned: This is a very risky trade, and we don’t recommend trying it. It’s good for you to know what it is and see how it works, but the risk is simply too high for most traders. You’ll find some better strategies for this later. First, you sell a call on the stock you’re targeting. Second, you sell a put on the stock you’re targeting with the same expiration date. As you know from the earlier sections, selling options comes with unique risks. Here, you’re selling two different options. The potential risk from selling a naked call is unlimited. There is no limit to how high a stock can rise, and you’re on the hook for buying it no matter what the price is. The way this trade works is you collect the premium from selling the two contracts, then if the stock stays flat and the contracts aren’t executed, you keep the cash as pure profit. But the moment the stock begins to move, this trade can backfire in a hurry. Long Strangle The long strangle is the same idea as the long straddle, but with a twist. With both strategies, you expect the share price of the stock to move. You just don’t know which direction. Here’s how the strangle works. See if you can spot the difference. First, buy a put on the target stock. Second, buy a call on the target stock with a strike price above the strike price of the put with the same expiration date. You don’t necessarily need to start with the put and look for a higher price on the call; you can start with a call and look for a lower strike price for the put, or split the difference. They key here is you’ll pay slightly less for a put with a lower strike price and slightly less for a call with a higher strike price. Here the goal is the same as the straddle: You want the price of the stock to move enough that it makes the put grow in value or the call grow in value. But by staggering the strike prices, you reduce a bit of your up-front costs, while you need the stock to move more aggressively to see one of the contract’s value to grow. Short Strangle Same as the short straddle, this is not a trade to try. Steer clear. With that said, we want you to see how it works (and hopefully see why it’s too risky to try). Again, like the short straddle, you want the share price of the stock to stay flat. To make money on a flat stock like that, a hedge fund pro (read: they are risking other people’s money, not their own) might use a short strangle. First, you’ll sell a put at a strike price below the current price of the stock. Second, you’ll sell a call option at a strike price above the current price of the stock. You’ll collect the cost of the premiums, but your risk is unlimited. You could be forced to buy the stock back at an infinitely higher price.
