Options contracts represent agreements that give an investor the right — and in some cases, the obligation — to buy or sell a particular security at a specific price by a set date in time. A single contract typically represents the right to buy or sell 100 shares.
Options involve two main elements: a strike price and an expiration date. The expiration date is when the contact is due, and the strike price is the price at which a contract must be delivered upon.
Interested investors who have already read a guide to options trading might be ready to go deeper and learn more about option trading strategies.
Related: 6 real questions about investing— answered
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Types of Options
The two most basic types of options are calls and puts.
A call gives an investor the right to buy an asset — it’s a bet that the price will rise.
A put gives an investor the right to sell an asset — it’s bet that the price will fall.
Combinations of calls and puts with different strike prices and expiration dates can be used to create different option trading strategies.
Common Options Trading Strategies
There are a few ways investors might use options in an effort to realize a profit or generate some income.
When using options, investors can either buy existing contracts, or they can “write” contracts for securities they currently hold. The former is generally used as a means of speculation, while the latter is most often used as a way of generating income.
There are also three categories contracts can fall into, depending on where the price of their underlying security lies in relation to their strike price.
- “In-the-money” means an option is already profitable (i.e., the stock price is below the strike for a put, or the stock price is above the strike price for a call).
- “Out-of-the-money” means the opposite (i.e., the stock is trading higher than the strike for a put, or the stock price is trading lower than the strike for a call).
- “At-the-money” means the strike price of the option and the stock price are about the same.
1. The Covered Call Strategy
The covered call strategy requires an investor to own shares of the underlying stock. They then write a call option on the stock and receive a premium payment.
The tradeoff is that if the stock rises above the strike price of the contract, the stock shares will be called away from them, and the shares (along with any future price rises) will be forfeit.
So this strategy works best when a stock is expected to stay flat or go down slightly.
If the stock price stays below the strike price when the option expires, the call writer keeps the shares and the premium and can then write another covered call if desired. If the stock rises above the strike price when the option expires, the call writer must sell the shares at that price.
2. The Cash-Secured Put Strategy
The cash-secured put strategy is one that can both provide income and let investors purchase a stock at a lower price than they might have been able to if using a simple market buy order.
Here’s how it works: An investor writes a put option for a stock they do not own with a strike price lower than shares are currently trading at. The investor needs to have enough cash in their account to cover the cost of buying 100 shares per contract written, in case the stock trades below the strike price upon expiration (in which case, they would be obligated to buy).
This strategy is typically used when a stock is expected to go down in the short-term. The option writer then receives cheap shares while also holding onto the premium.
Alternatively, if the stock trades sideways, the writer will still receive the premium, but no shares.
3. The Bull Put Spread Strategy
The previous two option strategies only involve one option “leg,” meaning there’s only one contract involved. More sophisticated strategies — like the bull put spread — involve writing or buying multiple options contracts at the same time to minimize risk.
A bull put spread involves one long put with a lower strike price and one short put with a higher strike price.
Both contracts have the same expiration date and underlying security. This strategy is intended to benefit from a rising stock price. But unlike a regular call option, which also benefits from a rising stock price, a bull put spread can also profit from time decay.
4. The Condor Strategy
The condor consists of four call option legs (two written calls and two buys of existing calls) and is designed to earn a small profit in a low-risk fashion when a stock is thought to have little volatility (Understanding stock volatility is important for any investor).
A trader can create a condor by writing an in-the-money call with a lower strike, buying an in-the-money call with an even lower strike, writing an out-of-the-money call with a higher strike, and buying another even higher striking out-of-the-money call.
5. The Butterfly Spread Strategy
Like the condor, the butterfly spread involves four different options legs. This strategy is used when a stock is expected to stay relatively flat until the options expire.
A butterfly spread is a combination of a bull spread and a bear spread and can be constructed with either calls or puts. In this example, we’ll use calls.
To create a butterfly spread, an investor can buy one in-the-money call with a lower strike price, write two at-the-money calls and buy another higher striking out-of-the-money call.
How to Use Options Trading Strategies
The average brokerage account should have most of these options available for selection, provided there are enough existing options contracts for a given security.
After choosing the type of strategy, an investor will have to pick the strike price and expiration date of each option leg. Inexperienced options traders, in particular, might want to consider sticking to strategies that only involve one option leg while learning how options work.
Most brokerages have different “levels” for trading options. New investors might only be able to write covered positions only. To use more advanced strategies like condors and butterflies, investors might have to take a short quiz demonstrating their understanding.
Options as a Risk-Hedging Tool
Sometimes, options can be used as a hedge. A hedge is something an investor uses to make up for potential losses somewhere else.
For example, gold is often referred to as an “inflation hedge,” because gold tends to perform well during times of inflation, even though the currency other investments are denominated in would be going down in real terms.
Likewise, traders can use various options trading strategies to hedge their existing portfolio positions.
One example might be an investor who is heavily invested in tech stocks, placing a put option on a tech-heavy ETF or index fund like the QQQ.
The QQQ ETF tracks the Nasdaq 100 index, a list of the top 100 best-performing stocks on the Nasdaq stock exchange, which is mainly geared toward tech companies (although there are other types of companies included as well).
In an effort to hedge a large long position in tech, an investor could possibly consider placing a long-term put option on the QQQ (typically more than 9 months). In theory, this put option would then rise in value if tech stocks took a beating. In this way, an investor could minimize losses.
Of course, the opposite also holds true. If tech stocks continue to rise, then the QQQ put option would lose value. In either case, the allocation is what’s important — determining what amount of money to place in each investment to create a balanced portfolio.
In this example, allocation would need to be calculated in a way that would ensure tech stock gains would outpace potential put option losses and vice versa. Asset allocation is a complex topic that is unique to each individual investor.
How Risky are Options?
While options can be used to hedge overall risk in a portfolio, trading options for profit can come with substantial risk.
Put options in particular can lead to large or even potentially unlimited losses for investors. Unlike a call option, in which a stock’s price has the potential to fall to zero, at which point maximum losses are realized, with a put option there is no upward limit on a stock’s price. Because of that, the put can continue losing more and more money if the stock keeps rising.
The other risk comes in the form of beginner investors not understanding what options contracts they are buying. When selecting a contract from an options chain, the choices can look confusing, and novice traders could easily misunderstand the actual bet they are making.
One way to remedy this might be to take advantage of any “paper money” trading options that brokerages offer. This sort of feature will allow traders to try different option strategies without risking real money.
Traders can learn from experience without losing by selecting different options and seeing how the results play out over time.
Options trading strategies offer a way to potentially profit in almost any market situation, whether prices are going up, down or sideways.
More option trading strategies exist beyond the common ones outlined here. There are many possible ways to combine options, some of them being rather complex.
Depending on how they’re used, options can come with a small amount of risk or an infinite amount of risk. In general, trading with instruments like options and futures is considered to be riskier than buying/selling stocks because these strategies require greater experience and understanding, and the risks involved might not always be as clear.
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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