Options are among the most popular vehicles for traders
because their price can change quickly and make (or lose) big bucks quickly.
Options strategies can range from the very simple to the very complex, with a
variety of payoffs and sometimes strange names. (Iron Condor, anyone?)
Regardless of their complexity, all options strategies are based on the two
basic types of options: the call and the put. Below are five popular
strategies, a breakdown of their rewards and risks, and when a trader might use
them for their next investment. Although these strategies are fairly simple,
they can make a trader a lot of money, but they are not without risk. Before we
get started, here are a few guides on the basics of call options and put
options.
1. Long call
In this strategy, the trader buys a call, known as a long
call, and expects the stock price to exceed the strike price by expiry. The
upside potential of this trade is unlimited and traders can earn multiples of
their initial investment if the stock rises.
When to Use It: A long call is a good choice if you expect
the stock to rise significantly before the option expires. If the stock rises
just slightly above the strike price, the option may still be in the money but
may not even pay back the premium paid, resulting in a net loss.
2. Covered call
A covered call involves selling a call option (short
selling), but with a twist. Here the trader sells a call but also buys the
stock underlying the option, 100 shares for each call sold. Owning the stock
turns a potentially risky trade, the short call, into a relatively safe trade
that can generate income. Traders expect the stock price to be below the strike
price at expiration. If the stock finishes above the strike price, the owner
must sell the stock to the call buyer at the strike price.
When to Use It: A covered call can be a good strategy to
generate income if you already own the stock and don't expect the stock to rise
significantly in the near future. So, the strategy can turn your already
existing holdings into a source of money. The covered call is popular with
older investors who need the income, and it can be useful for tax-deferred
accounts where you could otherwise pay tax on the premium and capital gains if
the stock is called.
3. Long put
In this strategy, the trader buys a put, known as a put long,
and expects the stock price to trade below the strike price until expiry. The
upside potential of this trade can be multiples of the original investment if
the stock falls significantly.
When to use it: A long put is a good choice if you expect the
stock to fall significantly before the option expires. If the stock falls just
slightly below the strike price, the option is in the money but may not repay
the premium paid, resulting in a net loss.
4. Short put
In this strategy, the trader buys a put, known as a put long,
and expects the stock price to trade below the strike price until expiry. The
upside potential of this trade can be multiples of the original investment if
the stock falls significantly.
When to use it: A long put is a good choice if you expect the
stock to fall significantly before the option expires. If the stock falls just
slightly below the strike price, the option is in the money but may not repay
the premium paid, resulting in a net loss.
5. Married put
This strategy is like the long put with a twist. The trader
owns the underlying stock and also buys a put. This is a hedged trade where the
trader expects the stock to go up but wants insurance in case the stock goes
down. If the stock falls, the long put will offset the fall.
When to Use It: A married put can be a good choice if you expect the stock price to rise significantly before the options expire, but think it could potentially fall significantly as well. The married put allows you to hold the stock and enjoy the potential upside if it rises, but still be protected from significant losses if the stock falls. For example, a trader might be waiting for news like earnings that could push the stock up or down and want to be covered.
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