Options Trading Strategies

Basic Concepts in Options Trading Strategies

There are several basic Options Trading strategies, but in order to execute any of them successfully an investor new to options will need to know some elementary concepts.

The most basic are the call and the put. Buying a call confers the right, but not the obligation, to buy at a pre-set price. Puts grant the buyer the right to sell at a pre-set price. But options are sold as well as bought. That seller grants the buyer the right, and takes on an obligation to fulfill the other side of the trade.

There are several basic variations:

Long Calls

The most basic, and easiest to understand, is the (long) call. MSFT (Microsoft), currently trading at $28, have June 31 options that expire on the third Friday of June, with a strike price (pre-set, 'if exercised, must-be-bought-at-price') of $31.

Short ('Naked') Calls

When the option seller (the 'writer') doesn't own the underlying stock he's obligated to sell (if the option is exercised), he is said to be selling a 'naked' call. Since he's on the selling side of the contract, his position is said to be 'short'.

If the market price of the underlying asset decreases, the short call position will profit by the amount of the premium. The price rises above the strike price by more than the premium, the short position incurs a loss.

Long Put

Traders who anticipate that the future market price of an asset, say a stock, will fall prior to expiration can buy the right to sell the stock at a fixed price. The put buyer has no obligation to sell the stock, but simply the right.

If, in fact, the market price does fall below the strike price (prior to expiration of the option) by more than the premium paid, he profits. If the price increases, or doesn't fall enough to cover the premium, the trader lets the contract 'expire worthless'.

Short Put

Traders who speculate that the future market price will increase, can sell the right to sell an asset at a pre-determined price.

If the asset's market price rises, the short put position makes a profit equal to the amount of the premium. (Excluding any transaction costs, such as commissions.) If the price falls below the strike price by more than the premium, the 'writer' loses money.

Several basic trading strategies utilize the characteristics of these four basic positions. These strategies are either pure profit plays - speculating on coming out on the plus side of the equation - or combinations of speculation and hedging.

Hedging involves taking positions that tend to move in opposite directions. They profit less than pure speculation, but make up for it by offloading some risk.

'Bull spreads', for example, use a long call with a low strike price in combination with a short call at a higher strike price and a short put with a higher strike price.

'Bear spreads', by contrast, involve a short call with a low strike price and a long call with a higher strike price. An alternative method uses a short put with low strike price and a long put with a higher strike price.

Options trading software can demonstrate several concrete examples of how any of these - under different assumptions about future prices, volume, etc in combination with different expiration dates and strike prices - can result in profit (or loss).

Profit and Risk

Risk isn't inherently bad. Without it, there would be far fewer opportunities for profit. In particular, there would be no options market at all. No one would have to speculate on price direction or other factors, since risk always implies uncertainty about the future.

But risks come in different flavors and degrees. Let's examine some trading strategies with an eye toward risk...

Long Calls

The simplest options trade, the one usually first executed by investors moving beyond stock or bond investing, is the long call. A call is a contract that confers the right to buy an underlying instrument at a set price, the strike price. For this right, the buyer pays a 'premium' - the cost of the option.

When that strike price is below the current market price, the option is said to be 'in the money', when above it's 'out of the money'. But whatever the market price when the option is purchased, the buyer is speculating that the market price will be above his cost (strike price + premium + commission) before the option expires.

The amount by which the market price is above that cost determines the amount of profit. Since, in theory, the market price can rise indefinitely, the profit potential is called 'uncapped'.

Unlimited potential profit, but not without risk. As the famous banker J.P. Morgan said when asked what the stock market would do: 'Prices will rise, and prices will fall.' When the price falls below, or fails to rise above the cost of the option the investor loses money. In this case, however, the risk is obviously limited to the amount of the option (plus a small commission).

These kinds of options make for wise investments for those with limited experience but who want to take advantage of the additional leverage provided by options. Leverage is the ability to control more than you own. Since the option price is typically around 5% of that of the underlying stock, the leverage is 20:1. This multiplier effect is one thing that makes options so attractive.

Be sure the option has adequate liquidity, though. Open interest (the total outstanding contracts) should be no less than 100. The higher the better.

Long Puts

J.P. Morgan was right, prices sometimes fall. Sometimes they fall far and for a long time. When an investor judges this is likely, the next simplest options trading strategy can be employed: buying a put.

A put is a contract granting the right to sell an asset at a set price before or by expiration. It's slightly more difficult to understand, since the idea of selling something you don't own is odd.

Just like shorting stock, the trade (imagining the option were exercised) actually involves effectively borrowing the shares then immediately selling them. However, the investor never sees the underlying mechanics. As with shorting stock, the investor is on the hook for the 'borrowed' amount.

In this scenario the put buyer is speculating that the market price will fall below the strike price.

This is another situation in which the maximum risk is capped, this time by the price paid for the put. The reward too is capped, since the market price can't fall below zero. The maximum profit in that case is the strike price minus the cost of the put.

As with calls, ensure you choose an underlying instrument with adequate liquidity, preferably shares of over 500,000 ADV (Average Daily Volume). Look for open interest amounts over 100.

When trading options always be sure to select those with enough time left to judge the market trend. An option near expiration will be cheaper (options contracts are themselves actively traded), but carry higher risk.