Options are an option of a derivative contract that confers the right (but not the duty) to purchase or sell a security at a specified price at some point in the future. Option purchasers are charged a sum known as a premium by sellers for this right. If market prices are adverse for option holders, they will allow the option to expire without being exercised, ensuring that possible losses do not exceed the premium. However, if the market swings in a direction that increases the value of this privilege, it will be utilized.
Options are often classified as "call" or "put" contracts. The call option traders acquire the right to purchase the underlying asset at a fixed price, known as the exercise price or strike price. A put option grants the buyer the right to sell the underlying asset at a fixed price in the future.
Let's look at some introductory calls and put methods that a novice investor can utilize to limit risk. The first two strategies involve using options to place direction bets with low losses if the wager is unsuccessful, and the others include overlaying hedging methods on existing positions.
There are numerous classic options trading techniques, but not all are suitable for all traders or investors. It would help if you utilized tactics that match your risk tolerance and reflect your market outlook for the life of the included options. You can lose all of your money if your market forecast is wrong, for example, by selling a naked put or call options or using a covered write strategy.
Unwinding option positions before expiration can result in unexpected costs, such as dealing spreads, time since the trade was launched, and changes in implied volatility or other option pricing factors. Before entering an options position, you should make sure that you can withstand any potential losses.
The conventional way for assessing the risk and reward associated with a given options trading strategy is to plot the payoff or profit and loss (P&L) profile at expiration. Typically, these charts depict profit or loss on the Y-axis and levels of the underlying asset on the X-axis. Generally, the shape of the strategy exhibits kinks at the strike prices of any options it includes.
1. Long Call or Put
A long call or put strategy entails purchasing the option in question. Each contract for stock options represents 100 shares on the U.S. stock exchange. A holder of a call or put option has the right to buy or sell 100 shares of stock at the option's high price before the option's expiration date.
When holding or shorting a stock, investors and traders might acquire options to mitigate their adverse risk. If your market outlook is incorrect, a long option position functions as an insurance policy by defining a worst-case scenario price and limiting losses to the initial premium paid for the option.
Consider the scenario in which you have a positive outlook and hence purchase one call option on 100 shares of stock with a high price. If the market declines, your downside is limited to the premium you paid; however, your gain is theoretically unlimited. Your breakeven point equals the option's strike price plus the premium paid.
2. Naked Short Call or Put
A short call or put strategy includes selling or "writing" an option "naked" or without a position in the underlying stock. Put another way. The stock option writer is compelled to either sell or buy 100 shares of stock at the option's termination date if it is a sold call or put, respectively.
If your broker permits it, you can sell put or call options to collect premium money when you have a bullish or bearish outlook on the underlying stock, respectively. While your possible profits are restricted to the premium paid, your potential losses are limitless if your market outlook is incorrect.
Consider a scenario in which you are pessimistic and choose to sell one call option on one hundred shares of stock with a strike price of A. Your downside exposure is theoretically unlimited if the market declines, while your upside exposure is restricted to your paid premium. Your breakeven point corresponds to the strike price minus the premium paid.
3. Covered Write
If you have a long or short position in the underlying asset, you may sell a call or put options against it. Many investors prefer to raise their income from stock ownership by selling covered calls in relatively stagnant market conditions, often known as a buy-write strategy. If the option is finally exercised, you will be required to deliver your underlying position into the option contract.
This options strategy mitigates potential limitless losses on the underlying position with the premium received from selling the option. In addition, your gains are restricted to the excess compensation obtained above the option's strike price. Note that the reward profile of this strategy is identical to that of a short options position.
Think about selling 100 shares of your stock as the basis for a call option contract. If the stock price increases to the call option's strike price, you will deliver the shares when the option is exercised, and any losses on the call option beyond that point are covered by gains on the underlying long stock position. If the stock price declines, you will receive the premium from selling the call option to offset any stock position losses.
4. Short Puts
Being short a put is comparable to being long a call in that both positions are bullish. However, when shorting a put, investors sell the put option and gain a premium through the deal. Nevertheless, if the put option buyer executes the contract, the seller would be required to purchase the shares.
Here is an example of a short statement: Transportation Stock is currently priced at $40 per share. An investor desires to purchase the shares for $35. However, instead of buying shares, the investor sells put options with a $35 strike price. If the shares never reach $35, the investor retains the premium from the sale of the put options.
Should the option buyer exercise these puts at $35, the investor would be required to purchase the underlying shares. Remember that the investor intended to buy at that price regardless. In addition, by selling short put options, they have already received a substantial premium.
5. Straddles and Strangles
Using straddles in the trading of options, investors can benefit regardless of the underlying stock or asset movement. In a long straddle, an investor anticipates greater volatility and simultaneously purchases a call and a put option. In short straddles, investors sell both a call and a put simultaneously.
Straddles and strangles are employed when projected movement in the underlying asset is minimal or neutral.
Let's examine a fictitious lengthy straddle. A trader pays $1 for a call option and $1 for a put option, and both have $10 strikes. The stock must either rise over $12 or fall below $8 for the investor to break even. We account for the $2 that they spent on premiums.
In a long strangle, an investor purchases a call and a put with varying strike prices. This is most likely due to their belief that the stock is more likely to increase than decrease, or vice versa. In a short strangle, the trader sells a call option and a put option with different strike prices.
This is an illustration of a short strangle. A trader sells a $3 call and puts an option on an exchange-traded fund (ETF). The highest profit the investor can realize is $6, which is the sum of the profits from selling the call and put options. An investor's maximum loss is unrestricted, as the underlying ETF can rise forever. Meanwhile, losses would cease when the price reached zero, but they would still be substantial.
6. Cash-Secured Puts
The cash-secured put strategy can provide income and allow investors to purchase a stock at a lower price than they would with a conventional market buy order.
A non-owner investor writes a put option on Miner CC with a strike price lower than the current market price of the shares. The investor must have sufficient funds to cover the cost of purchasing 100 shares per contract if the underlying security trades below the strike price at expiration (in which case they would be obligated to buy).
This strategy is often employed when an investor's opinion on the underlying asset ranges from bullish to neutral. The option writer receives inexpensive shares while retaining the premium. Alternately, if the company trades sideways, the writer will still earn the compensation but not accept any claims.
Unlike a long call or long put, a covered call is a strategy that is added to an existing long position in the underlying asset. It is essentially a call option offered in sufficient quantity to cover the current position. Thus, the covered call writer collects the option premium as a source of income but limits the upside potential of the underlying position. This position is suitable for traders who:
Expect no change or a slight increase in the underlying asset price, and collect the entire option premium.
They are ready to limit gain possibilities in exchange for some downside protection.
A covered call strategy requires the purchase of 100 shares of the underlying asset and the sale of a call option against those shares. When a trader sells a call option, they collect the option's premium, thereby reducing the cost basis of the shares and providing downside protection. By selling the option, the trader agrees to sell shares of the underlying asset at the option's strike price, limiting their upside potential.
At $44 a share, an investor gets 1,000 shares of the BP company, and in exchange for the cost of $0.25 per share, they write ten call options (one contract for every 100 shares) with an expiration date one month from now, costing him $25 per contract and $250 total. The $0.25 premium decreases the cost basis of the shares to $43.75; hence, any drop in the underlying below this point will be compensated by the premium obtained from the option position, thereby providing little downside protection.
If the share price increases above $46 before expiration, the short call option will be exercised, requiring the trader to deliver the stock at the option's strike price. In this situation, the trader will earn $2.25 per share in profit ($46 strike price minus $43.75 cost basis).
However, this example suggests that the trader does not anticipate BP to move considerably above or below $44 within the next month. As long as the shares do not climb beyond $46 and are not called away before the options expire, the trader will be able to keep the premium and continue selling calls against the shares.
Short call options can be executed if the underlying asset's price rises above the strike price before the expiration. The trader must deliver shares of the underlying asset at the strike price, even if it is lower than market pricing. A covered call strategy provides minimal downside protection in the form of the premium earned when selling the call option in return for this risk.
8. Protective Puts
The purchase of a downward put in an amount large enough to cover existing movements in the underlying asset is known as a protective put. In fact, this strategy establishes a loss limit below which more losses are impossible. Obviously, you will be required to pay the option's premium. In this manner, it functions as a form of insurance against losses. This is the strategy of choice for traders who own the underlying asset and desire downside protection.
Thus, a protective put is a long put, similar to the strategy outlined previously. As the name suggests, the objective is downside protection rather than profiting from a downward move. If a trader owns shares with a long-term bullish feeling but desires protection against a short-term downturn, they may acquire a protective put.
Suppose the underlying asset price grows and is above the strike price of the put option at expiration. In that case, the option expires worthless, and the trader loses the premium but still benefits from the increase in the underlying price. Alternatively, if the underlying price decreases, the trader's portfolio position loses value, but the gain from the put option position is substantially offset. Consequently, the position can be viewed as an insurance strategy.
9. The Married Put
Like the covered call, the married put is a little more complex option trade, and it "marries" a long put with the ownership of the underlying stock. For every 100 shares of stock, the investor purchases one put option. This strategy allows an investor to continue holding a stock for the possibility of appreciation while hedging the position against a potential decline. Like purchasing insurance, the owner pays a premium for protection against the asset's depreciation.
The share price of XYZ stock is $50, and a put option with a $50 strike price and a six-month expiration date is available for $5. The entire cost of the put is $500, which comprises the $5 premium multiplied by 100 shares. The investor already possesses 100 XYZ shares.
10. Bull or Bear Spreads
Options traders can use equal quantities of calls and puts to construct bullish or bearish strategies with limited upside and downside. In a so-called "vertical" spread, both options' underlying asset and expiration date are identical.
An optimistic trader, for example, may buy a lower strike price call and sell a higher strike price call. This strategy would have a lower net premium than purchasing the lower strike price call alone, but traders would not profit from an increase in the underlying asset beyond the higher strike price of the sold call.
What Are the Options Trading Levels?
Most brokers assign varying permission levels for trading options based on the level of risk and complexity involved. The four tactics presented here would be classified as Level 1 and Level 2 strategies. Customers of brokerages are often required to hold a margin account and be approved for trading options up to a specified quantity.
Level 1 consists of covered calls and protective puts for investors who already hold the underlying asset.
Level 2 includes long calls and puts and straddles and strangles.
Level 3: options spreads, which involve purchasing one or more options and simultaneously selling one or more options of the same underlying.
Level 4 is the sale (writing) of naked options, which are unhedged and carry the risk of unlimited losses.
Conclusion
Options provide investors with different ways to profit from the trading of underlying equities. Numerous techniques involve various combinations of options, underlying assets, and derivatives. Among the fundamental methods for beginners are the purchase of calls, puts, covered calls, and protective puts. There are advantages to trading options instead of underlying assets, such as downside protection and leveraged gains. However, there are also downsides, such as paying the premium in advance. The initial step in trading options is selecting a broker. Top1 Markets will assist you in your trading endeavors.
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