Long Calls/Puts #
The simplest options position is a long call (or put) by itself. This position profits if the price of the underlying rises (falls), and your downside is limited to loss of the option premium spent. If you simultaneously buy a call and put option with the same strike and expiration, you’ve created a straddle.
This position pays off if the underlying price rises or falls dramatically; however, if the price remains relatively stable, you lose premium on both the call and the put. You would enter this strategy if you expect a large move in the stock but are not sure which direction.
Basically, you need the stock to have a move outside of a range. A similar strategy betting on an outsized move in the securities when you expect high volatility (uncertainty) is to buy a call and buy a put with different strikes and the same expiration—known as a strangle. A strangle requires larger price moves in either direction to profit but is also less expensive than a straddle. On the other hand, being short either a straddle or a strangle (selling both options) would profit from a market that doesn’t move much.
Buying a Call #
This is the most basic option strategy. It is a relatively low-risk strategy since the maximum loss is restricted to the premium paid to buy the call, while the maximum reward is potentially limitless. Although, as stated earlier, the odds of the trade being very profitable are typically fairly low. “Low risk” assumes that the total cost of the option represents a very small percentage of the trader’s capital. Risking all capital on a single call option would make it a very risky trade because all the money could be lost if the option expires worthless.
Buying a Put #
This is another strategy with relatively low risk but the potentially high reward if the trade works out. Buying puts is a viable alternative to the riskier strategy of short selling the underlying asset. Puts can also be bought to hedge downside risk in a portfolio. But because equity indices typically trend higher over time, which means that stocks on average tend to advance more often than they decline, the risk/reward profile of the put buyer is slightly less favorable than that of a call buyer.
Writing a Put #
Put writing is a favored strategy of advanced options traders since, in the worst-case scenario, the stock is assigned to the put writer (they have to buy the stock), while the best-case scenario is that the writer retains the full amount of the option premium. The biggest risk of put writing is that the writer may end up paying too much for a stock if it subsequently tanks. The risk/reward profile of put writing is more unfavorable than that of put or call buying since the maximum reward equals the premium received, but the maximum loss is much higher. That said, as discussed before, the probability of being able to make a profit is higher.
Writing a Call #
Call writing comes in two forms, covered and naked. Covered call writing is another favorite strategy of intermediate to advanced option traders, and is generally used to generate extra income from a portfolio. It involves writing calls on stocks held within the portfolio. Uncovered or naked call writing is the exclusive province of risk-tolerant, sophisticated options traders, as it has a risk profile similar to that of a short sale in stock. The maximum reward in call writing is equal to the premium received. The biggest risk with a covered call strategy is that the underlying stock will be “called away.” With naked call writing, the maximum loss is theoretically unlimited, just as it is with a short sale.
Spreads and Combinations #
Spreads use two or more options positions of the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared to a single options leg. Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration, but a different strike.
A bull call spread, or bull call vertical spread, is created by buying a call and simultaneously selling another call with a higher strike price and the same expiration. The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one. Similarly, a bear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as a calendar spread or time spread.
Combinations are trades constructed with both a call and a put. There is a special type of combination known as a “synthetic.” The point of a synthetic is to create an options position that behaves like an underlying asset, but without actually controlling the asset. Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options.
A butterfly consists of options at three strikes, equally spaced apart, where all options are of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one).
If this ratio does not hold, it is not a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. Closely related to the butterfly is the condor – the difference is that the middle options are not at the same strike price.