Embarking on the journey of options trading? Here's a guide to five strategies that can help beginners navigate this complex financial landscape. Learn the ropes, understand the risks, and start building your investment portfolio with confidence.
Risk/reward
The trader’s potential loss from a long call is limited to the premium paid.
Bottom Line
Options offer alternative strategies for investors to profit from trading underlying securities.
- There are advantages to trading options rather than underlying assets, such as downside protection and leveraged returns, but there are also disadvantages like the requirement for upfront premium payment. Investors should choose a broker to handle their options trading.
Example
Suppose a trader wants to invest $5,000 in Apple (AAPL), trading at around $165 per share
- With this amount, they can purchase 30 shares for $4,950
- Assuming a call option on the stock with a strike price of $165 that expires about a month from now costs $5.50 per share or $550 per contract.
- Given the trader’s available investment budget and given the option contract controls 100 shares, the trader is effectively making a deal on 900 shares
- If the stock price increases 10% to $181.50 at expiration, the option will expire in the money and be worth $16.00 per share
Example
Expect large price fluctuations following an earnings announcement on Jan. 15
- Create a straddle by purchasing both $5 put option and a $5 call option at a $100 strike price
- Net option premium for this straddle is $10
- The trader would realize a profit if the price of the underlying security was above $110 (which is the strike price plus the net option premium) or below $90
Long Straddles
Buying a straddle lets you capitalize on future volatility but without having to take a bet whether the move will be to the upside or downside-either direction will profit.
Buying puts (Long Puts)
Preferred strategy for traders who: Are bearish on a particular stock, ETF, or index, but want to take on less risk than with a short-selling strategy
- Want to utilize leverage to take advantage of falling prices
- A put option works effectively in the exact opposite direction from a call option, gaining value as the price of the underlying decreases
What Are the Levels of Options Trading?
Most brokers assign different levels of options trading approval based on the riskiness involved and complexity involved.
- The four strategies discussed below would all fall under the most basic levels, level 1 and Level 2: covered calls and protective puts, when an investor already owns the underlying asset, long calls and puts, options spreads, options buys and sells, and naked options
Example
If you think the price of a stock is likely to decline from $60 to $50 or lower based on bad earnings, but you don’t want to risk selling the stock short in case you are wrong.
Buying Calls (Long Calls)
If you think the price of an asset will rise, you can buy a call option using less capital than the asset itself
- Options are leveraged instruments in that they allow traders to amplify the potential upside benefit by using smaller amounts than would otherwise be required if trading the underlying asset
Where Do Options Trade?
Listed options trade on specialized exchanges such as the Chicago Board Options Exchange (CBOE), the Boston Options Exchange, or the International Securities Exchange (ISE).
Basic Strategies to Hedge Market Risk
Options are a form of derivative contract that gives buyers of the contracts (the option holders) the right (but not the obligation) to buy or sell a security at a chosen price at some point in the future
- Option buyers are charged an amount called a premium by the sellers for such a right
- Basic strategies to hedge market risk
- Long calls, long puts, covered calls, protective puts, and straddles
Risk/reward
A long straddle can only lose a maximum of what you paid for it. Since it involves two options, however, it will cost more than either a call or put by itself.
Advantages and Disadvantages of Trading Options
The biggest advantage to buying options is that you have great upside potential with losses limited only to the option’s premium.
- However, options will expire worthless if the stock does not move enough to be in-the-money.
- The main disadvantage of options contracts is that they are complex and difficult to price.
Risk/reward
If the share price rises above the strike price before expiration, the short call option can be exercised and the trader will have to deliver shares of the underlying at the option’s strike price, even if it is below the market price.
Example
Suppose a trader buys 1,000 shares of BP (BP) at $44 per share and simultaneously writes 10 call options (one contract for every 100 shares) with a strike price of $46 expiring in one month, at a cost of $0.25 per share, or $25 per contract and $250 total for the 10 contracts.
- If the share price rises above $46 before expiration, the short call option will be exercised and the trader will have to deliver the stock at the option’s strike price.
Protective Puts
Buy a downside put to cover an existing position in the underlying asset
- The goal is downside protection, not to profit from a downside move
- If the price of the underlying increases and is above the strike price at maturity, the option expires worthless and the trader loses premium but still has the benefit of the increased underlying price
- On the other hand, if the underlying price decreases, the trader’s portfolio position loses value
Can You Trade Options for Free?
Many brokers now offer commission-free trading in stocks and ETFs, options trading still involves fees or commissions
- There will typically be a fee per trade ($4.95) plus a commission per contract (e.g., $0.50 per contract) if you buy 10 options under this pricing structure.
How Can I Start Trading Options?
Most online brokers today offer options trading. You will have to typically apply for options trading and be approved.
Example
A trader can set the strike price below the current price to reduce premium payment at the expense of decreasing downside protection.
- Suppose an investor buys 1,000 shares of Coca-Cola (KO) at a price of $44 and wants to protect the investment from adverse price movements over the next two months. The following put options are available:
- The cost of protection increases with the level thereof.
Risk/reward
If the price of the underlying stays the same or rises, the potential loss will be limited to the option premium, which is paid as insurance.
Some Basic Other Options Strategies
Other basic options strategies include: protective collar, married put, long strangle, vertical spread, and a few others
- Protective collar: an investor who holds a long position in the underlying buys an out-of-the-money (i.e., downside) put option, while at the same time writing an upside call option
- Long strangle: the buyer of a strangle goes long on both a call option and put option at once
- Vertical spread: simultaneous buying and selling of options of the same type, but at different strike prices
Risk/reward
The potential loss on a long put is limited to the premium paid for the options. The maximum profit from the position is capped because the underlying price cannot drop below zero.
Covered Calls
This is a preferred position for traders who: Expect no change or a slight increase in the underlying’s price, collecting the full option premium
- Are willing to limit upside potential in exchange for some downside protection
- A covered call strategy involves buying 100 shares of the underlying asset and selling a call option against those shares.
- When the trader sells the call, the option’s premium is collected and thus lowers the cost basis on the shares.
