Wall Street 101: Basic Options Strategies
/Isn’t the point of investing to make money while minimizing our losses? Spin the Wall Street roulette wheel and hedge your bets on options contracts.
The cool thing is that, while risky, gambling on options gives you, not the house, the advantage. So, how do you make them work for you?
What Is a Long Call?
A call option is a contract that gives you the right, but not the obligation, to buy an asset, such as a stock. The option specifies a strike price, which is what you will pay for the stock if you decide to buy, no matter what its actual value is. The contract has an expiration date, and you’ll pay a fee called a premium.
You would use a long call strategy when you expect the stock to go up. You’ll set a strike price above the stock’s current market value. If the stock’s price rises above the strike price before the expiration date, you can exercise your option, or buy it at the lower strike price. Now, you can profit by selling the stock back to the market for full price.
Your potential earnings are theoretically unlimited as the stock price continues to rise. Plus, if the stock tanks, “no obligation” means you don’t have to buy it at all, and you’ve only lost the premium.
Long calls are a cost-effective way to take advantage of a stock’s potential upside without buying the shares outright. For instance, instead of spending thousands on shares, you can pay a much smaller premium for the option and still benefit from substantial price increases. This gives you an advantage, as small changes in the stock price can result in larger percentage gains on the option.
What Is a Long Put?
A put option lets you sell assets at a predetermined strike price before the option expires, although, like a call, you don’t have to. If you think a stock is losing value, a long put is an appropriate strategy.
It works by paying a premium to buy a put option with a strike price lower than what the stock is worth at the time of purchase. If the stock takes a nosedive, you profit because you locked in your trade at a price higher than the actual share’s value at expiration. If the stock price doesn’t drop like you thought, you can let the option expire and keep the premium as gains.
Long puts can also act as insurance for stocks you own. If you’re worried about a stock’s price falling, buying a put can offset potential losses by increasing in value as the stock drops. This makes it an effective hedging tool in addition to being a speculative strategy.
Covered Call Strategy
You can make money by selling options, too. Selling a covered call gives someone else the right to buy your stock at the specified strike price. In return, you’ll earn an upfront premium.
If the stock price stays below the strike price, the buyer wouldn’t want to pay more than the stock is worth in the open market. In this case, the option expires worthless. You get to keep both your shares and the premium, profiting without giving up your stock.
Alternatively, the buyer will almost certainly exercise the option if the stock price rises above the strike price, and you’ll have to sell your shares. Unfortunately, you’ll miss out on the additional gains you could have made by selling at the higher market price. However, you still profit from the premium you collected and the difference between the strike price and what you originally paid for the stock.
Protective Put Strategy
Imagine you own a stock, but you’re worried the price will fall in the near future. To guard your shares, you can buy a protective put. This strategy acts as an insurance policy for your investment, limiting your potential losses if the stock price falls.
Typically, you’ll set the strike price slightly below the current market price. If the stock price plummets well below the strike price, the put option allows you to sell your shares at the higher strike price, earning more than you would by selling them at the reduced market price. While you lose the money paid for the premium, this cost is often much smaller than the potential losses you avoided.
On the other hand, if the stock price stays the same or even rises, the put option expires worthless, and you lose the premium. In this case, the gain is your peace of mind, knowing the protective put covered you against even bigger losses.
Cash-Secured Put Strategy
A cash-secured put is a conservative options strategy where you earn a premium by selling a put option on a stock you’re interested in buying. You typically choose a strike price below the stock’s current market value; then, you wait for the stock to take a dip.
If the stock price stays above the strike price, the option expires worthless, and you keep the premium as pure profit. The catch is that you need to have the cash on hand to purchase the shares if the stock’s value drops below the strike price. Since you were willing to own the stock at that price anyway, the assignment aligns with your goals, and you still benefit from keeping the premium.
However, the main downside is that if the stock’s price drops significantly below the strike price, you’ll still be obligated to purchase the shares at the higher strike price, potentially locking in an unrealized loss.
How To Execute a Covered Call
Executing a covered call is a straightforward way to earn income from stocks you already own. Here’s how it works:
Own at Least 100 Shares: A standard options contract is 100 shares, so that’s what you need to own before writing the option.
Choose Your Strike Price and Expiration Date: Set a strike price that you consider a fair value for selling your shares, typically slightly above the stock’s current market price. Next, select an expiration date.
Sell the Call Option: Once you’ve outlined the option’s parameters, sell the call option and immediately collect your premium.
Wait for Expiration or Assignment: After selling the call, sit back and wait. If the stock price stays below the strike price, it doesn’t make sense for the buyer to exercise the option, and it expires worthless. However, be ready to sell your shares if the stock price rises above the strike price.
While you may miss out on additional gains, you still profit from the premium and any price appreciation of the stock up to the strike price.
When To Use Protective Puts
Maybe you’re expecting your shares to go through some short-term turbulence due to earnings season jitters or market volatility. You don’t want to sell them just yet, but you also don’t want to lose everything if your stock runs off a cliff.
In this case, a protective put acts like an insurance policy for your investment. Set a strike price is set just below the stock’s current market value to balance the cost of the premium with the level of protection you want.
The protective put allows you to sell at the strike price if the stock’s value falls sharply, which prevents further losses and shields your portfolio from serious damage. While you do lose the cost of the premium you paid for the put, this small expense often outweighs the potential loss you could have faced without the option in place.
Pros and Cons of Basic Options Strategies
You would (hopefully) never walk into a casino and throw your money down without understanding the risks and rewards. Options contracts have their own pros and cons as well.
Call Strategies
Pros:
Big profit potential with less money upfront
Limited risk with a predictable maximum loss
Earn extra cash from stocks you already own
Cons:
Limited profit potential
Less freedom with your stock
Risk of losing your entire investment
Put Strategies
Pros:
Protect yourself from losing money on falling stock prices
Make money without betting against stocks directly
Understand your worst-case loss
Cons:
Time decay will decrease your option’s value
Could cost a lot for small returns
Limited profit potential
Examples of Basic Options Trades
So how does all this work in the real world? Here are a few examples.
Covered Call Strategy
You own 100 shares of $APPL at $228 each, and the market price isn’t moving. You don’t want to sell, but you do want to make money, so you write a 30-day call option with a strike price of $240. With a premium per share of $7, you immediately make $700.
In a month, the share price is up to $235. Your buyer obviously won’t want to exercise the option for more than the stock is worth. However, you’ve still earned a $700 profit from the premium without selling your stock.
Protective Put Strategy
You bought 100 shares of $TGT at $121 each, and the company is heading for trouble. You purchase a put option for an $8 premium, which gives you the right to sell your shares at $110 each.
You were correct, and the stock's value plummets to just a few dollars per share. Thanks to the put option, you sell the stock for $11,000.
After accounting for the $800 premium, your net proceeds are $10,200, protecting you from the massive losses you would have faced without the put option. Instead of holding near-worthless shares, you’ve managed to minimize your losses effectively.
Cash-Secured Put Strategy
You have cash ready to invest in 100 shares of $AMZN stock, but the current price of $198 feels too high. You sell a put option with a strike price of $190 at a premium of $6 per share, collecting $600 upfront.
By expiration, the market price rises to $210, so the buyer of the put option has no reason to exercise it since they can sell their shares for more on the open market. The option expires worthless, and you keep the entire $600 premium as profit. Plus, you also keep your original $19,000 of cash to invest elsewhere.
Place Your Stock Market Bets With Options Contracts
Options are powerful tools for you to use in investment strategies that include hedging and risk management, income generation, and portfolio diversification. You may, in actuality, be placing a bet, but unlike the casino, you can mitigate your losses with market analyses, industry research, and current event knowledge.
Ready to make every trade count?
Try our options calculator tool now and seize your next big opportunity!
