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On Options

Putting Options to Work

Put basic options knowledge into action with some basic options trading strategies.

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In the first part of this series, Getting Started With Options, we discussed the basics of trading options such as terminology, rights and obligations, open interest, pricing, sentiment and expiration cycles. Now it's time to put some of this new knowledge about how to trade options to work by examining some basic options trading strategies and how they can be used.

Bullish vs. bearish options trading strategies 

Bullish vs bearish options trading strategies

Long calls

Perhaps, the simplest option strategy to understand (though not necessarily the simplest with which to make a profit) may be the long call trade. A long call trade is often the first option strategy used by investors once they decide to venture into trading options. Unfortunately, long calls can often be difficult to trade profitably. However, it’s good to discuss the strategy because it helps to lay the foundation for more complex option strategies.

A long call option is a bullish strategy, but unlike a long stock trade, you generally have to be right about more than just the direction of the underlying stock to be profitable. As we discussed in part one of this series, the price of an option is based on many components. Three of these components are: (1) type of option (call vs. put), (2) the strike price of the option and (3) the amount of time until the option expires. To profit on a long call trade, you will need to be right about the direction of the underlying stock price movement and the number of points it moves in that direction, as well as how long it takes to make the move. Occasionally, you can be profitable if you are right on two of these three items, but direction alone is almost never enough.

Before you decide to enter into any option strategy, it is important to do some simple calculations to find the maximum gain, maximum loss and breakeven points (price of the underlying stock/index where there is neither a gain nor a loss) for the trade. The formula for these calculations on a long call trade (assuming the position is held until expiration) and a visual depiction of a profit-and-loss graph are illustrated below:

Long 1 XYZ Jan 50 Call @ $3

Maximum gain = unlimited

Maximum loss = $300 (3.00 option premium paid x 100 shares per contract)

Breakeven point = 53 (50 strike price + 3.00 option premium)

Long call

Long call

As you can see, while the maximum potential loss on a long call trade is the price paid for the option, the upside profit potential is theoretically unlimited. However, keep in mind that because the option has a limited lifespan, the underlying stock will need to move up enough to cover the cost of the option and offset the erosion in time value and possibly even offset changes in volatility. These factors work against the owner of a long option, resulting in a much more difficult profit-and-loss scenario than you might think.

Short calls

Although I don't recommend the use of short (naked) calls, and they would be particularly inappropriate for inexperienced option traders or traders without substantial risk capital, I think it's helpful to illustrate how selling a call creates a profit-and-loss scenario that is exactly the opposite of long call. Here's an example:  

Short 1 XYZ Jan 50 Call @ $3

Maximum gain = $300 (3.00 option premium received x 100 shares per contract)

Maximum loss = unlimited

Breakeven point = 53 (50 strike price + 3.00 option premium)

Uncovered ("Naked") call 

Uncovered (Naked) call

An uncovered (naked) call trade is an extremely risky position, because while the profit (if the stock drops in price) is limited to the premium received at the time the option is sold, the upside risk is unlimited. To enter an uncovered call trade, you’ll need the highest option approval level available at Schwab (level 3), and must have substantial funds to meet the higher margin requirements of this strategy.

Long puts

Similar to a long call trade, a long put trade is fairly straightforward. Although long put trades can be difficult to trade profitably, it's also worthwhile to discuss the strategy as a foundation for more complex option strategies.

A long put option is a bearish strategy, but unlike a short stock trade, you generally have to be right about more than just the direction of the underlying stock in order to be profitable. As with long calls, to be profitable, you will need to be right about the stock price movement direction and the magnitude and the time frame. You can occasionally be profitable if you are right on two of these three items, but direction alone is almost never enough.

As with long calls, before you decide to enter a long put trade, be sure to find the maximum gain, maximum loss and breakeven points. The formula for these calculations on a long put trade and a visual depiction of a profit-and-loss graph are illustrated below:

XLong 1 XYZ Jan 50 Put @ $3

Maximum gain = $4,700 (50 strike price – 3.00 option premium x 100 shares per contract)

Maximum loss = $300 (3.00 option premium paid x 100 shares per contract)

Breakeven point = 47 (50 strike price – 3.00 option premium)

Long put 

Long put

As you can see, while the maximum potential loss on a long put trade is the price paid for the option, the profit potential, as the stock drops in price, is significant. However, keep in mind that because the option has a limited lifespan, the underlying stock will need to move down enough to cover the cost of the option and offset the erosion in time value and possibly even changes in volatility. These factors work against the owner of a long option, resulting in a much more difficult profit-and-loss scenario than you might think.

Short puts

Although short (naked) puts are not quite as risky as short (naked) calls, they are still not a strategy for inexperienced option traders or traders without substantial risk capital. Selling a put creates a profit-and-loss scenario that is exactly the opposite of long put. 

Here's an example:

Short 1 XYZ Jan 50 Put @ $3

Maximum gain = $300 (3.00 option premium received x 100 shares per contract)

Maximum loss = $4,700 (50 strike price – 3.00 option premium x 100 shares per contract)

Breakeven = 47 (50 strike price – 3.00 option premium)

Naked put 

Naked put

An uncovered (naked) put trade is an extremely risky position, because while the profit (if the stock rises in price) is limited to the premium received at the time the option is sold, the downside risk can increase until the stock reaches zero. To enter an uncovered put trade, you'll need not only the highest option approval level available at Schwab (level 3), but also must have substantial funds to meet the high margin requirements of this strategy.

Selecting your strike price

When first introduced to options, many traders have little trouble understanding the risk/reward characteristics of options but often have difficulty deciding which strike prices to use. Whether those strike prices are in, at, or out of the money will affect the magnitude of the underlying move needed to reach profitability and also determine whether the trade can be profitable if the underlying stock remains unchanged. The tables below illustrate how to properly structure a long or short option trade to match your level of bullishness or bearishness.

For example, if you are extremely bullish, you may want to consider out-of-the-money (OOTM) long calls or in-the-money (ITM) short puts. Keep in mind, both will generally require a bullish move in the underlying stock of extreme magnitude in order to reach profitability. By contrast, if you are only slightly bullish, you may want to consider ITM long calls or OOTM short puts, the latter of which can sometimes be profitable with no movement in the underlying stock.

 

Bullish options strategies 

Bullish options strategies

In the same manner, if you are extremely bearish you may want to consider out-of-the-money (OOTM) long puts or in-the-money (ITM) short calls. Keep in mind, both will generally require a bearish move of extreme magnitude in the underlying stock in order to reach profitability. By contrast, if you are only slightly bearish, you may want to consider ITM long puts, or OOTM short calls, the latter of which can sometimes be profitable with no movement in the underlying stock.

Bearish options strategies

Bearish options strategies

As with most option strategies, the greater the underlying move needed, the higher the profit potential, but it’s also less likely that a profit will be made. In the case of OOTM short puts and OOTM short calls, because profitability is possible with no movement in the underlying stock, the potential profit will likely be very small. However, the risk on these trades is extremely high, which is why I don't recommend uncovered calls or puts. The use of credit spreads is a much safer alternative while generally providing only slightly less profit potential.

Hopefully, by now you have learned that you can take either a bullish or bearish position on an underlying instrument (stock, exchange-traded fund [ETF] or an index) using either calls or puts. It simply depends upon whether you buy or sell them first. Another important concept to understand is that when you pair stocks and options, your sentiment on the underlying stock does not change; you are simply using the option leg of the strategy to hedge your position or help generate additional income. The table below helps to illustrate this point.

Pairing stocks and options 

Pairing stocks and options

I hope this enhanced your understanding of options. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts.


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