Options trading strategies
An options strategy is generally based on three primary objectives as well as the outlook on the market.
Options trading strategies table
Neutral to bullish>Covered calls>Cash-secured puts
Neutral to bearish>Protective puts>Collars
Either direction>Long straddles>Vertical spreads
Examples of options trading strategies for generating income:
A covered call is when you sell someone else the right to purchase a stock that you already own (hence "covered"), at a specified price (strike price), by a certain date (expiration date). To learn more about covered calls and additional options trading strategies, check out our educational article Options Trading: Basics of a Covered Call Strategy.
- Offers potential income generation on assets you already own
- Can be profitable with little or no movement in the underlying asset
- Downside protection limited to the amount of premium received
- The potential profit is capped at the strike price, plus the premium received on the option
- The stock position is still vulnerable to downward price movement
- If exercised, you have to give up the stock
- May lose the dividend due to early assignment
Cash-secured puts are an options strategy where you sell a put option while also setting aside the entire sum of money you would have to pay if you're assigned a put. To learn more about cash-secured puts, check out our educational article Managing Cash-Secured Puts.
- May generate income without the initial investment of establishing a stock position
- The potential to purchase the stock at a strategically targeted price
- The premium received is kept, regardless of whether the option is assigned
- If the option expires due to the underlying stock price increasing, gains will be limited to the premium received
- Losses are only reduced by the amount of premium received
- Short option could be assigned at any time, obligating you to buy the underlying asset, potentially above the current market price
Examples of options trading strategies for hedging:
A protective put is a strategy that involves buying a put option with a strike price that is usually at or below the current price of a stock that you own and believe might go down in price. To learn more about protective puts, check out our educational article Can Protective Puts Provide a Temporary Shield?
- May provide downside protection on underlying assets you own
- Gives you the right but not the obligation to sell the underlying stock at the strike price until expiration
- The time frame is limited, and the puts may eventually expire and become worthless
- The value of options can move independently of the underlying stock, eroding the value over time
A collar is when a trader buys an out-of-the-money protective put for downside protection and simultaneously sells an out-of-the-money covered call. The premium earned from selling the call can help lower the overall cost of the protective put. To learn more about collars, check out our educational article Collaring Your Stock for Temporary Protection.
- May provide downside protection on underlying assets you own at little to no net cost, excluding fees, commission, and per-contract fees
- If the underlying price goes down, the protective put gives you the right to sell the stock at the strike price
- Creates the obligation to sell the underlying stock at the strike price of the call, which limits the upside profit potential
- If your short call options are in the money, you could be assigned at any time
- Stocks that pay dividends can be especially vulnerable to early assignment
Examples of options trading strategies for speculating:
While simple put and call strategies can be used for speculation purposes, there are also strategies specifically designed for speculating.
A long straddle is a strategy consisting of the purchase of both a call and a put option with the same expiration date and strike price on the same underlying security. A long straddle offers an opportunity to make money when a stock or index moves substantially. To learn more about long straddles and additional trading strategies for speculating, check out our educational article Straddles vs. Strangles Options Strategies.
- The ability to potentially profit when the underlying asset makes a large move in either direction
- Your risk is defined; the most you can lose is the cost of the options
- Because multiple contracts are involved, the cost of the options can be higher than with single-leg strategies
- If the stock doesn't move, you risk losing the premium
- In order to cover the cost of the two legs of the trade, the stock must make a larger move for the trade to be profitable
Vertical spreads are options strategies where you simultaneously buy and sell options that are of the same type (calls or puts) and have the same expiration date but with different strike prices. To learn more about vertical spreads, check out our educational article Out-of-the-Money and In-the-Money Vertical Spreads.
- Your risk is usually defined; the maximum potential loss is established from the outset of the trade
- Less capital intensive than establishing a long or short position in the underlying stock
- Your risk is defined from the outset, but so is your maximum potential gain
- The short leg of the vertical spread may be subject to assignment at any time before expiration
- If held to expiration, you may not know until the next trading day if the short option was assigned or not; this could result in an unanticipated long or short stock position
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