Options are one of the more complicated securities available for trade and aren’t well-suited to the beginner investor. That’s because this style of trading requires the use of one or more advanced trading strategies.
If you’re interested in buying and selling options contracts, you’ll want to familiarize yourself by following options strategies. Keep in mind that no strategy can guarantee success, and you’re at risk of losing your money any time you buy or sell securities or options.
Before we begin
Before we get into options strategies, it’s essential to understand these key terms you’ll encounter when trading options:
The table below describes what these terms mean.
|In the money||Strike price is lower than the market price of the asset||Strike price is higher than the market price of the asset|
|At the money||Strike price is the same as the market price of the asset||Strike price is the same as the market price of the asset|
|Out of the money||Strike price is higher than the market price of the asset||Strike price is lower than the market price of the asset|
This strategy is ideal for stocks you believe will maintain their value.
How to use the covered call strategy
- Purchase the stock. Options contracts typically have a contract multiplier of 100, so be prepared to purchase no fewer than 100 shares.
- Write a call option for that stock. Sell a call option for the 100 shares you’ve purchased to another trader for a premium.
How a covered call strategy works
Let’s say you purchase 100 Apple shares at $425 each. And the call option you sold gives the other trader the option to purchase those Apple shares from you for $450 apiece. This is the strike price.
What happens next depends on whether Apple’s share price meets the strike price.
If Apple’s share price meets or exceeds the strike price of $450 and the call option is exercised, you’ll need to sell your shares at the strike price. You pocket the premium from the options contract as well as the market gain on Apple’s shares — they were worth $425 when you purchased them and now you’re selling them at a higher price.
If Apple’s share price doesn’t meet or exceed the strike price, the other trader can’t exercise the options contract. You still pocket the premium from selling the contract and you still hold the 100 shares you purchased.
Though all investments carry the risk of loss, this strategy is designed to protect you from losses.
How to use a married put strategy
- Purchase the stock. Such as purchasing 100 Apple shares at $425 each.
- Purchase a put option for that stock.
- If the stock price goes up, do nothing. You profit from the stock’s increase in value minus the premium you paid for the put option.
- If the stock price goes down, exercise your put option. You can sell your stock for the price you paid for them, protecting you from further losses.
How a married put strategy works
The married put strategy acts as an insurance policy for your stock purchase. To demonstrate how it works, let’s use the example above of purchasing 100 Apple shares at $425 each.
To purchase 100 Apple shares at $425, you’ll need to spend $42,500. In addition to the shares, you also purchase a put option with a strike price of $425.
If Apple’s stock rises to $450, you let your put option expire worthless. You’re out the cost of the contract, but your Apple shares have gone up, so you can still turn a profit if you choose to sell them.
If Apple’s stock plummets to $400, you can exercise your put option, giving you the opportunity to sell your shares at the same price you bought them: $425. You get to sell your shares for more than they’re worth and offload a poorly performing stock. You’re still out the cost of the put contract, but you’ve protected your portfolio from a damaging loss.
This strategy is used by investors who believe that the company will outperform the market.
How to use a bull call spread strategy
- Identify an asset you predict will rise in value.
- Buy a call option at one strike price.
- Sell a call option at a higher strike price.
How bull call spreads work
First things first: For this strategy to work, you need your chosen stock’s value to increase. Let’s take a look at the strategy in action.
Say the market price for Walmart’s stock is $50. You purchase a call option for Walmart’s stock at a strike price of $55. And you sell a call option for Walmart’s stock at a strike price of $70.
You pay a premium to purchase the call option, but also receive a premium from the investor who purchases the call option from you, so the cost of buying and selling call options is offset.
As you predicted, Walmart’s stock starts to rise. Here’s what happens:
- Once Walmart’s stock gets to $55, you exercise your call option to purchase the stock at the strike price of $55.
- Walmart’s stock continues to rise and hits $70. Now the trader you sold the call option to has the right to purchase the stock from you at the strike price of $70.
- You sell your stocks and the profit you pocket is the difference between what you paid for the stock ($55) and the higher strike price you sold it for ($70).
This graph can help you visualize this:
The bear put spread works just like the bull call spread, except you choose an asset you expect to decrease in value.
How to use a bear put spread strategy
- Identify an asset you predict will fall in value.
- Buy a put option at one strike price.
- Sell a put option with a lower strike price.
How bear put options work
For this strategy to work, you need the value of the stock to decrease. You also need both put options — the one you purchased and the one you sold — to have the same expiration date. If the trade goes your way, both put options are exercised at the same time as a single trade.
As with the bull call spread, you pay a premium when you purchase the put option, which is offset by the premium you receive from the trader that purchases the put option from you.
Now, using the same example from above, say the market price for Walmart’s stock is $50. You’ve got a put option with a strike price of $45 and you’ve sold a put option for this stock at a strike price of $30.
As you predicted, Walmart’s stock begins to fall.
On the expiration date of your put option, Walmart’s stock trades at $25, which means both the put option you bought and the put option you sold can be exercised. You purchase the stocks from the trader you sold the put option to for $30 but can sell them at $45. Your profit from the trade is the difference between the two trades minus the cost to purchase the put contract.
Here’s another chart to help you visualize this:
This strategy aims to protect a stock from potential loss. It’s a practical option for investors who feel unsure about the direction a stock is going to move.
How to use a protective collar strategy
- Purchase the stock.
- Buy a put option.
- Sell a call option.
To use a protective collar strategy, you hold shares of a stock, purchase a put option and sell a call option. Both the put and call options hold the same expiration date.
Let’s circle back to our first example to see this strategy in action.
So, you purchase 100 Apple shares at $425 each. You hope the stock will do well, but you’re not sure. Apple seems like a solid bet, but it’s had some off days over the past few weeks and the price has been dipping and rising erratically. In this situation, you might use the protective collar strategy to safeguard your investment.
To protect your Apple shares, you buy a put option at $415. This gives you the option to sell your Apple shares at the strike price of $415 if the price of Apple’s stock falls to $415 or below.
You also sell a call option at $435. The trader that purchases this contract from you has the option to purchase your Apple stocks at $435 if Apple’s stock rises to $435 or above.
The protective collar strategy limits your potential losses — and gains. While the put option limits your losses in the event that Apple’s stock begins to plummet, the call option you sold obligates you to sell your shares the agreed upon strike price should Apple’s stock move in the opposite direction.
Why not simply purchase the put option as a safeguard against falling stock prices? Because selling the call option helps finance the purchase of the put option.
Options contracts cost money, and there’s a chance your put option could expire worthless if Apple’s stock never hits the strike price. The sale of the call option helps offset the cost of the put option — it limits potential gains, yes, but it also helps cover the cost of your insurance policy against market volatility.
Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.
Options are complicated — as are the strategies used to trade them. If you’re new to the market, learn more about how options contracts work before you invest.