Options trading allows you the right to purchase stocks when they hit a specific price (called the strike price). Often options are traded with some kind of strategy in mind. These are some of the strategies and how they work.
Options trading isn’t for the beginner investor though. If you’ve somehow found your way here while looking for some beginner investing guides try heading to our investing homepage and save yourself the headache of getting your head around these.
| Call – the right to buy | Put – the right to sell | |
|---|---|---|
| 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 designed for when you think a stock will maintain its value.
Say the price was to rise to $500 USD then your shares are now worth $50,000 USD. But, it’s likely that the other trader will purchase them from you for the agreed price of $450 USD each.
If they go ahead with this, then you have made a profit of the premium amount, but you’ve lost out on a potential gain on your shares.
If the share price was to go down to $400 per share, it’s unlikely that the other trader will purchase from you, as they can get them cheaper elsewhere. This way, you’ve made a profit with the premium and you still hold the shares.
This strategy tends to give you protection both ways but can limit your gains.
So you’ve got 100 Apple shares which you bought for $425 each, totalled at $42,500.
You also have a put option for those 100 shares to sell them for $425 each, meaning that you have the option to sell them for $42,500 if the price goes down.
This means that you’ve got protection both ways. If the stock price suddenly jumps to $500 per share then your shares are now worth $50,000 USD and you can choose not to use your call option. If the price plummets to $400 USD per share then you can exercise your right to sell the stocks for the price agreed, which is now higher than the going rate for the shares.
This type of trade is usually used by investors who believe that the company will outperform against the market.
You need the value of the stock to increase in price in order to make any money from this trade.
You pay a premium when you buy call options, but you’ll receive a premium from the other investors when they buy call options from you, so it is partially offset.
So, let’s say the market price for a stock is £50. You’ve got a call option for this stock with a strike price of £55 and you’ve sold another call option for this stock at a strike price of £70.
As the stock price rises, several things happen:
The bear put spread is exactly the same as the bull call spread, except you choose an asset that you expect to decrease in value.
To make money from this, you need the value of the stock to decrease. As with the bull call spread, you pay a premium when you purchase put options, which is then partially offset by the premium you receive from the other traders that purchase put options from you.
Now, using the same example from earlier, say the market price for a stock is £50. You’ve got a put option with a strike price of, say, £45 and you’ve sold a put option for this stock at a strike price of £30.
Say this went your way, and the value of the stock did indeed decrease in value.
Between £50 and £40, nothing happens, but once the stock price reaches £45, you have the option to sell the stocks for this price. Once the stocks reach £30, the other trader has the option to sell the stocks to you for £30.
This strategy is similar to the bear put strategy and bull call strategy with a key difference which we detail below.
To use a protective collar strategy, you simultaneously purchase a call option and a put option, pretty similar to the bear put strategy and bull call strategy. These have to be “out of the money”, which means, in the case of a call option, the strike price is higher than the market price of the asset and in the case of a put option, the strike price is lower than the market price of the asset.
The asset and expiration dates of both options are exactly the same.
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
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