Now that we’ve learned about short calls & puts and long calls & puts we can use these in combination with stock ownership to create option strategies. Combining any of the four basic options trades and the two basic stock trades (long & short) allows a range of strategies to employ.
Options strategies are often used to mitigate risk or provide speculator profit. One type of option strategy is called a butterfly. A butterfly offers limited risk, with a large probability of earning a small profit when volatility expectations are different from implied volatility. A long butterfly will earn a profit if future volatility is lower than implied volatility. A long butterfly would consist of a trader being long one X1 call (strike price of X-a), short two X2 calls (strike price of X) and long one X3 call (strike price of X +a). At expiration the value of the butterfly would be zero if the price of the underlying asset is below x-a or above x+a. The value would be positive at expiration if the underlying asset is between x-a and x+a.
Similar to the butterfly is the Iron condor which has different strike prices for the short options, this increases the likelihood of profit but lowers the expected payout compared to the butterfly spread.
Another strategy an option trader could use is called a straddle, this is when the trader sells both a put and a call at the exact same exercise price. This would allow the trader a greater profit potential than the butterfly if the final stock price nears the exercise price but may also result in a significant loss. Similar to this is the strangle, also constructed by a call and put but with different strike prices, this reduces the net debit of the trade but in turn reduces the likelihood of profit.
One of the most well known option strategies it the covered call, this is when you write a call on a stock you already own. If the price at expiry is higher than the strike price the option will be exercised by the buyer, the stock will be “called” away from you and you will receive a fixed profit. If the stock goes down in value your losses will be partially offset by the call premium that you received. For the most part the payoffs match the payoffs of selling a put. This is known as put-call parity.
Tags: call option, common stock, covered call, derivatives, iron condor, long butterfly, over the counter option, put option, strike price
Options are one of the most versatile financial instruments available. No matter what type of investor you are from conservative to aggressive, speculator to hedger there is an option strategy for you. Options contracts can be purchased on their own or be used in conjunction with the existing equities in your portfolio or even with other options. Before getting involved in the option markets it is important to understand the various option trading strategies and the breakeven point of each strategy. There are five very basic options strategies you may chose to employ. Long call, long put, short call, short put and covered calls.
First a long call the most bullish option strategy there is and often employs high leverage. A long call is simple, if you believe the stock price is going up, you purchase call options. This will give you unlimited upside potential and downside risk limited to the premium you paid for the call. Your breakeven price on a long call is the option strike price plus the option premium paid. For example suppose you thought ABC corp which is currently trading at $65 was going to increase in value. You purchase one February 65 call at 7 or $700. The premium paid is $700 and that is the most you can lose, your breakeven price is $72. Even if the stock goes to zero the maximum amount you have at risk is $700. Any price above $72 we will have a profit.
A long put on the other hand is a bearish strategy that can be used to profit if the price of a stock moves down. Put buying has limited risk (the option premium paid) and limited reward as the lowest price the stock can go to is zero. Therefore if you believe the stock price is going down you put puts. For example suppose you believe DEFG corp is going to go down in price and is currently trading at $36, you decide to buy a DEFG February 40 put for $6 or $600, you purchased the right to sell DEFG shares at a price of $40. The breakeven price for a long put is the strike price minus the put price. In this case it would be $34, we would not achieve a profit until the stock price goes below $34 per share. At expiration there are three possible scenarios, first if the stock price is above the strike price. In this case your option would expire worthless and you would loose $600. Second, the stock price could equal the strike price, so if DEFG is trading at $40, the option would also then be worthless and you would let it expire because there would be no advantage to exercising it. Third the stock price could be below the strike price. For example if at expiration DEFG is trading at $30, your option would be worth at least $10, in this case you would make $400 or a 66% return.
Next short call selling involves unlimited risk. A short call strategy is when you sell call options on stock that you don’t own. At expiration you are obligated to sell the shares to the purchaser of the call. Call selling is a neutral strategy, you don’t want the stock price to move much either way, your reward is the premium received, but if the stock price moves up significantly, you are obligated to buy those shares and sell them to the purchaser of the call at a lower price. For example, suppose you thought that the stock price of HIJK corp would remain neutral and is currently trading at $21. You sell a February 25 call for $1, receiving a total of $100, this is your maximum profit. The breakeven price for a call would be the strike price plus the premium, in this case $25 + $1 or $26. At expiration there can again be three possible scenarios. First the stock price moves up to say $30 per share, since you don’t own the stock you would be forced to go out into the market and purchase the shares for $30 and sell them to the call purchaser at $25. You would lose $500 on this transaction, but you got paid $100 so your total lose would be $400. Scenario two is that the stock price is equal to the strike price, in this case $25, it is unlikely that the holder of the option would exercise and you would keep the $100. The third scenario is that the stock price is below the strike price in this case you would again keep your premium because the purchaser of the call would let it expire without exercising.
Another bullish strategy is the short put option strategy. The put seller has the obligation to buy the stock at the strike price, if the put buyer chooses to exercise. Put selling has limited reward and large but limited risk because the lowest the stock can go is zero. In this situation you are betting that the stock price will move up so that the buyer of the option will not exercise it and you will get to keep the premium. The breakeven price is found by subtracting the premium from the strike price. For example suppose you are bullish on DEFG corp at $35, you sell a February 40 put for $5 or $500, this is your maximum profit. The breakeven is $40 – $5 or $35. At a price of $35 the option holder would exercise the put and we would be forced to buy at $40 but since we received $5 we would essentially breakeven. Once again there are three scenarios at expiration. First the stock price is above the strike price, the buyer of the option would then choose not to exercise their option and we would keep the premium. Second the stock price could equal the strike price, in this case the buyer would most likely choose not to exercise the option and we would again get to keep the premium. Third the stock price could be below the strike price. For example let’s say DEFG is trading at $30, the put buyer would exercise the option and we would be forced to purchase the shares at $40. Since we were paid $500 this is the same as us being forced to purchase the shares at $35 when they are trading at $30 and our total loss would be $500.
Another option trading strategy is covered calls. This is when you write a call on a stock that you already own, it is essentially the same as the short call except that in this case you own the underlying stock. This strategy essentially puts a cap on how high the stock can move while receiving some protection on our downside risk in the form of a premium. This strategy allows you to earn a little extra income on the stocks in your portfolio. Our breakeven price on a covered call strategy would be the stock price that we paid minus the premium received. For example suppose we bought 100 shares of LMN corp at $32 and sold a February 35 call for $3 or $3000 our breakeven would be $29. Once again there are three possible scenarios; first the stock price is trading above the strike price. If LMN is trading at 45 at expiration, we would have our shares called away at $35 but since we received the premium of $3 it is the same as us selling our shares for $38. Second the stock price could equal the strike price, if at expiration LMN is trading at $35 the call buyer would not exercise the call and we would keep the premium. Lastly the sock price could be below the strike price, for example trading at $25, once again the buyer of the option would chose not to exercise the call. Keep in mind that we own the stock at $32 so we are down $7 per share but because we collected a premium of $3 we are really only down $4 per share.
As you can see options are leveraged financial instruments offering both hedging opportunities and possible speculator profits. You should however be fully aware of the potential risks and rewards of trading options before buying and selling them.
Tags: covered call, long call, long put, option premium, Option Strategies, short call, short put