An option is a form of derivative contract that gives the buyer of the contract (the option holder) the right (but not the obligation) to buy or sell a security at a chosen price at some point in the future. The buyer of the option is charged an amount called a premium by the seller for the right. If the market price is not favorable to the option holder, they will let the option expire and not exercise this right, ensuring that the potential loss is not higher than the premium. On the other hand, if the market moves in a direction that makes this right more valuable, it takes advantage of it.
Options are generally divided into “call” and “put” contracts. With a call option, the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price, which is called the exercise price or strike price. With a put option, the buyer acquires the right to sell the underlying asset in the future at a predetermined price.
Let’s take a look at some basic strategies that novice investors can use with calls or puts to limit their risk. The first two involve using the option to place a directional bet with limited losses if the bet goes wrong. The second involves a hedging strategy that is placed on top of an existing position.
- Options trading may sound risky or complicated to novice investors, so they often stay away.
- Some basic strategies using options, however, can help novice investors hedge the downside and hedge market risk.
- Here we look at four of those strategies: long call, long call, closed call, and shield placement.
Buying Calls (Long Calls)
There are several advantages of trading options for those who wish to make directional bets on the market. If you think the price of an asset will go up, you can buy call options using less capital than the asset itself. At the same time, if the price drops instead, your loss is limited to the premium paid for the option and nothing more. This can be the strategy of choice for traders who:
- Are “bullish” or confident about a particular stock, exchange-traded fund (ETF), or index fund and want to limit risk
- Want to take advantage of leverage to take advantage of rising prices
Options are essentially leveraged instruments as they allow the trader to amplify potential upside gains using a smaller amount than would be necessary if trading the underlying asset itself. So instead of spending $10,000 to buy 100 shares of $100 shares, you could hypothetically spend, say, $2,000 on a call contract at a strike price 10% higher than the current market price.
Suppose a trader wants to invest $5,000 in Apple (AAPL), trading at around $165 per share. With this amount, they could buy 30 shares for $4,950. Suppose the stock price rises 10% to $181.50 during the following month. Ignoring broker commissions or transaction fees, the trader’s portfolio will increase to $5,445, leaving the trader with a net dollar return of $495, or 10% of the invested capital.
Now, let’s say a call option on a stock with a strike price of $165 expiring about a month from now costs $5.50 per share or $550 per contract. Given the trader’s available investment budget, they can purchase nine options for a cost of $4,950. Since the option contract controls 100 shares, the trader is effectively making a deal on 900 shares. If the share price increases 10% to $181.50 at expiration, the options expire in cash (ITM) and are valued at $16.50 per share (for a strike of $181.50 to $165), or $14,850 for 900 shares. That’s a net dollar return of $9.990, or 200% of invested capital, a much larger return than trading the underlying asset outright.
The trader’s potential loss from a long call is limited to the premium paid. The profit potential is limitless as the option payout will increase with the price of the underlying asset until expiration, and there is theoretically no limit to how high it can go.
Membeli Puts (Long Puts)
If a call option gives the holder the right to buy the underlying at a specified price before the contract expires, a put option gives the holder the right to sell the underlying at a specified price. This is the strategy of choice for traders who:
- Bearish on a particular stock, ETF, or index, but want to take less risk compared to a short-selling strategy
- Want to take advantage of leverage to take advantage of falling prices
Put options work effectively in the opposite direction of call options, with put options gaining value as the underlying price declines. While short-selling also allows traders to profit from falling prices, the risks with short positions are limitless as there is theoretically no limit to how high the price can rise. With a put option, if the base expires higher than the option strike price, the option expires with no value.
The potential loss on a long put is limited to the premium paid for the option. The maximum profit from the position is limited because the underlying price cannot drop below zero, but as with long put options, put options take advantage of the trader’s returns.
Unlike a long call or long put, a closed call is a strategy that is superimposed onto an existing long position in the underlying asset. This is basically a bullish call that is sold in an amount that will cover the size of the existing position. In this way, the closed call writer collects the option premium as income, but also limits the upside potential of the underlying position. This is the preferred position for traders who:
- Expect no change or slight increase in the underlying price, collect the full option premium
- Willing to limit potential upside in exchange for downside protection
A closed call strategy involves buying 100 shares of the underlying asset and selling a call option against those shares. When a trader sells a call, the option premium is collected, thereby lowering the cost base on the stock and providing downside protection. In return, by selling the option, the trader agrees to sell the underlying stock at the option’s strike price, limiting the trader’s potential upside.
Suppose a trader buys 1,000 shares of BP (BP) at $44 per share and simultaneously writes 10 call options (one contract for every 100 shares) at an strike price of $46 expiring in one month, costing $0.25 per share, or $25 per contract and a total of $250 for 10 contracts. The $0.25 premium reduces the cost basis on the stock to $43.75, so any underlying decline up to this point will be offset by the premium received from the option position, offering limited downside protection.
If the stock price rises above $46 before expiration, a short call option will be exercised (or “called”), meaning the trader must surrender the stock at the option’s strike price. In this case, the trader would have made a profit of $2.25 per share ($46 deal price – $43.75 cost basis).
However, this example implies traders do not expect BP to move above $46 or significantly below $44 over the next month. As long as the stock does not rise above $46 and is canceled before the option expires, the trader will keep the premium free and clear and can continue to sell calls against the stock if desired.
If the stock price rises above the strike price before expiration, a short call option can be exercised and the trader must surrender the underlying stock at the option strike price, even if it is below the market price. In exchange for this risk, the closed call strategy provides limited downside protection in the form of the premium received when selling call options.
A protective put involves buying a loss that is put in an amount to cover an existing position in the underlying asset. As a result, this strategy places a lower floor where you can’t afford to lose more. Of course, you have to pay the option premium. In this way, it acts as a kind of insurance policy against losses. This is the strategy of choice for traders who have underlying assets and want downside protection
So a protective put is a long put, like the strategy we discussed above; however, the goal, as the name suggests, is protection from the downside versus trying to profit from a downside move. If a trader owns a stock with a bullish sentiment in the long term but wants to protect against a decline in the short term, they can buy a protective put.
If the price of the underlying increases and is above the strike price of the put at expiration, the option expires and the trader loses the premium but still benefits from the increase in the base price. On the other hand, if the underlying price falls, the trader’s portfolio position loses its value, but this loss is largely covered by the gains from the put option position. Therefore, the position can effectively be considered an insurance strategy.
Merchants can set the strike price below the current price to reduce premium payments at the expense of drop protection. It can be considered as deductible insurance. Suppose, for example, that an investor buys 1,000 shares of Coca-Cola (KO) for $44 and wants to protect his investment from adverse price movements over the next two months. The following put options are available:
|Examples of Protective Nipples|
|June 2018 Options||Premium|
The table shows that the cost of protection increases with the level. For example, if a trader wants to protect an investment from falling prices, they can buy 10 put options at-the-money with a strike price of $44 for $1.23 per share, or $123 per contract, for a total cost of $1,230. However, if the trader is willing to tolerate some level of downside risk, opting for a cheaper out-of-the-money (OTM) option such as a $40 put can also work. In this case, the cost of the option position would be much lower at only $200.
If the underlying price remains the same or increases, the potential loss will be limited to the option premium, which is paid out as insurance. However, if the base price falls, the capital loss will be offset by an increase in the option price and is limited to the difference between the initial share price and the strike price plus the premium paid for the option. In the example above, at a strike price of $40, losses are limited to $4.20 per share ($44 – $40 + $0.20).
Some Other Choice Strategies
The four strategies outlined here are very easy and can be used by most novice traders or investors. However, there are strategies that are more complex and nuanced than simply buying calls or calls. While we cover this type of strategy elsewhere, here is a short list of some other basic options positions that will suit those comfortable with the ones discussed above:
- Married Put Strategy: Similar to a Protective Put, a Married Put involves buying an at-the-money (ATM) put option in bulk to cover an existing long position in the stock. In this way, it mimics a call option (sometimes called a synthetic call).
- Collar-protective strategy: With a collar, an investor holding a long position at the bottom buys an out-of-the-money (i.e., downside) put option, while at the same time writing an out-of-the-money (upside) call option to the same stock.
- Long straddle strategy: Buying a straddle allows you to take advantage of future volatility but without having to bet on whether the move will go up or down—whichever direction wins. Here, an investor buys a call option and a put option with the same strike price and expiration on the same basis. Because it involves buying two at-the-money options, it is more expensive than some of the other strategies.
- Long strangle strategy: Similar to a straddle, strangle buyers go long on out-of-the-money call options and put options at the same time. They will have the same expiration date, but they have a different deal price: The put deal price must be below the call deal price. This involves spending a lower premium than a straddle but also requires the stock to move higher up or lower down in order to be profitable.
What are Options Trading Levels?
Most brokers set different options trading approval levels based on the level of risk involved and the complexity involved. The four strategies discussed here will all fall under the most basic level, level 1 and Level 2. Brokerage customers usually need to be approved to trade options up to a certain level and maintain margin accounts.
- Level 1: closed calls and hedge placements, when the investor already owns the underlying asset
- Level 2: long calls and nipples, which also includes straddles and strangles
- Level 3: option spread, involves buying one or more options and at the same time selling one or more different options of the same base
- Level 4: selling (writing) bare options, which here means no hedging, giving unlimited possible losses
How Can I Start Trading Options?
Most online brokers today offer options trading. You usually have to apply for options trading and get approved. You also need a margin account. When approved, you can enter orders to trade options as you would for stocks but by using the options chain to identify the underlying, expiration date, and strike price, and whether it’s a call or a put. Then, you can place a limit order or market order for that option.
When to Trade All Day Options?
Equity options (stock options) are traded during normal stock market hours. This is usually 9:30 a.m. to 4 p.m. EST.
Can You Trade Options for Free?
Although many brokers now offer commission-free trading of stocks and ETFs, options trading still involves a fee or commission. Usually there will be a fee per trade (for example, $4.95) plus a commission per contract (for example, $0.50 per contract). Therefore, if you buy 10 options under this pricing structure, your cost is $4.95 + (10 x $0.50) = $9.95.
Options offer an alternative strategy for investors to profit from trading the underlying securities. There are various strategies that involve various combinations of options, underlying assets and other derivatives. Basic strategies for beginners include buying calls, buying puts, selling closed calls, and buying shields. There are advantages to trading options over the underlying asset, such as downside protection and leveraged returns, but there are also disadvantages such as upfront premium payment requirements. The first step for trading options is choosing a broker.
Luckily, InvestingClue has created a list of the best online brokers for options trading to make getting started even easier.