Options trading may seem complex, but at its core are four basic strategies. These strategies are the foundation of every advanced options trade, so they are crucial for anyone who wants to be able to move through the market with confidence.
Buying Calls
Definition: Buying a call gives you the right to buy an underlying stock at a specified price (strike price) before the contract expires.
When to Use: This strategy ensures you benefit from an upward movement of the stock price without even owning the stock.
You Buy Puts
Definition: Buying a put gives one the right to sell underlying stock at a certain price.
When to use: When you predict that its price is likely to lower, the option of selling it at a better price secures it from downward movement.
You Sell Calls
Definition: Selling a call obligates you to sell the stock if the buyer exercises the option.
When to Use: Often used as part of a covered call strategy, this generates income while capping potential gains.
Selling Puts
Definition: Selling a put obligates you to buy the stock if the buyer exercises the option.
When to Use: Use this strategy to earn premium income or potentially purchase a stock at a lower price.
Understanding the Jargon
“Call” Option
The seller is obligated to sell the stock if the buyer exercises the right to “call” it away.
“Put” Option
The seller is obligated to buy the stock if the buyer “puts” it to them.
These words illustrate the rights of buyers and the obligations undertaken by sellers.
The Protective Put Strategy: A Simple Insurance Analogy
A protective put is a great example of how options work as insurance for stock investments.
Case:
- Stock Price: $90
- Strike Price of Put: $85
If the stock price goes below $85, you can sell your shares at $85 and limit your loss. Meanwhile, you retain unlimited upside potential if the stock goes up.
This strategy is similar to car insurance. Insuring a high-value car like a Bentley costs more than insuring a Ford Taurus because of its higher value. Similarly, options premiums are higher for more expensive stocks.
The Deductible Analogy:
In car insurance, choosing a higher deductible reduces your premium cost but increases your out-of-pocket expense during a claim. In options, buying a lower strike price put, for example, $85 instead of $90 reduces the premium but increases your downside risk.
Factors That Influence Option Prices
Understanding the components that determine option prices is vital for making informed trades.
Asset Price
Higher-priced stocks tend to have more expensive options because they have a broader range of potential price movements. For instance, a $100 stock has a higher potential loss (all the way down to $0) than a $10 stock.
Time Value
The longer the time period, the more uncertainty, and the higher the price of the option. Just as a one-year car insurance policy is more expensive than a six-month policy, longer-dated options are more expensive.
Volatility
The more volatile the stock, the greater the potential price swings, which increases the chances of an option being profitable and therefore increases its premium.
Interest Rates
When sellers receive the premium in advance, they can make interest over it during the period of the option. This fact reduces the cost of options to a little extent.
Dividends
Stocks that pay dividends impact the price of options as the buyer loses the payments on those dividends when they don’t directly hold the stock.
Why These Strategies Matter
The four basic strategies—the buying of calls, the buying of puts, selling calls, and selling puts—are essentially the building blocks of all higher-level options trading strategies. Whether you’re looking at hedging risk, speculation about price movements, or generating income, these strategies are important to master first.
For instance, a protective put can protect your portfolio from deep losses but still allow some potential gains. Selling calls or puts can generate additional income, but they also give rise to obligations you will need to understand.
Starting with these basic principles, traders can feel comfortable entering more sophisticated strategies and learn how to fine-tune their approach to the dynamic nature of options trading.