Basic Options Strategies (Options Basics Part 2)

Guest post by The Duomo Initiative

There are many different strategies you can use options for, and in a range of different situations. Depending on how you use them you can put the focus more on reducing your risk or maximising your returns.

For now, we’re going to start with some of the basic approaches, which will give you the basis to begin understanding more advanced strategies later. 

Long Call & Put 

If you’re bullish on an asset, the strategy you may use is the long call, which is when you buy a call option. This is similar to going long on the asset. 

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A long call will allow a trader to profit from the value of the underlying asset increasing above the strike price, however, as we previously discussed, you don’t take all the risk that comes with owning the shares, as you can only lose the premium. 

On the other hand, you can also buy a put option, which means you’re bearish and want to short the asset. 

You profit from the value of the underlying asset falling below the strike price, again though, your risk is limited to the premium. 

When you buy a call or put option, you will have a range of strike prices you can purchase at. This is something we will cover in more detail later, but just keep in mind that it’s important to understand which strike price you are buying. If the strike price is far out of the money, the option may have a cheaper premium but it’s also unlikely the price will reach that point, meaning your option will expire worthless and you lose the premium. 

Short Call & Put

You can also sell a call and put where you make a profit on the premium if the option expires worthless, that means out of the money. However, your upside is capped at the premium while your downside is virtually unlimited which is why selling options is considered to be risky for beginner traders. 

If you sell a call, you profit from a bearish move, whereas if you sell a put you will profit from a bullish move. 

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Covered Call

One of the most popular strategies is a covered call. To pull off a covered call strategy, you first need to own the underlying asset you’ll be trading.

At the moment you would make a linear profit on the price increasing, or a linear loss on the price falling, as shown in the diagram of a typical stock trade. 

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To turn this into a covered call, you would need to then sell a call option. Remember, selling a call option means you profit from the premium if the option expires out of the money, but your downside could be unlimited. As shown in the diagram. 

So, for every 100 shares of a stock you own, you sell one call option, as one option is worth 100 shares. Preferably this would be an option with a strike price 'out of the money', in this case that would be a strike price higher than the current market price of the asset. 

Let’s take a look at the following diagram. The green line represents the stock we hold, the pink line represents the call we sold, and the orange line represents our overall covered call position. 

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If the price remains below the strike price when the option expires, you can make money from the premium. This can be a good strategy for when you speculate the price won’t move much. 

Because if the price declines, although you still make money from the premium, your shares will also decline in value which could lead to a loss overall, with the premium reducing the loss.

On the other hand, if the price goes above the strike price, you may be obligated to sell the shares at the strike price. Although you still make a profit on the premium, and your shares increase in value, you limit your upside potential above the strike price. 

What this means is that a covered call can reduce the downside risk of owning shares, because if the underlying asset price falls, the option will expire worthless and you get to keep the premium.

In fact, the stock price doesn’t even need to move due to time decay. The option will decrease in value the closer it gets to expiry, meaning you still get profit from the premium. This is the ideal scenario for this strategy. 

However, keep in mind you also reduce your upside opportunity, meaning if the stock price is above the strike price, the option may be assigned and you would need to sell your shares at the strike price, meaning you lose out on any additional profit. 

A covered call can be used to generate some income from existing stock positions. Since you already own the underlying stock, it reduces the risk of the price moving against you. You are making a profit on the premium.

Butterfly

A butterfly strategy involves buying and selling call or put options at three different strike prices to create a position that is designed to profit from a specific price range of the underlying asset.

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To create this position:

1. Buy one call option at a strike price below the expected range (X1).
2. Buy one call option at a strike price above the expected range (X3).
3. Sell two call options at a strike price in the middle of the range (X2).

The result is a position that has limited risk and limited profit potential. If the price of the underlying asset remains within the expected price range, the strategy will be profitable. If the price moves outside the expected range, the strategy can result in a loss.

The profit potential is highest if the price of the underlying asset ends up exactly at the middle strike price. This is because the two sold call options will expire worthless, while the two purchased call options will have value. If the price of the underlying asset ends up outside the expected range, the maximum loss occurs if the price reaches the strike price of the two purchased call options.

Married Put (Protective Put)

A married put strategy is designed to protect against a decline in the price of an asset you own. 

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To create this position:

1. Buy a put option with a strike price close to the current value of the asset you own. The expiration date should be far enough to allow time for the asset to appreciate (X1). 

Keep in mind that you would need to purchase one put option for every 100 shares you own. 

The put option acts as insurance against a decline in the stock's price. The premium paid for the put option represents the cost of the insurance.

If the stock price falls below the strike price of the put option (X1), the put option becomes valuable and can be used to sell the stock at the higher strike price.

This allows the stockholder to retain ownership of the stock while also providing downside protection. This can be useful in situations where the stockholder believes that the stock may decline in value, but does not want to sell the stock outright.

Long Straddle

A long straddle is an options strategy that is designed to profit from a significant price movement in the underlying asset, regardless of whether the movement is up or down.

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To create this position:

1. Buy a call option with a strike price at or near the current market price.
2. Buy a put option with the same expiration date as the call option and with a strike price at or near the current market price.

The key feature of the long straddle strategy is that it allows the investor to profit from a significant price movement in the underlying asset, without having to predict the direction of the movement.

If the price moves significantly in either direction, the strategy will result in a profit. If the price remains stable, the strategy will result in a loss as both options expire worthless.

The call option gives the holder the right to buy the underlying asset at the strike price, while the put option gives the holder the right to sell the underlying asset at the strike price. By purchasing both options, the strategy profits if the price of the underlying asset moves significantly in either direction.

Bull Spread

A bull spread strategy is designed to profit from a moderate increase in the price of the underlying asset.

To create this position:

1. Buy an in-the-money call option on the underlying asset with a lower strike price (X1).
2. Sell an out-of-the-money call option with a higher strike price (X2).

The strategy involves buying a call option with a lower strike price and simultaneously selling a call option with a higher strike price. The options are typically purchased and sold with the same expiration date.

The idea behind the strategy is that the profit from the call option with the lower strike price will offset the cost of the call option with the higher strike price.

The maximum profit of the bull spread is the difference between the strike prices of the call options, less the premium paid, while the maximum loss is the premium paid. It can be an effective way to profit from a moderate increase in the price of the underlying asset.

Collar

An options collar strategy, also known as a protective collar or a hedge collar, is designed to protect against downside risk while limiting potential gains on an underlying asset you already own.

To create this position:

1. Buy a put option on the underlying asset with a strike price below the current market price to protect against downside risk (X1).
2. Sell a call option on the underlying asset with a strike price above the current market price to generate income (X2).

The strategy involves owning the underlying asset, buying a put option to protect against downside risk, and selling a call option to generate income. The options are typically purchased and sold with the same expiration date.

The put option acts as insurance against a significant drop in the price of the underlying asset. If the price of the asset falls, the value of the put option increases, offsetting the loss in the value of the underlying asset.

The call option is sold to generate income, but it also limits the potential gain from owning the underlying asset. If the price of the asset rises above the strike price of the call option, the investor will be obligated to sell the asset at the strike price, limiting the potential gain.

The maximum profit is limited to the difference between the price of the underlying asset and the strike price of the call option, less the premiums paid for the put and call options. The maximum loss is limited to the cost of the put option.

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