Option are one of the more favored options for traders because their value can change quickly and make (or losing) an enormous amount of money quickly. Options strategies range from fairly simple to very complicated that include a wide range of payouts, and even bizarre names. (Iron condor, anyone?) Whatever their complexity, each option strategy is constructed around two basic kinds of options: the put and the call. Below are five common strategies with a breakdown of their rewards and risks and the times the times when traders might employ them in future investments. Although these strategies seem straightforward, they could make a trader a lot of money, but they aren’t risk-free. Here are a few guides on the fundamentals of call options and put options before we begin.
In this method, the trader buys a put — referred to as “going long” a call and hopes that the price of the stock to be higher than the strike price by expiration. The upside on this trade is uncapped and traders can earn many times their initial investment, if the price of the stock rises. Example: Stock X is trading at $20 per share. Similarly, calls with a strike value of $20 and expiration within 4 months is currently trading at $1. The contract cost $100 equivalent to one deal * 1 * 100 shares that are represented in each contract.
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Reward or risk: In this case the trader is able to break even at $21 per share, which is the strike value plus the premium of $1. Above $120, the option will increase the value of $100 for every dollar the stock goes up. The option expires worthless when the stock is at the strike price, but below. The upside for a long call is theoretically endless. If the price continues to increase prior to expiration, the call can keep climbing higher, too. This is why long calls are one of the most sought-after ways to bet on the rising price for stocks. The downside of a lengthy call is that it could result in a complete loss of your investment, $100 in this example. If the price of the stock falls lower than the price of strike, the call will expire worthless and you’ll be left with nothing.
When to apply It: An option with a long duration is a wise choice if you anticipate that the stock will rise substantially prior to the expiration. If the stock only rises marginally over the strike price, the option might still be in the black but it might not pay back the premium which leaves you with a net loss.
A covered call involves selling the option of a call (“going short”) however with an additional twist. In this case, the trader sells a call but also buys the stock that underlies the option, 100 shares for every call sold. Being a stock owner turns an unwise tradethe short callto a fairly safe option that generates income. The market expects the price to be below the strike price when it expires. If the stock is priced above what is listed, owner must transfer the company to the buy-out buyer for the amount of strike.
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Examples: Stock X is trading for $20 per share. calls with a strike price of $20, and expiration date of four months is priced at $1. The contract offers a price of $100, which is 1 contract * $1 = 100 shares by each contract. The trader buys 100 shares of stock for $2,000 and then sells one call for $100.
Reward/risk: In this example the trader is breaking even at $19 per share, or the strike price minus the $1 premium paid. If the price is less than $ 19, the investor would lose money as the stock will be unable to make money, far more compensating the $1 premium. At a price of $20, the trader would retain the entire premium and would hold onto the stock, too. Beyond $20, the profit is limited to $100. While the short call loses $100 for each dollar increase above $20, the loss is covered by the stock’s increase which leaves the trader with the initial $100 as the entire gain. The profit potential of an covered call limited to the premium received, regardless of how high the price of the stock goes. The covered call cannot make you greater than this, but it is possible to lose more. The gain you could have earned from rising stock prices is negated through the shorter call.The downside is a complete loss on the investment in stock, assuming the stock goes to zero, which is offset by the premium paid. The covered call can leave you open to a significant loss, in the event that the stock declines. In our case, if the stock declined to zero, your total loss would be 1 900 dollars. When to use it: A covered call can be a good strategy to earn income if already own the stock , but don’t expect the stock to rise significantly in the near future. Therefore, the strategy can transform your existing holdings into cash. The covered call is very popular with older investors who need the income, and it is a good option for tax-favored accounts where you’d otherwise be required to pay tax on the premium and capital gains if the stock is called.
In this method, the trader buys a puts — referred to as “going long” a put — and expects the stock price to be below the strike price upon expiration. The upside on this trade can be multiples of the initial investment if the stock falls significantly. Example: Stock X is trading for $20 per share, and puts with a strike price of $20, and expiration date of four months is trading at $1. The contract is $100, or an entire contract * 100 shares of shares for each contract.
Reward/risk In this example the put is at break-even in the event that the stock closes below the expiration of the option at $19 per share which is the strike value minus the $1 premium. The put is priced below $19 and increases by $100 per dollar decline in the stock. Beyond $20, the put expires as worthless and the seller loses the entire premium of $100.The upside on a long put is nearly as high as on a long call, because the gain can be multiples of the option premium. However, a put can never fall below zero, which limits the potential upside, while a long call could theoretically offer unlimited upside. Long put options are a popular and popular method to bet on the price decline of a stock. They are also they can be safer than shorting stocks. The downside on a long put is that it is only the premium paid, $100 here. If the stock closes above the strike price by the time of expiration of the option, it becomes worthless and you’ll lose your investment. When to utilize to use itA Long put an ideal option when you are expecting the stock to fall significantly before the expiration date. If the stock drops only marginally below the strike price, the option will be at the market, but will not earn back the premium paid, resulting in the loss.
This method is the reverse from the traditional long put, however, the trader here sells a put — known as “going short” a put and anticipates that the price of the stock will be higher than the strike value at the time of expiration. In exchange to sell a put the trader receives a cash premium which is the highest the short put could earn. If the stock is trading below the strike price at expiration time, the buyer has to purchase it at the strike price. Example: Stock X is trading for $20 per share. Similarly, the put that has a strike price of $20 with expiration time of four months, is currently trading at $1. The contract offers a price of $100, or 1 contract * $100 * 100 shares represented each contract.
When should you utilize It: A short put is a good strategy when you anticipate that the stock will close at the strike price or more when the option expires. The stock needs to be in the vicinity of the strike price to allow the option to cease to be ineffective and you can keep the whole premium received.
Your broker will want to make sure you have enough equity in your bank account to purchase the stock in the event that it is offered on you. Many traders will have enough money in their accounts to purchase the stock, should the put expires with cash. But, it’s also possible to end the option position prior to expiration, and thus take the net loss without having to purchase the stock at the time of expiration.
This is a variation of the long put but with a twist. The trader has the underlying stock, but also purchases a put. This is a hedged trade that is where the buyer believes that the stock will rise but needs “insurance” in the event that the stock declines. In the event that the stock drops the long put helps offset the decline. Example: Stock X is trading at $20 per share, and the put with a strike price of $20 and expiration in four months trades at $1. The contract costs $100, or one contract * $1 * 100 shares per contract. The buyer buys 100 shares at $2000 and purchases a put for $100.
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