Options are a lesser-understood asset class in the world of investment portfolios. These contracts allow investors to buy or sell assets at prearranged prices during a specified timeframe. They can include securities, commodities, ETFs, or indices.
Two fundamental types of options include:
- Call Options: These contracts grant the right to buy shares (usually 100) within a defined period. Investors use call options when they anticipate an asset's value will rise. By securing assets at a predetermined price (known as the strike price), they can profit from future value increases.
- Put Options: In contrast, put options allow the sale of 100 shares within a set timeframe. Investors favour put options when they expect a lower stock price in the future. Purchasing put options is essentially a bet on asset depreciation.
Options resemble bets on market movements, making them versatile tools for speculation or hedging. They can shield stock investments from losses and generate consistent income, contingent on your trading strategy.
The world of options trading is very technical. There is a good chance your default brokerage doesn't have much in terms of navigating the options market. To navigate options effectively, you need comprehensive research and an understanding of trading platforms like MT4.
Describing options trading with an example
Options trading involves buying and selling options contracts, demanding a deep market understanding and price prediction skills. Options are favoured for their lower initial investment than stocks but are much more speculative. Contracts can last anywhere from a week to years. For beginners, understanding options trading is best done through an example. Suppose Andrew holds an Apple call option at $400 per share.
If Apple drops to $300, he can let the contract expire. He wouldn't bother to buy 100 shares of Apple as detailed in the contract at $400 when he could buy them on the open market for $300. Conversely, if Apple rises to $450, he can buy at $400 and then sell at $450 for a profit.
5 top options trading strategies
In the "long call" strategy, a trader buys a call option, anticipating the stock price will exceed the strike price at expiration. This approach offers unlimited profit potential, with the chance to earn multiples of the initial investment if the stock surges.
For example, if Stock X is $20 per share, and a $20 strike call option with a four-month expiration costs $1, the total cost is $100 (1 contract * $1 * 100 shares per contract).
Breakeven occurs at $21 per share (strike price plus $1 premium). Beyond $20, the option gains $100 for every dollar the stock rises, expiring worthless if the stock remains at or below the strike price.
Long calls are popular for bullish bets due to their unlimited upside. However, they entail a total loss of the $100 investment if the stock falls below the strike price. Use long calls when expecting significant stock price growth; minor gains might not cover the premium, resulting in a net loss.
One approach in options trading involves purchasing a naked call option. At the same time, another employs an introductory covered call strategy. This essentially means you are selling the call option and collecting the premium versus paying it. The latter is favoured due to its income generation potential and the mitigation of stock exposure risk.
However, it necessitates a commitment to sell shares at a predefined value (the strike price). Remember, buying a call option gives us the right to buy 100 shares at a specific price. So it makes sense that when we sell a call option, we'd have to sell 100 shares at a specific price if the buyer chooses to exercise.
To execute this, one buys 100 shares of the underlying stock and concurrently writes (sells) a call option on the same shares. For example, if an investor purchases a hundred shares of stock, they simultaneously sell one call option.
It is termed a covered call, safeguarding against rapid stock price hikes as the long stock position covers the short call. Investors typically adopt this when they have a short-term stock position and a neutral outlook or wish to generate income and hedge against potential stock value declines.
Conversely, the short call strategy, an uncovered or naked call, entails selling a call without holding the underlying stock. It is a high-risk, low-reward strategy primarily used by advanced traders seeking premiums in specific situations. We wouldn't suggest it for anyone, really.
The short put option strategy bets that a stock will rise or remain stable until the option expires. If the put option expires out of the money (above the strike price), the trader keeps the premium as their maximum profit. Selling a put option is one of two bullish strategies, the other being the long call option.
This strategy obligates the seller to acquire the stock at the strike rate if the buyer exercises the contract. It's attractive to investors as it boosts income by taking premiums from traders anticipating stock declines. Short puts provide a cushion in flat markets.
However, caution is essential since sellers must purchase shares if the stock drops further down the strike price by expiration. Volatility levels impact risk and premium received, with higher volatility carrying more risk but yielding a larger premium.
Short puts help secure favourable stock prices by selling puts at lower strike prices, aligning with desired purchase levels.
To use the short put strategy, investors should believe the stock will remain above a specific price or want to buy it at a lower price. The investor keeps the premium if the stock stays above the strike price. They buy the stock at a potentially lower cost if it falls below.
This strategy results in a profit from the premium or an advantageous stock purchase, making it a win-win. Maximum gain equals the net premium received, while the maximum loss is unlimited. The breakeven point is the strike price minus the premium.
For example, selling a $90 strike-price put option on a $100 stock for a $2 premium means the breakeven is $88. If the stock falls to $90, the investor buys it at the desired price, earning the premium. If the stock rises or never reaches $90, they keep the $2 premium.
Bull call spread
Also known as a long call spread, it entails purchasing a lower strike price call and simultaneously selling a higher one with the same expiration date. The short call (point B) has a higher strike price than the long call (point A), requiring the investor to pay for the trade, with the short call helping cover the upfront cost.
The maximum profit equals the difference between the two strike prices minus the premium paid, realized when the strike surpasses the higher price at expiration. The maximum loss is the trade cost, occurring when the stock falls below the lower strike price at expiration.
The breakeven point is the lower strike price plus the trade cost: Breakeven = long call strike + net debit paid.
For instance, a 55-65 call spread costing $2.50 involves buying a 55-strike call and selling a 65-strike call. With a $10 strike width, the maximum profit is $7.50 after deducting the $2.50 premium paid.
Time decay favours the investor when both strikes are in the money but works against them if the spread is out of the money, as more time is needed for profitability.
The married put strategy is a nuanced approach that combines stock ownership with purchasing a put option. In this hedged trade, the trader anticipates a rise in the stock's value but seeks insurance in a downturn. If the stock does decline, the long put offsets the losses.
For instance, if Stock X trades at $20 per share, and a put with a $20 strike price and four-month expiration costs $1, the trader invests $2,000 in 100 shares of stock and $100 in one put contract.
The married put's breakeven point is $21, including the $1 premium. Below $20, the long put counterbalances the drop in the stock dollar for dollar. Above $21, profits increase by $100 for every dollar the stock rises, but the put expires worthless, resulting in a $100 loss.
The married put offers theoretically unlimited upside potential as long as the stock climbs, minus the put's cost. It acts as insurance, protecting against substantial losses.
This strategy suits situations where the trader expects significant stock price fluctuations, like impending earnings reports, while providing both growth potential and downside protection.