Understanding Basic Options Strategies

UNDERSTANDING OPTION STRATEGIES

In my bestselling book, Understanding Options, I introduced a variety of option strategies. To help you understand these strategies in more depth, I wrote the following option articles for one of my corporate clients, which is also posted on their website.

Here are four basic options strategies:

PART ONE: BASIC STRATEGIES

  1. Covered Calls
  2. Buying Calls
  3. Collars
  4. Straddles

 

COVERED CALLS

Options strategy: How to sell covered calls
Income potential, while theoretically reducing the risk of simply owning a stock.

If you’re looking for an options strategy that provides the ability to produce income but may be less risky than simply buying stocks, you might want to consider selling covered calls. As long as you’re aware of the potential risks — including transaction costs and tax and wash sale implications — this basic strategy is designed to help generate income from stocks you already own, even within an IRA.

 

Understanding covered calls
As you may know, there are only two types of options: calls and puts.

Calls: The buyer of a call has the right to buy the underlying stock at a set price until the option contract expires.

Puts: The buyer of a put has the right to sell the underlying stock at a set price until the contract expires.

Although many option strategies have exotic-sounding names, every strategy is based on the buying and selling of calls and puts.

When you sell a covered call, also known as writing a call, it means that you already own shares of the underlying stock and you are selling someone the right, but not the obligation, to buy that stock at a set price until the option expires—the price won’t change no matter which way the market goes. If you didn’t own the stock, it would be known as a naked call—a much riskier proposition.

Why would you want to sell the rights to your stock? Because you receive cash, also known as the premium.

For some people, receiving extra income on stocks they already own sounds too good to be true, but like any options strategy, there are risks as well as benefits.

 

How this strategy works
Before you make your first trade, it’s essential that you understand how it works. For example, let’s say in February you already own 100 shares of XYZ, which is currently at $30 a share. You decide to sell (or write) one call, which covers 100 shares of stock. (If you owned 200 shares of XYZ, you could sell two calls.)

 

The strike price
You agreed to sell those 100 shares at an agreed-upon price, known as the strike price. When you look up the options quotes on your screen, you’ll see an assortment of strike prices. The strike price you choose determines how much premium you receive for selling the option. With covered calls, for a given stock, the higher the strike price is from the stock price, the less valuable the premium.

Therefore, a $32 strike price is more valuable than a $35 strike price. Why? Because it is more likely for XYZ to reach $32 than it is for it to reach $35, and therefore more likely that the buyer of the call will make money. Because of that, the premium is higher.

 

The expiration date
In addition to deciding on the most appropriate strike price, you also have a choice of an expiration date, which is the third Saturday of the expiration month. For example, let’s say in February you choose a March expiration date. On the third Friday in March, trading on the option ends and the following day it expires. Either your option is assigned and the stock is sold at the strike price or you keep the stock. Because some people don’t want to tie up their stock for too long, they may choose expiration dates that are only a month or two away. Hint: The further away the expiration date, the more valuable the premium because a longer time span gives the underlying stock more opportunity to reach the option’s strike price.

Note: It takes experience to find strike prices and expiration dates that work for you. As a new options investor, you may want to experiment with one options contract and different strike prices and expiration dates. Eventually you’ll find a combination that works for you.

 

Your first covered call trade
Now that you have a general idea of how this strategy works, let’s look at more specific examples.

Note: Before placing a trade, you must be approved for an options account.

In February, you own 100 shares of XYZ, which is currently at $30 a share.

You sell one covered call with a strike price of $33 and an expiration date of March. The bid price (the premium) for this option is $1.25.

If you were willing to pay the additional commissions and initiated this trade over the phone, you’d say, “I’d like to sell one covered call for XYZ March 33 for a limit price of $1.25 good for the day only.” Hint: It’s suggested you place a limit order, not a market order, so that you can specify the price.

If the call is sold at $1.25, the premium you receive is $125 (100 shares x $1.25) less commission.

Now that you sold your first covered call, you simply monitor the underlying stock until the March expiration date.

Let’s take a look at what could go right, or wrong, with this transaction.

Example one: The underlying stock, XYZ, is above the $33 strike price on the expiration date.

If the underlying stock rises above the strike price at expiration, even by a penny, the stock will most likely be “called away” from you. In options terminology, this means you are assigned an exercise notice. You are obligated to sell the stock at the strike price (at $33 in this example) at expiration. If you sell covered calls, you must expect and plan to have your stock sold. Fortunately, after it’s sold, you can always buy the stock back and sell covered calls on it the following month.

One of the criticisms of selling covered calls is there is limited gain. In other words, if XYZ suddenly zoomed to $37 a share at expiration, the stock would still be sold at $33 (the strike price). You would not participate in the gains past the strike price. If you are looking to make a big score, then selling covered calls may not be an ideal strategy.

Benefit: You keep the premium, stock gains, and dividends, but the stock will be sold at the strike price.

Risk: You lose out on potential gains past the strike price. In addition, your stock is tied up until the expiration date.

Hint: Choose from your existing underlying stocks that are slightly bullish and not too volatile.

Example two: The underlying stock is below the strike price on the expiration date.

If the underlying stock is below $33 a share (the strike price) at expiration, the option has a greater likelihood to expire unexercised and you keep the stock and the premium. You could also sell another covered call for a later month. Although some people hope their stock goes down so they can keep the stock and collect the premium, be careful what you wish for.

For example, if XYZ drops a lot, for example, from $30 to $25 a share, although the $125 premium you receive will reduce the pain, you still lost $500 on the underlying stock.

Benefit: The premium will reduce, but not eliminate, stock losses. 
Risk: You lose money on the underlying stock when it falls.

Advanced note: If you are worried that the underlying stock might fall, you can always initiate a collar, that is, you can buy a protective put on the covered call, allowing you to sell the stock at a set price, no matter how far the markets drop.

Example three: The underlying stock is near the strike price on the expiration date.

Some might say this is the most satisfactory result for a covered call. If the underlying stock is slightly below the strike price at expiration, you keep the premium and the stock. You can then sell a covered call for the following month, bringing in extra income. If, however, the stock rises above the strike price at expiration by even a penny, the option will most likely be called away.

Benefit: You keep the stock and premium, and can continue to sell calls on the same stock.

Risk: The stock falls, costing you money.

 

Advanced covered call strategies
Some people use the covered call strategy to sell stocks they no longer want. If successful, the stock is called away at the strike price and sold. You also keep the premium for selling the covered calls.

If you want to avoid having the stock assigned and losing your underlying stock position, you can usually buy back the option in a closing purchase transaction, perhaps at a loss, and take back control of your stock.

 

BUYING CALLS

Options strategy: how to buy calls
Buying calls can help to increase the returns, and risks, of your investments.

If you’re looking for a strategy that gives you the potential for larger returns without having to invest a lot of money up front, you may want to consider buying call options. When you buy calls, you profit if the market or an individual stock rises far enough within a certain period of time. If you are right, you can participate in the rise of the stock without actually having to buy it, and only pay a fraction of the cost that would be involved if you purchased actual shares of the stock.

To be profitable, you must be correct both about both the direction and timing of the stock price change. For example, if you believe that a stock will go up within the next month, you could consider buying a call option rather than buying the stock. Like any strategy, the goal is to be profitable while minimizing risk. Buying calls has the potential to help you achieve this goal.

 

Understanding call options
Before you buy your first call, it’s essential that you understand how they work. For example, let’s say XYZ stock is $30 a share in February. If you wanted to buy 100 shares, it would cost you $3,000. Instead, you could buy one call option, which gives the right to buy 100 shares of the stock at a set price, known as the strike price. The cost of the option contract is usually a fraction of investing in the actual stock. So, in this hypothetical example, instead of paying $3,000 to own the stock, you might pay $300.

Say you are trying to decide between buying a call or the stock itself in the above example—100 shares would cost $3,000, and the option contract would cost $300. If the stock price goes from $30 to $35 by the options expiration, the shares of the stock would rise in value from $3,000 to $3,500, and you would make 17%, or $500, for this time period. As the stock price rises, the value of the option at expiration would rise from $300 to $500, a $200 gain, or a 67% return for the period that you held the option. But what if the stock price falls to $28? At expiration the option would expire worthless and you will lose 100% of your investment. Every options contract has a few key criteria that option traders must be aware of:

Strike price. When you buy a call, you have an opinion about the direction of the stock. Let’s say you believe that XYZ will rise from $28 to $32 a share within one month. Options contracts let you choose the best way to take advantage of your forecast by choosing the best strike price. The strike price is the price at which you can buy the underlying stock for call options. For example, the option may have strike prices of $30, $35, and $40. Every investor needs to review the available strike prices, and find one that matches their investment forecast. For instance, if you think the price of the underlying stock will reach $32, you may want to look at a $30 strike price.

Expiration date. When you buy calls, time is not on your side. In fact, as soon as you buy a call, the clock is ticking. All options contracts have an expiration date. The standard expiration date is the Saturday following the third Friday of the month. It is important that you choose the expiration date that is going to let your forecast be realized.

Commissions. As they do with most investments, brokerages charge commissions when you buy or sell options contracts. Those commissions—which aren’t reflected in the examples used in this article—can reduce your returns.

 

Buying your first call option
Now that you have a general idea of how this strategy works, let’s take a look at more specific examples.

Note: Before placing a trade, you must be approved to trade options in your account.

In February, you decide to buy one call option (equal to 100 shares) of XYZ, which is currently at $30 a share.

You choose an XYZ April 30 call option currently trading at $1.50.

If you initiated this trade over the phone, you’d say, “I’d like to buy (or go long) one XYZ April 30 call for a limit price of $1.50 good for the day only.” You may want to consider placing a limit order, not a market order, so that you can specify the price you are willing to pay.

If the call is bought at the limit price of $1.50, you will pay a total of $150 (100 shares x $1.50), plus commission.

Now that you bought your first call, you have to closely monitor the underlying stock until the April expiration date. Since time is not on your side, there are a number of choices you have to make.

 

How a trade may play out
Let’s take a look at what could go right, or wrong, with this transaction.

Example One: The underlying stock, XYZ, rises from $30 to $35 on the expiration date.

You expect and want the underlying stock to rise above the strike price. The higher the stock goes, the more valuable the call option. At any time before the expiration date, you can close your position and take the profits. Many option traders will lock in gains based on their profit forecast, because the price of the stock could fall.

In this example, as XYZ rose to $35, the call option at expiration was worth $5 ($35 – $30). You decide to sell the call to close. You are left with a $350 profit ($5.00 gain – $1.50 premium = $3.50 net gain x 100 shares), less commissions.

Benefit: In this example, the call option had a larger return (by percentage) than the underlying stock, while requiring less capital to make the investment.

Risk: The stock could fall and you lose some if not all of the premium paid.

Caution: Although buying calls may look attractive when compared with buying stock, in real life there are many things to consider before making your investment.

Example Two: The underlying stock, XYZ, drops below $30 at or before expiration.

If the underlying stock falls below your strike price at expiration, the option will be worthless. In fact, as the stock gets closer to the expiration date, the option can deteriorate quickly because of lost time value.

In this example, the underlying stock fell to $28 a share a few weeks later, causing a partial loss. You sold the call for $0.60 as your exit strategy ($150 investment – $60 sales price = $90 loss).

Risk: You could lose all or part of your $150 investment.

Example Three: The underlying stock, XYZ, is near the $30 strike price at or before expiration.

This scenario is similar to Example Two. Because of diminishing time value, the option may expire worthless. Therefore, in this example, you could lose your entire investment of $150. You always have the choice of selling the option before the expiration date and closing the position to minimize losses.

Risk: You could lose all or part of your $150 investment.

 

Exercising call options
In the first example, when the underlying stock rose above the strike price (the option is “in-the-money”), you can sell the call and take the profit. You also have another choice, and that is to exercise the option. In this example, you can convert the single call option into 100 shares of stock by paying the strike price. You might be interested in converting shares into stock if you think the stock will continue to rise, and are comfortable owning the stock in your portfolio.

Important: Although you have the right to exercise, many option traders simply buy and sell the option without exercising. By selling the option, the trader does not have to assume the risk and cost of owning the underlying stock.

 

Options and stocks don’t always move together
Although buying calls is usually a straightforward strategy, there is some nuance. For example, some people are confused when, on occasion, the stock goes up but the option doesn’t follow. “Sometimes a stock could rise in value but an ‘out-of-the-money’ call could drop,” says Joe Harwood, manager of the Options Industry Council (OIC) help desk. The solution is to take the time to learn how options are priced. “Many people think that options are pegged to the stock price, but they are not. Options are a derivative of stocks, but they are not pegged.” This means that prices fluctuate based on the options market and other forces, not purely on the price of the stock.

 

Bottom line
Buying calls can offer an alternative strategy to buying stock, for investors looking to increase the size of returns relative to the amount of money they choose to invest.

 

COLLARS

Put a collar on this market
Here’s a sophisticated options strategy designed to limit losses and protect gains.

The S&P 500® Index has gained 9% so far in 2012. That’s a huge gain over a very short period of time. You may have stocks that have generated strong returns in the rally, and such a big move might raise red flags for a potential correction. If you’re looking to protect gains on current stock positions, or you are moderately bullish on a particular asset but could be concerned about a potential downturn, consider the collar options strategy.

 

Getting to know collars
A collar is a relatively complex options strategy that puts a cap on both gains and losses (see graphic below). There are three components to constructing a collar:

Purchasing or having an existing stock position (e.g., owning shares of XYZ Company)

Selling a call (the seller of a call has an obligation to sell the stock at the strike price until expiration or until he or she closes the short call position)

Buying a put (the buyer of a put has the right to sell the stock at the strike price until the expiration or until he or she closes the long put position)

This strategy can help mitigate downside risk via the purchase of a put, and some or all of the cost for the purchased put may be covered by selling a covered call on a new or existing stock position.

The premium, or cost of the position, that you pay for the collar is similar to paying an insurance premium. The put could expire worthless if the underlying stock stays the same or rises, but may become more valuable if the underlying stock falls. This allows you to protect the value of the investment by limiting losses in the event of a decline. You are also selling a covered call (to cover some or all of the cost of the put), and become obligated to sell the underlying stock if it rises above your call strike at expiration or is assigned.

You might be asking yourself: Why buy protection for a stock you think might go down in value? Why not just sell the stock? One reason is that there might be significant tax consequences or transaction costs. You may prefer to maintain your position in a stock rather than selling it. However, sometimes selling the stock may be the right answer if you no longer are bullish on the stock.

 

Let’s take a closer look at collars
Now that you have a basic idea of how this strategy works, looking at a specific example will help you. Please note that before placing a collar, you must fill out an options agreement and be approved for the appropriate options trading level.

In our example, we will look at a hypothetical scenario for XYZ Company.

  1. In January, assume you decide to buy 100 shares of XYZ Company for $53 a share.
  2. Four months later, with the stock trading at close to $53, you become concerned about a potential stock market decline but do not want to sell the shares, so you decide to construct a collar. To do this, you buy a September 52 put selling at $2.45 per contract. Each options contract typically covers 100 shares, so you pay $245 ($2.45 per contract x 100 shares x 1 contract). This out-of-the-money put acts as an insurance policy, effectively protecting your XYZ shares in case of decline below $52.
  3. At the same time, you sell a call on XYZ at the September 55 strike price that costs $2.30 per contract. Each options contract typically covers 100 shares, so you receive $230 ($2.30 x 100 x 1 contract) in premium for this one contract. The primary purpose of selling this call is to cover some of the cost of buying the put.

You now have a collar on your XYZ shares. The net cost of options needed to create the collar is $15 ($245 – $230). The maximum gain on the position is now $185, which is equal to the call strike price ($55) less the purchase price of the underlying shares ($53), multiplied by 100, less the net cost of the collar ($15). The maximum loss is now $115, which is equal to the purchase price of the underlying shares ($53) less the put strike price ($52), multiplied by 100, plus the net cost of the collar ($15).

Breakeven, or the price at which the underlying asset must settle for the costs of the trade to equal profit, is equal to $53.15. This is calculated as the purchase price of the underlying shares ($53) plus the net cost of the collar per 100 shares ($0.15).

 

Managing the collar trade
Assume that the share price of XYZ rises to $57 on the expiration date. In all likelihood, the holder of the call option that you sold will exercise the call, so you are forced to sell the stock at the $55 strike price. On the other hand, the put would expire worthless because it is out of the money. Although you incurred a net debit of $15 to construct the collar, you made a two-point gain, or $200, on the underlying stock (bought at $53 and sold at the $55 strike price). In this example, the put acts as unused insurance protection.

Now suppose the share price of XYZ falls to $49 on the expiration date. The most obvious impact here is that the value of your stock position falls $400 ($53 to $49 price decline, multiplied by 100 shares you own). However, because XYZ is below $55 at expiration, the call you sold will expire worthless and you will keep the $230 premium received from the covered call. This offsets some of the loss you have experienced on the stock.

Also, while the covered call expires worthless, the put you bought rises in value. In this example the put premium price has risen from $2.45 to $3.00, so you realize a gain of $55 ($300 – $245). As the stock price falls, the put increases in value.

You still have a loss of $115 ($55 put option + $230 call option – $400 loss on the stock). This highlights how the collar provides protection in a down market.

Finally, let’s assume that XYZ rises to $54 on the expiration date. If XYZ moves between the strike price of the covered call ($55) and the strike price of the put ($52) at expiration, no action needs to be taken, as both options will expire worthless. In this event, you lose the $15 difference between the cost of the put and the money you took in for selling the call.

 

STRADDLES

Straddling the market for opportunities
Here’s an options strategy designed to profit when you expect a big move.

Stocks have been broadly advancing at a steady pace since mid-December of last year. But in the event that the rally slows or market volatility returns, what will you do? Well, when you aren’t sure which direction a stock is going to go but you are expecting a big move, you may want to consider an options strategy known as the straddle.

 

Getting to know straddles
You can buy or sell straddles. In a long straddle, you buy both a call and a put option for the same underlying stock, with the same strike price and expiration date. If the underlying stock moves a lot in either direction before the expiration date, you can make a profit. However, if the stock is flat (trades in a very tight range), you may lose all or part of your initial investment.

Here are a few key concepts to know about straddles:

They offer unlimited profit potential but with limited risk of loss.

The more volatile the stock or index (the larger the expected price swing), the greater the probability the stock will make a strong move.

Higher volatility may also increase the total cost of a long straddle position.

In comparison to other options strategies, the upfront cost of a straddle may be slightly higher because you are buying multiple options and volatility is typically higher.

The concept behind the long straddle is relatively straightforward. If the underlying stock goes up, then the value of the call option increases while the value of the put option decreases. Conversely, if the underlying stock goes down, the put option increases and the call option decreases. While it is possible to lose on both legs (or, more rarely, make money on both legs), the goal is to produce enough profit from the option that increases in value so it covers the cost of buying both options and leaves you with a net gain.

 

What to look for before making a trade
Our focus is the long straddle because it is a strategy designed to profit when volatility is high while limiting potential exposure to losses, but it is worth mentioning the short straddle. This position involves selling a call and put option, with the same strike price and expiration date. This nondirectional strategy would be used when there is the expectation that the market will not move much at all (i.e., there will be low volatility). With the short straddle, you are taking in upfront income (the premium received from selling the options) but are exposed to potentially unlimited losses and higher margin requirements.

 

Let’s dive into straddles
With a basic understanding of how this strategy works, let’s look at specific examples. Please note that before placing a straddle, you must fill out an options agreement and be approved for options trading.

In our example, we will look at a hypothetical scenario for XYZ Company.

In August, you forecast that XYZ, then trading at $40.75 a share, will either rise or fall sharply based on an earnings report that is set to be released in a week. Due to this expectation, you believe that a straddle would be an ideal strategy to profit from the forecasted volatility.

To construct a straddle, you buy 1 XYZ October 40 call for $2.25, paying $225 ($2.25 x 100). We multiply by 100 here because each options contract typically represents 100 shares of the underlying stock. At the same time, you buy 1 XYZ October 40 put for $1.50, paying $150 ($1.50 x 100). Note that in this example, the call and put options are at or near the money. Your total cost, or debit, for this trade is $375 ($225 + $150), plus commissions.

The maximum possible gain is theoretically unlimited because the call option has no ceiling (the underlying stock could rise indefinitely). The maximum risk, or the most you can lose on this trade, is the initial debit paid, which is $375, plus commissions. This would occur if the underlying stock closes at $40 at the expiration date of the options.

Let’s make use of breakeven here. In this example, the cost of the straddle (in terms of the total price for each contract) is $3.75 ($2.25 + $1.50). Breakeven in the event that the stock rises is $43.75 ($40 + $3.75), while breakeven if the stock falls is $36.25 ($40 – $3.75). With this information, you know that XYZ must close above $43.75 or below $36.25 at expiration to be profitable.

 

Managing a winning trade when things go right
Assume XYZ releases a very positive earnings report. As a result, XYZ rises to $46.30 a share before the expiration date. Because XYZ rose above the $43.75 breakeven price, our September 40 call option is profitable and might be worth $6.40. Conversely, our September 40 put option has almost no value; let’s say it is worth $0.05.

Before expiration, you might choose to close both legs of the trade. In the above example, you could simultaneously sell to close the call for $6.40, and sell to close the put for $0.05, for a gain of $645 ($6.40 + $0.05). Your total profit would be $270 (the gain of $645 less your initial investment of $375), minus any commission costs.

Now, consider a scenario where instead of a positive earnings report, XYZ’s quarterly profits plunged and the stock falls to $33 before expiration.

Because XYZ fell below the $36.25 breakeven price, the September 40 put option might be worth $7.25. Conversely, the September 40 call option is worth just $0.15.

Before expiration, you might choose to close both legs of the trade by simultaneously selling to close the put for $725 ($7.25 x 100) as well as the call for $15 ($0.15 x 100). The gain on the trade is $740 ($725 + $15), and the total profit is $365 (the $740 gain less the $375 cost to enter the trade), minus commissions.

 

Managing a losing trade
The risk of the long straddle is that the underlying asset doesn’t move at all. Assume XYZ rises to $41 before the expiration date. Although the underlying stock went up, it did not rise above the $43.75 breakeven price. More than likely, both options will have deteriorated in value. You can either sell to close both the call and put for a loss, or you can wait longer and hope for a sudden turnaround.

Let’s assume that with just a week left until expiration, the XYZ October 40 call is worth $1.35, and the XYZ October 40 put is worth $0.35. Since XYZ didn’t perform as expected, you might decide to cut your losses and close both legs of the option for $170 ([$1.35 + $0.35] x 100). Your loss for this trade would be $205 (the $170 gain, minus the $375 cost of entering into the straddle), plus commissions.

The risk of waiting until expiration is the possibility of losing your entire initial $375 investment. Both options could expire worthless if the stock finishes at $40. This is called pinning: the stock finishes at the stock price.

 

Other considerations
Timing is an important factor in deciding when to close a trade. There are cases when it can be preferential to close a trade early, most notably “time decay.” Time decay is the rate of change in the value of an option as time to expiration decreases and, because of that and other reasons, traders might choose not to hold straddles to expiration. Instead, they might take their profits (or losses) in advance of expiration.

In addition to time decay, there are other factors that can influence options used in the straddle trade. Learn about the factors that influence options used in the straddle trade and keep the straddle in your trading arsenal in case high volatility makes a comeback.

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