Options Strategy Primer
A high level overview of different options strategies
Options strategies provide investors with tools to capitalize on market moves, generate income, or hedge risk. In this primer, we’ll cover a range of strategies, including selling puts, covered calls, protective puts, and the versatile strangle strategy.
1. Selling Puts: A Bullish Strategy
What It Is
Selling a put option involves agreeing to buy a stock at a specific price (the strike price) if the option buyer exercises their right. This strategy works well when you expect the stock price to rise or stay steady.
Example
You believe Stock XYZ (currently at $50) will rise. You sell a put with:
Strike Price: $48
Premium Received: $2/share
Scenarios:
Stock Stays Above $48:
The put expires worthless. You keep the $2/share premium, earning $200 for 1 contract (100 shares).
Stock Falls Below $48:
You’re obligated to buy the stock at $48/share. With the $2/share premium, your effective cost basis is $46/share.
Best For: Bullish investors willing to own the stock at a discount.
2. Covered Call: Conservative Income Generation
What It Is
This strategy involves owning a stock and selling a call option on it. You collect a premium but cap your potential upside gains.
Example
You own 100 shares of Stock XYZ at $50 and sell a call with:
Strike Price: $55
Premium Received: $1/share
Scenarios:
Stock Stays Below $55:
The call expires worthless, and you keep the $1/share premium.
Stock Rises Above $55:
Your stock is sold at $55/share. Including the $1/share premium, your effective sale price is $56/share.
Best For: Investors seeking income while holding a stock they don’t mind selling at a higher price.
3. Protective Put: Hedging Against Downside Risk
What It Is
Buying a put option on a stock you own to protect against potential losses. This strategy acts as insurance.
Example
You own Stock XYZ at $50 and buy a put with:
Strike Price: $48
Cost: $1/share
Scenarios:
Stock Drops Below $48:
You can sell your shares at $48, limiting your losses to $3/share ($50 - $48 + $1 premium).
Stock Rises Above $48:
The put expires worthless, and you only lose the $1/share premium.
Best For: Risk-averse investors seeking to protect their portfolio in volatile markets.
4. Strangles: Profiting from Big Moves in Either Direction
What It Is
A strangle involves buying both a call option and a put option on the same stock with different strike prices but the same expiration date. This strategy profits when the stock makes a significant move, regardless of direction.
Example
Stock XYZ is trading at $50. You buy:
A call option with a strike price of $55 for $1/share.
A put option with a strike price of $45 for $1/share.
Scenarios:
Stock Moves Sharply (Above $55 or Below $45):
If the stock rises above $55, the call gains value.
If the stock falls below $45, the put gains value.
The gain must exceed the $2/share total cost (premium for both options) to be profitable.
Stock Stays Between $45 and $55:
Both options expire worthless, and you lose the $2/share premium.
Best For: Traders expecting high volatility but uncertain about the direction of the move (e.g., around earnings announcements).
Final Thoughts
Each options strategy comes with its own risk-reward profile and works best in specific market conditions. Selling puts is ideal for bullish investors, while strangles are excellent for volatility plays. Understanding your market outlook and risk tolerance is key to choosing the right approach.