Investor strategies

Intro

A trader may use Options to achieve a number of different outcomes depending on the strategy he/she deploys.

Traders who are new to Options may activate buy Calls and Puts in anticipation of rising as well as falling markets.

Buying Call or Long Call

The Long Call Option strategy is a basic step whereby the trader buys Call Options with the belief that the price of the Stock will rise significantly beyond the Strike price before its expiration date.

Leverage:

Compared to buying the underlying outright, the Call Option buyer is able to gain leverage since the value of the lower priced calls appreciate faster in percentage terms, for a rise in price point of the underlying. However, call options have a limited lifespan. If the underlying Stock price does not move above the Strike price before the Option's expiration date, the Call Option will expire worthless.



Unlimited profilt potential

The maximum profit possible when implementing a Long Call Option strategy is governed by the strength (or weakness) or its Stock price at expiration date.

  •  Maximum profit = governed by the underlying Stock price
  • Profit is achieved when price of its underlying Stock is more than Strike price + premium paid on the Long Call Option
  • Profit = Price of its underlying Stock – Strike price of Long Call Option – premium paid on the Long Call Option

Limited risk

Loss on a Long Call Options strategy is limited to the price paid for the Call Option regardless of its underlying Stock price. A loss occurs when price of its underlying Stock is less than or equals Strike price of the Long Call Option.

  • Maximum Loss = premium + commission paid on the Long Call Option

Breakeven point

  • Breakeven Point = Strike Price of Long Call + Premium Paid

Bear Put Spread

The bear put spread option strategy is employed when the price of the underlying asset is assumed to go down moderately in the near term.

Bear put spreads can be implemented by buying a higher in-the-money put option and selling a lower out-of-the-money put option with the same expiration date.

Bear Put Spread Construction
Buy 1 ITM Put
Sell 1 OTM Put

By shorting the out-of-the-money put, the options trader reduces the cost of establishing the bearish position but forgoes the chance of making a large profit should the underlying plummet.

Limited downside profit

To reach maximum profit, the underlying needs to close at the strike price of the lower out-of-the-money put on the expiration date. Both options would expire in the money with the higher strike put that was purchased having more intrinsic value than the lower strike put that was sold. Thus, maximum profit for the bear put spread options strategy is equal to the difference in strike prices minus the cost when the position was entered.

  • Max profit = Strike Price of Long Put – Strike Price of Short Put – Net Premium Paid – Commissions
  • Max Profit is achieved when Strike of Short Put is more than Price of Underlying

Limited upside risk

If the stock price rises above the higher put options strike price at the expiration date, the spread strategy would suffer a maximum loss equivalent to the cost of trade.

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss occurs when Price of Underlying is more than the Strike Price of Long Put

Breakeven point

  • Breakeven Point = Strike Price of Long Put – Net Premium Paid

    Bull Call Spread

    The bull call spread options strategy is employed when the price of the underlying asset is expected to go up moderately in the near term.

    Implement Bull call spreads by buying an at-the-money call option while simultaneously selling a higher striking out-of-the-money call option of the same expiration month.

    Bull Call Spread Construction
    Buy 1 ATM Call
    Sell 1 OTM Call

    By shorting the out-of-the-money call, the options trader reduces the cost of establishing the bullish position but forgoes the chance of making a large profit in the event the price experiences a steep rise unexpectedly.

    Limited upside profits

    Maximum gain is reached for the bull call spread options strategy when the underlying price moves above the higher strike price of the two calls and it is equal to the difference between the price strike of the two call options minus the cost to enter the position.

    • Max Profit = Strike Price of Short Call – Strike Price of Long Call – Net Premium Paid – Commissions Paid
    • Max Profit is achieved when Price of Underlying is more than Strike of Short Call

    Limited downside risk

    The bull call spread strategy will result in a loss if the underlying price declines at expiration. Maximum loss cannot be more than the cost to enter the spread position.

    • Max Loss = Net Premium Paid + Commissions Paid
    • Max Loss occurs when Price of Underlying is less than Strike Price of Long Call

    Breakeven point

    • Breakeven Point = Strike Price of Long Call + Net Premium Paid

    Covered calls

    A covered call is derived when call options are written against a holding of the underlying security.

    Covered Call (OTM) construction
    Long 100 shares
    Sell 1 Call

    With the covered call option strategy, earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless an exercise notice is assigned on the written call.

    However, the profit potential of covered call writing is limited to the premium, having given up the chance to fully profit from a substantial rise in the price of the underlying.

    Out-of-the-money covered call

    This is a strategy where the moderately bullish investor sells out-of-the-money calls against a holding of the underlying shares. The OTM covered call is a popular strategy used to collect premium whilst enjoying capital gains should the underlying stock rallies.

     
    Limited profit potential
     
    In addition to the premium received for writing the call, the OTM covered call strategy's profit also includes gain if the underlying stock price rises, above the strike price of the call option sold.
    • Max Profit = Premium received – Purchase Price of the Underlying + Strike Price of Short Call – Commissions Paid
    • Max Profit is achieved when Price of Underlying is more than strike Price of Short Call

    Unlimited loss potential

    Potential losses for this strategy can be very large and occurs when the price of the stock falls. However, this risk is similar to that which the stock owner is exposed to. In fact, the covered call writer's loss is buffered by the premiums received for writing the calls.

    • Maximum loss = Unlimited
    • Loss Occurs When Price of Underlying is less than Purchase Price of Underlying – Premium received
    • Loss = Purchase Price of Underlying – Price of Underlying – Max Profit + Commissions Paid

    Breakeven point

    • Breakeven Point = Purchase Price of Underlying – Premium Received

    Long Put

    The long put option strategy is a basic strategy taken when the price of the underlying is expected to fall significantly below the strike price before the expiration date.

    Compared to short-selling the underlying, it is more convenient to bet against an underlying by purchasing put options. The risk is capped at the premium paid for the put options, as opposed to unlimited risk when one short-sells the underlying outright.


    Unlimited potential


    Since the stock price, in theory, can reach zero at the expiration date, the maximum profit of the long put strategy is the strike price of the purchased put less the price paid for the option.
    • Maximum Profit = Unlimited
    • Profit Achieved when Price of Underlying = 0
    • Profit = Strike Price of Long Put – Premium Paid

    Limited risk

    Risk for implementing the long put strategy is limited to the price paid for the put option no matter how high the underlying price is trading on expiration date.
    • Max Loss = Premium Paid + Commissions Paid
    • Max Loss occurs when Price of Underlying is more than Strike Price of Long Put

    Breakeven point

    • Breakeven Point = Strike Price of Long Put – Premium Paid

    Long straddle

    The long straddle is a neutral strategy that involves the simultaneous buying of a put and a call of the same underlying asset, strike price and expiration date.

    Long straddle construction
    Buy 1 ATM Call
    Buy 1 ATM Put

    Long straddle options are unlimited profit/limited risk options trading strategies that are used when the options trader thinks that the underlying asset will experience significant volatility in the near term.

    Long strangle

    The long strangle, is a neutral strategy that involves the simultaneous buying of an out-of-the-money put and an out-of-the-money call of the same expiration date.

    Long Strangle Construction
    Buy 1 OTM Call
    Buy 1 OTM Put

    The long options strangle is an unlimited profit/limited risk strategy used when the the underlying stock is expected to experience significant volatility in the near term. Long strangles are debit spreads as a net debit is taken to enter the trade.

    Unlimited profit potential

    A large gain is attained if the underlying stock price makes a very strong move either upwards or downwards at expiration.
    • Maximum Profit Unlimited
    • Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium Paid or Price of Underlying < strike Price of Long Put – Net Premium Paid
    • Profit = Price of Underlying – Strike Price of Long Call – Net Premium Paid or Strike Price of Long Put – Price of Underlying – Net Premium Paid

    Limited risk

    Maximum loss occurs when the underlying stock price on expiration date is trading between the 2 strike prices of the options bought. At this level, both options expire worthless and the options trader loses the entire cost to enter the trade.

    • Max Loss = Net Premium Paid + Commissions Paid
    • Max Loss Occurs When Price of Underlying is in between Strike Price of Long Call and Strike Price of Long Put

    Breakeven points

    There are two breakeven points for the long strangle position. The breakeven points are:

    • Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
    • Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid

    Naked Call Writing

    The naked call write is a risky trading strategy where one sells calls against stocks which he does not own. Also known as uncovered call writing, the out-of-the-money naked call strategy involves writing out-of-the money call options without owning the underlying stock. It is a premium collection options strategy employed when one is neutral to mildly bearish on the underlying.

    Limited profit potential

    Maximum gain is limited and is equal to the premium collected for selling the call options.

    • Max Profit = Premium received – Commissions Paid
    • Max Profit is achieved When Price of Underlying is less than Strike Price of Short Call

    Unlimited loss potential

    If the underlying price goes up dramatically at expiration, the out-of-the-money naked call writer will be required to satisfy the options requirements to sell the obligated underlying to the options holder at the lower price, and buy the underlying at the open market price. As there is no cap on the underlying price at expiration, the maximum potential losses for writing out-of-the-money naked calls is theoretically limitless.

    • Maximum Loss = Unlimited
    • Loss Occurs When Price of Underlying > Strike Price of Short Call + Premium Received
    • Loss = Price of Underlying – Strike price of Short Call – Premium Received + Commissions Paid

    Breakeven point

    • Breakeven Point = Strike Price of Short Call +Premium Received

    Risk Reversal

    A risk reversal, or collar, is constructed by holding shares of the underlying while simultaneously buying protective puts and selling call options against the holding. The puts and the calls are both out-of-the-money options having the same expiration and must be equal in number of contracts.

    Risk Reversal Strategy Construction
    Long 100 shares
    Sell 1 OTM Call
    Buy 1 OTM Put

    Technically, the risk reversal strategy is the equivalent of an out-of-the-money covered call strategy with the purchase of an additional protective put.

    The risk reversal strategy can be used if the investor wishes to protect himself from an unexpected sharp drop in the price of the underlying with a written covered call to earn premium.

    Limited profit potential

    • Max Profit = Strike Price of Short Call – Purchase Price of Underlying + Net Premium Received – Commissions Paid
    • Max Profit is achieved When Price of Underlying is more than Strike Price of Short Call

    Limited risk

    • Max Loss = Purchase Price of Underlying – Strike Price of Long Put – Net Premium Received + Commissions Paid.
    • Max Loss occurs when Price of Underlying is less than Strike Price of Long Put

    Breakeven point

    • Breakeven Point = Purchase Price of Underlying + Net Premium Paid

    Uncovered Put write

    Writing uncovered puts is involves the selling of put options without shorting the obligated underlying. Also known as a naked put write or cash secured put, this is a bullish options strategy that is executed to earn a consistent profit by ongoing collection of premium.

    Uncovered Put Write Construction
    Sell 1 ATM Put


    Limited profits with no upside risk

    Profit for the uncovered put write is limited to the premiums received for the options sold.

    The naked put writer sells slightly out-of-the-money puts month after month, collecting premiums as long as the stock price of the underlying remains above the put strike price at expiration.

    • Max Profit = Premium received – Commissions Paid
    • Max Profit is achieved when Price of Underlying is more than Strike Price of short Put

    Unlimited downside risk with little downside protection

    While the premium collected can cushion a slight drop in the underlying price, loss resulting from a catastrophic drop in the price of the underlying can be huge.

    • Maximum Loss = Unlimited
    • Loss Occurs When Price of Underlying < Strike Price of Short Put – Premium Received
    • Loss = Strike Price of Short Put – Price of Underlying – Premium received + Commissions Paid

    Breakeven point

    The stock price at which breakeven is achieved for the uncovered put write position is:

    • Breakeven Point = Strike Price of Short Put – Premium Received

    Short straddle

    The short straddle or naked straddle sale is a neutral options strategy that involves the simultaneous selling of a put and a call of the same underlying stock, strike price and expiration date.

    Short straddles are limited profit/unlimited risk options trading strategies that are used when the underlying security is expected to experience little volatility in the near term.

    Short Straddle Construction
    Sell 1 ATM Call
    Sell 1 ATM Put


    Limited profit

    Maximum profit for the short straddle is achieved when the underlying on expiration date is trading at the strike price of the options sold. At this price, both options expire worthless and the options trader gets to keep the entire credit taken as profit.

    • Max Profit = Net Premium Received
    • Max Profit Achieved When Price of Underlying = Strike Price of Short Call/Put

    Unlimited risk

    Large losses for the short straddle can be incurred when the underlying makes a strong move either upwards or downwards at expiration, causing the short call or the short put to expire deep in the money.

    • Maximum Loss = Unlimited
    • Loss Occurs when Price of Underlying > Strike Price of Short call + Net premium received or Price of underlying < Strike Price of Short put – Premium received.

    Breakeven points

    There are two breakeven points for the short straddle position. The breakeven points are:

    • Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
    • Lower Breakeven Point = Strike Price of Short Put – Net Premium Received

    Short Strangle

    The short strangle is a limited profit/unlimited risk options trading strategy that is used when the underlying is expected to experience little volatility in the near term.

    Short Strangle Construction
    Sell 1 OTM Call
    Sell 1 OTM Put


    Limited profit

    Maximum profit for the short strangle occurs when the underlying on expiration date is trading between the strike prices. At this price, both options expire worthless and the options trader gets to keep the entire credit taken as profit.

    • Max Profit = Net Premium Received
    • Max Profit Achieved When Price of underlying is in between the Strike Price of the Short Call and the Strike Price of the Short Put

    Unlimited risk

    Large losses for the short strangle can be experienced when the underlying stock price makes a strong move either upwards or downwards at expiration.

    • Maximum Loss = Unlimited
    • Loss Occurs When Price of underlying > Strike Price of short Call + Net Premium Received or Price of Underlying < Strike Price of Short Put – Net Premium Received
    • Loss = Price of Underlying – strike Price of Short Call – Net Premium received or Strike Price of short Put – Price of Underlying – Net Premium Received

    Breakeven points

    There are two breakeven points for the short strangle position. The breakeven points are:

    • Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
    • Lower Breakeven Point = Strike Price of Short Put – Net Premium Received