Strategies

Long Call – The primary motivation of this investor is to realize financial reward from an increase in the price of the underlying stock – one call option contract equals 100 shares. Purchasing calls has remained the most popular strategy with investors since options were first introduced. While holding the call option, the investor retains the right to purchase an equivalent number of underlying stock shares at any time at the predetermined strike price until the contract expires. Most investors holding an in-the-money call will elect to sell the option in the marketplace if it has value, before the end of trading on the option’s last trading day. For example, if a stock is trading at $50. An option investor has purchased two long call options with a strike price of $55 for a premium paid of $1.50.  The price of the options contracts is $300 ($1.50 per share X’s 100 shares X’s 2 contracts).

Bull Call Spread – An investor often employs the bull call spread wants to capitalize on a modest advance in price of the underlying stock. Establishing a bull call spread involves the purchase of a call option on a particular underlying stock, while simultaneously selling a call option on the same underlying stock with the same expiration month, at a higher strike price. Both the buy and the sell sides of this spread are always the same number of contracts. The bull call spread can be considered a hedged strategy – the price paid for the call with the lower strike price is partially offset by the credit received from selling the call with a higher strike price. The maximum profit for this spread will generally occur as the underlying stock price rises above the higher strike price, and both options expire in-the-money. For example, let’s assume that a stock is trading at $40. An option investor has purchased three call options with a strike price of $40 for a premium paid of $2.50 and sold three call options with a higher strike price of $45 for a premium received of $1.50. The price of the option contract is $300 (($2.50 paid – $1.50 credit) X’s 100 shares X’s 3 contracts).

Bear Call Spread – A type of options strategy used when a decline in the price of the underlying stock is expected. It is achieved by selling call options at a specific strike price while also buying the same number of calls, but at a higher strike price. The maximum profit to be gained using this strategy is equal to the difference between the price paid for the long option and the amount collected on the sold option. This type of strategy (buying one option and selling another with a higher strike price) is known as a credit spread because the amount received by selling the call option with a lower strike is more than enough to cover the cost of purchasing the call with the higher strike. For example, let’s assume that a stock is trading at $30. An option investor has purchased one call option with a strike price of $35 for a premium paid of $0.50 and sold one call option with a lower strike price of $30 for a premium received of $2.50. If the price of the underlying stock closes below $30 upon expiration, then the investor collects $200 (($2.50 credit – $0.50 paid) X’s 100 shares X’s 1 contract).

Long Put – The primary motivation of this investor is to realize financial reward from a decrease in price of the underlying stock – one put option contract equals 100 shares. A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price move in the underlying stock. While holding the put option, the investor retains the right to sell an equivalent number of underlying shares at any time at the predetermined strike price until the contract expires. As with a long call, an investor who purchased and is holding a long put has a predetermined, limited financial risk. At expiration most investors holding an in-the-money put will elect to sell the option in the marketplace if it has value, before the end of trading on the option’s last trading day. For example, if a stock is trading at $60. An option investor has purchased three long put options with a strike price of $55 for a premium paid of $1.75.  The price of the options contracts is $525 ($1.75 per share X’s 100 shares X’s 3 contracts).

Bull Put Spread – A type of options strategy used when an increase in the price of the underlying stock is expected. This strategy is constructed by purchasing one put option while simultaneously selling another put option with a higher strike price. The goal of this strategy is realized when the price of the stock stays above the higher strike price, which causes the sold option to expire worthless, resulting in the trader keeping the premium. This type of strategy (buying one option and selling another with a higher strike price) is known as a credit spread because the amount received by selling the put option with a higher strike is more than enough to cover the cost of purchasing the put with the lower strike. For example, let’s assume that a stock is trading at $40. An option investor has purchased one put option with a strike price of $30 for a premium paid of $0.75 and sold one put option with a higher strike price of $35 for a premium received of $3.00. If the price of the underlying stock closes above $35 upon expiration, then the investor collects $225 (($3.00 credit – $0.75 paid) X’s 100 shares X’s 1 contract).

Bear Put Spread – An investor often employs the bear put spread in moderately bearish market environments, and wants to capitalize on a modest decrease in price of the underlying stock. Establishing a bear put spread involves the purchase of a put option on a particular underlying stock, while simultaneously selling a put option on the same underlying stock with the same expiration month, but with a lower strike price. Both the buy and the sell sides of this spread are always the same number of contracts. The bear put spread can be considered a hedged strategy – the price paid for the put with the higher strike price is partially offset by the credit received from selling the put with a lower strike price. The maximum profit for this spread will generally occur as the underlying stock price declines below the lower strike price, and both options expire in-the-money (this will be the case no matter how low the underlying stock has declined in price.) For example, let’s assume that a stock is trading at $50. An option investor has purchased two put options with a strike price of $50 for a premium paid of $3.50 and sold two put options with a lower strike price of $45 for a premium received of $1.50. The price of the option contract is $400 (($3.50 paid – $1.50 credit) X’s 100 shares X’s 2 contracts).

Iron Condor – This strategy is mainly used when a trader has a neutral outlook on the movement of the underlying asset from which the options are derived. The iron condor trade involves the execution of both a Bear Call Spread and Bull Put Spread on the same security (as described above). These are both credit spreads that have different strike prices, but the same expiration date. The maximum profit from this strategy is realized when the price of the security remains below the sold call spread AND above the sold put spread. The objective is for all the option contracts to expire worthless resulting in the trader keeping the premium from both spreads. For example, let’s assume that a stock is trading at $50. An option investor has purchased one call option with a strike price of $60 for a premium paid of $0.50 and sold one call option with a lower strike price of $55 for a premium received of $1.50, the investor collects $100 (($1.50 credit – $0.50 paid) X’s 100 shares X’s 1 contract). Also the option investor has purchased one put option with a strike price of $40 for a premium paid of $0.75 and sold one put option with a higher strike price of $45 for a premium received of $2.00. The investor collects another $125 (($2.00 credit – $0.75 paid) X’s 100 shares X’s 1 contract). If the price of the underlying security closes between $55 and $45 upon expiration the investor retains the $225 premium ($100 from call spread +$125 from put spread).

 

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