Options are contracts that give investors the right to buy and sell an underlying asset at a certain price or before a certain date. Options trading allow investors to exercise this right to gain profit. They are a big part of trading, thus it is important to gain a solid basic knowledge of how they work before beginning to trade. Below are some basic option trading strategies.
Covered Call Writing
A covered call often referred to as a “buy-write”, is when an investor sells a stock they already own at a set price, usually a little higher than what they had purchased the stocks for. If the price of the stock stays below the price set by the investor until the stocks are sold, the investor will gain profit. If the stock increases in price and becomes bigger than the price set by the investor, they will then lose profit. Because of this, a covered call can be used to protect an investor from potential loss if the stock continues to do badly, or if an investor has a short-term view of an asset.
This strategy is not used by investors who have a bullish investment style, as they are often confident that the prices of the stock they own will increase over time.
Cash-Secured Put
The goal of a cash-secured put is to allow an investor to buy a stock that is priced below its current market price. The lowered price set by the investor trying to buy the stock is called the ‘strike price’. This strategy involves writing a put option (strike price) in the hopes of a temporary downturn in the price of the stocks so that their put can be assigned and they can acquire the stock at a lower price.
However, there is a risk that the stock will decline way below the strike price and the investor will have to buy the shares at the strike price which is way above the market price of the stock.
Collar
Investors use this options strategy after a stock has risen substantially. Unlike covered call writing, this strategy is employed by investors who have a bullish investment style, though they do try to decrease the risk of a potential drop in value. This strategy involves a combination of covered call and cash-secured put. For example, an investor purchases 50 shares at $50 each, as well as a protective put with the strike price at $47 and sell a covered call of $55. The investor can now either earn $5 per share or lose $3 per share.
This strategy is a good way to protect the gains of a stock while lowering the risk of losses.
Credit Spread
This refers to the purchase of a lowered price option and the sale of a higher priced option of the same underlying security (for example, the same stock). Because of both profits and losses are limited to this strategy, it is employed by both bullish and bearish investors. An investor with a more bullish approach to trading will use credit spread when a stock price is projected to rise; while an investor with a more bearish approach to trading will use credit spread when a stock price is projected to decrease.
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