Introduction: Now that we understand the language of options (the Greeks) and how to read a contract chain, it is time to step onto the field. In this article we look at the basic strategies that form the cornerstone of the options market. We start with simple directional strategies, then move to the strategies professional investors use to generate income.
1. Simple directional speculation (Long Call & Long Put)
This is the most common strategy among beginners. It is simply buying a contract based on a clear view of the stock's direction.
Buying a Call (Long Call)
- Technical view: you expect the stock to rise sharply within a set period.
- Execution: you pay a premium (Premium) to buy a Call.
- Risk and reward: the maximum loss is the amount you paid for the contract (the premium). The gain is unlimited (in theory) because a stock can rise without a ceiling.
- Hidden trap: if the stock moves slowly or stalls, you lose money to time decay (Theta Decay). The stock has to move faster than time for you to profit.
- Technical view: you expect the stock to collapse or correct sharply.
- Execution: you pay a premium (Premium) to buy a Put.
- Risk and reward: the maximum loss is the premium. The gain is large, capped only by the stock falling to zero.
- How professionals use it: Professionals use this strategy to speculate, and also as insurance (Protective Put) to protect large portfolios from crashes.
Buying a Put (Long Put)
2. Income Generation strategies
If the earlier strategies rely on "paying" money in hope of a bigger gain, income strategies rely on "receiving" money up front. In these strategies you play the role of the market maker or the insurance company.
Strategy one: selling a Covered Call
This is the best strategy for someone who already owns the stock and wants extra return from it.
- Requirements: you must own 100 shares of the company (or a multiple of that).
- Execution: you "sell" a Call (Short Call) at a Strike above the stock's current price. In return for this sale, you receive an immediate cash amount (Premium) in your account.
- Scenarios:
1. The stock did not reach the strike price: the contract expires worthless, you keep your shares, and you keep the premium you received. (Net profit.)
2. The stock moved past the strike: you will be forced to sell your 100 shares at the agreed strike price. You made a gain from the stock's rise up to the strike and kept the premium, but you missed any further upside.
Tip: do not sell a Covered Call on a stock you love and expect to soar, and do not want to part with, because you may have to sell it!
Strategy two: selling a Cash-Secured Put
Warren Buffett and other large investors use this strategy to buy stocks they like at a discount, and they get paid while they wait!
- Requirements: you must hold enough cash in your account to buy 100 shares at the strike price you choose.
- Execution: you pick a stock you would like to own but find expensive today. You "sell" a Put (Short Put) at a Strike below the current price. You receive the premium (Premium) right away.
- Scenarios:
1. The stock stayed above the strike: the contract expires, you keep your cash, and you keep the premium.
2. The stock fell below the strike: you will be forced to buy 100 shares at the price you set in advance (a discounted price you wanted). You now own the stock at a price you like, and the premium you received lowered your total purchase cost!
Important warning: never use a Cash-Secured Put on a "bad" stock or a company close to bankruptcy just because the premium is tempting. Remember, you may be forced to buy that stock!
In the next article, we move to a higher level of tactics: price spreads (Spreads), to learn how to lower entry cost and limit risk at the same time.
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