Options are versatile investment vehicles. An option trade can include one option contract, two or more options contracts or options combined with a stock purchase. How to structure the option trade depends on the trader’s purpose for the trade and expectations regarding future price changes.
Exotic option strategies can utilize four or more different option contracts (or legs). Most basic strategies typically involve just one option either by itself or together with an underlying stock position.
Buy a Call Option
A call option gives the option holder the right, prior to the option contract’s expiration date, to purchase a stock at a specified price (the strike price). Buying a call option is a way to trade on an anticipated stock price increase. If the stock price rises before the option contract expiration date, a call option can generate a much larger percentage return than buying the actual stock.
For example, 100 shares of a $47.50 stock would cost $4,750. A price increase of $5 will yield a $500 profit on the $4,750 investment (10.5%). Buying one 50 call option (an option with a strike price of $50) for $45 would result in a $205 profit for a return of 455%!
Unfortunately, options also cause greater losses (at least on a percentage basis) when a trade is not profitable. Option traders can lose their entire investment because the option can expire worthless. Buying the underlying stock does not carry this same risk because a stock price will not normally go to zero.
Position sizing will determine the dollar amount of a loss. In the previous example, a price decrease of $1 per share would equal a $100 loss – more than double the entire cost of the option contract.
Buy a Put Option
An investor who expects a price decrease in a stock can profit by purchasing a put option. Put options give their holders the right to sell the underlying stock for a fixed price during the option contract period. Similar to using call options to profit from price increases, put options provide a magnified return on investment for price drops. Buying a put carries the same risk profile as buying a call; the maximum loss is the premium paid for the option.
Sell Covered Calls
Selling covered calls can generate enhanced return on a long term stock investment. The covered call writer (the seller of the call option) sells call options on stock he owns. Alternatively, selling a call option at the same time as purchasing the stock reduces the cost of the stock by the amount of premium received for selling the call, which provides a cushion against a modest price decrease.
Most options expire worthless. When an option contract expires without being exercised, the option writer keeps the premium paid for that option.
If the stock price increases and the option is exercised, then the option writer effectively sells the stock for the strike price of the call option sold. Therefore, selling a covered call limits the maximum profit from a stock price increase.
According to the Chicago Board Options Exchange (CBOE) online publication, “Equity Option Strategies”, a covered call strategy is appropriate for an investor with moderately bullish expectations for the underlying stock.
Buy Protective Puts
A protective put insures against losses on owning the underlying stock. Puts can also lock in profits by allowing the option owner to sell stock for the strike price of the put. If the stock price does not go lower, then the investor loses the premium paid for the put option as insurance for the investment.
CBOE’s “Equity Option Strategies” states that a protective put strategy should be used by an investor who either wants to continue to own a stock and protect profits or wishes to purchase a stock but wants to guard against a price decrease.
Tips and Warnings
Investors should educate themselves on the characteristics and risks of options before trading them. Options are not a simple proxy for buying or selling the underlying stock. They have a limited lifespan and factors other than changes in the underlying asset’s value (such as implied volatility and days left until the option’s expiration date) can drastically affect the price of an option.