CONTENT:: OPTION STRATEGIES
1. LONG CALL::..............................................................................................................................1
Profit/Loss....................................................................................................................................2
Breakeven.....................................................................................................................................2
2. SHORT CALL::............................................................................................................................2
Profit/Loss.....................................................................................................................................3
Breakeven......................................................................................................................................3
3. LONG PUT::.................................................................................................................................3
Profit/Loss.....................................................................................................................................4
Breakeven......................................................................................................................................4
4. SHORT PUT::...............................................................................................................................4
Profit/Loss.....................................................................................................................................5
Breakeven......................................................................................................................................5
5. COVERED CALL::.......................................................................................................................5
Profit/Loss.....................................................................................................................................6
Breakeven......................................................................................................................................6
1. LONG CALL::
Long call options give an investor a chance to bet on whether the underlying stock will rise in
value or stay above a strike price. This is one of two bull option contract types, the other
being selling put option contracts. The Long call option strategy allows traders to profit
without having all the risk associated with owning the stock outright. Because calls are less
expensive than the stock itself, a trader can leverage more shares than they could with just
the stock.
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For an investor who buys a call option, they have the right to purchase stock at the strike
price up until the date the option contract expires. In most cases, one option contract gives the
call option holder the right to buy 100 shares of stock. Just like stock, as the value of the
underlying asset goes up in value, so do the call options. The holder of the call option may
either exercise the contract and take delivery of the stock or sell the call option before the
expiration date.
To purchase a call option, the buyer must pay a premium, which represents the price paid for
the right to buy the stock at a predetermined price. Unlike stock, which can keep dropping in
price and accumulating losses for the investor, the buyer of a call option can only lose the
premium they paid no matter how far the stock drops.
If the stock’s price is above the strike price on expiration, the profit/loss is calculated by
taking the stock price and then subtracting the strike price and the premium paid, then
multiplying that by the number of controlled shares.
Profit/Loss
Maximum Loss = Net Premium Paid
The maximum gain for a long call strategy is unlimited as the stock can continue to move up
gaining more and more value.
Breakeven
The breakeven on a long call option is calculated by adding the premium from the strike
price. If a stock is trading Rs 100 and an investor wants to buy a 110-strike price call for Rs
2.0, then the breakeven would be Rs 112.00.
2. SHORT CALL::
The short call option strategy, also known as uncovered or naked call, consist of selling a
call without taking a position in the underlying stock. For those who are new to options, they
should avoid the short call option as it is a high-risk strategy with limited profits. More
advanced traders use a short call to profit from unique situations where they receive a
premium for taking on risk. Let’s take a more in-depth look at the short call option strategy.
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Investors open the short call strategy when the prediction for the underlying asset is bearish
to neutral. Upon making the sale, the trader has an obligation to sell the stock at the strike
price if the buyer of the short call exercises the option. This should not be confused with
the short put option, where the seller has an obligation to buy the stock at the strike price. In
the chart above, once the stock moves past strike price A, the trader starts to lose their profit.
Once it moves past the strike price by more than the premium received, they start taking a
loss.
With this strategy, it’s in the investor’s interest if the call option has no value at expiration,
thus expiring worthless. When executing this option strategy, it’s a good practice to wait until
the strike price is one standard deviation out of the money (the stock price is lower than the
strike price). However, the strike price well negatively affect the premium received, the more
risk, the higher the reward.
With a short call, the trader wants the implied volatility (IV) to decrease as this will reduce
the price of the options they’re short. Here, if the investor decides to close the position before
the expiration date, the trade will cost them less to buy back. Similarly, decreasing time to
expiration is also a positive factor with this strategy because the less time to expiration, the
lower the value of the call option, enabling the investor to close the position for less.
Profit/Loss
Maximum Profit = Net Premium Received
The maximum loss for a short call strategy is unlimited, as the stock can continue to move
higher with no limit.
Breakeven
The breakeven on a short call option is calculated by adding the premium to the strike price.
If a stock is trading Rs100 and an investor wants to sell a Rs110-strike price call for Rs2.00,
then the breakeven would be Rs112.00.
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3. LONG PUT::
The long put options trading strategy offers an individual the right to sell an underlying stock
at the specified price, point A, as listed on the graph. When the investor purchases a put
option, he or she is betting that the stock will fall below the strike price before the expiration
date. Using a put instead of shorting the stock reduces the risk to the investor as they can only
lose the cost of the put, verses unlimited risk associated with shorting the stock.
If the stock rises, the long put option will expire worthless, and the investor will lose only the
cost of the option. Likewise, an investor who shorted the stock will continue to lose more and
more as the stock continues to climb higher. When purchasing puts, especially short term,
there is a need for investors to be careful. If an investor buys many put contracts, their risk
also increases. This is because the options can expire worthless, whereby the investor would
lose the entire investment.
There are many reasons to buy put option contracts, these can be for speculative purposes,
meaning the investor believes a stock price is going to fall. A long put can also be used as a
hedge against stock already owned, to protect an asset if it’s to have a sudden turnaround in
value, also known as a protective put.
Profit/Loss
Maximum Loss = Net Premium Paid
The maximum gain for a long put strategy is unlimited as the stock can continue to move
down gaining more and more value, at least until it reaches zero.
Breakeven
The breakeven on a long put option is calculated by subtracting the premium from the strike
price. If a stock is trading Rs100 and an investor wants to buy a 90-strike price put for
Rs2.0, then the breakeven would be Rs88.00.
4. SHORT PUT::
With the short put option strategy, the investor is betting on the fact that the stock will rise or
stay flat until the option expires. If the put option expires worthless, out of the money (above
the strike price), then the trader keeps the entire premium, which represents their maximum
profit on the trade. When it comes to single option trades, selling a put option is one of two
bull market strategies, the other being the long call option.
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As seen on the graph, the seller of the short put is obligated to purchase the stock, in most
cases 100 shares per contract, at the strike price A if the buyer wants to exercise the contract.
Selling a put option can be valuable to investors as it allows them to increase their income,
taking premium from other traders who are betting the stocks would fall. Therefore, when
using the short put strategy, the investor receives the premium, cushioning themselves from a
flat market with little movement. Nevertheless, investors need to sell their puts sparingly
because they are on the hook to purchase shares if the stock falls below the strike-price by
expiration.
An investor should keep a close eye on volatility levels when selling put options. The higher
the volatility, the more risk to the trader, but the higher premium they receive for taking on
this type of options trade.
Profit/Loss
Maximum Gain = Net Premium Received
The maximum loss for a short put strategy is unlimited as the stock can continue to move
against the trader, at least until it reaches zero.
Breakeven
The breakeven on a short put option is calculated by subtracting the premium from the strike
price. If a stock is trading Rs100 and an investor wants to sell a 90-strike price put for
Rs2.0, then the breakeven would be Rs88.00.
5. COVERED CALL::
The covered call strategy involves the trader writing a call option against stock they’re
purchasing or already hold. Besides earning a premium for the sale, with covered calls, the
holder also gets access to the benefits of owning the underlying asset all the way up to the
strike price, where the stock would get called away.
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There are many different uses of the covered call strategy. Some use the strategy to make
additional profits to the stock they hold while markets trade relatively flat. This is popular
option strategy among traders, because, besides the premium, investors can benefit from
capital gains should the underlying asset increase in value. Out of the money (OTM) call
trades are placed when the outlook is neutral to bullish.
The covered call strategy is usually opened with 30 to 60 days before expiration. This
allows a trader to benefit from time decay. Of course, the optimum time for implementing
the strategy depends on the investors goals. If the goal is to sell calls and make money on the
stock, then it’s best if there isn’t a lot of difference between the stock price and the strike
price. If the goal is to sell the stock and the call, then you should be in a position where the
calls will be assigned. For this to happen, the stock price will need to stay above the strike
price until expiration.
Profit/Loss
The maximum profit with this strategy is the difference between the strike price and the
current stock, plus the premium received for selling the call options contract. Beware of
the pitfalls of this strategy, though. The potential loss of this strategy can be substantial. This
loss happens when the price of the underlying asset decreases. However, unlike stock
trading, the downside is slightly less painful due to the premium received, that will cushion
any downside stock movement.
Breakeven
The breakeven point is the difference between the current stock price and the premium
received for selling call options.
