There are many options strategies that investors can use to diversify their portfolio and generate a profit.
Options strategies range from being very simple to being very complex. However, every option strategy involves using calls and puts. This article will introduce seven option strategies that every investor should be aware of. When studied and used effectively, these seven strategies will become great tools investors can use to better their investing portfolio.
- Covered Call: A covered call is an option strategy where an investor writes a call option for a stock that he already owns. The covered call is used when an investor expects the underlying stock to have a slight increase or decrease in price. This is not a strategy to use when an investor is heavily bullish, or bearish. By using this strategy, an investor walks away with a premium regardless of what happens to the underlying stock’s price. However, this strategy puts a cap on the stock’s profit potential.
- Married Put: The married put is an option strategy where an investor buys an “at-the-money” put option while simultaneously buying an equivalent number of shares of the underlying stock. The married put is an effective strategy to protect against depreciation in a stock’s price. This strategy would be used when an investor is bullish on a stock, but also has certain uncertainties about the stock in the near-future. A married put has unlimited profit potential, as there is no ceiling on the price appreciation of the underlying stock. However, the profit potential from using this strategy is lower than it would be for just owning the stock. This is because of the premium paid when purchasing the put option. An investor would incur the cost of the premium in order to protect his stock from downside risk. This strategy is known as a capital preserving strategy, rather than a profit-making strategy.
- Long Straddle: A long straddle is an options strategy where an investor simultaneously buys a call and put with the same strike price and expiration date for the same underlying stock. A straddle is an effective strategy to use when an investor expects an underlying security to have significant volatility in the near future. This strategy is appealing to investors because it has unlimited profit potential and limited risk. By using a straddle, an investor will experience large profits no matter if the stock’s price increase or decreases, as long as the move in the stock is large enough. The maximum loss that could occur when using this strategy is the cost of the two premiums for the call and put option.
- Long Strangle: A long strangle is an options strategy where an investor simultaneously buys a call and put that have different strike prices but the same expiration date for the same underlying stock. To construct a strangle position, an investor buys an “out-of-the-money” call option while buying an “out-of-the-money” put option. This strategy will profit whether the underlying stock’s price increases or decreases, as long as the move in the stock’s price is significant. The risk that comes with this strategy is limited to the premiums paid for the two options. If an investor expects an underlying stock to have a significant price move in the near future, then a strangle is a good strategy to use to profit from the stock’s price move. Generally, the strangle strategy is cheaper than the straddle strategy.
- Butterfly Spread: In the butterfly spread, the investor sells two option contracts at the middle strike price, while buying an option contract at a lower strike price and buying another option contract at a higher strike price. For example, assume an underlying security is priced at $25. An investor sells two call options with a strike price of $25. Then, the investor buys two call options with one having a strike price of $20 and the other having a strike price of $30. If the underlying security is priced between $20 and $30 at expiration, then it could be a loss or a profit depending on the premiums. The investor will realize his maximize profit from this strategy if the underlying security is priced at $25 by the options’ expiration date. If the underlying is priced below $20 or above $30 at expiration, then he will realize his maximize loss, which would be the cost of buying the wing options plus the proceeds of selling the two middle strike options. The options that are bought at the lower and higher strike prices should be equidistant from the middle strike price; these are known as the wing options. This strategy is used when an investor believes that the price of the underlying security will not deviate much from the current market price.
- Iron Condor: The iron condor is an option strategy that involves two calls and two puts, each with the same expiration date, but different strike prices. The iron condor is a useful strategy when an investor wants to profit from a security with low volatility. This strategy has limited upside and downside risk with limited potential profit. The high and low strike options, also known as the wings, protect against significant increases or decreases in the underlying security’s price. The iron condor is most profitable when each of the options expire worthless, which is only possible if the price of the underlying security closes between the two middle strike prices.
- Bull Call Spread: A bull call spread is when an investor purchases a call option at a certain strike price while simultaneously selling a call option with the same expiration date, but at a higher strike price. The potential profit from this strategy comes from owning the call option. Selling the other option reduces the cost for the option that is bought. The maximum profit is the difference in the strike prices between the option bought and the option sold, minus the total cost of both options. As the underlying security’s price increases up to the strike price of the sold option, the profit increases. However, this strategy will not profit further beyond the sold option’s strike price.
These seven strategies are all useful and effective when used properly. However, each strategy comes with risk. Before using one of the seven strategies listed above, investors should do further research on the strategies that interest them.
— The Option Specialist