Option Trading Strategy Part 1 - Basics
There are several basic trading strategies, but in order to execute any of them successfully an investor new to options will need to know some elementary concepts.
The most basic are the call and the put. Buying a call confers the right, but not the obligation, to buy at a pre-set price. Puts grant the buyer the right to sell at a pre-set price. But options are sold as well as bought. That seller grants the buyer the right, and takes on an obligation to fulfill the other side of the trade.
There are several basic variations.
The most basic, and easiest to understand, is the (long) call. MSFT (Microsoft), currently trading at $28, have June 31 options that expire on the third Friday of June, with a strike price (pre-set, 'if exercised, must-be-bought-at-price') of $31.
Short ('Naked') Calls
When the option seller (the 'writer') doesn't own the underlying stock he's obligated to sell (if the option is exercised), he is said to be selling a 'naked' call. Since he's on the selling side of the contract, his position is said to be 'short'.
If the market price of the underlying asset decreases, the short call position will profit by the amount of the premium. The price rises above the strike price by more than the premium, the short position incurs a loss.
Traders who anticipate that the future market price of an asset, say a stock, will fall prior to expiration can buy the right to sell the stock at a fixed price. The put buyer has no obligation to sell the stock, but simply the right.
If, in fact, the market price does fall below the strike price (prior to expiration of the option) by more than the premium paid, he profits. If the price increases, or doesn't fall enough to cover the premium, the trader lets the contract 'expire worthless'.
Traders who speculate that the future market price will increase, can sell the right to sell an asset at a pre-determined price.
If the asset's market price rises, the short put position makes a profit equal to the amount of the premium. (Excluding any transaction costs, such as commissions.) If the price falls below the strike price by more than the premium, the 'writer' loses money.
Several basic trading strategies utilize the characteristics of these four basic positions. These strategies are either pure profit plays - speculating on coming out on the plus side of the equation - or combinations of speculation and hedging.
Hedging involves taking positions that tend to move in opposite directions. They profit less than pure speculation, but make up for it by offloading some risk.
- 'Bull spreads', for example, use a long call with a low strike price in combination with a short call at a higher strike price and a short put with a higher strike price.
- 'Bear spreads', by contrast, involve a short call with a low strike price and a long call with a higher strike price. An alternative method uses a short put with low strike price and a long put with a higher strike price.
Options trading software can demonstrate several concrete examples of how any of these - under different assumptions about future prices, volume, etc in combination with different expiration dates and strike prices - can result in profit (or loss).