Option Strategies

Long Puts

For aggressive investors who have a strong feeling that a particular stock is about to move lower, long puts are an excellent low risk, high reward strategy. Rather than opening yourself to enormous risk of short selling stock, you could buy puts (the right to sell the stock).

Example Increase in Volatility Time Erosion
Buy Put Helps position Hurts position

Now let's imagine that you have a strong feeling a particular stock is about to move lower. Before puts came into existence, your only alternative was to sell the stock short. Short selling stock is a risky strategy. Should the stock move higher, your loss would be theoretically unlimited. Rather than opening yourself to this risk, you could buy puts (the right to "put" (sell) the stock). Lets suppose XYZ stock is trading @ $90. The 90 puts might be trading for $5. For $500 you could buy one 90 put (100 shares x $5).

Since each contract controls 100 shares, you now have the right to sell 100 shares at $90 per share. If the stock stays at or above $90 before the options expire, the most you could lose is your initial investment of $500. On the other hand, if the stock falls to $60 at expiration, the 90 put will be worth $30 (strike price: $90 - current stock price: $60). At this point, the puts are worth $3,000 ($30 x 100 shares). Before commissions, this represents a 500% gain on your investment. To achieve the same percentage gain on a typical stock trade, a $100 stock would have to increase in value to $600. Needless to say, that doesn't happen every day.

With both puts and calls, the risks fall into the same categories, time and market direction. To make a profit, the buyer of these options has to be right about the price movement of the stock and the time frame in which it will occur. If the stock doesn't make its move before the options expire, they will expire worthless. While a stockholder is concerned with market direction, the timeframe isn't as critical because stock doesn't have an expiration date. You can hold a stock for decades. You can't do the same with options. With the exception of LEAPS (longer-term option contracts), most options expire in a matter of months.

Naked Calls

Selling naked calls is a very risky strategy which should be utilized with extreme caution. By selling calls without owning the underlying stock, you collect the option premium and hope the stock either stays steady or declines in value. If the stock increases in value this strategy has unlimited risk.

Example Increase in Volatility Time Erosion
Sell Call Hurts position Helps position

Unlike covered calls, where the option seller owns the underlying stock, the writer of naked calls remains completely exposed to upside risk. Nevertheless, if you are comfortable using this strategy, it is most effective using current (near-term) month options because they decay more rapidly. And that's what you want. The faster these options become worthless, the better.

To see how this works, consider the following:
Stock price: $87
90 call: $6

By selling the 90 call at 6, you would receive the $600 option premium, your maximum profit. At expiration, if the stock is at or below $90, you keep the full $600. However, your profit disappears as the stock climbs toward $96. Above $96, your loss grows without limit.

Bear Put Spreads

Also known as a Debit Spread. For bearish investors who want a nice low risk, limited return strategy, bear put spreads are another alternative. The bear put spread involves buying and selling the same number of put options at different strike prices. Since puts with the higher strike price are bought, the bear put spread trade is initiated for a debit.

Example Increase in Volatility Time Erosion
Buy Put (Higher Strike)
Sell Put (Lower Strike)
Increase in implied volatility hurts position unless stock price drops as well Hurts position

When your feeling on a stock is generally negative, Bear Put Spreads are nice low risk, limited reward strategies. To create a Bear Put Spread you will use put options at or near the current market price of the stock.

Like bear call spreads, bear put spreads profit when the price of the underlying stock decreases. Typically buying near the money puts and selling out-of-the-money puts creates the bear put spread.

By selling the 90 call at 6, you would receive the $600 option premium, your maximum profit. At expiration, if the stock is at or below $90, you keep the full $600. However, your profit disappears as the stock climbs toward $96. Above $96, your loss grows without limit.

Bear Call Spreads

Also known as a Credit Spread. For investors who maintain a generally negative feeling about a stock, bear spreads are a nice low risk, low reward strategy. This trade involves selling a lower strike call, usually at or near the current stock price, and buying a higher strike, out-of-the-money call. This spread profits when the stock price decreases and both calls expire worthless.

Example Increase in Volatility Time Erosion
Sell Call (Lower Strike)
Buy Call (Higher Strike)
Increase in implied volatility hurts position unless stock price drops as well Helps position

When your feeling on a stock is generally negative, Bear Call Spreads are nice low risk, limited reward strategy. To create a Bear Call Spread you will use call options at or near the current market price of the stock.

Like bear put spreads, bear call spreads profit when the price of the underlying stock decreases. Selling slightly out-of-the-money calls and then buying a little further out-of-the-money calls are typically the way bear call spreads are constructed.

With the underlying stock trading near $50, you'd sell the 50 calls for $5 and buy the 55 calls for $2. This way, you'd initiate the spread for a credit of $300, your maximum profit. If you are correct and the stock moves lower, both calls will expire worthless and you'll keep the $300 premium you collected when you initiated the position.