Option Strategies

Covered Calls

For conservative investors, selling calls against a long stock position can be an excellent way to generate income without assuming the risks associated with uncovered calls. In this case, investors would sell one call contract for each 100 shares of stock they own.

Example Increase in Volatility Time Erosion
Buy Stock
Sell Call
Minimal impact on position Helps position

When writing covered calls, most investors tend to sell current (near) month options for two reasons. First, the earlier the expiration, the less opportunity the stock has to trade through the strike price. Second, and equally important, is the role time decay plays in the value of the options. Like all out-of-the-money options, they have no intrinsic value. As such, the only value is the time premium or time value which, in the final month of expiration, decays more and more rapidly. For these reasons, investors often sell options that have one month remaining until expiration.

Long Calls

For aggressive investors who are bullish about the short-term prospects for a stock, buying calls can be an excellent way to capture the upside potential with limited downside risk.

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

Let's imagine you have a strong feeling a particular stock is about to move higher. You can either purchase the stock, or purchase "the right to purchase the stock" (but not the obligation), otherwise known as a call option. Buying a call is similar to the concept of leasing. Like a lease, a call gives you the benefits of owning a stock, yet requires less capital than actually purchasing the stock. Just as a lease has a fixed amount of time, a call has a limited amount of time as well and can expire worthless.

Bull Call Spreads

Also known as Debit Spreads. For bullish investors who want a nice low risk, limited return strategy without buying or selling the underlying stock, bull call spreads are a great alternative. This strategy involves buying and selling the same number of calls at different strike prices to minimize the cash outlay and the overall risk.

Example Increase in Volatility Time Erosion
Buy Call (Lower Strike)
Sell Call (Higher Strike)
Helps position as long as stock price increases Hurts position

When your feeling on a stock is generally positive, Bull Call Spreads represent a nice low risk, limited reward strategy. To create a Bull Call Spread you will use call options at or near the current market price of the stock. If the underlying stock is trading at $50, you could buy the 50 calls and sell the same number of 55 calls.

Bull Put Spreads

Also known as Credit Spreads. For bullish investors who want a nice low risk, limited return strategy, bull put spreads are another alternative. Like the bull call spread, the bull put spread involves buying and selling the same number of put options at different strike prices. Since puts with the higher strike price are sold, the trade is initiated for a credit.

Example Increase in Volatility Time Erosion
Buy Put (Lower Strike)
Sell Put (Higher Strike)
Helps position as long as stock price increases Helps position

When your feeling on a stock is generally positive, bull put spreads are great low risk, limited reward strategies. To create a bull put spread by using put options at or near the current market price of the stock.

For example, if you have a bullish short-term feeling about XYZ when it is trading at $46, you enter a bull put spread by selling the 45 put @ 7 and buying the 40 put for 3. In this case, the maximum profit would be the $400 you received when you initiated the position.

Protective Puts

For investors who want to protect the stocks in their portfolio from falling prices, protective puts provide a relatively low-cost method of portfolio insurance. In this case, investors would purchase one put contract for each 100 shares of stock they own.

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

Using protective puts is simple and can be relatively inexpensive given the insurance value. For each 100 shares of stock you buy, buy one protective put at a strike price or two below the current market price. For example, if you buy a stock at $87, you'd buy either the 85 put or the 80 put. That way, if the stock plummets, you'll be able to sell the stock for close to what you paid for it.

As the stock moves higher, you might want to adjust the puts up by selling the contracts you own and buying more at a higher strike price. This way, you can lock in profit from the move higher. Too many investors have learned the hard way that what goes up rapidly can drop with equal momentum. So, if the stock jumps from $87 to $132, the 85 puts won't provide much downside protection. That's why it would be advisable to lock in profits by purchasing puts at the 125 or 130 strike.

Selling Naked Puts

For bullish investors who are interested in buying a stock at a price below the current market price, selling naked put can be an excellent strategy. In this case, however, the risk is substantial because the writer of the option is obligated to purchase the stock at the strike price regardless of where the stock is trading.

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

Let's take the case of selling naked puts. When a put option is "put' (assigned), the seller (writer) is obligated to buy stock at a fixed price, regardless of the current market of the stock. For example, the stock might be trading at $20, but if the seller sold the 45 put (strike price of the option is $45), the option seller must buy the stock for $45 per share.

Given this scenario, it's easy to see why an individual investor would probably view selling naked puts as having limited reward and unlimited risk. The reality however is that the risk is limited, yes that's correct the stock can only fall to zero so in this case the risk would be limited to 45 (minus the premium received). This is a great way to buy stock wholesale.

By selling slightly out of the money puts, one is able to buy the stock at a discount (if the stock is put to them) relative to where it currently trades if the stock moves down in price. At the same time, the position would have earned additional income from the premium associated with the options. If the stock advances, naked put writers keep the premium collected from the options that expire worthless. Selling Naked puts as use in the latter way is often used to create monthly cash flow.

Call Back-Spreads

For bullish investors who expect big moves in already volatile stocks, call back spreads are a great limited risk, unlimited reward strategy. The trade itself involves selling a call (or calls) at a lower strike and buying a greater number of calls at a higher strike price.

Example Increase in Volatility Time Erosion
Sell Calls (Lower Strike)
Buy Calls (Higher Strike)
Helps position Hurts position

Call back-spreads are great strategies when you are expecting big moves in already volatile stocks. The trade itself involves selling a call (or calls) at a lower strike and buying a greater number of calls at a higher strike price. Ideally, this trade is initiated for a minimal debit or possibly a small credit. This way, if the stock heads south, you won't suffer much either way. On the other hand, if the stock takes off, the profit potential will be unlimited because you have more long than short calls.

To maximize the potential for this position, many traders use in-the-money options because they have a higher likelihood of finishing in-the-money. Using XYZ, a company that historically has been quite volatile, we can create a ratio backspread using in-the-money options.