Basic Options Trading Strategies

The second in our free options trading course covers basic options trading strategies which includes buying call options, buying put options, selling covered calls, selling covered puts, selling naked calls (uncovered calls), selling naked puts (uncovered puts), and selling cash-secured puts.

Buying a Call Option

Basic options trading strategies often involve buying call options on stocks to generate profit potential while managing risk. In this lesson, we will explore the benefits and risks of buying call options, using a case study of Bill who decides to buy a call option on a XYZ Corp.

As w previously mentioned, a call option is a contract that gives the buyer the right, but not the obligation, to buy a specific stock at a predetermined price (strike price) on or before a specific date (expiration date). The buyer of the call option pays a premium to the seller for the right to buy the stock at the strike price. The seller, in turn, is obligated to sell the stock if the buyer decides to exercise the option.

One of the primary benefits of buying call options is the profit potential. If the stock price increases above the strike price before the expiration date, the buyer can exercise the option and buy the stock at the lower strike price, then immediately sell it at the higher market price, generating a profit. This is known as a “long call” strategy, where the call option buyer is betting that the stock price will rise.

However, buying call options also comes with risks. If the stock price does not increase above the strike price, the option will expire worthless, and the buyer will lose the premium paid. This risk is limited to the premium paid, but it can still result in a significant loss.

Let’s take a look at a case study of Bill, who trades stocks and options and decides to buy a call option on XYZ Corp stock. XYZ is currently trading at $50 per share, and Bill believes the stock will increase in value in the next month. Rather than buying the stock, Bill decides to buy a call option with a strike price of $55 and an expiration date in one month, at a premium of $2 per share.

If the stock price is above $55 by the expiration date, Bill can exercise the call option and buy the stock at the lower strike price of $55, then sell it at the higher market price, generating a profit. If the stock price increases to $60, for example, Bill can buy the stock at $55 and immediately sell it at $60, generating a profit of $3 per share. However, if the stock price does not increase above $55 by the expiration date, the option will expire worthless, and Bill will lose the $2 per share premium paid.

Buying call options on a stock can be a profitable strategy in options trading, but it also comes with risks. It is essential to understand the risks and benefits of buying call options and to manage risk appropriately. In Bill’s case, he would need to weigh the potential profits against the premium paid and the risk of the option expiring worthless. Basic options trading strategies, such as buying call options, can be a valuable tool for investors, but it is important to do your research and understand the risks involved.

Buying a Put Option

Buying put options is a basic options trading strategy that can provide investors with an opportunity to profit from a stock price decline. When an investor buys a put option, they have the right but not the obligation to sell a specific stock at a certain price (the strike price) on or before a certain date (the expiration date).

One example of an investor buying a put option is Michelle. She has been closely following the cosmetics company Ulta and believes the stock is overvalued. She decides to buy a put option on Ulta with a strike price of $350, an expiration date of three months from now, and a premium of $5 per share. The premium is the price Michelle pays for the put option and represents the maximum amount she can lose.

If Ulta’s stock price declines below the $350 strike price before the expiration date, Michelle can exercise her put option and sell the stock at the higher strike price. For example, if the stock price drops to $300 per share, Michelle can buy the shares on the open market and sell them at the $350 strike price, realizing a profit of $45 ($350 strike price – $300 market price – $5 premium paid).

On the other hand, if the stock price remains above the $350 strike price at expiration, Michelle’s put option will expire worthless, and she will lose the entire $5 per share premium paid for the option. This is the maximum loss Michelle can incur, and it is limited to the amount of the premium paid.

Buying put options comes with risk, as the stock price could remain above the strike price or only drop slightly, resulting in a loss for the investor. It is important for investors to have a solid understanding of the underlying stock’s fundamentals and technicals, as well as market conditions, before entering into any options trading strategy.

Buying put options is a basic options trading strategy that can provide investors with the potential to profit from a stock price decline. Michelle’s case study demonstrates how an investor can use put options to limit their risk and potentially realize a profit. As with any investment strategy, it is essential to conduct thorough research and analysis before making any investment decisions.

Selling Covered Calls

Selling covered calls is a basic options trading strategy that can be used to generate additional income from a stock portfolio. It involves selling call options on a stock that you own, with the goal of earning the premium paid by the option buyer. In this essay, we will explore the risks and profit potential of selling covered calls using a case study with fictitious numbers.

Let’s say that Brian owns 100 shares of Tesla, a company that is currently trading at $200 per share. He believes that the stock price will remain relatively stable in the near term, and he is interested in generating additional income from his investment. Brian decides to sell covered calls on his Tesla shares.

Brian sells one call option contract with a strike price of $250 and an expiration date in three months. The option buyer pays a premium of $5 per share, or $500 for the entire contract. In exchange for this premium, Brian has the obligation to sell his 100 shares of Tesla at the strike price of $250 if the option buyer chooses to exercise the option before it expires.

If Tesla’s stock price remains below the strike price of $250 until the option expires, the option buyer will not exercise their option and Brian will keep the premium of $500. In this scenario, Brian earns a profit of $500, which is the premium he received for selling the call option. This represents a return of 2.5% on his investment, which is not insignificant.

However, if Tesla’s stock price rises above the strike price of $250, the option buyer may choose to exercise their option and buy Brian’s shares at the lower price. In this case, Brian will be obligated to sell his shares at the strike price of $250, which means he will miss out on any additional gains in the stock price above this level.

For example, if Tesla’s stock price rises to $280, the option buyer will exercise their option and buy Brian’s shares at $250. Brian will earn a profit of $500 from the premium he received for selling the call option, but he will miss out on an additional profit of $3,000 ($30 per share x 100 shares) that he could have earned if he had held onto his shares.

The risk of selling covered calls is that the stock price may rise above the strike price of the call option, which means you may miss out on additional gains in the stock price. However, the profit potential of this strategy is the premium earned from selling the call option, which can be a significant source of income for investors.

Selling covered calls is a basic options trading strategy that can be used to generate additional income from a stock portfolio. By selling call options on a stock that you own, you can earn a premium in exchange for the obligation to sell your shares at a predetermined price if the option buyer chooses to exercise their option. While this strategy carries the risk of missing out on additional gains in the stock price, it can be a profitable way to generate income in a stable or slightly rising market.

Selling Naked Puts

Basic Options Trading Strategies: Selling Naked Puts

Options trading can be a great way to profit from the stock market, but it can also be very risky. One basic options trading strategy is selling naked puts. In this strategy, the trader sells a put option on a stock they don’t own, with the hope that the stock will not drop below the strike price of the put option before expiration. If the stock stays above the strike price, the trader keeps the premium they collected from selling the put option. However, if the stock falls below the strike price, the trader is obligated to buy the stock at the strike price.

Risk and Profit Potential

The risk of selling naked puts is that the trader can potentially lose a lot of money if the stock drops significantly below the strike price. In the worst-case scenario, the trader could end up owning a stock that has lost a significant amount of value. However, the profit potential of selling naked puts is limited to the premium collected from selling the put option.

Basic Options Trading Strategies Case Study: Lucy Sells Naked Puts on SPY

Lucy is bullish on the stock market and believes that the SPDR S&P 500 ETF (SPY) will not drop below $350 before expiration. SPY is currently trading at $380. Lucy decides to sell a naked put with a strike price of $350 and an expiration date of one month from now. She collects a premium of $5 for selling the put option.

Basic Options Trading Strategies Scenario 1: SPY Stays Above $350

If SPY stays above $350 before expiration, Lucy keeps the $5 premium she collected from selling the put option. This is her profit from the trade.

Basic Options Trading Strategies Scenario 2: SPY Drops Below $350

If SPY drops below $350 before expiration, Lucy is obligated to buy 100 shares of SPY at $350 per share. This means she will have to pay $35,000 to purchase the shares. If SPY drops to $300, for example, Lucy would have a loss of $5,000 ($35,000 – $30,000, where $30,000 is the current value of the shares at $300 per share). However, Lucy can potentially offset this loss by selling the shares at a later time if SPY recovers in price.

Selling naked puts is a basic options trading strategy that can be profitable if done correctly. However, it also carries significant risks. It’s important for traders to thoroughly research the stock they plan to sell naked puts on and carefully consider their risk tolerance before making the trade. In addition, traders should have a plan in place for how they will handle the trade if the stock drops significantly below the strike price.

Selling Cash Secured Puts

Selling cash secured put is one of the basic options trading strategies that can generate profits for investors who are bullish on a particular stock. This strategy involves selling put options with cash in the account to cover the cost of buying the underlying stock if the option is exercised. In this lesson, we will explain the risks and profit potential of this options trading strategy and provide a case study of Donna who decides to sell a cash secured put on Microsoft.

Risk and Profit Potential: The risk of selling a cash secured put is that the stock price can decrease below the strike price, and the option buyer can exercise the option. In this case, the seller would be obligated to buy the stock at the strike price, even if it is lower than the market price. To limit the risk, the seller must have enough cash in the account to buy the stock at the strike price.

On the other hand, the profit potential of selling a cash secured put is the premium received from selling the put option. If the stock price stays above the strike price until the option expiration date, the seller keeps the premium as profit. If the stock price falls below the strike price, the seller buys the stock at a lower price and can either sell it for a profit or hold it as a long-term investment.

Case Study: Donna is bullish on Microsoft and thinks the stock price will increase over time. She decides to sell a cash secured put option with a strike price of $200 and a premium of $5 per share. She has $20,000 in cash in her account to cover the cost of buying the underlying stock if the option is exercised.

If the stock price stays above $200 until the option expiration date, Donna keeps the $5 premium as profit, which represents a 2.5% return on her cash investment. If the stock price falls below $200 and the option is exercised, Donna is obligated to buy the stock at $200 per share. However, since she has enough cash in her account, she can buy 100 shares of Microsoft and hold it as a long-term investment and sell covered call to generate income, or she can sell it for a profit if the stock price increases.

Selling cash secured put is a basic options trading strategy that can generate profits for investors who are bullish on a particular stock. The risk of this strategy is that the stock price can decrease below the strike price, and the put option seller is obligated to buy the stock at a potentially lower price.

The profit potential is limited to the premium received from selling the put option. In the case study of Donna, she sells a cash secured put on Microsoft and either keeps the premium as profit or buys the stock at a lower price to hold it as a long-term investment. It is important to have enough cash in the account to cover the cost of buying the underlying stock if the option is exercised.

This concludes the Basic Options Trading Strategies. Please use the menu below to navigate to the lesson of your choice.