By Lucas Downey Updated May 29, Traders often jump into trading options with little understanding of the options strategies that are available to them. There are many options strategies that both limit risk and maximize return. With a little effort, traders can learn how to take advantage of the flexibility and power that stock options can provide.
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Here are 10 options strategies that every investor should know. This is a very popular strategy because it generates income and reduces some risk of being long on the stock alone. The trade-off is that you must be willing to sell your shares at a set price— the short strike price. To execute the strategy, you purchase the underlying stock as you normally would, and simultaneously write—or sell—a call option on those same shares.
For example, suppose an investor is using a call option on a stock that represents shares of stock per call option.
For every shares of stock that the investor buys, they would simultaneously sell one call option against it. This strategy is referred to as a covered call because, in the event that a stock price increases rapidly, this investor's short call is covered by the long stock position.
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Investors may choose to use this strategy when they have a short-term position in the stock and a neutral opinion on its direction. Because the investor receives a premium from selling the call, as the stock moves through the strike price to the upside, the premium that they received allows them to effectively sell their stock at a higher level than the strike price: strike price plus the premium received.
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The holder of a put option has the right to sell stock at the strike price, and each contract is worth shares. An investor may choose to option trading this strategy as a way of protecting their downside risk when holding a stock.
The strike price may be set by reference to the spot price market price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction i.
This strategy functions similarly to an insurance policy; it establishes a price floor in the event the stock's price falls sharply. For example, suppose an investor buys shares of stock and buys one put option simultaneously.
This strategy may be appealing for this investor because they are protected to the downside, option trading the event that a negative change in the stock price occurs. At the same time, the investor would be able to participate in every upside opportunity if the stock gains in value.
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The only disadvantage of this strategy is that if the stock does not fall in value, option trading investor loses the amount of the premium paid for the put option. With the long put and long stock positions combined, you can see that as the stock price falls, the losses are limited.
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However, the stock is able to participate in the upside above the premium spent on the put. Both call options will have the same expiration date and underlying asset. Using this strategy, the investor is able to limit their upside on the trade while also reducing the net premium spent compared to buying a naked call option outright.
For option trading strategy to be executed properly, the trader needs the stock to increase in price in order to make a profit on the trade. The trade-off of a bull call spread is that your upside is limited even though the amount spent on the premium is reduced. When outright calls are expensive, one way to offset the higher premium is by selling higher strike calls against them.
Option buyers are charged an amount called a "premium" by the sellers for such a right. In contrast, option sellers option writers assume greater risk than the option buyers, which is why they demand this premium.
This is how a bull call spread is constructed. In this strategy, the investor simultaneously purchases put options at a specific strike price and also sells the same number of puts at a lower strike price. Both options are purchased for the same underlying asset and have the same expiration date.
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This strategy is used when the trader has a bearish sentiment about the underlying asset and expects the asset's price to decline. The strategy offers both limited losses and limited gains. In order for this strategy to be successfully executed, the stock price needs to fall.
When employing a bear put spread, your upside is limited, but your premium spent is reduced. If outright puts are expensive, one way to offset the high premium is by selling lower strike puts against them. This is how a bear put spread is constructed.