An options contract is a conditional derivative contract that permits a buyer to either sell or purchase a security at a predetermined price at some point in the future. The seller charges the options buyers with a certain ‘premium’ for the right to buy an options contract. If the market prices are not favorable, the contract will expire worthlessly. The contracts for options are of two types: ‘call options’ an ‘put options.’ With the former option, a call option buyer gets the right to buy or ‘call’ the underlying security at a predetermined price at some point in the future. Alternatively, with a put option, the buyer gets the right to sell an asset at a predetermined price at some point in the future.
What is option strategy?
There are many types of options strategies to maximize earnings when using futures and options contracts for one’s trades. In general, these can be divided into buying call options or put options at a certain frequency. The options strategies are detailed below as follows:
1. Long Call
A long call is when options traders buy call options such that they leverage their trades by taking advantage of rising prices. Traders who utilize long calls are confident or bullish towards a particular stock, index, or exchange-traded fund. As they are sure its price is going to increase at some point in the future, they take a call option for it at a predetermined price so that when its price increases, they are still obligated to buy it at the lower price set by them earlier. This way they can sell that security for a much higher price by using their call option to their advantage. Hence, a long call allows traders to maximize earnings by being bullish towards a particular stock and mitigating the risk associated with buying it directly.
2. Long Put
On the other hand, a long put strategy is a short-selling options strategy. Long puts are ideal for traders who have a bearish sentiment towards a certain stock, exchange traded fund, or index. Over here, traders are waiting for prices to fall so they can take advantage of their put options as leverage. By setting the put option at a predetermined high price early on when the price was higher, the trader gets to take advantage of the falling prices by short selling their contracts once the security’s market value falls. Now, the security may be trading for a lower price than the options contract, but one is obligated to sell their security at the contract’s maturity, thereby earning returns.
3. Covered Call
The third type of options strategy is the covered call which is the preferred strategy for those who are lower risk takers and are willing to limit their potential to walk away with higher earnings in exchange for most protection in case the stock performs unexpectedly. One may expect a slight or minimal change in the price of the security if they opt for the covered call strategy. It involves buying around 100 shares from the underlying asset followed by selling a call option against all of those shares. Upon selling the call one will collect the premium which lowers their cost basis on the shares they purchased while giving the trader a cushion against an underperforming stock.
Risk vs Reward with Options Trading
There are risks and rewards to each and every option strategy. The main risk for each of these strategies is that the stock price moves in the opposite direction than was expected or not at all. This is why some traders prefer a downside protection options strategy like the covered call to protect their bases. The rewards with some strategies like the long call and long put are higher than the potential rewards of using a covered call options strategy. Hence, based on personal investment goals and one’s risk appetite, one can pick the options strategies best geared to them.
There are a slew of other options strategies like the protective put, married put, long straddle, and more. However, they all utilize the core principles of having the right to buy or sell a security at some point in the future and leveraging this opportunity.