Trading equity options can involve aggressive, risky strategies as well as conservative, low-risk approaches. There are many trading strategies that employ these vehicles, and I will describe some of the basic option strategies which can be low risk and take advantage of the premiums that speculators bid up as part of more aggressive strategies The conservative investor can take advantage of these premiums to make money with less risk. Although this article is not meant to be a primer on options, I will start by stating the basic definition of what an equity option is: it is a contract that gives its holder the right (but not obligation) to purchase (in the case of a call option) or sell (in the case of a put option) a specific stock for a specific price (known as the “strike”) within a specified time. For more details on the basics of options, a good source is the Chicago Board Options Exchange(CBOE).
Obviously the most basic option strategy is to simply purchase a contract hoping it will go up in value. If you think the underlying stock will go up in value you would buy a call option, and if you think it will go down you would buy a put option. The advantage over just buying (or selling short) the underlying stock is the leverage that comes from owning a security whose price will respond to the difference in price between the strike and the market value of the stock. This leverage can be significant if the purchase is made when the option is “out of the money”. Disadvantages of this simple approach are the time-limited nature of the option: it will expire and become worthless if the stock price is not above (or below in the case of a put) the strike. This is why accountants refer to it as a wasting asset – if the market does not change, then the mere passage of time will degrade its value, eventually to zero.
More interesting results can be achieved by selling instead of buying options. By this I mean selling an option that you did not buy-this is known as “writing” an option (after all it is a contract). You can write an option giving the buyer the right to purchase from you (in the case of a call) or sell to you (for a put) a particular stock within a given time frame at a particular price. Obviously, the owner of that contract will only want to exercise this right if the stock has moved into favorable territory with respect to the strike (then the option is said to be “in the money”). Simply selling an option is very risky, because in theory you can open yourself up to potentially unlimited losses, many times the value you received for selling the contract (known as the “premium”). However it can be very satisfying to sell something that is very likely to expire worthless and you get to keep the premium. In fact, if you sell an out-of-the money option you will keep 100% of your premium if the stock does not move at all (or if it moves in the opposite direction). Unlike when you buy a stock, you can make money in a market that is not even changing! And here’s an interesting statistic: 80% of call options expire worthless! So the odds are on your side.
Of course, the large risk in selling options naked (meaning not covered by another position) is excessive for most investors. This risk can be reduced by purchasing an offsetting position. The simplest example of this is the basic strategy known as a buy-write also referred to as covered call writing. In this case you simply buy the stock and sell call option against it. Then if the stock moves up through the strike during the life of the contract your stock will be “called away” by the option purchaser. You will have made money on the call premium plus the difference between the strike and what you paid for the stock (this strategy is usually implemented with out-of-the-money calls).
But you don’t have to own the stock to have an offsetting (and risk-reducing) position when you sell a call. Another approach it to buy a similar option at a farther out strike to limit your potential losses. This is known as a vertical spread. It is a lower-cost position than buying the underlying stock, but does not limit your potential loss as much on a percentage basis. By careful selection of expiration dates and strikes you can choose how much risk and potential gain you want. There are even more complicated versions of this kind of trading strategy that go by names like straddle, strangle, and butterfly. The details of these strategies are beyond the scope of this article, but can be found at the web sites I have already referenced.
My favorite option strategy is only slightly more complex than the buy-write trade, and is known as a covered combination. I describe this strategy is great detail along with an example showing how to take advantage of the temporary volatility in the stock BP (British Petroleum) during their Gulf Oil leak incident in another article which I encourage you to check out if you are interested.