5 Simple Options Trading Strategies

Investing, Investing Strategy, Investments
Options Trading 101: 3 Simple Options Trading Strategies

Options trading strategies run the gamut from simple, “one-legged” trades to exotic multilegged beasts that seem like they’ve emerged from a fantasy novel. But simple or complex, what all strategies have in common is that they’re based on two fundamental option types: calls and puts.

Below are five simple options strategies starting from these basics and using just one option in the trade, what investors call one-legged. Simple doesn’t mean risk-free, but these are some good ways to get started with options trading.

The long call

The long call is a strategy where you buy a call option, or “go long.” This straightforward strategy is a wager that the underlying stock will rise above the strike price by expiration.

Example: XYZ stock trades at $50 per share, and a call at a $50 strike is available for $5 with an expiration in six months. The contract is for 100 shares, which means this call costs $500: the $5 premium x 100. Here’s the payoff profile of one long call contract.

Stock price at expirationLong call's profit
$80$2,500
$70$1,500
$60$500
$55$0
$50-$500
$40-$500
$30-$500
$20-$500

Potential upside/downside: If the call is well-timed, the upside on a long call is theoretically infinite, until the expiration, as long as the stock moves higher. Even if the stock moves the wrong way, traders often can salvage some of the premium by selling the call before expiration. The downside is a complete loss of the premium paid — $500 in this example.

Why use it: If you’re not concerned about losing the entire premium, a long call is a way to wager on a stock rising and to earn much more profit than if you owned the stock directly. It can also be a way to limit the risk of owning the stock directly. For example, some traders might use a long call rather than owning a comparable number of shares of stock because it gives them upside while limiting their downside to just the call’s cost — versus the much higher expense of owning the stock — if they worry a stock might fall in the interim.

The long put

The long put is similar to the long call, except that you’re wagering on a stock’s decline rather than its rise. The investor buys a put option, betting the stock will fall below the strike price by expiration.

Example: XYZ stock trades at $50 per share, and a put at a $50 strike is available for $5 with an expiration in six months. In total, the put costs $500: the $5 premium x 100 shares. Here’s the payoff profile of one long put contract.

Stock price at expirationLong put's profit
$80-$500
$70-$500
$60-$500
$50-$500
$45$0
$40$500
$30$1,500
$20$2,500

Potential upside/downside: The long put is worth the most when the stock is at $0 per share, so its maximal value is the strike price x 100 x the number of contracts. In this example, that’s $5,000. Even if the stock rises, traders can still sell the put and often save some of the premium, as long as there’s some time to expiration. The maximum downside is a complete loss of the premium, or $500 here.

Why use it: A long put is a way to wager on a stock’s decline, if you can stomach the potential loss of the whole premium. If the stock declines significantly, traders will earn much more by owning puts than they would by short-selling the stock. Some traders might use a long put to limit their potential losses, compared with short-selling, where the risk is uncapped because theoretically a stock’s price could continue rising indefinitely and a stock has no expiration.

The short put

The short put is the opposite of the long put, with the investor selling a put, or “going short.” This strategy wagers that the stock will stay flat or rise until the expiration, with the put expiring worthless and the put seller walking away with the whole premium. Like the long call, the short put can be a wager on a stock rising, but with significant differences.

Example: XYZ stock trades at $50 per share, and a put at a $50 strike can be sold for $5 with an expiration in six months. In total, the put is sold for $500: the $5 premium x 100 shares. The payoff profile of one short put is exactly the opposite of the long put.

Stock price at expirationShort put's profit
$80$500
$70$500
$60$500
$50$500
$45$0
$40-$500
$30-$1,500
$20-$2,500

Potential upside/downside: Whereas a long call bets on a significant increase in a stock, a short put is a more modest bet and pays off more modestly. While the long call can return multiples of the original investment, the maximum return for a short put is the premium, or $500, which the seller receives upfront.

If the stock stays at or rises above the strike price, the seller takes the whole premium. If the stock sits below the strike price at expiration, the put seller is forced to buy the stock at the strike, realizing a loss. The maximum downside occurs if the stock falls to $0 per share. In that case, the short put would lose the strike price x 100 x the number of contracts, or $5,000.

Why use it: Investors often use short puts to generate income, selling the premium to other investors who are betting that a stock will fall. Like someone selling insurance, put sellers aim to sell the premium and not get stuck having to pay out. However, investors should sell puts sparingly, because they’re on the hook to buy shares if the stock falls below the strike at expiration. A falling stock can quickly eat up any of the premiums received from selling puts.

Sometimes investors use a short put to bet on a stock’s appreciation, especially since the trade requires no immediate outlay. But the strategy’s upside is capped, unlike a long call, and it retains more substantial downside if the stock falls.

Investors also use short puts to achieve a better buy price on a too-expensive stock, selling puts at a much lower strike price, where they’d like to buy the stock. For example, with XYZ stock at $50, an investor could sell a put with a $40 strike price for $2, then:

  • If the stock dips below the strike at expiration, the put seller is assigned the stock, with the premium offsetting the purchase price. The investor pays a net $38 per share for the stock, or the $40 strike price minus the $2 premium already received.
  • If the stock remains above the strike at expiration, the put seller keeps the cash and can try the strategy again.

The covered call

The covered call starts to get fancy because it has two parts. The investor must first own the underlying stock and then sell a call on the stock. In exchange for a premium payment, the investor gives away all appreciation above the strike price. This strategy wagers that the stock will stay flat or go just slightly down until expiration, allowing the call seller to pocket the premium and keep the stock.

If the stock sits below the strike price at expiration, the call seller keeps the stock and can write a new covered call. If the stock rises above the strike, the investor must deliver the shares to the call buyer, selling them at the strike price.

One critical point: For each 100 shares of stock, the investor sells at most one call; otherwise, the investor would be short “naked” calls, with exposure to potentially uncapped losses if the stock rose. Nevertheless, covered calls transform an unattractive options strategy — naked calls — into a safer and still potentially effective one, and it’s a favorite among investors looking for income.

Example: XYZ stock trades at $50 per share, and a call at a $50 strike can be sold for $5 with an expiration in six months. In total, the call is sold for $500: the $5 premium x 100 shares. The investor buys or already owns 100 shares of XYZ.

Stock price at expirationCall's profitStock's profitTotal profit
$80-$2,500$3,000$500
$70-$1,500$2,000$500
$60-$500$1,000$500
$55$0$500$500
$50$500$0$500
$45$500-$500$0
$40$500-$1,000-$500
$30$500-$2,000-$1,500
$20$500-$3,000-$2,500

Potential upside/downside: The maximum upside of the covered call is the premium, or $500, if the stock remains at or just below the strike price at expiration. As the stock rises above the strike price, the call option becomes more costly, offsetting most stock gains and capping upside. Because upside is capped, call sellers might lose a stock profit that they otherwise would have made by not setting up a covered call, but they don’t lose any new capital. Meantime, the potential downside is a total loss of the stock’s value, less the $500 premium, or $4,500.

Why use it: The covered call is a favorite of investors looking to generate income with limited risk while expecting the stock to remain flat or slightly down until the option’s expiration.

Investors can also use a covered call to receive a better sell price for a stock, selling calls at an attractive higher strike price, at which they’d be happy to sell the stock. For example, with XYZ stock at $50, an investor could sell a call with a $60 strike price for $2, then:

  • If the stock rises above the strike at expiration, the call seller must sell the stock at the strike price, with the premium as a bonus. The investor receives a net $62 per share for the stock, or the $60 strike price plus the $2 premium already received.
  • If the stock remains below the strike at expiration, the call seller keeps the cash and can try the strategy again.

The married put

Like the covered call, the married put is a little more sophisticated than a basic options trade. It combines a long put with owning the underlying stock, “marrying” the two. For each 100 shares of stock, the investor buys one put. This strategy allows an investor to continue owning a stock for potential appreciation while hedging the position if the stock falls. It works similarly to buying insurance, with an owner paying a premium for protection against a decline in the asset.

Example: XYZ stock trades at $50 per share, and a put at a $50 strike is available for $5 with an expiration in six months. In total, the put costs $500: the $5 premium x 100 shares. The investor already owns 100 shares of XYZ.

Stock price at expirationPut's profitStock's profitTotal profit
$80-$500$3,000$2,500
$70-$500$2,000$1,500
$60-$500$1,000$500
$55-$500$500$0
$50-$500$0-$500
$45$0-$500-$500
$40$500-$1,000-$500
$30$1,500-$2,000-$500
$20$2,500-$3,000-$500

Potential upside/downside: The upside depends on whether the stock goes up or not. If the married put allowed the investor to continue owning a stock that rose, the maximum gain is potentially infinite, minus the premium of the long put. The put pays off if the stock falls, generally matching any declines and offsetting the loss on the stock minus the premium, capping downside at $500. The investor hedges losses and can continue holding the stock for potential appreciation after expiration.

Why use it: It’s a hedge. Investors use a married put if they’re looking for continued stock appreciation or are trying to protect gains they’ve already made while waiting for more.

James F. Royal, Ph.D., is a staff writer at NerdWallet, a personal finance website. Email: jroyal@nerdwallet.com. Twitter: @JimRoyalPhD.

Updated June 5, 2017.