In today’s markets, it is virtually impossible to find any investment that offers more flexibility, limited risk than stock option trading, and leverage. Especially at this time in history with online option trading which puts the strength of these sophisticated investments at the elimination of both the aspiring trader as well as the veteran trader? Unfortunately, the strengths of such investments are also the biggest obstacles to mastery for most traders as some strategies become seemingly to complex to master by most would-be option traders. However, by understanding the four basic stock option trading strategies you can construct a basis for trading mastery with stock options. The four basic strategies you must understand are the long call, the long put, the short call, and the short put.
A long call strategy is taken when a trader is bullish on a given stock and looks to utilize the leverage of options to capture a greater gain on a stocks upward move. A call option allows the option trader to control 100 shares of a stock for a small premium while restricting his risk to just the price of the premium. This strategy allows your reward potential to be unlimited while your risk is restricted to the cost of the call option. As the expiration date for the call option approaches though time decay works against this position so you must factor time into your trading decision when using this strategy.
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The naked call strategy, or the short call strategy, is a bearish strategy that is deemed to be somewhat of an advanced strategy by most stock brokers. The strategy is used when a trader is of the view that a stock is going to decline and you allow another trader to sell you a call option which is where you receive the premium from that option. You do this because you feel the stock will fall and it enables the other trader to hedge his risk by selling you the call option. Time decay works for you in this trade but your reward is restricted to the call option premium while your risk is almost unlimited if the stock rallies.
The long put strategy is the opposite of the long call strategy where you’re looking for the stock to decline rather than rally. When you buy a put option you control 100 shares of stock in a corporation and lets you take advantage of enormous leverage. Your reward potential is theoretically unlimited while your risk is restricted to the cost of the put option. You must be sure to give yourself adequate time to profit with your trading method because time decay works against you with this strategy.
FAQ’s: Stock options strategy?What is an option strategy I can apply to profit from a stock I think is going to trend in a range between one or two dollars over the next few months?
If you mean you think the stock value will remain above $1.00 and below $2.00 there are probably no options available for the stock. (New options will not be issued for a stock trading for less than $3.00 per share.) If there are some left over options from when the stock was trading higher about the only strategy available would be to sell naked calls, assuming there is someone willing to buy them. This is about the highest risk option strategy there is, and I certainly would not recommend it. If you mean the stock will remain in a $2 range, such as between $56 and $58, there are several strategies, basically all of which make a profit due to "time decay" of the option price. Some appropriate strategies include Ratio vertical spreads Sell straddles Sell strangles Buy at the money winged spreads (butterflies or condors) Sell at the money time (calendar) spreads Until you understand why these are appropriate strategies for the situation, and what the risks are, I suggest you avoid these strategies. ———— I see another answer recommends covered calls. That is certainly not an optimal strategy since it has a definate bullish bias. Also statement "Third, check the 'Delta' of the stock." is a clear sign he does not understand delta very well. The delta of a stock is always 1.00.
The short put strategy, likewise called the naked put strategy, is used when you’re expecting a stock to rise in price or remain at near the same price level for a specific amount of time. Your reward is the cost of the put option if the stock rises or remains static but your risk is theoretically unlimited if the stock declines. If it falls in price and hits your stop loss point you must buy back the puts to limit your risk. This is a bullish strategy that is a short term income generator when used properly.
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Risk is lower because with the options at zero cost, the major risk is in the short call. If the stock’s market value falls, the short call becomes worthless and the long put’s value grows one dollar for every dollar of decline in intrinsic value (stock price below the strike). However, if the stock’s price rises, the put becomes worthless and the short call is at risk of exercise. But you have a number of things going for you… you don’t have when you short stock. First, the short call’s time value declines as expiration nears, so the short position often can be closed at a profit. The position can also be rolled forward to a later exercise date, a move that produces more premium income. Finally, the short call can be targeted by the purchase of a long call or 100 shares of stock. None of these strategies are possible with short stock.
Another way to set up synthetic short stock passes through a collar. In this strategy, you always have the short call and the long put. However, you also own 100 shares of the underlying stock. The collar gives you many additional benefits. If the short call gets exercised, the stock is called away at a profit (assuming the strike is more than your original stock basis). Second, you earn dividends as long as you own stock by the ex-dividend date. Third, the offsetting option positions are still at or near zero cost. And finally, if your stock declines in value, the long put provides downside protection point for point below the strike.
The synthetic short stock position, whether involving an uncovered short call or a covered call within the collar, is an intriguing alternative to two other positions: Shorting stock. This is expensive and high-risk, or buying puts for insurance, which requires payment of a premium for protection only until expiration.
There are over 60 option strategies to trade for huge returns in the current markets and how you use them can be for your advantage but it all starts with these four basic strategies detailed here. By taking the time to look at how each of these strategies are employed in the market individually you’ll begin to see how they work in combination with each other. Soon, you gain mastery of stock option trading and how they’re implemented to put you in the better position to profit while limiting your risk.