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Review for Beginning Option Traders
As you read the educational articles on this site, it will become clear that you can profit using options whether the market is rising or falling. Investors tend to favor calls over puts, but puts can play as important a role as calls in a well-designed investment plan. Both calls and puts can be used purely for speculation, to generate income, or hedge the risk of stock positions. Let’s take the time to review some general rules for using options. First, we will go over the four basic approaches to using options, since every combinational option strategy grows out of these: - Using calls when you are optimistic. You believe the stock is going to rise, so you go long and buy call options. Other strategies include bull call spreads and covered calls when you own the stock.
- Using calls when you are pessimistic. You believe the stock is going to remain within a trading range or fall in value, so you go short and sell bear call spreads.
- Using puts when you are optimistic. If you believe the stock is going to rise, you can go short and sell naked puts; if the stock does rise, the put loses value and can be closed at a profit or allowed to expire. (This should be done only if you believe the stock would be a good value at the strike price. Remember, if the stock price falls below that, the put could be exercised and you would have to buy 100 shares at the strike price.) Alternatively, you can initiate a bull put spread.
- Using puts when you are pessimistic. If you believe a stock is going to fall in value, you can go long and buy puts or initiate a bear put spread. If you’re right, the puts and/or spread will increase in value. If you own stock, you can also buy puts to protect against price drops on stocks in your portfolio.
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The most basic combination of options is a vertical spread. A vertical spread means you purchase an option, and then sell another option of the same type in the same expiration month, but with a different strike price. Vertical spreads formed using puts have performance curves that mirror those of call debit and credit spreads. The following table is a summary of the four types of vertical spreads and their directional bias: | Call Debit Spread | Bullish | | Call Credit Spread | Bearish | | Put Debit Spread | Bearish | | Put Credit Spread | Bullish |
Practically, there is little difference between the way debit spreads and credit spreads perform. Debit and credit spreads are directional trades with limited profit and limited loss. A credit spread can usually lose more than it can earn. Out-of-the-money credit spreads have the added advantage of being able to earn a profit as long as the market doesn't move too much in the opposite direction. The possible profit is equal to the credit received when you place the trade, while the maximum loss is equal the difference between the strikes minus the credit received. There are a number of reasons to buy or sell options. Depending on the specific strategy, you can use them to speculate, produce income, or hedge risk. In some market conditions, buying or selling calls may not make as much sense as the corresponding use of puts. Thus, it is always wise to look at both sides – calls and puts – to find the strategy that will maximize your profits no matter what the overall market is doing. The beauty of options is that calls and puts in the right mix, or at the right time, can produce profits in any kind of market: up, down, or stagnant. There is always a strategy available that will produce profits.
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(ODD).
Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago,
Illinois 60606. The information on this website is provided solely for general education and information purposes and therefore should not be considered complete,
precise, or current. No statement within the website should be construed as a recommendation to buy or sell a security or to provide investment advice. The inclusion
of advertisements on the website should not be construed as an endorsement or an indication of the value of any product, service, or website.
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