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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