Why would anyone put money in a savings account or under their bed when they can earn high returns trading stocks? Well, for most people, the answer is risk. They know that stocks are high-return and high-risk assets and they are afraid to lose money. What if there is a way to cap or minimise the risks involved with stocks while also increasing their potential returns? Fortunately, that is exactly what stock options trading strategies are for.
If you can implement the right stock option trading strategies, you can limit your potential losses (downside risk) while improving the return potential on the upside.
But options can be complex, volatile, and especially risky, if not done right.
In what follows, we will introduce you to the world of options trading and highlight five simple strategies that you can explore. We’ll cover:
- What is option trading in the stock market?
- Day trading options vs. stocks: Factors to consider
- How to select stocks for option trading
- Stock option trading strategies: How to trade stock options successfully (And basic definitions for each option type)
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1. What is option trading in the stock market?
What are stock options?
An option is a financial derivative that gives the buyer a right but not an obligation to buy or sell an asset (in this case, a stock) at a specific price on a specific date.
There are six key terms crucial to understanding the basics of stock options:
- Underlying asset: This is the asset that the option buyer can buy or sell at a specific price on a specific date. In our case, the underlying asset is a stock.
- Expiration: The right to buy or sell for a specific price does not last indefinitely. Every option has an expiry date after which it no longer exists.
- Exercise: When the option buyer has exercised the right to buy or sell the underlying security at the strike price.
- Strike price (exercise price): This is the price at which you can buy or sell the underlying security.
- Premium: This is the price you pay for the right to buy or sell the underlying security at the strike price.
- Options contract: An option contract represents 100 shares of the underlying stock.
Is all this still confusing? Let’s make it clearer with an example.
Suppose you believe that the market price of NVDA (NVIDIA Corporation), which is currently at $135, will increase to $150 in a month’s time (July 19, for our purpose).
Consequently, you purchase a call option contract with the right to purchase NVDA at $150 on or before July 19. For this right, you will pay $3.50 per share.
In this case, NVDA is the underlying asset, $150 is the strike price, $3.50 is the premium, and July 19 is the expiration.
Let’s leap forward to July 19. Suppose NVDA is now trading at $155. If you exercise your right, you can buy NVDA at $150 and sell for $155 for a $5 gross profit. However, given that you paid a $3.50 premium for each share, your net profit is $1.5 per share or a total of $150 (remember that a single contract represents 100 shares).
It all sounds good at this point.
But what if the price falls?
Suppose now that NVDA was trading at $130 on July 19.
Well, since what you have is a right, not an obligation, you can cancel the contract instead of purchasing at $150 and selling at $130.
In this case, the only money you will lose is the premium you have paid for the contract – $350 ($3.50*100).
Note that if you had bought NVDA at $135 on June 19 (instead of purchasing an option contract) and sold at $130 on July 19, your net loss would have been $500 ($5*100).
While you might not make a profit on the downside if the market goes against you, an option can still reduce your losses (even significantly) on the downside.
Types of stock options
Below are the four types of options you should be familiar with:
- Calls or call option: The example above is a call option. It confers the right to buy the underlying security at the strike price on or before the expiration date.
Traders use calls when they believe the underlying asset’s price will increase. It is equivalent (in terms of expectations) to taking a long position on the underlying asset.
- Puts or put option: A put option confers the right to sell an underlying security at the strike price on or before the expiration date.
Traders use puts when they are bearish (they believe the underlying asset’s price will decrease). It is equivalent to taking a short position on the underlying asset.
Suppose our example above was a put option that confers you a right to sell the underlying security. Let’s assume that NVDA was still trading at $135 and you bought a put option (that will expire on July 19) at the strike price of $150.
If NVDA goes down to $125 on July 15, for example, you can exercise your put option and sell to the counterparty (the option seller) at $150 instead of selling in the market at $125. Your gross profit will be $25 per share, and your net profit will be $21.5 (assuming a premium of $3.5 per share) or a total of $2,150. If you had sold in the market (if you didn’t have an option), then you would have lost $10 per share (buying at $135 and selling at $125) or a total of $1,000.
What if NVDA goes up to $160 in the market? In this case, it is more profitable to sell in the market and you will cancel the option contract. You would lose a total of $350 in the premium paid for the contract but selling for $170 instead of $150 will give you a gross profit of $2,000, which makes the $350 loss insignificant.
Source: Royal Bank
Parties to options trade
For the sake of simplicity, we have focused solely on the buyer of the option contract. However, you can also be selling options (puts and calls) or acting as the counterparty to the buyer.
When you sell an option, you are said to be writing a contract. As the option seller, you will receive the premium from the options buyer.
You can sell a call option if, unlike the buyer, you believe the underlying asset’s price will be lower than or equal to the strike price during the contract’s lifetime (for American options) or on the expiration date (for European options).
Unlike option buyers, option sellers have an obligation to buy or sell as long as the buyers have chosen to exercise their right.
In our example, let’s assume that the market price on July 16 is $145. Since the strike price is $150, it is not profitable for the options buyer to exercise the option (buying at $150 and selling in the market at $145). Consequently, they will cancel the contract and you will earn the premium paid.
On the other hand, you can sell a put option if you are bullish on the underlying security – you believe the market price will be equal to or higher than the strike price.
In our example, if you are right and the price increases to $160, the option buyer will cancel the contract since they can sell in the market for a price higher than the strike price. Consequently, you will earn the premium that was paid for the contract.
Types of option traders
- Day traders: The examples we have used are based on options that expire in days. But not all options last for days; some are short-term, expiring within a day. Traders of these types of options are called day traders.
- Swing traders: Swing traders focus on options that expire within days and weeks.
- Position traders: Position traders have a longer timeframe, focusing on options that expire in months.
- Market makers: Market makers are traders who ensure that there is enough liquidity in the options market. They act as counterparties to both buyers and sellers (as the case may be) so that the market can keep moving.
How is the price of an option determined?
The price of an option (the premium) has two components:
- The intrinsic value: This is the difference between the strike price of the option and the current market price.
- Time value: This is the difference between the premium and the intrinsic value. It depends mainly on the time left before the option expires.
Option prices (or premiums) can increase or decrease as the current market price of the underlying asset changes and the expiration date gets closer.
Consequently, you can choose to trade the option contract without waiting to exercise the right it confers.
For example, if you bought a call option at a premium of $50 and the market price of the underlying asset increases, you can sell the option for a higher premium. You can do the same if the underlying asset’s market price reduces for a put option.
In-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM) option
An option is said to be in the money if it has intrinsic and time values. The strike price of an in-the-money option is less than the market price (or spot price) of the underlying asset.
If the spot price is equal to the strike price, then the option has no intrinsic value and will be an at-the-money option.
Source: WallStreetZen
Finally, if the spot price exceeds the market price, the option will be an out-of-the-money option (and it will have no intrinsic value).
2. Day trading options vs. stocks: Factors to consider
If a call option is equivalent to a long position and a put option to a short position, why then should you choose options?
Let’s consider certain unique features and benefits of options that make them preferable to directly buying or selling the underlying security:
- Limited risk: As we saw in the call option example, the premium paid for the contract is the maximum amount you can lose. Therefore, the risk of losing money on the downside is limited.
With a call option, the total loss is $50 (the premium). However, if you had bought at $135 and sold at $130, the total loss would be $500.
- Lower capital requirement: To enter into a call option, you only need to pay the option premium. However, to go long on the underlying security, you must buy the 100 shares and then wait to sell them.
- Higher returns on the upside: There are many stock options trading strategies that you can execute that will provide higher returns than opening a long or short position on the underlying security.
For example, if you buy a put option, you can sell at a price higher than the market price, which increases your returns.
- Multiple strategies: With stocks, you are limited to either going long or short. On the other hand, there are multiple options trading strategies that you can use to minimise risk and maximise returns.
- Cost efficiency: A successful call option allows you to buy the underlying security cheaper than the current market price.
Despite these advantages, there are certain concerns about stock options:
- Volatility: Option prices are very volatile. They can move significantly even within a day, causing rapid changes in the economics of the contract.
- Complexity: Some option trading strategies can be complicated for non-professional investors to understand. For example, you have to get both the direction and timing of the market trend right before you can profit from an option.
- Limited time: Unlike stocks, options have expiration dates. After expiration, the option becomes worthless.
- Time value decay: As options get closer to expiration, their time value decays. Consequently, some options will be worthless at the time they expire.
- Commission: The commission payable on options is higher than those payable on stocks.
- Higher risk: With some option trading strategies, you can lose more money than you invested in the option. This is why you must understand your risk tolerance before choosing any of the stock option trading strategies.
To enjoy the benefits of options trading given these concerns, you must devote time to understanding the various options strategies and choosing the one(s) that is best for you.
3. How to select stocks for option trading
Before a stock can be a good underlying security for options trading, it must meet the standard conditions that make a stock appropriate for trading:
- Liquidity: A stock is good for trading if it has a high trading volume. This makes it easy to enter and exit the trade quickly without prices adjusting to affect the economics of the trade.
- Volatility: Also, traders look for high volatility. Prices must be able to move significantly for traders to profit from their positions.
Once a stock meets these conditions as a stock, its options must also meet the same conditions as options:
- Liquidity: There must be high trading volume and a large number of participants in the options market for the stock.
Some options traders use the open interest – the number of outstanding options contracts – to determine liquidity. When open interest is high, that is evidence of high liquidity and a large number of participants.
- Volatility: Options traders use the implied volatility rank of an underlying security to determine whether they should sell or buy. High implied volatility often means an opportunity to sell options, and vice versa.
4. Stock option trading strategies: How to trade stock options successfully (and basic definitions of each option type)
Now that we have considered what options are, why they are traded, and how to identify stocks that are appropriate for options trading, we can now identify the five common options trading strategies that you can consider:
Long call
The basics
Definition
A long-call strategy involves a trader buying a call option.
Objective
The long call is a good strategy when you expect prices to increase significantly. As long as the difference between the market price and the strike price is greater than the premium, the strategy will be profitable.
Strategies that bet on prices increasing are also called bullish options strategies.
Risk and reward
As we have seen before, this strategy is profitable when market prices increase and they are higher than the strike price. Since price increases are indefinite, the profit on a long call is unlimited.
However, if the market price is equal to or less than the strike price, there will be a loss equal to the premium paid.
Thus, profit is limitless on the upside and limited to the premium paid on the downside.
Example
Suppose you bought a call option of NVDA with a strike price of $150 at a premium of $3.50. The option expires in 30 days.
If the price increases to $180, for example, you can exercise the option and buy the stock at $150 per share. You can then sell in the market at $180 for a $30 gross profit per share and a net profit of $26.50 (after paying $3.50 premium).
Most importantly, the profit on this call option is unlimited as price can increase indefinitely.
On the other hand, if price drops to $120, you can choose not to exercise the option. In which case you only lose the $3.50 per share premium paid for the option.
Also, the call’s breakeven price at expiration is $153.50, which is the strike price plus the premium. At that point, you will make a profit of $3.50 per share which is also equal to the premium paid per share. Thus, at that point, profit is zero.
Factors to consider
For a long call strategy, you need to be confident that the stock’s price will rise during the period covered by the option.
More importantly, you must be sure that it will be higher than the strike price and that the difference is greater than the premium. This will ensure that you actually make a profit rather than just breaking even. In our example, you must be confident that the price will exceed $153.50 on or before the expiration date.
Managing your position
Understanding your position
A long call is only profitable when the stock’s price rises above the strike price by more than the premium paid.
Closing your position
You can sell your position or roll into another long call to realize any profits or losses. This is a good option if you believe prices will fall and put your position at risk.
If the current market price is already at your target price, you can also exercise the long call early (instead of waiting till expiration) and realize your profit.
Source: Project Finance
Long put
The basics
Definition
A long put strategy involves a trader buying a put option. This gives them the right but not the obligation to sell the underlying stock.
Objective
Traders use a long put strategy when they are confident that the underlying stock’s price will fall significantly within the period covered by the put contract.
Strategies that bet on the market price of a stock going down are also called bearish options strategies.
Risk and reward
If the stock’s price falls, you can make a profit equal to the difference between the strike price and the current market price. Unlike a long call, however, profit is capped at the strike price. This is because while a stock’s price can increase indefinitely, it cannot fall below $0.
On the other hand, if the stock’s price increases, your losses are limited to the premium paid as you can choose not to exercise the contract.
Example
Let’s say you bought a put option with a strike price of $150 at a premium of $3.50 and the option expires in 30 days.
If the price falls to $100, you can buy the stock in the market for $100 and sell to the put seller for $150, for a $50 gross profit per share and a $46.50 net profit per share. Gross profit is limited to $150 per share (and net profit to $146.50 per share) because the stock’s price cannot fall below $0.
On the other hand, if the price rises to $200, there is no point exercising the contract (buying for $200 and selling for $150) and you will only lose the premium.
The breakeven price is $146.50, which is the strike price minus the premium per share.
Factors to consider
Just as with a long call, you need to be confident that the stock’s price will fall and that the fall will be greater than the premium.
If the fall is only equal to the premium, then we will be at the breakeven price at which profit is zero.
Managing your position
Understanding your position
A long put only makes sense if the stock’s price falls significantly below the strike price. If the price rises above the strike price, you will lose the premium paid.
Closing your position
You can sell your position or roll it into another long put to realize the profits and losses on the trade before expiration.
Source: Project Finance
Cash-secured put
The basics
Definition
A short put strategy involves a trader selling a put option. This means that the seller is obligated to buy the underlying stock from the put option buyer at the strike price.
The “cash-secured” part means that the seller of the put option must have enough money in their account to buy the underlying stock at the strike price in the event that the buyer exercises the right.
Objective
The cash-secured put contract seller is confident that the stock’s price will stay the same or increase, therefore they are confident of taking the opposite side of the put option buyer (who believes it will fall).
Risk and reward
If the market price rises above the strike price, the buyer will not exercise the contract and the seller will have a profit equal to the premium paid by the buyer.
On the other hand, if the market price falls below the strike price, the seller will have to buy the shares from the put buyer at a price higher than what they can buy in the market for the underlying stock.
Thus, they will lose an amount equal to the opportunity cost of buying for the strike price instead of the market price.
Source: Investopedia
The net loss will be this opportunity cost minus the premium received. However, the seller can break even if the difference between the market price and the strike price is equal to the premium. Anything higher than that will result in a net loss.
Example
Let’s continue with the example we have been using: strike price of $150 and a premium of $3.50.
If the price rises to $200, the put buyer will not exercise the contract and you will earn a profit equal to the premium received. Thus, the profit on a short put strategy is capped at the premium received.
On the other hand, if the market price falls to $100, the put buyer will exercise the option (sell for $150 instead of $100). You will then have to buy for $150 what you could have bought for $100, for a $50 gross loss.
Since the stock’s price can only fall down to zero, the maximum gross loss per share is the strike price.
The net loss will be the gross loss minus the premium you have received. In our example, this will be $46.50. And the maximum net loss is the gross loss minus the premium ($146.50 in this example).
Furthermore, the breakeven price is the strike price minus the premium. In our example, this is $146.50. If the price falls to this breakeven price, the loss will be equal to $3.50 ($150 – $146.50) but this will be compensated for by the premium received, which is also $3.50.
Factors to consider
While the buyer must be confident that the stock’s price will fall significantly, the seller only needs to be sure that the stock’s price will stay the same or increase.
The size of the increase is irrelevant since profit on the upside is capped at the premium received. Whether the price increased to $155 or $180, the profit to the put seller is $3.50 per share.
Managing your position
Understanding your position
As we have seen, you are only in profit when the stock’s price stays the same or increases. If it falls, you will lose money except the price does not fall below the breakeven price, at which point you are neither losing money or losing it.
Closing your position
You can buy your position or roll it to another short put position to realize your gains or losses. This can be especially useful if the price starts falling.
You can also exercise your option early if the price has increased above the strike price.
Covered call
The basics
Definition
A covered call strategy occurs when the trader owns an underlying asset and also sells a call option contract on that asset.
Selling a call option contract means that the seller thinks the price of the underlying stock will fall. However, if the seller is unsure about this downward movement, they can go long on the underlying asset simultaneously.
Objective
A covered call strategy is appropriate when you are unsure about how the underlying stock will move. It can also be used when you believe that there will only be a minor increase or decrease in the price of the underlying stock.
Also, options traders often use covered calls when they need income from shares they already own without selling them.
Risk and reward
Normally, when the price of the underlying security is less than or equal to the strike price, the call seller will earn a profit equal to the premium that the call buyer paid. This is because the call buyer will not exercise the call option and would rather buy the stock in the market.
However, the call seller can lose money when the market price goes above the strike price instead. In this case, the call buyer will exercise the option, buy at the strike price, and sell for a profit.
The loss to the call seller is the opportunity cost of selling at the (lower) strike price instead of the (higher) current market price and it is unlimited.
With a covered call, the call seller, unsure of price movement, can hedge against this risk. By selling a call option based on stocks they already own, the potential loss is limited.
Example
Suppose you bought 100 shares of NVDA at $150 and you sold a call option of the stock with a strike price of $150 at a premium of $3.50.
If the price remains below $150 throughout the lifetime of the option, then the call buyer will not exercise the contract. In this case, you will have a maximum profit (on the option) equal to the premium you received from the buyer – $3.50 per share.
Since the call buyer did not exercise the option, you still have the shares to your name. However, because the current market price is lower than the price you bought it for, there will be a loss on the underlying security equal to the strike price minus the current market price.
On the other hand, if the price rises above $150, the call buyer will exercise the contract and your profit will only be the premium you have received.
Since you already own the stocks, you would not have to buy at the current market price only to sell at the strike price, which would have resulted in an unlimited loss. By owning the stocks already, potential losses on the call option when the stock’s price increases is compensated for by the gain on the underlying security.
The only “loss” is the opportunity cost of selling for the strike price instead of the higher current market price.
In all, the maximum profit on a covered call is the premium received while the maximum loss is the strike price minus the premium received (when the stock goes to $0).
Factors to consider
Covered calls only make sense when you expect only very little changes in the stock’s price. Therefore, you should consider if there is any factor that can cause huge upside or downside movement.
You should also consider the premium you will receive since that is your maximum profit.
Managing your position
Understanding your position
A covered call strategy makes the most sense when the price of the underlying stock rises. In that case, your profit is the premium and there is no loss since you already own the stock.
However, if the price falls and you retain the shares, you would lose money except the difference between the strike price and the current market price is equal to the premium (in which case you will only break even).
Closing your position
You don’t need to wait until expiration before you close your position.
Below are some ways to close your covered call position:
- Buyback: By buying back the call option, you can ensure that you don’t lose the underlying shares to the call buyer. At the time of the buyback, any gain or loss will be realized.
- Roll your position: You can buy back the call option and then sell another one with a different expiration date. With this, you can maintain the same position on the new call while realizing losses or gains on the older one.
Aside from ensuring continued access to the underlying stock, buying back and rolling your position can help you realize your gains and minimise your losses (especially if you believe the stock’s price will keep falling).
Source: Project Finance
Married put or protective put
The basics
Definition
Here, a trader who has a long position on an underlying stock also purchases a put option based on the underlying security.
Objective
It is traditionally used when traders expect prices to increase but also want to hedge against the risk that prices will fall instead.
Risk and reward
If the stock’s price falls, the trader will sell the shares they already own at the strike price. Whether there is a net profit, net loss, or break even will depend on if there is a difference between the strike price of the put and the price at which the long position was taken (more below).
On the other hand, if the stock’s price rises, the trader makes money on the long position while failing to exercise the put option. Net profit is the difference between the profit on the long position and the premium paid for the put option.
Example
Suppose the strike price is $150 and you also entered the long position at $150. If the price is now $120, you will sell the shares at $150. Since you bought the shares at $150, the only money you lose is the premium paid for the put option.
However, if prices increase as you projected (say to $170), the net profit will be positive. How so?
At $170, there is a $20 per share profit on the long position. At this price, you will not exercise the put contract and your loss on the option will be limited to the premium paid. With a premium of $3.50 per share, net profit is $16.50 per share.
Interestingly, since the stock’s price can increase indefinitely, profit on a married put is limitless.
But if the market price increases by only the amount of premium paid, you will only break even. That is, break-even price is the strike price plus the premium paid ($153.50 in this example).
Let’s go back to the downside to make an important point.
We assumed in this example that the strike price and the price you entered the long position are the same ($150). But it is possible for these prices to differ (if you bought the shares well before you entered the put option).
If you took the long position at a price lower than the strike price of the put (say $130), then by selling at $150, you are making a gross profit of $20 per share and a net profit of $16.50 per share.
In this case, you are making a profit on both the upside and the downside.
However, if the difference between the strike price and the price at which you entered the long position is equal to the premium paid, then you will break even. That is, the break-even price is the strike price minus the premium paid ($146.50 in this example).
Source: Redot
Factors to consider
A married put makes sense if you have good reasons to doubt your projection that the stock’s price will increase. If the market turns against you, it will limit your losses or even make you money (depending on the price you took the long position).
Managing your position
Understanding your position
You will be profitable if the stock’s price increases and your upside potential is limitless.
If it falls, you can be in profit (limited in this case) if you took the long position at a price lower than the strike price. If not, you will lose money but your losses are capped at the premium paid.
Closing your position
You can also close your position before expiration by rolling over to another married put and selling your position.
We have focused on these five popular and proven strategies because they are less risky and are thus appropriate for beginners.
However, if you are willing to learn more about advanced (and riskier) strategies, consider reading about: short call, bull call spread, bear put spread, long strangles, short straddles, long straddles, bear call spread, bull put spread, long call butterfly, short strangle, iron condor, and iron butterfly strategies.
How to trade options in the UAE
If you are in the UAE, you can buy and sell stocks and stock options through the Sarwa Trade app. At the moment, you can execute the long call, long put, cash-secured put, and covered call strategies on the platform.
With Sarwa Trade, your data and money are secured with bank-level SSL security. We also reduce your trading expenses by charging low commissions on trades (less than the average brokerage fees) and allowing free transfers from your local bank account to your trading account, and vice versa.
Our low capital requirement and the provision of fractional trading also ensure that low-capital retail investors can get their trading career started.
[Do you want to limit your downside risk by trading options in the UAE? Sign up for Sarwa Trade to trade popular US stock options in a low-cost, secure, and seamless way.]
Takeaways
- Options are financial derivatives that confer the rights to buy or sell an underlying asset for a specific price on or before a specific date. Options can be calls (right to buy) or puts (right to sell)
- Some traders prefer options to stocks because they can limit downside risk, increase returns, and often require lower capital commitment, among others. However, options can also be complex, volatile, and risky.
- A stock will be appropriate for options trading if it is volatile and liquid.
- There are many options trading strategies you can use to achieve your trading goals including bull call spread, bear put spread, covered call, and married put, among others.
Disclaimer
Options trading carries significant risks, including the potential for substantial or total loss of your capital. Level 1 strategies, such as covered calls and cash-secured puts, involve risks like assignment and price volatility. Level 2 strategies, including buying calls and puts, add further risks due to leverage, time decay, and the chance of losing the entire premium if options expire out of the money. No financial advice is provided; you must exercise your own discretion. Ensure you understand these risks and are financially prepared. Examples are for illustrative purposes only. Past performance is not indicative of future results, and market conditions can lead to unforeseen losses.