Regardless of whether you are a low-risk buy-and-hold investor or an active day trader, there are a few basic options trading strategies that you should know about. When options are used properly, they are a powerful way to reduce risk in a portfolio and generate income.
For the casual investor, who perhaps only buys stock once a month, the covered call option strategy is an amazing way to generate income with essentially no additional risk. Plus, it’s a very simple strategy. It only involves selling 1 call option for every 100 shares of long stock.
For example, if a trader is long 1,000 shares of HTMW stock (not a real stock) at $40 a share, he could sell a total of 10 $45 call options against his long stock. Or he could sell 10 $50 call options. The strike price of the options contracts is yours to choose! The price that options trade at will always vary, but for this example let’s assume he sold 10 calls for $0.30 each. Because each option contract is equal to 100 shares, the trader will receive $300 in call option premium for placing this trade!
As long as HTMW is below $45 by the time the option is set to expire, the trader will keep his 1,000 shares of stock and the $300. It is important to know that regardless of what happens, the trader will always keep the $300 in option premium. If the stock is above $45 at expiration, the 1,000 shares will be called away to cover the 10 short call options, but that would result in a profit of $5 per share, or $5,000 plus the $300 in premium already received!
This is what makes covered calls so popular among buy-and-hold investors. If the stock rallies, the trader will profit, and if the stock sells-off, the trader will lose money, but the amazing thing about covered calls is that they cushion some of the downside movement.
In this case, the $300 in call option premium would offset minor declines in the stock. Moreover, if the trader never sold the calls in the first place, he wouldn’t have this downside cushion and he would technically lose more money if the stock declined.
The only thing covered calls do is limit the potential max profit of a trade. If HTMW went to infinity, it wouldn’t do the trader any good. But how frequently do stocks go to infinity? It’s far more likely that the trader will keep collecting the call option premium!
If this trade is repeated with 60 days until expiration only 5 separate times per year, assuming the stock is never called away, it would result in a $1,500 profit for doing nothing! Pretty sweet!
With all of this said, some investors want more action. They don’t want to trade only 5 times every year.
For active traders who are comfortable with a little more risk, they can look into selling options without simultaneously having a position in the underlying stock. This is commonly referred to as “selling options naked.” Essentially, instead of covering the short call position with 1,000 shares of HTMW, the trader would just sell the 10 call options and collect the $300 in premium.
Why would anyone want to do this? Well, the main reason is that the trade has no downside risk. Meaning, if stock HTMW collapsed to zero, it would wipe out the option seller who’s position is covered with long shares.
Selling options without covering the trade is highly risky, but that means the reward is also better. Additionally, it often requires less capital to sell options naked.
However, active traders willing to speculate in an attempt to generate higher returns are not just limited to selling calls. The other popular options tactic is to capture put option premium by selling puts either naked or cash-secured.
Just like in the example above, a trader could sell 10 $35 put options of HTMW and collect all of the premium as long as HTMW stays above $35 by the time the options expire. Since this is effectively the opposite position of selling calls, instead of being long 1,000 shares to cover the position, the put seller would have to be short 1,000 shares to cover the position. But advanced traders often don’t see the need to cover their positions, because they’d rather just use leverage and close out the position if it comes to it.
At the end of the day, options trading offers so many additional ways to make (and potentially lose) money than the boring old “stock market” does. Whether you’re an active trader or a diehard buy-and-hold investor, it behooves you to look at the “options” (no pun intended) that options trading gives you! There’s something for everyone!