This article will be a follow-up to my ‘a beginners guide in options’. After we’ve learned what options are, now it’s time to learn how to trade them.
The Risk Profile Chart
The risk profile chart is a simple x-y axis that shows the price of the underline asset against the profit or loss on the option. The vertical axis shows the profit/loss, and the horizontal axis shows the movement of the price of the underline asset.
The above graph is an example of a risk profile of a long call position, which will be further explained below.
As mentioned, the vertical axis shows the profit/loss, and the horizontal axis shows the movement of the price of the underline asset. The horizontal money at the vertical 0 shows the break-even point and its call ‘breakeven line’. The blue line shows the profit or loss that we will have in a possible upward or downward move of the underline asset. If the price of the underline asset stays at $100 then we break even. If it moves towards $120 then we will profit as shown. In case of a move towards $80.
The orange line shows the outcome of our position at the expiration date. We will either have lost the premium invested to buy the option contract or we will have gained a dollar amount as shown.
The Four Basic Option Strategies
01. Long (Buy) Call
Explanation
Our first options strategy is called ‘Long Call’, where long is another word for buying. When we use this strategy we need to be very bullish on the underline asset. In this strategy, time is also against us, because the option can expire worthless at-the-money or slightly in-the-money. In this scenario, we lose the premium that we paid to acquire the option contract. An important note here is that one option contract equals 100 stocks. This means that when we buy a $4.34 option contract we pay $434.
Uses and Market Conditions
This is a ‘simple’ arbitrage strategy (buy low, sell high) or is been used to hedge a short position on the underline asset. In the first scenario, we need the underline asset to follow an upward trend. In the second one, we need the underline asset to move in the exact opposite direction of the underline asset.
Strategy Checklist (Rule of thumb)
- Implied volatility < 40%
- Days until expiration = 60 to 90
- Delta between 0.5 and 0.6
- Risk management = Premium < 2% of our account’s equity
- Buying an at-the-money or slightly in-the-money strike price
- Ask and bid Spread = not greater than $0.40 to $0.50
- Open interest between 100 and 500
02. Short (Sell or Write) Call
Explanation
Shorting a call means that we provide the insurance to a buyer in case that his or her underline asset moves against his or her position, we will buy from him 100 underline stocks (as an example) at a predetermined price. In this scenario, the loss can be bigger than our profit, that is the premium we received. Again, note that for if we sell an option contract for $1, that means that we insure 100 underline stocks, and thus we will receive $100 worth of premium. When we sell an option we receive the premium upfront and we need to stay in that position until around the expiration of the option contract. Time decay, in that case, is in our favour.
Uses and Market Conditions
We are in favour of a downward movement of the underline asset. We can also profit if the underline asset makes a sideways movement.
Strategy Checklist (Rule of thumb)
- Open interest between 100 and 500
- Selling an out-the-money strike price (1 or 2 strike prices above the ATM)
- Implied volatility > 50%
- Days until expiration = 30 to 40
- Delta between 0.4 and 0.5
This chart means that our profit will be $5 as the price of the underline asset stays the same or falls, and our risk goes up as the underline asset gain in price.
03. Long Put
Explanation
The exact opposite position of a ‘Long Call’, is the ‘Long Put’. When we use this strategy we need to be very bearish on the underline asset. In this strategy, time is also against us, because the option can expire worthless at-the-money or slightly in-the-money. In this scenario, we lose the premium that we paid to acquire the option contract. An important note here is that one option contract equals 100 stocks. This means that when we buy a $4.34 option contract we pay $434.
Uses and Market Conditions
This is a ‘simple’ arbitrage strategy (sell high, buyback lower) or is been used to hedge a long position on the underline asset. In the first scenario, we need the underline asset to follow a downtrend trend. In the second one, we need the underline asset to move in the exact opposite direction of the underline asset.
Strategy Checklist (Rule of thumb)
- Implied volatility < 40%
- Days until expiration = 60 to 90
- Delta between 0.5 and 0.6
- Risk management = Premium < 2% of our account’s equity
- Buying an at-the-money or slightly in-the-money strike price
- Ask and bid Spread = not greater than $0.40 to $0.50
- Open interest between 100 and 500
04. Short (Sell or Write) Put
Explanation
This is the exact opposite position of the Short Call position. Again, in this scenario, the loss can be bigger than our profit, that is the premium we received. Time decay, again, is in our favour.
Uses and Market Conditions
We are in favour of an upward movement of the underline asset. We can also profit if the underline asset makes a sideways movement.
Strategy Checklist (Rule of thumb)
- Open interest between 100 and 500
- Selling an out-the-money strike price (1 or 2 strike prices above the ATM)
- Implied volatility > 50%
- Days until expiration = 30 to 40
- Delta between 0.4 and 0.5
The two basic option selling strategies and their collaterals.
Naked Call/Put
Naked call or put is called a position in which we sell options contracts without having any form of collateral to cover our position in the case that the position moves against our favour.
Covered Call/Put
Convert call or put is the case in which, we hold the underline asset (times 100), and we will transfer them to the owner of the option contract if our position goes against our favour.
Cash-Covered Call/Put
In that case, we hold the amount needed in cash to buy the underline asset (times 100, in case that we sold a US option contract on equities) in our account, If our position goes against our favour.
The name of the option contract sold changes according to our collateral asset if it exists.
Sources
- Get Rich with Options by Lee Lowell.
- OptionAlpha Courses — https://optionalpha.com/
- Fundamentals of Futures and Options Markets by John Hull
- Options as a Strategic Investment by Lawrence McMillan
- https://tastytrade.thinkific.com/
- The Bible of Options Strategies by Guy Cohen