Basic Trading Strategies for Call and Put Options
There are several basic option trading strategies, but in order to execute any of them successfully an option investor new to options will need to know some elementary concepts.
The most basic are the call option and the put option. Buying a call option confers the right, but not the obligation, to buy an underlying instrument (stock, index, commodity, foreign exchange currency) at a pre-set price. Put options grant the buyer the right to sell an underlying instrument at a pre-set price. But options are sold as well as bought. That seller grants the buyer the right, and takes on an obligation to fulfill the other side of the option trade.
There are several basic trading strategies for call options and put options:
Long Call Option
The most basic, and easiest to understand, is the (long) call. AAPL (Apple), currently trading at $188 has a June 190 call option that expires on the third Friday of June, with a strike price (pre-set, 'if exercised, must-be-bought-at-price') of $190.
If the market price of the underlying asset increase above the call option strike price plus the cost of the option, the long call position will be profitable. If the price falls below strike price plus the cost of call option, the long position incurs a loss.
Short ('Naked') Call Options
When the option seller (the 'writer') doesn't own the underlying stock he's obligated to sell (if the option is exercised), he is said to be selling a 'naked' call. Since he's on the selling side of the contract, his position is said to be 'short'.
If the market price of the underlying asset decreases below the call option strike price, the short call position will profit by the amount of the premium. The price rises above the strike price by more than the premium, the short position incurs a loss.
Long Put Options
Traders who anticipate that the future market price of an asset, say a stock, will fall prior to expiration can buy the right to sell the stock at a fixed price. The put buyer has no obligation to sell the stock, but simply the right.
If, in fact, the market price does fall below the strike price (prior to expiration of the option) by more than the premium paid, he profits. If the price increases, or doesn't fall enough to cover the premium, the trader lets the contract 'expire worthless'.
Short Put Options
Traders who speculate that the future market price will increase, can sell the right to sell an asset at a pre-determined price.
If the asset's market price rises, the short put position makes a profit equal to the amount of the premium. If the price falls below the strike price by more than the premium, the 'writer' loses money.
When calculating your profit or loss always remember to include any transactions cost such as commissions.
Several successful option trading strategies utilize the characteristics of these four basic positions. These strategies are either pure profit plays - speculating on coming out on the plus side of the equation - or combinations of speculation and hedging.
Hedging involves taking positions that tend to move in opposite directions. They profit less than pure speculation, but make up for it by offloading some risk.
Options trading software can demonstrate several concrete examples of how any of these - under different assumptions about future prices, volume, etc in combination with different expiration dates and strike prices - can result in profit (or loss).
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