A stock option gives an investor the right, but not the obligation, to buy or sell a stock at an agreed upon price and date. There are two types of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock will rise.
- Call: bet that a stock will rise. To excise the right to buy the stock in the future for the strike price and sell it back to the seller of the contract at the market price.
- Put: bet that a stock will fall. To excise the right to buy the stock at the current market price and sell it at the strike price.
- Expiration Date: Options do not only allow a trader to bet on a stock rising or falling but also enable the trader to choose a specific date when they expect the stock to rise or fall by. This is known as the expiration date.
- Strike Price: Strike price determines whether an option should be exercised. It is the price that a trader expects the stock to be above or below by the expiration date.
- Contracts: Contracts represent the number of options a trader may be looking to buy. One contract is equal to 100 shares of the underlying stock.
- Premium: The premium is determined by taking the price of the contract and multiplying it by the number of contracts bought, then multiplying it by 100
- American Options: Options can be excised at any point between the purchase date of the option and the expiration date
- European Options: Can only be excised on the expiration date
Consider an investor who speculates that the price of stock A will rise in 3 months. Currently, stock A is valued at $10. The investor then buys a call option with a $50 strike price, which is the price that the stock must exceed in order for the investor to make a profit. Fast-forward to the expiration date, where now, stock A has risen to $70. This call option would be worth $20 as stock A’s price is $20 higher than the strike price of $50. By contrast, an investor would profit from a put option if the underlying stock were to fall below his strike price by the expiration date.
Option Pricing Factors
- Underlying stock price (higher = higher call premium, lower put premium)
- Underlying stock price volatility [expected] (higher = higher option premium)
- Underlying stock dividends (higher = lower call premium, higher put premium)
- Option’s strike price (higher = lower call premium, higher put premium)
- Time until expiration (longer = higher option premium)
- Interest rates (higher = higher call premium, lower put premium)
- Very popular strategy because it generates income and reduces some risk of being long on the stock alone
- To execute the strategy, you purchase the underlying stock as you normally would, and simultaneously write–or sell–a call option on those same shares
- Example: For every 100 shares of stock that the investor buys, they would simultaneously sell one call option against it
- Investors may choose to use this strategy when they have a short-term position in the stock and a neutral opinion on its direction. They might be looking to generate income through the sale of the call premium
- Investor purchases an asset—such as shares of stock—and simultaneously purchases put options for an equivalent number of shares
- This strategy may be appealing for this investor because they are protected to the downside, in the event that a negative change in the stock price occurs. At the same time, the investor would be able to participate in every upside opportunity if the stock gains in value.
- The only disadvantage of this strategy is that if the stock does not fall in value, the investor loses the amount of the premium paid for the put option
Bull Call Spread
- Investor simultaneously buys calls at a specific strike price while also selling the same number of calls at a higher strike price
- Often used when an investor is bullish on the underlying asset and expects a moderate rise in the price of the asset
- Using this strategy, the investor is able to limit their upside on the trade while also reducing the net premium spent (compared to buying a naked call option outright)
Bear Put Spread
- Investor simultaneously purchases put options at a specific strike price and also sells the same number of puts at a lower strike price
- Both options are purchased for the same underlying asset and have the same expiration date.
- This strategy is used when the trader has a bearish sentiment about the underlying asset and expects the asset’s price to decline
- A protective collar strategy is performed by purchasing an out-of-the-money put option and simultaneously writing an out-of-the-money call option.
- The underlying asset and the expiration date must be the same.
- This strategy is often used by investors after a long position in a stock has experienced substantial gains.
- This allows investors to have downside protection as the long put helps lock in the potential sale price.
- However, the trade-off is that they may be obligated to sell shares at a higher price, thereby forgoing the possibility for further profits
- A long straddle options strategy occurs when an investor simultaneously purchases a call and put option on the same underlying asset with the same strike price and expiration date.
- An investor will often use this strategy when they believe the price of the underlying asset will move significantly out of a specific range, but they are unsure of which direction the move will take.
- Theoretically, this strategy allows the investor to have the opportunity for unlimited gains. At the same time, the maximum loss this investor can experience is limited to the cost of both options contracts combined.
- In a long strangle options strategy, the investor purchases an out-of-the-money call option and an out-of-the-money put option simultaneously on the same underlying asset with the same expiration date.
- An investor who uses this strategy believes the underlying asset’s price will experience a very large movement but is unsure of which direction the move will take.
Long Call Butterfly Spread
- Long butterfly spread using call options, an investor will combine both a bull spread strategy and a bear spread strategy.
- They will also use three different strike prices. All options are for the same underlying asset and expiration date.
- An investor would enter into a long butterfly call spread when they think the stock will not move much before expiration.
- Iron condor strategy, the investor simultaneously holds a bull put spread and a bear call spread.
- The iron condor is constructed by selling one out-of-the-money put and buying one out-of-the-money put of a lower strike–a bull put spread–and selling one out-of-the-money call and buying one out-of-the-money call of a higher strike–a bear call spread.
- All options have the same expiration date and are on the same underlying asset. Typically, the put and call sides have the same spread width.
- This trading strategy earns a net premium on the structure and is designed to take advantage of a stock experiencing low volatility.
- Many traders use this strategy for its perceived high probability of earning a small amount of premium.