I’m a big evangelist of penny stocks.
Sometimes though, the leverage options give me way better than penny stocks…especially when I’m exercising bull puts and buying in-the-money calls on oversold stocks.
There are a ton of option trading strategies which can be thrown into 3 broad categories — bullish, bearish, or neutral.
I won’t talk about all of them in this article, but there are 3 important strategies every options trader should know.
Before I dive in and talk about each strategy, let’s define some key options terms.
An option contract offers the buyer the opportunity to buy or sell the underlying stock. Each standard option contract is equivalent to 100 shares of the underlying asset.
Call options: give the trader the right, but not the obligation, to buy the stock at a stated price within a specific time period.
Put options: give the trader the right, but not the obligation, to sell the asset at a stated price within a specific time period.
Expiration date: is the date at which an options contract is no longer valid and the holder must exercise their option. For standard contracts, it is usually the third Friday of the contract month.
Strike price: is the price at which the option holder will buy or sell the underlying stock at expiration.
1. Bull Call Spread
This is one of the most popular bullish options strategies out there. And it’s mostly used when traders expect the price of the stock to increase a bit.
In this case, traders buy calls at one strike price and then sell the same number of calls at a higher strike price.
The reason I like this strategy is that it protects me when the prices fall and the profit amount is also limited.
To make this work, I choose a stock that I think will likely appreciate moderately over a set period of time (usually a few days or weeks).
Then I buy a call option for a strike price above the current market with a specific expiration date while simultaneously selling a call option at a higher strike price that has the same expiration date as the first call option.
The difference between the premium received for selling the call and the premium paid for buying the call is the cost of the strategy.
Bull put is a great alternative to just buying a call option when the traders are not aggressively bullish on a stock.
2. Bull Put Spread
This is one of the trading strategies that options traders can implement when they are slightly bullish on the movement of a stock.
This strategy is similar to the bull call spread I just mentioned above. But in this case, instead of buying calls, traders would buy put options.
The gist here is basically short selling a put option, and then buying another put option…with the same expiration date…but at a lower strike price.
One advantage of this strategy is that if both options expire, I won’t have to pay any commissions to get out of my position.
3. Protective Put
A protective put is an option trading strategy that is often used by traders who are bullish on a long-term price rise for a stock but bearish over the short term.
As you know, when you own a stock, you can earn a profit if that stock gains value, and you can lose money if the stock loses value.
Remember, put options give the holder of the option the right, but not the obligation, to sell shares to the option seller at a set price, called the strike price.
A protective put sets a minimum price at which traders can sell shares, thereby limiting their potential losses.
So if I buy a put option on a stock (in addition to the shares I already own) that allows me to sell my shares to the option seller at the price I bought the shares — no matter what their market value is….then I’ve just employed a protective put.
Here’s how it works:
Let’s assume I have shares of a certain stock, say…ABC…that I bought at $20 per share.
Then I went ahead to buy a put on ABC with the strike price of $15 (and I also paid $2 as the option premium).
This means my break-even point is $17.
Now, assuming the price of ABC shares starts dropping, I can decide to cut my losses by exercising my put option and selling shares of ABC at $15 a share.
If the price of the stock keeps dipping to about $8 per share, then my loss per share would be $8 – $20 = $12.
By exercising my put and selling the shares at $15, my gain would be $15 – $8 = $7.
This means, that my loss per share would be: $7
Since loss per share = Loss on stock price + Gain on put exercise – options premium = -$12+ $7 -$2 = -$7
So, my maximum loss would then equal ($7) * 100 = -$700, which when compared to the maximum loss if I didn’t have the put $1,200 (-$12 * 100)…is a much, much smaller loss.
Please note: In this scenario, I won’t be under any obligation to exercise the put, so that if the stock price rises rather than drops, I’ll still have my potential profit.