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How To Determine the Best Options Trade Strategies

T raders use a variety of options trade strategies to earn income or hedge against downside risks. Understanding the most common types of strategies can help you familiarize yourself with the different ways you can use them to earn income or protect yourself against potential losses. It can also help you understand which strategies carry the greatest risks that you may want to avoid.

  • Stock options give buyers the option, although not the obligation, to buy or sell shares of stock at a specific price within a predetermined time frame.
  • Options sellers, or writers, generally assume the greatest amount of risk with potentially limitless losses, depending on the type of option they’re selling.
  • Options strategies can act as an insurance policy, hedging against downside risk or protecting gains.

What Are Stock Options?

Image via Unsplash by William Iven

A stock option is a contract to purchase shares of a stock, usually 100 shares, for a specific price within a specific amount of time. The price that the trader locks in when they buy the stock option is called the strike price. While they are under no obligation to do anything more after paying the premium (the fee for the contract), if they choose to take action and buy or sell the shares of the stock, the act of buying or selling is referred to as exercising the option.

Types of Stock Options

T here are two different types of stock options: call options and put options. A call option is where the trader buys the right to buy shares of the stock at the strike price. A trader might want to do this if they think that the price of the underlying stock is going to go up. Once the price of the stock rises above the strike price, the value of the option increases, and the trader can exercise their option by buying the shares and then selling them for a profit.

A put option is when the trader has the right to sell shares of the stock at the strike price. They may do this if they think the stock is going to drop in value. As the price of the stock moves away from the strike price, dropping lower, then the put option increases in value, and the trader can exercise their option and enjoy the profit.

Options Trade Strategies and How to Determine Which Is Best

Let’s take a deeper look at different options trading strategies and how you can determine which you should be using.

Long Call

With this strategy, an options trader buys a call option with the expectation that the underlying stock will rise above the strike price before the option expires. If it doesn’t move above the strike price before the expiration date, then the option will expire, worthless. However, losses with this strategy are limited because the trader is only out the cost of the premium they paid for the contract.

If the long call is well-timed, then the upside potential is, hypothetically, limitless, because there is no cap on how high market prices can go. If the price of the stock goes the wrong way, then the trader can try to recoup some of the cost they spent on the premium by trying to sell it before it expires. The downside is that the option will expire, and the options trader will lose the entire amount they invested in the premium.

If you’re unconcerned about the risk of losing your premium payment and you feel confident that the underlying stock is going to rise, then this can be a great way to enjoy the benefits of the price going up without actually making the larger investment and buying the shares outright. You’re also limiting your risk in the event that you’re wrong and the price doesn’t go up. You know you’ll only be out the cost of the premium.

Long Put

This strategy is essentially the same as the long call, except that instead of wagering that the cost of the stock is going to go up, you’re betting that the cost is going to drop under the strike price before the option expires. Unlike the call option, the upside potential for put options is limited, as the price for the shares can only drop as low as $0. It’s at that point that the long put is most valuable.

However, even if the stock prices don’t drop as much as anticipated, the trader can still often recoup some of their investment by selling the put option. This is an option as long as there’s some time remaining before the contract expires. This may be a good option trade strategy for you if you think the prices are going to drop and you’re comfortable with the downside risk of potentially losing the premium payment.

Short Put

With this type of strategy, you’re selling, or writing, a put option. The investor is selling the put option because they believe that the stock market is going to stay relatively flat or even rise and that the option will expire without value. The seller earns a profit when they walk away with the entire premium. The maximum amount that an options writer can earn with a short put is the amount that the buyer pays for the premium. As long as the stock stays at or above the strike price, then the option will expire and the writer will enjoy the whole premium.

However, if the price of the stock on the market moves below the strike price before the contract expires, then the put seller is obligated to buy the shares of stock at that price. The maximum amount of loss would occur if the stock reaches a price of $0.

A trader might want to use this strategy if they want to generate income when the market is stagnant or if they think that the price of the shares is only going to go up. However, traders should be cautious and sell puts sparingly, as they’re obligated to buy the shares if the price drops.

Covered Call

Similar to a short put, a covered call is when an options trader sells a call option because they think that the price of the stock will either stay flat or go down. The primary difference with the covered call is that the trader actually owns the stock they’re selling the option for. As long as their bet is accurate and the price either stays flat or goes down, the call seller can keep their stock and earn income on the premium.

It’s important to note that you can only sell one call for every 100 shares of stock you own. If you don’t own at least 100 shares of the stock, it is called a ‘naked’ call. The risk of selling naked calls can expose an options trader to uncapped losses if their bet is wrong and the stock rises, as the trader would have to purchase the shares of stock and then sell them at the lower strike price.

If you’re selling covered calls, there’s still a risk since you may be forced to sell shares of your stock when you didn’t actually want to, but the risk is limited. Traders use this type of strategy if they expect that a stock will remain flat, as it allows them to earn income on shares of stock that aren’t otherwise earning them income.

Married Put

A married put is a strategy that combines owning shares and buying put options of the same share, essentially ‘marrying’ them. The way this works is that for every 100 shares of stock that a trader owns, they buy one put option. Traders sometimes do this because it allows them to own a stock and enjoy the appreciation if the shares go up in price while still hedging their position if the prices plummet. They essentially have an insurance policy, knowing that they can limit losses and sell at the strike price if the prices of the shares start dropping.

They also can hold on to the shares longer since they have until the expiration date to exercise their option. That means that if the market prices are volatile, they won’t feel compelled to sell shares to limit losses. They can wait until just before the expiry date to see if the shares will go back up in price before exercising their option.

Long Straddle

With this strategy, an options trader purchases a call and a put for the same stock option. The call and put options both have the same expiration date and strike price. A trader will use this type of strategy if they feel confident that the price of the stock is going to move significantly but they aren’t sure in which direction. For example, if a company is about to release an earnings report and you know that it will have a big impact on the company’s stock, you might want to use this type of strategy.

Long Strangle

This strategy is like a long straddle, but it’s cheaper since you use options that haven’t reached their value. To execute this strategy, a trader would buy a call and put option at a strike price that’s above and below the current price of the stock. For this strategy to work, the stock has to move. If you’re expecting big moves in the market prices, then the long strangle can be a better option than the long straddle because it’s cheaper to set up.

These are just a few of the top options strategies that traders use. However, there are many other options that combine calls and puts to maximize upside and minimize risk. Learning about the different options and understanding the various risks can help you determine whether you want to start trading options yourself.