At a fundamental level, Stock Options (we’ll be referring to them as “Options” throughout the rest of this article) are another vehicle for trading stocks in the stock market. Options are slightly more complex than owning stocks and traders can deploy extensive strategies that can help them generate periodic income, create wealth, and sometimes be speculative also.
As with any stock market trading technique, there are risks involved with options, and depending on the strategy, a trader can win or lose big. Before we get into the basic strategies of trading in Options, you need to have a foundational understanding of what options are and how their trading functions.
What are Options?
Options are financial contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) on or before a specified expiration date
Breaking this definition down, there are three main components to an Option trade:
- An underlying asset: Traders trade Options of a stock in general i.e. there is an underlying stock that one must pick/choose to be able to exchange the available Options for it.
- Predetermined price: Options are purchased or sold at a price that the trader predetermines. The predetermined price (strike price) will be different from the current market price (the price the stock is being traded for on a given day). Most stocks have many Options strike prices that are available to trade either above or below their current market price
- Specified expiration date: This is a big one. Unlike stocks, Options have an expiration date. Since Option is only a contract, one does not own the stock and the contract has an expiration date. The Options trader will have the opportunity to trade the option before the expiration date or otherwise face the outcome of the contract expiring at the date selected (we’ll discuss in detail what those outcomes are a little later).
Just like stocks, traders have to BUY (also called “LONG”) or SELL (also called “SHORT”) Options to generate profit or sometimes reduce their losses.
It is also important to keep in mind the two variations of options:
Call Options: Give the holder the right to buy an underlying asset at the strike price.
Put Options: Give the holder the right to sell an underlying asset at the strike price.
An options trader can “BUY” or “SELL” a Call Option. Similarly, they can “BUY” or “SELL” a Put Option. However, there is one key difference between these two variations that we will further explain below in the Options strategy section.
Why Options Trading?
One may ask why trade in Options when one can trade in regular stocks. People trade Options for various reasons:
- Small Investment: While buying a stock requires the full price/amount to purchase the stock, Options only require a fraction of the amount to own the right to buy the stock. Here is an example below:
If a general stock trader wants to buy 100 stocks of AAPL, they will require a substantial amount of money to purchase it
Ex) 100 x $245 current price = $245000/-
If an Options trader wants to buy the right to buy 100 stocks of AAPL, depending on the strike price and expiration date, they may be able to purchase it for a fraction of the cost
Ex) 1 Options contract x $50 ) x 100 underlying stocks = $5000/-
- Hedging: Protecting an existing position against potential losses. If a trader wants to protect their asset/stock against large market fluctuations, they can buy/sell Options against the asset and ride the market.
- Speculation: Attempting to profit from price movements in the underlying asset. If a trader wants to take advantage of large market fluctuation, they can buy/sell Options to benefit from the market swing
- Income Generation: Generating income through the sale of options premiums. Quite a few traders generate weekly, monthly, and consistent annual income from buying/selling options and collecting premiums
Basic Options Strategies
Long Calls
A very basic strategy for Options trading is buying Call options. The basis of a long call is when a Trader speculates that the price of a certain stock will go up within a certain time period
Strategy
The trader simply buys an Option contract for that stock with a strike price that is slightly Out of the Money* that expires a little later than his speculated time period. To purchase this contract the Trader has to pay up the premium to buy the contract.
Let’s take an example: CMG (Chipotle, Inc.) stock currently trading around $50, the Trader thinks that the price will go up to $60 by Oct. So, so they Buy a Call contract (a contract is worth 100 shares) with a strike price of $56 (to be on the safe side) for a premium of $3 per stock i.e. $3 * 100 = $300/- that expires on Nov 6th.
Outcome(s)
As you can see the trader paid $300 to buy this contract. This is considered his MAX LOSS i.e. in the case that the stock price does not reach the strike price, the trader will lose the money he put in to purchase the contract. The upside though is beneficial:
Scenario 1: On Nov 6th, the stock price of CMG is $63/-
The Trader earned from the contract ($63 market price – $56 strike price) = $7 *100 = $700
Don’t forget they paid $300 for this contract. So their net profit is $400
Scenario 2: On Nov 6th, the stock price of CMG is $57/-
The Trader earned from the contract ($57 market price – $56 strike price) = $1 *100 = $100
Don’t forget they paid $300 for this contract. So their net loss is $200
Scenario 3: On Nov 6th, the stock price of CMG is $53/-
Since the market price is below the strike price the Trader makes no money = $0.
Don’t forget they paid $300 for this contract. So their net loss is $300
In this situation, anything below $56 will yield a maximum loss of $300. A market price above $56 can yield profit only if it is above a price that covers the premium cost i.e. $59. However, think of the unlimited potential upwards. Can you calculate what the Trader would make if the market price on Nov 6th for CMG is $82?
Risk(s)
Long Calls have the risk of losing the premium amount that was paid to buy the Option. This is called MAX LOSS. Long Calls also gain or lose value over the time period. For example, as the expiration date comes closer and let’s say there is not much price movement in the stock, the Option will start losing value, but still under the max loss.
Long Puts
Another basic strategy for Options trading is selling Put options. In a Long Put, a Trader speculates that the price of a certain stock will go down within a certain time period
Strategy
The trader simply buys a Put Option contract for that stock with a strike price that is slightly Out of the Money* that expires a little later than his speculated time period. To purchase this contract the Trader has to pay up the premium to buy the contract.
Let’s take an example: AAL (American Airlines) stock is currently trading around $15, and the Trader thinks that the price will go down to $10 by Sep. So, they Buy a Put contract (a contract is worth 100 shares) with a strike price of $10 (to be on the safe side) for a premium of $1 per stock i.e. $1 * 100 = $100/- that expires on Oct 12th.
Outcome(s)
As you can see the trader paid $100 to buy this contract. This is considered his MAX LOSS i.e. in the case that the stock price does not reach the strike price, the trader will lose the money he put in to purchase the contract. However, the upside though is unlimited:
Scenario 1: On Oct 12th, the stock price of AAL went down all the way to $7/-
The Trader earned from the contract ($10 strike price – $7 market price) = $3 *100 = $300
Don’t forget they paid $100 for this contract. So their net profit is $200
Scenario 2: On Oct 12th, the stock price of CMG is $9/-
The Trader earned from the contract ($10 strike price – $9 market price) = $1 *100 = $100
Don’t forget they paid $100 for this contract. So their net is $0
Scenario 3: On Oct 12th, the stock price of AAL went up to $16
Since the market price is above the strike price the Trader makes no money = $0.
Don’t forget they paid $100 for this contract. So their net loss is $100
As you can see anything above $10 will yield a max loss of $100. A market price below $10 can yield profit only if it is below a price that covers the premium cost i.e. $100. However, think of the unlimited potential downwards. Can you calculate what the Trader would make if the market price on Oct 12th for AAL is $2?
Risk(s)
Long Puts have the risk of losing the premium amount that was paid to buy the Option. This is called MAX LOSS. Long Puts also gain or lose value over the time period. For example, as the expiration date comes closer and let’s say there is not much price movement in the stock, the Option will start losing value, however still under the max loss.
Covered Calls
This strategy works when you hold stock of a certain company and want to either generate monthly income or sell it for a certain higher price
Strategy
The trader simply sells a Call Option contract for the stock they own with a strike price that is acceptable to them (in case the price goes up) and expires within a certain time period. To sell this contract the Trader collects the premium to sell the contract.
Let’s take an example: NVDA (Nvidia) stock currently trading around $110, the Trader owns 100 stocks (they bought it at $108) of this company and thinks that the price is unlikely to go to $130 in Sep. So, they Sell a Call contract (a contract is worth 100 shares) with a strike price of $130 (to be on the safe side) for a premium of $2 per stock i.e. $2 * 100 = $200/- that expires on Oct 12th.
Outcome(s)
As you can, since the trader sold the Call, they collected $200 to sell this contract. This is considered their MAX PROFIT from this trade. However, they also make a profit by selling the stock. Let me show you:
Scenario 1: On Oct 12th, the stock price of NVDA went up to 125/-
Since the market price is below the strike price, the Option contract expires worthless and the Trader keeps the stock
Don’t forget they collected $200 for this contract. So their net profit is $200 and they still keep the underlying stocks
Scenario 2: On Oct 12th, the stock price of NVDA is $112/-
Again, Since the market price is below the strike price, the Option contract expires worthless and the Trader keeps the stock
Don’t forget they collected $200 for this contract. So their net profit is $200 and they still keep the underlying stocks
Scenario 3: On Oct 12th, the stock price of NVDA went up to $135
Since the market price is above strike price the Trader has now to give the stock to the buyer. They still collected $200 for this contract. Don’t forget they had bought the stock at $108, so they also get to collect the profit by selling the stock at $130 which is $130-$108 * 100 = $2200 for a total of $2400 in profit.
As you can see anything above the strike price and the trader has to let go of their stock. However, they collect profit on selling the stock and also credit for the Covered Call option. As long as one can determine a far enough price that they would be comfortable selling the stock, they will make money in both the profit from the stock and the premium collected selling it.
Risk(s)
Covered Calls are a great strategy for collecting money on a periodic basis as long as one can speculate the selling price and collect a decent premium. The downside of this strategy is that the trader may end up
losing the stock and missing out on further gains of the stock.
Cash Secured Puts
Background
This strategy works when a trader has cash in their account and is ok with buying an underlying stock if they get assigned. Let me explain
Strategy
The trader simply sells a Put Option contract for the stock they wouldn’t mind owning at a lower price. It also helps generate some income while you wait for the price to go down. To sell this contract the Trader collects the premium to sell the contract.
Let’s take an earlier example: NVDA (Nvidia) stock currently trading around $110, the Trader doesn’t mind owning the stocks of NVDA if it was sold to them for a lower price. So, they Sell a Put contract (a contract is worth 100 shares) with a strike price of $99 (to be on the safe side) for a premium of $3 per stock i.e. $3 * 100 = $300/- that expires on Oct 12th.
Outcome(s)
As you can, since the trader sold the Put, they collected $300 from selling this contract. This is considered their MAX PROFIT from this trade. However, they may also get a chance to own the stock at a lower price. Let me show you:
Scenario 1: On Oct 12th, the stock price of NVDA went up to 125/-
Since the market price is above the strike price, the Option contract expires worthless.
Don’t forget they collected $300 for this contract. So their net profit is $300
Scenario 2: On Oct 12th, the stock price of NVDA is $112/-
Again, Since the market price is above the strike price, the Option contract expires worthless
Don’t forget they collected $300 for this contract. So their net profit is $300
Scenario 3: On Oct 12th, the stock price of NVDA went up to $98
Since the market price is below the strike price the Trader has now to own the stock to the buyer. They still collected $300 for this contract. They now own 100 stocks of NVDA at a low price of $99 (strike price)
As you can see anything below the strike price and the trader has to buy that stock or finish the trade. For this they have to have $99*100 = $9000 cash in their account to complete the trade. The potential of Nvidia stock going back up is great and the trader can leverage other strategies to either collect more income or sell the stock at a higher price to collect more profit.
Risk(s)
Cash Secured Puts are a great strategy for collecting money on a periodic basis as long as one has some cash and doesn’t mind holding a good stock they believe in. The only downside of this strategy is that the stock price may end up going lower than what the trader paid for and they might end up holding a stock at a higher price for a longer period of time.
Takeaways
Stock options trading offers a range of strategies, from basic long calls and puts to more advanced approaches like covered calls and cash-secured puts, each with varying levels of risk and reward. While options trading can generate income, hedge positions, or speculate on market movements, it requires careful risk management and a deep understanding of how options work. Beyond options, investors may explore other strategies like dividend investing, index funds, or real estate, which can provide more stable, long-term growth. Regardless of the approach, success in investing requires continuous learning and disciplined decision-making.
Out of the Money*: Options that do not have any intrinsic value; they only have extrinsic, or time value.
