As we navigate these dynamics, we believe options can offer traders potential tools to help protect their portfolios. Let's explore three popular options trading strategies, complete with practical examples and rationales, to help you to learn how to make more informed decisions in various market conditions. Keep in mind, capital at risk and options are considered high risk investments due to their complex nature and are not suitable for all investors.
Long Calls
- Buying calls (a long call position) is a strategy used by some investors who believe a stock or ETF’s price will rise
- By purchasing a call option, you gain the right but not the obligation to buy shares at a specific price (strike price) before the option expires
- These types of trades are used by some investors to position for a rebound after a market sell off with a smaller spend than buying the stock or the ETF
Risk:
The maximum loss is limited to the premium paid for the option. If the price of the stock does not rise above the strike price by the expiration date, the option expires worthless, and the investor loses the premium paid.
Example:
Strategy: Purchase a call option, giving you the right to buy shares at a specific price before expiration.
Example: An investor buys a call option on ABC stock, currently at $50, with a $52 strike price expiring in 30 days for a $2 premium. If ABC rises to $60, they can exercise the option for a $6 per share profit.
Long Puts
- On the other hand, buying puts (long puts) can make sense for some investors with bearish market outlooks
- When you buy a put option, you acquire the right to sell shares at a predetermined price
- This strategy can be used to potentially protect existing investments or potentially profit from anticipated price declines
- Put options can be bought to potentially hedge investor portfolios against moves lower in stocks or ETFs that they own
Risk: The maximum loss is limited to the premium paid for the option. If the price of the stock doesn't fall below the strike price before the expiration, the option expires worthless, and the investor loses the premium paid.
Investa streamlines the long call and long put trading journey with cards that aim to make the key features of the trade very clear. In app tools such as Sidekick enable traders to simply conduct scenario analysis to help compare different call and put positions over different time frames to assist in the decision making process.
Example:
Strategy: Buying a put option, granting the right to sell shares at a predetermined price.
Example: An investor owning 100 XYZ shares at $100 buys a put with a $95 strike price, expiring in 60 days, for a $3 premium. If XYZ falls to $85, exercising the option limits their loss to $8 per share instead of $15.
Covered Calls
- Covered calls involve owning a stock or an ETF - and then also selling call options on the same stock or ETF
- This means that the investor collects a premium for selling the calls initially. Then, if at the expiration of the option, if the stock has increased beyond the strike price, the investor sells the stock at the strike price
- When volatility is higher, the level of income premium that an investor can potentially earn by selling calls increases, as typically demand for the options they are selling is increased
- This strategy serves to generate additional income in volatile market conditions, with the risk of missing out on some of the gains in the stock if its price increases beyond the strike price considerably
Risk:
- Limited Upside Potential: If the stock price rises above the strike price, you'll have to sell your shares at the strike price, which limits your upside potential. Essentially, you miss out on gains beyond the strike price.
- Downside Risk: If the stock price declines, you still face the risk of losing money on your stock position. The premium you received from selling the call option can help offset some of the losses, but it's not a full hedge.
Example:
Strategy: Hold a long position in a stock while selling call options on the same asset.
Example: An investor with 100 Starbucks shares at $50 sells a call with a $52 strike price, expiring in 45 days, for a $1.50 premium. They keep the $150 premium if the stock stays below $52, or profit from appreciation up to $52 plus the premium if called away.
Investa helps traders screen for stocks where volatility is higher, that can be potentially attractive covered call candidates, due to market conditions such as the ones we have seen more recently. Investors can search this using in-app tools.
We aim to help investors potentially improve their understanding of options through providing educational resources, but despite this you should be mindful that options are complex products and are not suitable for all investors..
There are also common pitfalls that newer options traders should aim to avoid. It is important to consider the following when it comes to next steps and placing your first options trades:
- Start small with simpler strategies
- Never invest more than you can afford to lose
- Use limit orders to manage your option sales
- Stay informed about market news and events
- Remember that options have time value - which can lead to losses as the option’s value erodes even if the underlying asset moves in your favour. Time as well as direction and volatility matters when learning to trade options.