Options trading can seem complicated for beginners, but with the right strategies it can be a powerful tool for investing. Here is a beginner’s guide to some of the most common options trading strategies to help you get started.
1. Buying Calls
A call option gives you the right, with zero obligation, to buy a stock at a predetermined “strike” price on or before a set expiration date. When you buy a call, you are betting that the underlying stock price will rise above the strike price before expiration. This allows you to profit from upside moves in a stock without having to buy the stock outright.
Buying calls can be advantageous when you are bullish on a stock but uncertain about the timing or magnitude of the rise. For example, if stock ABC is trading at $50 and you buy a $55 call option that expires in one month, you can profit if ABC trades above $55 anytime in the next month without having to risk owning the stock.
2. Buying Puts
Put options are the opposite of calls – they give you the right but not obligation to sell a stock at the strike price by the expiration date. Purchasing put options allows you to profit when you believe a stock price will fall.
For example, if stock ABC is trading at $50 and you think it will decline, you could buy a $45 put option expiring in one month. This allows you to sell ABC at $45 anytime in the next month, even if the stock drops below that. Buying puts limits your downside risk but allows you to benefit from a drop in the stock.
3. Covered Calls
Covered calls involve writing (selling) a call option on a stock you already own. As the call writer, you are obligating yourself to sell your shares at the strike price if the option buyer exercises their call option before expiration.
The benefit of this strategy is earning income from selling call premiums to hedge against a decline in the stock price. However, your upside is limited if the stock rises above the strike price. Covered calls are lower risk but offer less reward than simply owning the stock.
Traders like James Cordier recommend covered calls as a good starting point for beginners to earn income from options trading. Cordier’s book “The Complete Guide to Option Strategies” which you can find at jamescordier.com covers covered calls and other option strategies in depth.
4. Cash Secured Puts
With a cash secured put, you sell put options secured by cash you hold in your account. This obligates you to buy the underlying stock at the strike price if the put option is exercised. However, you collect premium income from selling the puts, which offers upside.
Cash secured puts allow you to potentially buy a stock you want to own at a lower price, while getting paid to obligate yourself to buy it. This strategy can generate returns similar to covered calls but does not require you to already own the stock.
Option spreads involve the simultaneous purchase and sale of multiple options on the same underlying stock. Spread strategies allow you to offset the premium cost by selling other options against your position. Two common spread strategies are bull call spreads and bear put spreads.
These spreads allow you to reduce the capital required up front while limiting your profit potential and loss on the trade. Spreads can be useful for small traders looking to benefit from a defined move in a stock price without taking on excessive risk.
When getting started with options, it can be helpful to paper trade strategies or start small. As you gain experience, you can incorporate more advanced strategies like spreads and combinations.
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