In this final installment of a two-part series, we review basic options trading strategies and how they can be used. Find out how you might select the strike price for your option depending on your level of bullishness or bearishness. In the first part of this series, Getting Started With Options , we discussed the basics of options such as terminology, rights and obligations, open interest, pricing, sentiment and expiration cycles.
Perhaps, the simplest option strategy to understand though not necessarily the simplest with which to make a profit may be the long call trade. A long call trade is often the first option strategy used by investors once they decide to venture into trading options. Unfortunately, long calls can often be difficult to trade profitably. A long call option is a bullish strategy , but unlike a long stock trade, you generally have to be right about more than just the direction of the underlying stock to be profitable.
As we discussed in part one of this series, the price of an option is based on many components. Three of these components are: To profit on a long call trade, you will need to be right about the direction of the underlying stock price movement and the number of points it moves in that direction, as well as how long it takes to make the move. Occasionally, you can be profitable if you are right on two of these three items, but direction alone is almost never enough.
The formula for these calculations on a long call trade assuming the position is held until expiration and a visual depiction of a profit-and-loss graph are illustrated below:. As you can see, while the maximum potential loss on a long call trade is the price paid for the option, the upside profit potential is theoretically unlimited.
However, keep in mind that because the option has a limited lifespan, the underlying stock will need to move up enough to cover the cost of the option and offset the erosion in time value and possibly even offset changes in volatility. These factors work against the owner of a long option, resulting in a much more difficult profit-and-loss scenario than you might think. Chart depicts strategy at expiration. An uncovered naked call trade is an extremely risky position, because while the profit if the stock drops in price is limited to the premium received at the time the option is sold, the upside risk is unlimited.
Similar to a long call trade, a long put trade is fairly straightforward. A long put option is a bearish strategy, but unlike a short stock trade, you generally have to be right about more than just the direction of the underlying stock in order to be profitable.
As with long calls, to be profitable, you will need to be right about the stock price movement direction and the magnitude and the time frame. You can occasionally be profitable if you are right on two of these three items, but direction alone is almost never enough. As with long calls, before you decide to enter a long put trade, be sure to find the maximum gain, maximum loss and breakeven points.
The formula for these calculations on a long put trade and a visual depiction of a profit-and-loss graph are illustrated below:. As you can see, while the maximum potential loss on a long put trade is the price paid for the option, the profit potential, as the stock drops in price, is significant.
However, keep in mind that because the option has a limited lifespan, the underlying stock will need to move down enough to cover the cost of the option and offset the erosion in time value and possibly even changes in volatility.
Although short naked puts are not quite as risky as short naked calls, they are still not a strategy for inexperienced option traders or traders without substantial risk capital. Selling a put creates a profit-and-loss scenario that is exactly the opposite of long put. An uncovered naked put trade is an extremely risky position, because while the profit if the stock rises in price is limited to the premium received at the time the option is sold, the downside risk can increase until the stock reaches zero.
Whether those strike prices are in, at, or out of the money will affect the magnitude of the underlying move needed to reach profitability and also determine whether the trade can be profitable if the underlying stock remains unchanged. The tables below illustrate how to properly structure a long or short option trade to match your level of bullishness or bearishness.
Keep in mind, both will generally require a bullish move in the underlying stock of extreme magnitude in order to reach profitability. By contrast, if you are only slightly bullish, you may want to consider ITM long calls or OOTM short puts, the latter of which can sometimes be profitable with no movement in the underlying stock.
In the same manner, if you are extremely bearish you may want to consider out-of-the-money OOTM long puts or in-the-money ITM short calls. Keep in mind, both will generally require a bearish move of extreme magnitude in the underlying stock in order to reach profitability.
By contrast, if you are only slightly bearish, you may want to consider ITM long puts, or OOTM short calls, the latter of which can sometimes be profitable with no movement in the underlying stock. In the case of OOTM short puts and OOTM short calls, because profitability is possible with no movement in the underlying stock, the potential profit will likely be very small.
The use of credit spreads is a much safer alternative while generally providing only slightly less profit potential. Hopefully, by now you have learned that you can take either a bullish or bearish position on an underlying instrument stock, exchange-traded fund [ETF] or an index using either calls or puts. It simply depends upon whether you buy or sell them first. Another important concept to understand is that when you pair stocks and options, your sentiment on the underlying stock does not change; you are simply using the option leg of the strategy to hedge your position or help generate additional income.
The table below helps to illustrate this point. I hope this enhanced your understanding of options. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. Options carry a high level of risk and are not suitable for all investors.
Certain requirements must be met to trade options through Schwab. Spread trading must be done in a margin account. Multiple leg strategies will involve multiple commissions. Please read the Options Disclosure Document titled " Characteristics and Risks of Standardized Options "before considering any option transaction.
Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss. Uncovered option writing and short selling are advanced trading strategies involving potentially unlimited risks, and must be done in a margin account. For the sake of simplicity, the examples in this presentation do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of strategies displayed.
Please contact a tax advisor for the tax implications involved in these strategies. Supporting documentation for any claims or statistical information is available upon request. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources.
However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Any written feedback or comments collected on this page will not be published. Skip to main navigation Skip to content. You are here Home Options. Key Points In this final installment of a two-part series, we review basic options trading strategies and how they can be used.
Discover more about long calls, short calls, long puts and short puts. Next Steps Schwab clients: Not yet a client? Leave this field blank. Talk trading with a Schwab specialist anytime. Call M-F, 8: Important Disclosures Options carry a high level of risk and are not suitable for all investors.More...