Stock Option Trading Strategies

Basic options trading options strategies for beginners. When you buy options you deal with predetermined risk and unlimited profit potential. You know, for example, that in the worse situation you lose 100% of your capital, but the loss will be limited to the premium paid for options which is a fraction of money required to purchase stocks outright. The probability of a winning trade heavily favors the seller of options rather than a buyer. In fact, available statistics suggest that a buyer of options loses four out of five times. One of the reasons for this is that most investors pay heavily for the time premium of options and only rarely pay for the intrinsic value. The section below describes the strategies aimed at increasing the probabilities of success including “spread” combination.

Option Purchase Strategies

Purchase of the proper option
Option purchases are done by investors whose assessment of the market is either strongly bullish, in the case of Call purchases, or strongly bearish, in the case of Put purchases. This strategy carries an unlimited profit potential with a limited risk.
The biggest problem an investor has to solve is the purchase of a proper option. Let’s assume that IBM stock sells at $75 a share and you can buy the following IBM July Calls: IBM 70 (in the money), IBM 75 (at the money) and IBM 80 (out of the money). Which option should you buy? An investor always wants to pay the cheapest price. The cheapest Call will be IBM 80, the most expensive Call will be IBM 70. When it comes to options, the cheapest price, however, usually means a total loss. You have to answer the question, “How many cents will the price of the option increase for every one dollar increase in price of the underlying stock?”
In the case described above, an IBM 70 Call will increase $0.75, an IBM 75 will increase $0.50 and an IBM 80 Call will increase $0.125. These figures also represent the probability of success. In other words an IBM 70 Call has the 75% probability of success, IBM 75 50% and IBM 80 12.5%. Therefore, its clear you should be buying the most expensive option (IBM 70) as it gives you the highest probability of success at 75%.

Spread Strategy

The spread strategy is used by investors whose assessment of the market is mildly bullish, as in the case of Call spread, and mildly bearish, as in the case of Put spread. This strategy carries a limited profit potential with a limited risk.
A spread involves being both the buyer and writer of the same type of option (Puts or Calls) on the same underlying stock with the options having different exercise prices and and/or expiration dates. The two most commonly used spread strategies are called vertical and calendar spreads.
The vertical spread strategy takes advantage of the relationship between the stock and strike prices. The calendar spread takes advantage of the time component in option pricing. Investors “buy the difference” when the option premium paid is larger than the option premium received (debit transaction). They “sell the difference” when the option premium received is larger than the premium paid (credit transaction). Investors make a profit when the premium difference:
– expands, in the case of “buying the difference”,
– shrinks, in the case of “selling the difference”.
Practically all calendar spreads start as a debit transaction because an investor establishes a short position in options expiring nearby and a long position in options expiring further out. As already discussed, the premium for further out options is always larger than for the premium for nearby options. The premium difference between the two should expand as the time premium of options approaching expiration evaporates much more rapidly than the options which still have several months of life in them.

The example below illustrates a calendar spread. In setting up a calendar spread, the advantage is taken of the fact that an option nearing its expiration loses the time premium much faster than an option which has several months of “life” in it. Let’s assume that at the beginning of May IBM trades for $70 a share and the July and October Calls with a strike price of $70 trade for $4 and $6 respectively. An investor sets up a calendar spread by selling one July Call and buying one October Call for a debit of $2. In the next two months, the July Call will fetch $0.50 and the October Call $4 provided the prices of IBM do not change. An investor will unwind the spread with a $3.50 credit by simply repurchasing short July Call and selling long October Call. The profit is equaled to $1.50 or 75%.
The advantage of doing a spread is the price reduction of the resulting entity, as well as the vast improvement in the probability of success. The disadvantage of this strategy is a limited, even though quite huge profit.
The following is an example of vertical spread. Let’s assume that when an ABC stock is selling at $112 a share, an ABC May 105 Call sells at $9 and an ABC May 115 Call sells at $2.5. The intrinsic value of ABC 105 Call equals $7 and an ABC 115 Call doesn’t have any intrinsic value.

The proper strategy would be to purchase an ABC 105 Call for $9 and; simultaneously sell an ABC 115 Call for $2.50. The net cost of a spread; would be $6.50 or $0.50 below the intrinsic value of an ABC Call.
If the price of the ABC stock doesn’t change you would make $0.50 on the transaction. The most you could ever make would be at the time when your ABC stock sells at $115 or above. You would make $3.50 on your investment of $6.50 or a little more than 50%. You would start losing money at the time the ABC stock declines below $111.50 a share ($105 + $6.50 = $111.50). You would lose 100% of your capital with an ABQ stock declining below $105 a share. If you would buy just an ABC 105 Call instead of doing a spread strategy, your option would cost you $9 or almost 50% more than a spread and your ABC stock would have to sell at $114 to break even. On the other hand your profit potential would be unlimited.
An investor, depending on his market assessment, may choose various strategies of trade options which are shown in Table below.

Strongly Bullish

Buy CALL

Mildly Bullish

Sell PUT

Buy CALL Spread

Sell PUT Spread

Stable

Sell Straddle

(Sell CALL and PUT)

Volatile

Buy Straddle

(Buy CALL andPUT)

Mildly

Sell CALL

Sell CALL Spread

Buy PUT Spread

Strongly

Buy PUT

Sell Naked CALL

In the section above, the option strategies described aim at increasing the probability of success. Well thought out investments in options could indeed be very profitable. They require discipline, patience and sizable capital.