4 Ways to Trade Options
1. Covered Call Writing
A covered call is a strategy where you hold a long position in an asset and sell call options on that same asset. This approach is ideal for those who want to generate additional income from their holdings while being willing to sell the asset if the option is exercised.
How It Works: You own 100 shares of a stock and sell one call option contract for those shares. The premium received from selling the call option provides you with extra income. If the stock price exceeds the strike price, you may have to sell the stock at the strike price, but you keep the premium regardless.
Pros:
- Generates additional income through premiums.
- Reduces the cost basis of the stock.
Cons:
- Limits potential upside if the stock price rises significantly.
- Risk of losing stock if the option is exercised.
Example: Suppose you own 100 shares of XYZ Corporation, currently trading at $50. You sell a call option with a strike price of $55 for a premium of $2. If XYZ stays below $55, you keep the premium and can write another call option next month. If it goes above $55, you sell the stock at $55 but still benefit from the $2 premium.
2. Protective Put
A protective put involves buying a put option for an asset you already own. This strategy acts as an insurance policy against a decline in the asset’s price.
How It Works: You hold 100 shares of a stock and purchase one put option for those shares. If the stock price falls below the put option’s strike price, the value of the put option increases, offsetting the losses in the stock position.
Pros:
- Provides downside protection.
- Allows you to keep the stock if the price rebounds.
Cons:
- Requires payment of the put option premium.
- Limits potential gains if the stock price rises significantly.
Example: Suppose you own 100 shares of ABC Inc., trading at $80, and you buy a put option with a strike price of $75 for a premium of $3. If ABC’s price falls to $70, you can sell your shares at $75, reducing your loss compared to selling at the lower market price.
3. Iron Condor
An iron condor is an advanced options strategy that involves selling an out-of-the-money call and put, while simultaneously buying a further out-of-the-money call and put. This strategy is used to profit from low volatility and range-bound markets.
How It Works: You sell a call option with a higher strike price, buy a call option with an even higher strike price, sell a put option with a lower strike price, and buy a put option with an even lower strike price. The goal is to profit from the price staying within a specific range.
Pros:
- Limited risk and reward.
- Profits from stable price movements.
Cons:
- Limited profit potential.
- Requires precise market movement predictions.
Example: You set up an iron condor on DEF Corporation, with a stock price of $60. You sell a $65 call and a $55 put, and buy a $70 call and a $50 put. If DEF’s stock remains between $55 and $65 until expiration, you keep the premiums from the options sold, minus the cost of the options bought.
4. Straddle
A straddle is a strategy used when you expect significant price movement but are unsure of the direction. It involves buying both a call and put option with the same strike price and expiration date.
How It Works: You purchase a call and put option with the same strike price on the same asset. The potential for profit arises if the asset moves significantly in either direction.
Pros:
- Profits from large price movements in either direction.
- No need to predict the direction of the move.
Cons:
- Requires higher premiums due to buying both call and put options.
- Can result in losses if the asset remains relatively stable.
Example: You expect a significant move in GHI Corp., which is trading at $100. You buy both a $100 call and a $100 put option. If GHI’s stock moves to $120 or $80, you can profit from the movement, but if it stays around $100, you may lose money on the premiums paid.
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