5 options trading strategies for beginners
Options are among the most popular vehicles for traders, because their price can move fast, making (or losing) a lot of money quickly. Options strategies can range from quite simple to very complex, with a variety of payoffs and sometimes odd names. (Iron condor, anyone?)
Regardless of their complexity, all options strategies are based on the two basic types of options: the call and the put.
Below are five popular options trading strategies, a breakdown of their reward and risk and when a trader might leverage them for their next investment. While these strategies are fairly straightforward, they can make a trader a lot of money — but they aren’t risk-free. Here are a few guides on the basics of call options and put options before we get started.
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5 options trading strategies for beginners
1. Long call
In this option trading strategy, the trader buys a call — referred to as “going long” a call — and expects the stock price to exceed the strike price by expiration. The upside on this trade is uncapped and traders can earn many times their initial investment if the stock soars.
Example: Stock X is trading for $20 per share, and a call with a strike price of $20 and expiration in four months is trading at $1. The contract costs $100, or one contract * $1 * 100 shares represented per contract.
Here’s the profit on the long call at expiration:
Reward/risk: In this example, the trader breaks even at $21 per share, or the strike price plus the $1 premium paid. Above $20, the option increases in value by $100 for every dollar the stock increases. The option expires worthless when the stock is at the strike price and below.
The upside on a long call is theoretically unlimited. If the stock continues to rise before expiration, the call can keep climbing higher, too. For this reason, long calls are one of the most popular ways to wager on a rising stock price.
The downside on a long call is a total loss of your investment, $100 in this example. If the stock finishes below the strike price, the call will expire worthless, and you’ll be left with nothing.
When to use it: A long call is a good choice when you expect the stock to rise significantly before the option’s expiration. If the stock rises only a little above the strike price, the option may still be in the money, but may not even return the premium paid, leaving you with a net loss.
2. Covered call
A covered call involves selling a call option (“going short”) but with a twist. Here the trader sells a call but also buys the stock underlying the option, 100 shares for each call sold. Owning the stock turns a potentially risky trade — the short call — into a relatively safe trade that can generate income. Traders expect the stock price to be below the strike price at expiration. If the stock finishes above the strike price, the owner must sell the stock to the call buyer at the strike price.
Example: Stock X is trading for $20 per share, and a call with a strike price of $20 and expiration in four months is trading at $1. The contract pays a premium of $100, or one contract * $1 * 100 shares represented per contract. The trader buys 100 shares of stock for $2,000 and sells one call to receive $100.
Here’s the profit on the covered call strategy:
Reward/risk: In this example, the trader breaks even at $19 per share, or the strike price minus the $1 premium received. Below $19, the trader would lose money, because the stock would lose money, more than offsetting the $1 premium. At exactly $20, the trader would keep the full premium and hang onto the stock, too. Above $20, the gain is capped at $100. While the short call loses $100 for every dollar increase above $20, it’s totally offset by the stock’s gain, leaving the trader with the initial $100 premium received as the total profit.
The upside on the covered call is limited to the premium received, regardless of how high the stock price rises. You can’t make any more than that, but you can lose a lot more. Any gain that you otherwise would have made with the stock’s rise is completely offset by the short call.
The downside is a complete loss of the stock investment, assuming the stock goes to zero, offset by the premium received. The covered call leaves you open to a significant loss if the stock falls. In our example, if the stock fell to zero, the total loss would be $1,900.
When to use it: A covered call can be a good options trading strategy to generate income if you already own the stock and don’t expect the stock to rise significantly in the near future. So the strategy can transform your already-existing holdings into a source of cash. The covered call is popular with older investors who need the income, and it can be useful in tax-advantaged accounts where you might otherwise pay taxes on the premium and capital gains if the stock is called.
Here’s more on the covered call, including its advantages and disadvantages.
3. Long put
In this beginning option trading strategy, the trader buys a put — referred to as “going long” a put — and expects the stock price to be below the strike price by expiration. The upside on this trade can be many multiples of the initial investment if the stock falls significantly.
Example: Stock X is trading for $20 per share, and a put with a strike price of $20 and expiration in four months is trading at $1. The contract costs $100, or one contract * $1 * 100 shares represented per contract.
Here’s the profit on the long put at expiration:
Reward/risk: In this example, the put breaks even when the stock closes at option expiration at $19 per share, or the strike price minus the $1 premium paid. Below $20, the put increases in value $100 for every dollar decline in the stock. Above $20, the put expires worthless and the trader loses the full premium of $100.
The upside on a long put is almost as good as on a long call, because the gain can be multiples of the option premium paid. However, a stock can never go below zero, capping the upside, whereas the long call has theoretically unlimited upside. Long puts are another simple and popular way to wager on the decline of a stock, and they can be safer than shorting a stock.
The downside on a long put is capped at the premium paid, $100 here. If the stock closes above the strike price at expiration of the option, the put expires worthless and you’ll lose your investment.
When to use it: A long put is a good choice when you expect the stock to fall significantly before the option expires. If the stock falls only slightly below the strike price, the option will be in the money, but may not return the premium paid, handing you a net loss.
4. Short put
This options trading strategy is the flip side of the long put, but here the trader sells a put — referred to as “going short” a put — and expects the stock price to be above the strike price by expiration. In exchange for selling a put, the trader receives a cash premium, which is the most a short put can earn. If the stock closes below the strike price at option expiration, the trader must buy it at the strike price.
Example: Stock X is trading for $20 per share, and a put with a strike price of $20 and expiration in four months is trading at $1. The contract pays a premium of $100, or one contract * $1 * 100 shares represented per contract.
Here’s the profit on the short put at expiration:
Reward/risk: In this example, the short put breaks even at $19, or the strike price less the premium received. Below $19, the short put costs the trader $100 for every dollar decline in price, while above $20, the put seller earns the full $100 premium. Between $19 and $20, the put seller would earn some but not all of the premium.
The upside on the short put is never more than the premium received, $100 here. Like the short call or covered call, the maximum return on a short put is what the seller receives upfront.
The downside of a short put is the total value of the underlying stock minus the premium received, and that would happen if the stock went to zero. In this example, the trader would have to buy $2,000 of the stock (100 shares * $20 strike price), but this would be offset by the $100 premium received, for a total loss of $1,900.
When to use it: A short put is an appropriate strategy when you expect the stock to close at the strike price or above at expiration of the option. The stock needs to be only at or above the strike price for the option to expire worthless, letting you keep the whole premium received.
Your broker will want to make sure you have enough equity in your account to buy the stock if it’s put to you. Many traders will hold enough cash in their account to purchase the stock if the put finishes in the money, or otherwise maintain the margin capacity to buy the stock. However, it’s possible to close out the options position before expiration and take the net loss without having to buy the stock directly.
This strategy may also be appropriate for longer-term investors who might like to buy the stock at the strike price, if the stock falls below that level, and receive a little extra cash for doing so.
5. Married put
This strategy is like the long put with a twist. The trader owns the underlying stock and also buys a put. This is a hedged trade, in which the trader expects the stock to rise but wants “insurance” in the event that the stock falls. If the stock does fall, the long put offsets the decline.
Example: Stock X is trading for $20 per share, and a put with a strike price of $20 and expiration in four months is trading at $1. The contract costs $100, or one contract * $1 * 100 shares represented per contract. The trader owns 100 shares of stock already and buys one put for $100.
Here’s the profit on the married put strategy:
Reward/risk: In this example, the married put breaks even at $21, or the strike price plus the cost of the $1 premium. Below $20, the long put offsets the decline in the stock dollar for dollar. Above $21, the total profit increases $100 for every dollar increase in the stock, though the put expires worthless and the trader loses the full amount of the premium paid, $100 here.
The maximum upside of the married put is theoretically uncapped, as long as the stock continues rising, minus the cost of the put. The married put is a hedged position, and so the premium is the cost of insuring the stock and giving it the opportunity to rise with limited downside.
The downside of the married put is the cost of the premium paid. As the value of the stock position falls, the put increases in value, covering the decline dollar for dollar. Because of this hedge, the trader only loses the cost of the option rather than the bigger stock loss.
When to use it: A married put can be a good choice when you expect a stock’s price to increase significantly before the option’s expiration, but you think it may have a chance to fall significantly, too. The married put allows you to hold the stock and enjoy the potential upside if it rises, but still be covered from substantial loss if the stock falls. For example, a trader might be awaiting news, such as earnings, that may drive the stock up or down, and wants to be covered.
How much money do you need to trade options?
If you’re looking to trade options, the good news is that it often doesn’t take a lot of money to get started. As in these examples, you could buy a low-cost option and make many times your money. However, it’s very easy to lose your money while “swinging for the fences.”
If you’re looking to get started, you could begin trading options with just a few hundred dollars. However, if you make a wrong bet, you could lose your whole investment in weeks or months. A safer strategy is to become a long-term, buy-and-hold investor and grow your wealth over time.
How to trade options
To start trading options, you’ll need to find a broker that offers options trading and then enable that feature on your account. You’ll need to answer a few questions about what kind of options trading you want to do, because some options strategies (such as selling puts and calls) are riskier than others, and you could lose more money than you put into the trade.
If you’re doing riskier trades, then the brokerage will require you to have a margin account, which allows you to purchase stock without having cash in the account. However, if you’re doing trades where your loss is limited to the capital you put in, you may not need to have margin. In these cases, you may be approved to trade some options without a margin account.
The requirements for options trading may differ at each broker — and some brokers don’t offer it at all — so you’ll need to investigate what each requires if you decide to enable that feature. However, even many of the best investment apps offer options trading, so you won’t have too much trouble gaining access.
And if you’re looking for free options trades — here are the best brokers for that.
Bottom line
While options are normally associated with high risk, traders can turn to several basic option trading strategies that have limited risk. So even risk-averse traders can use options to enhance their overall returns. However, it’s always important to understand the downside to any investment so that you know what you could possibly lose — and whether it’s worth the potential gain.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
