Options Trading

Options are generally divided into "call" and "put" contracts. With a call option, the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price, called exercise price or strike price. With a put option, the buyer acquires the right to sell the underlying asset in the future at the predetermined price.

Let's take a look at some basic strategies that a beginner investor can use with calls or puts to limit their risk. The first two involve using options to place a direction bet with a limited downside if the bet goes wrong. The others involve hedging strategies laid on top of existing positions.

---

Buying Calls (Long Calls)

There are some advantages to trading options for those looking to make a directional bet in the market. If you think the price of an asset will rise, you can buy a call option using less capital than the asset itself. At the same time, if the price instead falls, your losses are limited to the premium paid for the options and no more. This could be a preferred strategy for traders who:

Are "bullish" or confident about a particular stock, exchange-traded fund (ETF), or index fund and want to limit risk Want to utilize leverage to take advantage of rising prices Options are essentially leveraged instruments in that they allow traders to amplify the potential upside benefit by using smaller amounts than would otherwise be required if trading the underlying asset itself. So, instead of laying out $10,000 to buy 100 shares of a $100 stock, you could hypothetically spend, say, $2,000 on a call contract with a strike price 10% higher than the current market price.

Risk/Reward

The trader's potential loss from a long call is limited to the premium paid. Potential profit is unlimited because the option payoff will increase along with the underlying asset price until expiration, and there is theoretically no limit to how high it can go.

Buying Puts (Long Puts)

If a call option gives the holder the right to purchase the underlying at a set price before the contract expires, a put option gives the holder the right to sell the underlying at a set price. This is a preferred strategy for traders who:

* Are bearish on a particular stock, ETF, or index, but want to take on less risk than with a short-selling strategy
* Want to utilize leverage to take advantage of falling prices

---

A put option works effectively in the exact opposite direction from the way a call option does, with the put option gaining value as the price of the underlying decreases. Though short-selling also allows a trader to profit from falling prices, the risk with a short position is unlimited because there is theoretically no limit to how high a price can rise. With a put option, if the underlying ends up higher than the option's strike price, the option will simply expire worthless.

Covered Calls

Unlike the long call or long put, a covered call is a strategy that is overlaid onto an existing long position in the underlying asset. It is essentially an upside call that is sold in an amount that would cover that existing position size. In this way, the covered call writer collects the option premium as income, but also limits the upside potential of the underlying position. This is a preferred position for traders who:

* Expect no change or a slight increase in the underlying's price, collecting the full option premium
* Are willing to limit upside potential in exchange for some downside protection

A covered call strategy involves buying 100 shares of the underlying asset and selling a call option against those shares. When the trader sells the call, the option's premium is collected, thus lowering the cost basis on the shares and providing some downside protection. In return, by selling the option, the trader is agreeing to sell shares of the underlying at the option's strike price, thereby capping the trader's upside potential.

---

Protective Puts

A protective put involves buying a downside put in an amount to cover an existing position in the underlying asset. In effect, this strategy puts a lower floor below which you cannot lose more. Of course, you will have to pay for the option's premium. In this way, it acts as a sort of insurance policy against losses. This is a preferred strategy for traders who own the underlying asset and want downside protection

Thus, a protective put is a long put, like the strategy we discussed above; however, the goal, as the name implies, is downside protection versus attempting to profit from a downside move. If a trader owns shares with a bullish sentiment in the long run but wants to protect against a decline in the short run, they may purchase a protective put.

If the price of the underlying increases and is above the put's strike price at maturity, the option expires worthless and the trader loses the premium but still has the benefit of the increased underlying price. On the other hand, if the underlying price decreases, the trader’s portfolio position loses value, but this loss is largely covered by the gain from the put option position. Hence, the position can effectively be thought of as an insurance strategy.

Long Straddles

Buying a straddle lets you capitalize on future volatility but without having to take a bet whether the move will be to the upside or downside—either direction will profit.

Here, an investor buys both a call option and a put option at the same strike price and expiration on the same underlying. Because it involves purchasing two at-the-money options, it is more expensive than some other strategies.