Because options prices are dependent upon the prices of their underlying securities, options can be used in various combinations to earn profits with reduced risk. Below is a list of the most common strategies, but there are many more—infinitely more. But this list will give you an idea of the possibilities. Any investor contemplating these strategies should keep in mind the risks, which are more complex than with simple stock options, the tax consequences, the margin requirements, and the commissions that must be paid to effect these strategies. One particular risk to remember is that any American-style options — which are most options where the exercise must be settled by delivering the underlying asset rather than by paying cash — that you write can be exercised at any time; thus, the consequences of being assigned an exercise before expiration must be considered. (The examples in this article ignore transaction costs.)
The simplest option strategy is the covered call, which simply involves writing a call for stock already owned. If the call is unexercised, then the call writer keeps the premium, but retains the stock, for which he can still receive any dividends. If the call is exercised, then the call writer gets the exercise price for his stock in addition to the premium, but he foregoes the stock profit above the strike price. A more complete discussion can be found at Covered Calls.
On October 6, 2006, you own 1,000 shares of Microsoft stock, which is currently trading at $27.87 per share. You write 10 call contracts for Microsoft with a strike price of $30 per share that expire in January, 2007. You receive .35 per share for your calls, which equals $35.00 per contract for a total of $350.00. If Microsoft doesn’t rise above $30, you get to keep the premium as well as the stock. If Microsoft is above $30 per share at expiration, then you still get $30,000 for your stock, and you still get to keep the $350 premium.
A stockholder buys protective puts for stock already owned to protect his position by minimizing any loss. If the stock rises, then the put expires worthless, but the stockholder benefits from the rise in the stock price. If the stock price drops below the strike price of the put, then the put’s value increases 1 dollar for each dollar drop in the stock price, thus, minimizing losses. The net payoff for the protective put position is the value of the stock plus the put, minus the premium paid for the put.
Protective Put Payoff = Stock Value + Put Value – Put Premium
Using the same example above for the covered call, you instead buy 10 put contracts at $0.25 per share, or $25.00 per contract for a total of $250 for the 10 puts with a strike of $25 that expires in January, 2007. If Microsoft drops to $20 a share, your puts are worth $5,000 and your stock is worth $20,000 for a total of $25,000. No matter how far Microsoft drops, the value of your puts will increase proportionately, so your position will not be worth less than $25,000 before the expiration of the puts—thus, the puts protect your position.
A collar is the use of a protective put and covered call to collar the value of a security position between 2 bounds. A protective put is bought to protect the lower bound, while a call is sold at a strike price for the upper bound, which helps pay for the protective put. This position limits an investor’s potential loss, but allows a reasonable profit. However, as with the covered call, the upside potential is limited to the strike price of the written call.
On October 6, 2006, you own 1,000 shares of Microsoft stock, which is currently trading at $27.87 per share. You want to hang onto the stock until next year to delay paying taxes on your profit, and to pay only the lower long-term capital gains tax. To protect your position, you buy 10 protective puts with a strike price of $25 that expires in January, 2007, and sell 10 calls with a strike price of $30 that also expires in January, 2007. You get $350.00 for the 10 call contracts, and you pay $250 for the 10 put contracts for a net of $100. If Microsoft rises above $30 per share, then you get $30,000 for your 1,000 shares of Microsoft. If Microsoft should drop to $23 per share, then your Microsoft stock is worth $23,000, and your puts are worth a total of $2,000. If Microsoft drops further, then the puts become more valuable — increasing in value in direct proportion to the drop in the stock price below the strike. Thus, the most you’ll get is $30,000 for your stock, but the least value of your position will be $25,000. And since you earned $100 net by selling the calls and writing the puts, your position is collared at $25,100 below and $30,100. Note, however, that your risk is that the written calls might be exercised before the end of the year, thus forcing you, anyway, to pay short-term capital gains taxes in 2007 instead of long-term capital gains taxes in 2008.
A long straddle is established by buying both a put and call on the same security at the same strike price and with the same expiration. This investment strategy is profitable if the stock moves substantially up or down, and is often done in anticipation of a big movement in the stock price, but without knowing which way it will go. For instance, if an important court case is going to be decided soon that will have a substantial impact on the stock price, but whether it will favor or hurt the company is not known beforehand, then the straddle would be a good investment strategy. The greatest loss for the straddle is the premiums paid for the put and call, which will expire worthless if the stock price doesn’t move enough.
To be profitable, the price of the underlier must move substantially before the expiration date of the options; otherwise, they will expire either worthless or for a fraction of the premium paid. The straddle buyer can only profit if the value of either the call or the put is greater than the cost of the premiums of both options.
A short straddle is created when one writes both a put and a call with the same strike price and expiration date, which one would do if she believes that the stock will not move much before the expiration of the options. If the stock price remains flat, then both options expire worthless, allowing the straddle writer to keep both premiums.
A strap is a specific option contract consisting of 1 put and 2 calls for the same stock, strike price, and expiration date. A strip is a contract for 2 puts and 1 call for the same stock. Because strips and straps are 1 contract for 3 options, they are also called triple options, and the premiums are less then if each option were purchased individually. See Straddles and Strangles: Non-Directional Option Strategies for more in-depth coverage.
Example—Long Straddle and Short Straddle
Merck is embroiled in potentially thousands of lawsuits concerning VIOXX, which was withdrawn from the market. On October, 31, 2006, Merck’s stock was trading at $45.29, near its 52-week high. Merck has been winning and losing the lawsuits. If the trend goes one way or the other in a definite direction, it could have a major impact on the stock price, and you think it might happen before 2008, so you buy 10 puts with a strike price of $40 and 10 calls with a strike price of $50 that expire in January, 2008. You pay $2.30 per share for the calls, for a total of $2,300 for 10 contracts. You pay $1.75 per share for the puts, for a total of $1,750 for the 10 put contracts. Your total cost is $4,050 plus commissions. On the other hand, your sister, Sally, decides to write the straddle, receiving the total premium of $4,050 minus commissions.
Let’s say, that, by expiration, Merck is clearly losing; it’s stock price drops to $30 per share. Your calls expire worthless, but your puts are now in the money by $10 per share, for a net value of $10,000. Therefore, your total profit is almost $6,000 after subtracting the premiums for the options and the commissions to buy them, as well as the exercise commission to exercise your puts. Your sister, Sally, has lost that much. She buys the 1,000 shares of Merck for $40 per share as per the put contracts that she sold, but the stock is only worth $30 per share, for a net $30,000. Her loss of $10,000 is offset by the $4,050 premiums that she received for writing the straddle. Your gain is her loss. (Actually, she lost a little more than you gained, because commissions have to be subtracted from your gains and added to her losses.) A similar scenario would occur if Merck wins, and the stock rises to $60 per share. However, if, by expiration, the stock is less than $50 but more than $40, then all of your options expire worthless, and you lose the entire $4,050 plus the commissions to buy those options. For you to make any money, the stock would either have to fall a little below $36 per share or rise a little above $54 per share to compensate you for the premiums for both the calls and the puts and the commission to buy them and exercise them.
A spread is established by buying or selling various combinations of calls and puts, at different strike prices and/or different expiration dates on the same underlying security. There are many possibilities of spreads, but they can be classified based on a few parameters.
The money earned writing options lowers the cost of buying long option positions, and may even be profitable. A credit spread results from buying a long position that costs less than the premium received selling the short position of the spread; a debit spread results when the long position costs more than the premium received for the short position — nonetheless, the debit spread still lowers the cost of the position.
A money spread, or vertical spread, involves the buying of options and the writing of other options with different strike prices, but with the same expiration dates.
A time spread, or calendar spread, involves buying and writing options with different expiration dates. A horizontal spread is a time spread with the same strike prices. A diagonal spread has different strike prices and different expiration dates.
A bullish spread increases in value as the stock price increases, whereas a bearish spread increases in value as the stock price decreases.
Example — Bullish Money Spread
On October 6, 2006, you buy, for $850, 10 calls for Microsoft, with a strike price of $30 that expires in April, 2007, and you write 10 calls for Microsoft with a strike price of $32.50 that expires in April, 2007, for which you receive $200. At expiration, if the stock price stays below $30 per share, then both calls expire worthless, which results in a net loss, excluding commissions, of $650 ($850 paid for long calls - $200 received for written short calls). If the stock rises to $32.50, then the 10 calls that you purchased are worth $2,500, and your written calls expire worthless. This results in a net $1,850 ($2,500 long call value + $200 premium for short call - $850 premium for the long call). If the price of Microsoft rises above $32.50, then you exercise your long call to cover your short call, netting you the difference of $2,500 plus the premium of your short call minus the premium of your long call minus commissions.