Six key strategies for trading options

Whether you’re looking to help protect your portfolio, generate extra income, or just have a feeling that a stock is going to make a move either up or down, you might consider trading options.

The safety net - portfolio protection

1. Protective put

This options strategy can be used for times when you own a stock, but feel nervous about its price dropping.

• How it works: You buy a ‘put option’ for a stock that you own which you think may drop in value. This assigns a known floor price for the stock, below which no added money can be lost if the value falls. For this you pay a fee, known as a premium.
• Why use it: This strategy is like buying a protection policy for your stock - and for your wallet - if the market dips.  

Example: You own 100 shares of stock A, currently trading at $50 each. You’re worried it might drop, so you buy a put option at $45 per share. If stock A falls to $40, your put option increases in value, helping to offset the losses on your stock.

2. Collar

A collar strategy can be used if you're optimistic about a stock you own in the longer-term, but worry about short-term volatility in the market. It involves two components - the put option discussed above, and a call option.

• How it works: You buy a put option for a stock you own to limit potential losses. To offset the cost of this, you can also sell a ‘call option’ for a later date. This is a contract between a buyer and seller to exchange a security at a set price at an agreed point in time. This can normally be done for a small cost, no cost or sometimes even a small credit.  
• Why use it: The collar strategy can be useful for investors who want to lock in gains for the longer-term while minimizing losses in the short term.

Example: Suppose you own 100 shares of Stock C at $50 each and want to protect against any downturns. You buy a put option at $45 (for downside protection) and sell a call option at $55. If the stock price drops, your put option value rises, keeping your losses in check. But if it jumps above $55, you sell it at that price, securing some income while staying protected. Safety first!

Income generation

3. Covered call

A collar strategy encompasses both a put and call option, but selling a call option can be used as an options trading strategy all on its own. Known as a covered call, when you use this strategy successfully it can kind of be like getting paid rent on stocks you already own.

• How it works: You sell a call option on a stock you own, in return for a premium. If the option ‘expires’ (passes the agreed duration of time) below the agreed price (or ‘strike price’), you get to keep the premium and retain your shares. There is a risk however - if the option expires above the agreed strike price, the buyer only has to pay you what you previously agreed.
• Why use it: If used successfully, a covered call strategy can be a great way to generate income.

Example: You own shares of Stock B, currently trading at $60. You sell a call option with a strike price of $65. If the stock doesn’t reach $65 by an agreed expiration date, you keep the stocks and premium.

However, if the stock ends up reaching $67 by the agreed expiration date, you still have to sell at $65, meaning you miss out on the extra $2. But you still get to keep the premium!

Take a chance - speculation

4. Long call

This gives you the right (but not the obligation) to buy a stock at a set price if it goes up.

• How it works: Above we looked at what happens when you sell a call option. If you are using the long call strategy when investing with options, you buy a call option. This gives you the right to purchase the stock at an agreed price, if it rises. However - it’s important to note that if the stock doesn’t go up, you will lose any premium you paid.
• Why use it: A long call allows you to bet on a stock’s rise without having to buy it outright. Your potential loss is limited to the premium, but your potential gain may be much higher.

Example: Let’s say Stock C is currently priced at $40. You think it’s going to skyrocket, so you buy a call option with a strike price of $45. If the stock shoots up to $60, you can exercise your option and buy at $45 - pocketing the difference. Or just sell the call option as it will have increased in value, like trading shares.

5. Long put

A long put strategy is a way to profit from falling stock prices without having to own the stock.

• How it works: You buy a put option, which gives you the right (but not the obligation) to sell a stock at a specific strike price. If the stock price drops below the strike price, you can sell the stock at the higher strike price and make a profit. The lower the stock goes, the more your put option is worth.
• Why use it: If you believe a stock or market is going to fall, a long put lets you benefit from that downturn. Again, the most you can lose is the premium you paid.

Example: You own 100 shares of stock A, currently trading at $40 each. You think this may drop in value so buy a put option at $35 per share. Then, if you are correct and stock A falls to $30, you sell and pocket the extra $5.

6. Long strangle

The long strangle strategy can help you prepare for any big market surprise.

• How it works: You buy a call option (to profit if the stock goes up) and a put option (for a potential win if the stock drops) with different strike prices but the same expiration date. If the stock price moves large enough in either direction, one of the options will increase in value, offsetting the cost of both.
• Why use it: Expecting a major move? The long strangle helps you benefit no matter if it’s a rise or fall, with limited risk (only the premium you paid for the call or put option).

Example: Let’s say Stock B is trading at $50, and you sense it’s about to swing but don’t know which way. You buy a $55 call option and a $45 put option. If the stock moves up past $55 or down below $45 by more than the combined cost, you could be in territory.

For more information on trading options with CommSec, click here. Or to open a CommSec Options Account, login and add ‘options’ to your list of accounts.

You can view the Exchange Traded Options Product Disclosure Statement and Terms and Conditions, and Financial Services Guide and should consider them before making any decision about these products and services. There can be high levels of risk associated with trading in Options; only investors familiar with the risks of Options trading should consider these products.

The target market for this product can be found within the product’s Target Market Determination, available here.