Option Strategies Bullish Limited Risk Bullish Unlimited Risk Bearish Limited Risk Bearish Unlimited Risk Neutral Limited Risk Neutral Limited Risk Buy Call Bull Call Spread Bull Put Spread Call Ratio Backspread     Buy Stock Sell Put Covered Call Call Ratio Spread       Buy Put Bear Put Spread Bear Call Spread Put Ratio Backspread       Sell Stock Sell Call Covered Put Put Ratio Spread       Long Straddle Long Strangle Long Synthetic Straddle Put Ratio Spread Long Butterfly Long Condor Long Iron Butterfly Short Straddle Short Strangle Call Ratio Spread Put Ratio Spread

Covered Call Strategy vs. Long Stock Strategy Market Scenario Covered Call Long Stock Stock price increases:  Call is exercised and the underlying stock shares are sold at the call's strike price. Stock price remains stable: Call expires worthless and the trader still owns the stock shares. Stock price decreases:  Call expires worthless and the trader still owns the stock shares. Profits are limited to the premium received on the short call plus the profit made from the difference between the stock's price at initiation and the call strike price. Profits are limited to the premium received on the short call. The breakeven on the stock is lowered by the premium received on the short call.  Profits may be garnered if the stock is sold at the higher price.     No profit is made.   Losses accumulate as the stock price declines below the initial price paid for the stock.

Strategy:  Buy the underlying security and sell an OTM call option. Market Opportunity:  Look for a bullish to neutral market where a slow rise in the price of the underlying is anticipated with little risk of decline. Maximum Risk:  Virtually unlimited to the downside below the breakeven all the way to zero. Maximum Profit:  Limited to the credit received from the short call option + [short call strike price - price of long underlying asset] times value per point. Breakeven:  Price of the underlying asset at initiation - short call premium received. Margin:  Required. The amount is subject to your broker's discretion.

Vertical Spread Options Strategies   Since all markets have the potential to fluctuate beyond their normal trend, it is essential to learn how to use strategies that limit your losses to a manageable amount. There are a variety of options strategies that can be employed to hedge risk and leverage capital. Each strategy has an optimal set of circumstances that trigger its application in a particular market. Vertical spreads are the most basic limited risk strategies and that's why they are often introduced relatively early. These simple hedging strategies enable traders to take advantage of the way options premiums change in relation to movement in the underlying asset. Vertical spreads combine long and short options with different strike prices and the same expiration date to profit on a directional move in the price of the underlying asset. They offer limited potential profits as well as limited risks. One of the keys to understanding these managed risk spreads comes from grasping the concepts of intrinsic value and time value-variables that provide major contributions to the fluctuating price of an option. In order to understand these important concepts, let's take a closer look at the components that affect option pricing.

Bull Call Spread Options Strategies A bull call spread is a debit spread created by purchasing a lower strike call and selling a higher strike call with the same expiration dates. This strategy is best implemented in a moderately bullish market to provide high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying asset. However, the total investment is usually far less than that required to purchase the stock. The strategy has both limited profit potential and limited downside risk. Steps to Using a Bull Call Spread     1.  Look for a moderately bullish market where you anticipate a modest increase in the price of the underlying stock-not a large move.     2.  Check to see if this stock has options.     3.  Review call options premiums per expiration dates and strike prices.     4.  Investigate implied volatility values to see if the options are overpriced or undervalued.     5.  Explore past price trends and liquidity by reviewing price and volume charts over the last year.     6.  Choose a lower strike call to buy and a higher strike call to sell with the same expiration date.     7.  Calculate the maximum potential profit by multiplying the value per point by the difference in strike prices and subtracting the net debit paid.     8.  Calculate the maximum potential risk by figuring out the net debit of the two option premiums.     9.  Calculate the breakeven by adding the lower strike price to the net debit.     10.  Create a risk profile for the trade to graphically determine the trade's feasibility.     11.  Write down the trade in your trader's journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.     12.  Contact your broker to buy and sell the chosen call options.     13.  Watch the market closely as it fluctuates. The profit on this strategy is limited-a loss occurs if the underlying stock closes at or below the breakeven point.     14.  To exit the trade, you need to sell the lower strike call and buy the higher strike call or simply let the options expire. The maximum profit occurs when the underlying stock rises above the short call strike price. If and when the short call is exercised by the assigned option holder, you can exercise the long call and deliver those shares to the option holder at the lower long call price, pocketing the difference plus the premium from the short call.

Bull Put Spread Options Strategies   A bull put spread is a credit spread created by purchasing a lower strike put and selling a higher strike put with the same expiration dates. This strategy is best implemented in a moderately bullish market to provide high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying. However, the total investment is usually far less than that required to buy the stock shares. The strategy has both limited profit potential and limited downside risk. Steps to Using a Bull Put Spread     1.  Look for a moderately bullish market where you anticipate a modest increase in the price of the underlying stock-not a large move.     2.  Check to see if this stock has options.     3.  Review put options premiums per expiration dates and strike prices.     4.  Investigate implied volatility values to see if the options are overpriced or undervalued.     5.  Explore past price trends and liquidity by reviewing price and volume charts over the last year.     6.  Choose a lower strike put to buy and a higher strike put to sell with the same expiration date.     7.  Calculate the maximum potential profit by computing the net credit of the two option premiums.     8.  Calculate the maximum potential risk by multiplying the value per point by the difference in strike prices and subtracting the net credit received.     9.  Calculate the breakeven by subtracting the net credit from the higher strike price.     10.  Create a risk profile for the trade to graphically determine the trade's feasibility.     11.  Write down the trade in your trader's journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.     12.  Contact your broker to buy and sell the chosen put options.     13.  Watch the market closely as it fluctuates. The profit on this strategy is limited-a loss occurs if the underlying stock falls to or below the breakeven point.     14.  To exit the trade, you need to sell the lower strike put and buy the higher strike put or simply let the options expire.

Covered Put Strategy Strategy: Sell the underlying security and sell an OTM put option. Market Opportunity: Look for a bearish or stable market where a decline in the price of the underlying is anticipated with little risk of the market rising. Maximum Risk:  Unlimited to the upside. Maximum Profit:  Limited to the credit received on the short put option plus (price of the short underlying asset - put option strike price) times the value per point Breakeven: Price of the underlying asset + short put premium received. Margin:  Required. The amount is subject to your broker's discretion.

 

What Affects Equity Option Prices?

    1.  The current price of the underlying financial instrument
    2.  The strike price of the option in comparison to the current market price (intrinsic value)
    3.  The type of option (put or call)
    4.  The amount of time remaining until expiration (time value)
    5.  The current risk-free interest rate
    6.  The volatility of the underlying financial instrument
    7.  The dividend rate, if any, of the underlying financial instrument

Each of these factors plays a unique part in the price of an option. In most cases, the first 4 are pretty easy to figure out. The rest are often forgotten or overlooked. However, although they may be a little confusing, each is important. For example, when it comes to trading with options, reviewing volatility levels can help traders determine the right options strategy to employ.

In addition, it is noteworthy to assess the current risk-free interest rate and whether or not a particular stock is prone to the release of dividends. Higher interest rates can increase option premiums, while lower interest rates can lead to a decrease in option premiums. Dividends act in a similar way, increasing and decreasing an option premium as they increase or decrease the price of the underlying asset. Also, if a stock were to pay a dividend, a short seller would be responsible for that payment. This means that a short seller in securities not only has unlimited risk of the stock price rising, but also is responsible for the dividends paid out.
 

Volatility
 
Volatility is one of the most important factors in an option's price. It measures the amount by which an underlying asset is expected to fluctuate in a given period of time. It significantly impacts the price of an option's premium and heavily contributes to an option's time value. In basic terms, volatility can be viewed as the speed of change in the market, although you may prefer to think of it as market confusion. The more confused a market is, the better chance an option has of ending up in-the-money. A stable market moves slowly. Volatility measures the speed of change in the price of the underlying instrument or the option. The higher the volatility, the more chance an option has of becoming profitable by expiration. That's why volatility is a primary determinant in the valuation of options' premiums. There are options strategies that can be used to take advantage of either scenario.
 

Liquidity
 
Options strategies must be applied in specific market conditions to be money-makers. Liquidity is one of these market conditions. Liquidity is the ease with which a market can be traded. A plentiful number of buyers and sellers boosts the volume of trading producing a liquid market. Liquidity allows traders to get their orders filled easily as well as to quickly exit a position.

The best way to discover which markets have liquidity is to actually visit an exchange. The pits where you see absolute chaos are markets with liquidity. As long as there are plenty of floor traders screaming and yelling out orders as if their lives depended on it, you will probably have no problem getting in and out of a trade. However, I tend to avoid the pits where the floor traders are falling asleep as they read the newspapers. These are obviously illiquid markets and it would not be a wise move to place an options-based trade there.

If you don't have the ability to actually visit an exchange, you can still check out the liquidity of a market by reviewing the market's volume to see how many shares have been bought and sold in one day. As a rule of thumb, I choose markets that trade at least 300,000 shares a day, although one million shares a day is even better. It is also vital to ascertain whether or not trading volume is increasing or decreasing. This kind of volume movement is studied to indicate turning points in market price action. You can also monitor liquidity by monitoring the buying and selling of block trades-orders of 5,000 shares at a time-by institutional traders.
 

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