4 Basic Options Trading Strategies
Trading in options nets you contracts to buy or sell a stock at a specific price on an agreed-upon date. So unlike trading in stocks, where everyone can independently purchase shares, options trading is more like roulette. Options are usually seen as a tool for making quick money, but with the right knowledge of the market anyone can play the game.
What Are Options?
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The two types of options are calls and puts. The difference between a call vs put has to do with whether you are buying or selling the option. Call options allow you to buy a stock at a set price on a set date. Put options allow you to sell a stock at a set price on a set date. Profit is gained from the difference between the price of the contract you buy and the final price of the stock. The starting price of a stock when a contract is written is called the strike price.
In a long put, you are expecting the stock to fall from its strike price by the time the put expires. With a long put, you buy the stock for profit at the difference between the premium you pay for the contract and the amount the stock has fallen below the original strike price. If the strike price rises at the time of expiration, then the premium you paid for the contract is lost. This option type should be used if you expect the price to fall.
A short put is the opposite of a long put. The holder of the asset sells a put assuming the strike price is going to rise and receives the cash premium. The only profit gained in this option would be the premium. However, it is a safer position than a long put because the premium is received upfront. This strategy is preferable when you think a stock is going to rise by the end of the contract.
A long call has the potential to earn magnitudes greater than the initial investment. In a long call, the trader buys a call expecting that a stock will rise by the expiration. When the trader buys a call, the optimal outcome is that the stock will rise greater than the strike price plus their contract cost, leaving them with a virtually uncapped profit. However, if the stock falls below the strike price then the investment is lost.
A covered call is an option with a bit of a twist on the short call. It allows the trader to minimize risk while maximizing profit potential. This entails buying shares in the stock you write a call option to sell on. You will be generating passive income from the shares held as an asset with the potential for greater return if the strike price falls.
As a new trader in options, there are many choices on how to proceed based on your market knowledge. Options are an excellent tool that you can add to your repertoire to round out your investment earnings potential.