Options trading allows you to profit from any type of market, whether it's moving up, moving down or treading water. An option strategy involves combining several different contracts into a single trade, and you may buy some and sell others to produce a profit if the market moves as predicted. About three dozen different, creatively named strategies can be used, requiring you to just select the specific options you want to use, designate the strategy in your brokerage account and place the trade.
Puts and Calls, Buying and Selling
Options come in two flavors. Calls give the buyer the right to buy a stock at a preset share price, and puts come with the right to sell at the designated price. Options are time limited, and a single stock, exchange-traded fund or stock index will have many different puts and calls trading with different strike prices and expiration dates. Traders can take either side of an options trade, buying options to get the rights or selling to receive the cost or premium with the obligation to deliver or buy shares if the buyer chooses to exercise her rights.
Covered Call Strategy
The covered call options strategy is considered the most conservative of all options strategies and is the starting point for many new option traders. Using covered calls will put extra income into your account during directionless periods in the market. The strategy consists of buying shares of stock and selling call options against those shares. One option is for 100 shares, so for every 100 shares you buy, you sell one call. The calls typically have a strike price just above the current share price. If the stock moves above the strike price by the expiration date, you keep the sold option premium and get a little more for your shares than you paid when they are called away. If the stock stays below the strike price, you keep the stock shares and the option premiums and sell some more calls, repeating the trade.
Straddles and Strangles
The straddle and strangle strategies involve the simultaneous selling of both calls and puts. You put the premiums received from the sales in your brokerage account with an outlook that the stock price will not stray far from the option strike prices. With a straddle, the puts and calls have the same strike price, requiring precision stock price forecasting. The strangle spreads out the strike prices, leaving a range the stock can be in at expiration to produce a profit. These are high-risk strategies with potential losses that are theoretically unlimited. Your broker will only authorize them for experienced and well-capitalized traders. With a market going nowhere, these strategies produce profits when a stock trades in a narrow range.
Iron Butterfly, Iron Condor
The iron butterfly and iron condor strategies add two more option positions to the straddle and strangle to limit the losses if the underlying stock price does make a move out of the directionless price range. Along with selling calls and puts, the iron strategies add in the purchase of cheaper calls and puts to backstop the sold option positions. With these strategies, you net less in option premiums than with a straddle or strangle, but your maximum potential loss is known in advance. A broker will approve these types of strategies for traders with a limited amount of trading experience -- or even no experience.
Visualizing Option Strategies
Your online brokerage account will provide a couple of options trading tools that demonstrate how a particular options strategy will work. A graph that shows where a strategy is profitable and where it loses money in relation to the different strike prices shows you where you want the stock to be at expiration to maximize your profits. Use the graph to see how a strategy will profit if stock prices are range bound. A potential profit vs. loss calculator puts the same information into dollar terms and lets you adjust strike prices and number of contracts per leg to get a potential risk-reward ratio you like.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.