Options give investors ways to profit whether stocks rise, fall or hold steady. But they also come with their own complexities and pitfalls. Options traders have developed an expansive set of strategies that aim to help them hedge against risk, generate income or profit from speculation while also not exposing them to undue risk. Strategies exist to fit a variety of different views of future market trends from bullish to bearish. Talk to a financial advisor about options strategies that may fit your portfolio and risk tolerance.
Options Ins and Outs
An option is a contract giving an investor the right, but not the obligation, to buy or sell a stock or other asset at a set strike price by a certain expiration date. Investors pay an upfront fee, or premium, for options contracts. There are two main types of options:
Calls. Allow buying the underlying asset at the strike price by the expiration date. Investors buy calls when they expect the asset’s price to rise above the strike price by expiration, allowing them to buy at a discount.
Puts. Allow selling the underlying asset at the strike price by expiration. Investors buy puts when they expect the asset’s price to fall below the strike price by expiration, allowing them to sell at a higher price.
The goal is for the asset’s market price at expiration to exceed the strike price defined in calls or fall below the strike price for puts. The greater the difference between market price and strike price at expiration, the bigger investors’ gains. However, those gains must also sufficiently exceed the premiums paid upfront for the options contracts. If strike prices aren’t hit by expiration dates, options expire worthless and investors lose the premiums paid.
Options Trading Limitations
While options offer opportunities, they also come with downsides and risks. Investors must weigh:
Downside risks. Options lose entire premium values if strike prices aren’t hit by expiration dates.
Uncapped losses. Certain high-risk options strategies can potentially expose investors to uncapped losses. Naked call options, for example, can put investors at risk when underlying stock prices increase significantly above strike prices for those options.
Tax inefficiencies. Profits on options held less than one year trigger short term capital gains tax rates vs. lower long term stock gains rates.
Volatility risks. Options prices derived from underlying assets can swing quickly based on news events, spiking potential losses.
Investors should use only discretionary money they can afford to lose when speculating on higher-risk options trades rather than tying up principal needed for near-term essentials. Conservative investors may prefer limiting options exposure to a set, typically small, percentage of their portfolios.
Types of Options Investing Strategies
Investors use options strategies for three broad purposes – income generation, hedging and speculation. Here is how those types stack up:
Income strategies. These include covered calls and cash-secured puts involve selling options to collect premiums upfront. This generates income, but also caps upside potential.
Hedging strategies. Protective puts and collars guard against downward moves in asset prices. Here, investors sacrifice some upside potential for downside protection.
Speculation strategies. More complex options spreads allow speculating on sharply rising or falling asset prices. Defined-risk spreads balance risks and rewards. Speculation strategies such as naked call options carry unlimited risk.
Strategies also reflect bullish, bearish or neutral views on asset price directions. Bullish trades expect rising prices. Bearish trades expect declines. Neutral trades expect prices to hold steady. Combining directional views, risk appetites and desired outcomes allows tailoring options approaches.
6 Options Trading Strategies
Scores of options strategies have been developed, many carrying whimsical names and involving complex trading moves. Here are summaries of six common options trading strategies both beginning and advanced investors could consider, including their purposes, how they work, benefits and risks:
Name | Purpose | How it Works | Benefits | Risks |
Covered Calls | Income | Investor owns underlying stocks and sells call options allowing buyer to purchase the shares at set strike price by expiration date. | Generates income by earning options premiums upfront. Downside protection from owning stocks. | Caps upside if shares get called away. Missing dividends if assigned early. |
Protective Puts | Hedging | Investor buys put options allowing them to sell underlying stocks they own at strike price. | Downside protection regardless of how low shares fall. | Puts expire worthless if strike price not hit. |
Collars | Hedging | Combines protective puts with covered calls sold on same underlying stocks. | Put protects downside while call premium offsets cost of buying put. | Gains capped if shares called away. Loss of dividends from assignments. |
Long Straddles | Speculation | Buying call and put options on same underlying stocks at same strike prices and expiration. | Profit if share prices rise or fall sharply beyond combined premium costs. | Requires big price moves to sufficiently offset the high premium costs. |
Covered Strangles | Income | Selling out-of-the money call and put options against stocks owned. Out-of-the-money options have lower odds of being exercised. | Higher potential premiums than covered calls alone due to greater perceived risk. | Uncapped downside exposure if puts exercised below purchase prices. |
Vertical Spreads | Speculation | Pairs buying and selling of calls or puts on same expiration but different strikes. Often defined-risk. | Limits costs more than naked calls or puts alone. Establishes maximum rewards. | Limited profit if asset prices move beyond short and long strike prices. Assignment risks. |
Bottom Line
Options offer income, hedging and ways to speculate based on market views. Dozens of different options trading strategies exist and can be tailored to fit a variety of investor needs and viewpoints. But they carry risks, from losing principal to facing uncapped losses in some strategies. Investors should research options thoroughly, start small to test strategies and use only discretionary money they can afford to lose.
Investing Planning Tips
Interested in options but confused by all the jargon? Schedule a consultation with a financial advisor to walk through the basics. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you canhave a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Asset allocation is one of the most significant factors determining portfolio performance and suitability. SmartAsset’s asset allocation calculator helps you maintain the desired balance among asset classes.
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