Option Strategies You Need to Know

Options are one of the most popular trading methods because their price can vary quickly, allowing traders to make (or lose) a lot of money quickly. Options strategies can be simple or complex, with a wide range of techniques and occasionally strange names. (Selling Naked Calls?)

All option strategies are based on Call Options and Put Options. Make sure to take a look and read our previous post on How Exactly Options Work in order for you to understand the following strategies.

There are five highly techniques shown below, including an analysis of their reward and risk, as well as when a trader might use them for their next investment. While these methods are simple, they have the potential to make a trader a lot of money – but they are not without any risk.

Option Strategies Overview

#1. Bullish

option strategies long call
The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.
option strategies protective put
The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

#2. Bearish

option strategies long put
The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.
option strategies protective call
The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

#3. Neutral

option strategies covered call
The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

#4. Collar

option strategies collar
The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

#5. Spreads

option strategies bull call spread
The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.
option strategies bear put spread
The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

These strategies are the basic building blocks for more advanced strategies. We will be using creative changes to the above strategies to create credits and use these credits to purchase our outlook in the stock. Always keep in mind that whatever strategy we create will be a limited risk exposure strategy.


Long Call

Purchasing calls has remained the most popular strategy with investors since listed options were first introduced. Before moving into more complex bullish and bearish strategies, an investor should thoroughly understand the fundamentals of buying and holding call options.

The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

Market Opinion

Bullish to very Bullish.

When to Use

Bullish Speculation

This strategy appeals to an investor who is generally more interested in the dollar amount of his initial investment and the leveraged financial reward that long calls can offer. The primary motivation of this investor is to realize financial reward from an increase in the price of the underlying security.

Experience and precision, are key to selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the call is the more bullish the strategy as bigger increases in the underlying stock price is required for the option to reach the break-even point.

As Stock Substitute

An investor who buys a call instead of purchasing the underlying stock considers the lower dollar cost of purchasing a call contract versus an equivalent amount of stock as a form of insurance.

The uncommitted capital is “insured” against a decline in the price of the call option’s underlying stock, and can be invested elsewhere. This investor is generally more interested in the number of shares of the stock underlying the call contracts purchased than in the specific amount of the initial investment – one call option contract for every 100 shares he wants to own.

While holding the call option, the investor retains the right to purchase an equivalent number of underlying shares at any time at the predetermined strike price until the contract expires.

Note: Equity option holders do not enjoy the rights due to stockholders-e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of the underlying shares to be eligible for these rights.

Benefits

A long call option offers a leveraged alternative to a position in the stock. As the contract becomes more profitable, increasing leverage can result in large percentage profits because purchasing calls generally require lower up-front capital commitment than with an outright purchase of the underlying stock. Long call contracts offer the investor a pre-determined risk.

Risk vs. Reward

Maximum Profit: Unlimited

Maximum Loss: Limited to net premium paid.

Upside Profit at Expiration Stock Price – Strike Price – Premium Paid/assuming Stock Price above BEP (break-even point).

Your maximum profit depends only on the potential price increase of the underlying security; in theory, it is unlimited. At expiration, an in-the-money call will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premium initially paid for the call. Whatever your motivation for purchasing the call, weigh the potential reward against the potential loss of the entire premium paid.

Break-even Point (BEP)

BEP Strike Price + Premium Paid

Before expiration, however, if the contract’s market price has sufficient time value remaining, the BEP can occur at a lower stock price.

Volatility

If Volatility Increases: Positive Effect

If Volatility Decreases: Negative Effect

Any effect of volatility on the option’s total premium is on the time value portion.

Time Decay

Passage of Time: Negative Effect

The time value portion of an option’s premium, which the option holder has “purchased” by paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration.

Alternatives before expiration

At any given time before expiration, a call option holder can sell the call in the listed options marketplace to close out the position. This can be done to either realize a profitable gain in the option’s premium or to cut a loss.

Alternatives at expiration

At expiration, most investors holding an in-the-money call option will elect to sell the option in the marketplace if it has value, before the end of trading on the option’s last trading day. An alternative is to exercise the call, resulting in the purchase of an equivalent number of underlying shares at the strike price.


Protective Put

An investor who purchases a put option while holding shares of the underlying stock is employing a “protective put.”

The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

Market Opinion

Bullish on the underlying stock.

When to Use

The investor employing the protective put strategy owns shares of the underlying stock. He might have concerns about unknown, downside market risks in the near term and wants some protection for the share value of his stock position. Purchasing puts while holding shares of the underlying stock is a directional strategy, a bullish one,

Benefit

The protective put investor retains all benefits of continuing stock ownership (dividends, voting rights, etc.) during the lifetime of the put contract unless he sells his stock. At the same time, the protective put serves to limit downside loss in the underlying stock’s value. No matter how much the underlying stock decreases in value during the option’s lifetime, the put guarantees the investor the right to sell his shares at the put strike price until the option expires.

If there is a sudden, significant decrease in the market price of the underlying stock, a put owner has the luxury of time to react. The put contract has conveyed to him a guaranteed selling price at the strike price, and control over when he chooses to sell his stock.

Risk vs. Reward

Maximum Profit: Unlimited

Maximum Loss: Limited: Stock Price-Strike Price+ Premium Paid

Upside Profit at Expiration: Gains in Underlying Share Value – Premium Paid

The potential maximum profit for this strategy depends only on the potential price increase of the underlying security; in theory, it is unlimited. If the put expires in the money, any gains realized from an increase in its value will offset any decline in the underlying shares below the strike price of the put. On the other hand, if the put expires at- or out-of-the-money the investor will lose the entire premium paid for the put.

Break-Even Point (BEP)

BEP: Stock Purchase Price + Premium Paid

Volatility

If Volatility Increases: Positive Effect

If Volatility Decreases: Negative Effect

Any effect of volatility on the option’s total premium is on the time value portion.

Time Decay

Passage of Time: Negative Effect

The time value portion of an option’s premium, which the option holder has “purchased” when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration.

Alternatives before expiration

The investor employing the protective put is free to sell his stock and/or his long put at any time before it expires. For instance, if the investor loses concern over a possible decline in the market value of his hedged underlying shares, the put option may be sold if it has market value remaining.

Alternatives at expiration

If the put option expires with no value, no action needs to be taken; the investor will retain his shares. If the option closes in-the-money, the investor can elect to exercise his right to sell the underlying shares at the put strike price.

Alternatively, the investor may sell the put option, if it has market value before the market closes on the option’s last trading day. The premium received from the long option’s sale will offset any financial loss from a decline in underlying share value.


Long Put

A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price movement in the underlying stock. Before moving into more complex bearish strategies, an investor should thoroughly understand the fundamentals of buying and holding put options.

The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

Market Opinion

Bearish.

When to Use

Purchasing puts without owning shares of the underlying stock is a purely directional strategy used for bearish speculation. The primary motivation of this investor is to realize financial reward from a decrease in the price of the underlying security.

This investor is generally more interested in the dollar amount of his initial investment and the leveraged financial reward that long puts can offer than in the number of contracts purchased.

Experience and precision are key in selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the put purchased is, the more bearish the strategy, as bigger decreases in the underlying stock price, are required for the option to reach the break-even point.

Benefit

A long put offers a leveraged alternative to a bearish, or “short sell” of the underlying stock, and offers less potential risk to the investor. As with a long call, an investor who purchased and is holding a long put has predetermined, limited financial risk versus the unlimited upside risk from a short stock sell.

Purchasing a put generally requires a lower up-front capital commitment than the margin required to establish a short-stock position. Regardless of market conditions, a long put will never require a margin call. As the contract becomes more profitable, increasing leverage can result in a large percentage of profits.

Risk vs. Reward

Maximum Profit: Limited Only by Stock Declining to Zero

Maximum Loss: Limited to premium paid

Upside Profit at Expiration Strike Price – Stock Price at Expiration – Premium Paid

The maximum profit amount can be limited by the stock’s potential decrease to no less than zero. At expiration, an in-the-money put will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premium initially paid for the put. Whatever your motivation for purchasing the put, weigh the potential reward against the potential loss of the entire premium paid.

Break-Even Point (BEP)

BEP: Strike Price – Premium Paid

Before expiration, however, if the contract’s market price has sufficient time value remaining, the BEP can occur at a higher stock price.

Volatility

If Volatility Increases: Positive Effect

If Volatility Decreases: Negative Effect

Any effect of volatility on the option’s total premium is on the time value portion.

Time Decay

Passage of Time: Negative Effect

The time value portion of an option’s premium, which the option holder has “purchased” when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration.

Alternatives before expiration

At any given time before expiration, a put option holder can sell the put in the listed options marketplace to close out the position. This can be done to either realize a profitable gain in the option’s premium or to cut a loss.

Alternatives at expiration

At the expiration, most investors holding an in-the-money put will elect to sell the option in the marketplace if it has value, before the ending of trading on the option’s last trading day. The second choice, one resulting in considerable risk, is to exercise the put, sell the underlying shares and establish a short stock position in an appropriate type of brokerage account.


Protective Call

An investor who purchases a call option while short-selling shares of the underlying stock are employing a “protective call.”

The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

Market Opinion

Bearish on the underlying stock.

When to Use

The investor employing the protective call strategy is short-selling shares of the underlying stock awaiting stock prices to drop in the near term. He has concerns about the unknown, upside market risks in the near term and wants protection from stock price rising as this could potentially be unlimited.

Purchasing calls while short-selling shares of the underlying stock is a directional strategy, a bearish one.

Benefit

The protective call allows the investor to short sell stock to profit while stock prices drop and at the same time, the investor does not have to worry about the stock rising in value above the call strike price, which would impose on the investor an unlimited risk exposure without the call option.

No matter how much the underlying stock increases in value during the option’s lifetime, the call guarantees the investor the right to buy shares at the call strike price until the option expires. If there is a sudden, significant increase in the market price of the underlying stock, a call owner has the luxury of time to react.

The call contract has conveyed to him a guaranteed purchase price at the strike price, and control over when he chooses to buy back the stock.

Risk vs. Reward

Maximum Profit: Limited, to the stock price declining to zero.

Maximum Loss: Limited, Strike Price – Stock Short Sell Price + Premium Paid

Upside Profit at Expiration: Decline in Underlying Share Value – Premium Paid

Potential maximum profit for this strategy depends only on the potential price decline of the underlying security: limited to stock price going to zero. If the call expires in-the-money, any gains realized from an increase in its value will offset any increase in the price of the underlying shares limiting the upside risk exposure on the short sell stock position.

On the other hand, if the call expires at- or out-of-the-money the investor will lose the entire premium paid for the call.

Break-Even Point (BEP)

BEP: Stock Short Sell Price- Premium Paid

Volatility

If Volatility Increases: Positive Effect

If Volatility Decreases: Negative Effect

Any effect of volatility on the option’s total premium is on the time value portion.

Time Decay

Passage of Time: Negative Effect

The time value portion of an option’s premium, which the option holder has “purchased” when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration.

Alternatives before expiration

The investor employing the protective call is free to buy back the short-sell stock position and/or sell his long call at any time before it expires, which is not advisable as this would impose an unlimited risk exposure on the short-stock position.

Alternatives at expiration

If the call option expires with no value, the investor will retain the short stock position, however, it is advisable to buy back the stock so as not to have an unlimited risk exposure if the stock price rises or purchase another call option. If the option closes in-the-money, the investor can elect to exercise his right to buy the underlying shares at the call strike price.

Alternatively, the investor may sell the call option, if it has market value before the market closes on the option’s last trading day. The premium received from the long option’s sale will offset any financial loss from an increase in underlying share value.


Covered Call

The covered call is a strategy in which an investor writes a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If this stock is purchased simultaneously with writing the call contract, the strategy is commonly referred to as a “buy-write.” If the shares are already held from a previous purchase, it is commonly referred to as an “overwrite.”

In either case, the stock is generally held in the same brokerage account from which the investor writes the call, and fully collateralizes, or “covers,” the obligation conveyed by writing a call option contract. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership.

The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

Market Opinion

Neutral to bullish on the underlying stock.

When to Use

Though the covered call can be utilized in any market condition, it is most often employed when the investor, while bullish on the underlying stock, feels that its market value will experience little range over the lifetime of the call contract. The investor desires to either generate additional income (over dividends) from shares of the underlying stock and/or provide a limited amount of protection against a decline in underlying stock value.

Benefit

While this strategy can offer limited protection from a decline in the price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call.

At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.

Risk vs. Reward

Profit Potential: Limited

Loss Potential: Substantial stock may go to zero,

Upside Profit at Expiration If Assigned: Premium Received + Difference (if any) Between Strike Price and Stock Purchase Price

Upside Profit at Expiration If Not Assigned: Any Gains in Stock Value + Premium Received

Maximum profit will occur if the price of the underlying stock you own is at or above the call option’s strike price, either at its expiration or when you might be assigned an exercise notice for the call before it expires.

The risk of real financial loss with this strategy comes from the shares of stock held by the investor. This loss can become substantial if the stock price continues to decline in price as the written call expires.

At the call’s expiration, the loss can be calculated as the original purchase price of the stock less its current market price, less the premium received from the initial sale of the call. Any loss accrued from a decline in stock price is offset by the premium you received from the initial sale of the call option.

As long as the underlying shares of stock are not sold, this would be an unrealized loss. Assignment on a written call is always possible.

Break-Even Point (BEP)

BEP: Stock Purchase Price – Premium Received

Volatility

If Volatility Increases: Negative Effect

If Volatility Decreases: Positive Effect

Any effect of volatility on the option’s price is on the time value portion of the option’s premium.

Time Decay

Passage of Time: Positive Effect

With the passage of time, the time value portion of the option’s premium generally decreases – a positive effect for an investor with a short option position.

Alternatives before expiration

If the investor’s opinion on the underlying stock changes significantly before the written call expires, whether more bullish or more bearish, the investor can make a closing purchase transaction of the call in the marketplace. This would close out the written call contract, relieving the investor of an obligation to sell his stock at the call’s strike price.

Before taking this action, the investor should weigh any realized profit or loss from the written call’s purchase against any unrealized profit or loss from holding shares of the underlying stock. If the written call position is closed out in this manner, the investor can decide whether to make another option transaction to either generate income from and/or protect his shares, to hold the stock unprotected with options, or sell the shares.

Alternatives at expiration

As the expiration day for the call option nears, the investor considers three scenarios and then accordingly makes a decision. The written call contract will either be in-the-money, at-the money or out-of-the-money.

If the investor feels the call will expire in-the-money, he can choose to be assigned an exercise notice on the written contract and sell an equivalent number of shares at the call’s strike price. Alternatively, the investor can choose to close out the written call with a closing purchase transaction, canceling his obligation to sell stock at the call’s strike price, and retain ownership of the underlying shares.

Before taking this action, the investor should weigh any realized profit or loss from the written call’s purchase against any unrealized profit or loss from holding shares of the underlying stock.

If the investor feels the written call will expire out-of-the-money, no action is necessary. He can let the call option expire with no value and retain the entire premium received from its initial sale. If the written call expires exactly at-the-money, the investor should realize that assignment of an exercise notice on such a contract is possible, but should not be assumed.

Consult with your brokerage firm or a financial advisor on the advisability of what action to take in this case.


Collar

A collar can be established by holding shares of an underlying stock, purchasing a protective put, and writing a covered call on that stock. The option portions of this strategy are referred to as a combination.

Generally, the put and the call are both out-of-the-money when this combination is established, and have the same expiration month. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. In other words, one collar equals one long put and one written call along with owning 100 shares of the underlying stock.

The primary concern in employing a collar is the protection of profits accrued from underlying shares rather than increasing returns on the upside.

The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

Market Opinion

Neutral, following a period of appreciation.

When to Use

An investor will employ this strategy after accruing unrealized profits from the underlying shares and wants to protect these gains with the purchase of a protective put. At the same time, the investor is willing to sell his stock at a price higher than the current market price so an out-of-the-money call contract is written, covered in this case by the underlying stock.

Benefit

This strategy offers the stock protection of a put. However, in return for accepting a limited upside profit potential on his underlying shares (to the call’s strike price), the investor writes a call contract. Because the premium received from writing the call can offset the cost of the put, the investor is obtaining downside put protection at a smaller net cost than the cost of the put alone.

In some cases, depending on the strike prices and the expiration month chosen, the premium received from writing the call will be more than the cost of the put.

In other words, the combination can sometimes be established for a net credit the investor receives cash for establishing the position. The investor keeps the cash credit, regardless of the price of the underlying stock when the options expire.

Until the investor either exercise his put and sells the underlying stock, or is assigned an exercise notice on the written call and is obligated to sell his stock, all rights of stock ownership are retained. See both Protective Put and Covered Call strategies presented earlier in this section of the site.

Risk vs. Reward

This example assumes an accrued profit from the investor’s underlying shares at the time the call and put positions are established, and that this unrealized profit is being protected on the downside by the long put. Therefore, the discussion of maximum loss does not apply. Rather, in evaluating profit and/or loss below, bear in mind the underlying stock’s purchase price (or cost basis).

Compare that to the net price received at expiration on the downside from exercising the put and selling the underlying shares, or the net sale price of the stock on the upside if assigned on the written call option. This example also assumes that when the combined position is established, both the written call and purchased put are out-of-the money.

Net Upside Stock Sale Price if Assigned on the Written Call:

Call Strike Price + Net Credit Received for Combination

or

Call Strike Price – Net Debit Paid for Combination

Net Downside Stock Sale Price if Exercising the Long Puts:

Put Strike Price + Net Credit Received for Combination

or

Put Strike Price – Net Debit Paid for Combination

If the underlying stock price is between the strike prices of the call and put when the options expire, both options will generally expire with no value. In this case, the investor will lose the entire net premium paid when establishing the combination or keep the entire net cash credit received when establishing the combination. Balance either results with the underlying stock.

Break-Even Point (BEP)

In this example, the investor is protecting his accrued profits from the underlying stock with a sale price for the shares guaranteed at the long put strike price. In this case, consideration of BEP does not apply.

Volatility

If Volatility Increases: Effect Varies

If Volatility Decreases: Effect Varies

The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options’ premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration.

Time Decay

Passage of Time: Effect Varies

The effect of time decay on this strategy varies with the underlying stock’s price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the lower strike price of the long put, losses generally increase at a faster rate as time passes.

Alternatively, if the underlying stock price is closer to the higher strike price of the written call, profits generally increase at a faster rate as time passes.

Alternatives before expiration

The combination may be closed out as a unit just as it was established as a unit. To do this, the investor enters a combination order to buy a call with the same contract and sell a put with the same contract terms, paying a net debit or receiving a net cash credit as determined by current option prices in the marketplace.

Alternatives at expiration

If the underlying stock price is between the put and call strike prices when the options expire, the options will generally expire with no value. The investor will retain ownership of the underlying shares and can either sell them or hedge them again with new option contracts. If the stock price is below the put’s strike price as the options expire, the put will be in-the-money and have value.

The investor can elect to either sell the put before the close of the market on the option’s last trading day and receive cash, or exercise the put and sell the underlying shares at the put’s strike price.

Alternatively, if the stock price is above the call’s strike price as the options expire, the short call will be in-the-money and the investor can expect assignment to sell the underlying shares at the strike price. Or, if retaining ownership of the shares is now desired, the investor can close out the short call position by purchasing a call with the same contract terms before the close of trading.


Bull Call Spread

Establishing a bull call spread involves the purchase of a call option on a particular underlying stock, while simultaneously writing a call option on the same underlying stock with the same expiration month, at a higher strike price.

Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a “vertical spread”: a family of spreads involving options of the same stock, same expiration month, but different strike prices.

They can be created with either all calls or all puts, and be bullish or bearish. The bull call spread, as any spread, can be executed as a “unit” in one single transaction, not as separate buy and sell transactions. For this bullish vertical spread, a bid and offer for the whole package can be requested through your brokerage firm from an exchange where the options are listed and traded.

The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

Market Opinion

Moderately bullish to bullish.

When to Use

Moderately Bullish: An investor often employs the bull call spread in moderately bullish market environments and wants to capitalize on a modest advance in the price of the underlying stock. If the investor’s opinion is very bullish on a stock it will generally prove more profitable to make a simple call purchase.

Risk Reduction: An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long call alone or with the conviction of his bullish market opinion.

Benefit

The bull call spread can be considered a doubly hedged strategy. The price paid for the call with the lower strike price is partially offset by the premium received from writing the call with a higher strike price. Thus, the investor’s investment in the long call, and the risk of losing the entire premium paid for it, is reduced or hedged.

On the other hand, the long call with the lower strike price caps or hedges the financial risk of the written call with the higher strike price.

If the investor is assigned an exercise notice on the written call and must sell an equivalent number of underlying shares at the strike price, those shares can be purchased at a predetermined price by exercising the purchased call with the lower strike price. As a trade-off for the hedge it offers, this written call limits the potential maximum profit for the strategy.

Risk vs. Reward

Upside Maximum Profit: Limited Difference Between Strike Prices-Net Debit Paid

Maximum Loss: Limited Net Debit Paid

A bull call spread tends to be profitable when the underlying stock increases in price. It can be established in one transaction, but always at a debit (net cash outflow). The call with the lower strike price will always be purchased at a price greater than the offsetting premium received from writing the call with the higher strike price.

Maximum loss for this spread will generally occur as the underlying stock price declines below the lower strike price. If both options expire out-of-the-money with no value, the entire net debit paid for the spread will be lost.

The maximum profit for this spread will generally occur as the underlying stock price rises above the higher strike price, and both options expire in-the-money. The investor can exercise the long call, buy the stock at its lower strike price, and sell that stock at the written call’s higher strike price if assigned an exercise notice.

This will be the case no matter how high the underlying stock has risen in price. If the underlying stock price is in between the strike prices when the calls expire, the long call will be in-the-money and worth its intrinsic value. The written call will be out-of-the-money, and have no value.

Break-Even Point (BEP)

BEP: Strike Price of Purchased Call + Net Debit Paid

Volatility

If Volatility Increases: Effect Varies

If Volatility Decreases: Effect Varies

The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options’ premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration.

Time Decay

Passage of Time: Effect Varies

The effect of time decay on this strategy varies with the underlying stock’s price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal.

If the stock price is closer to the lower strike price of the long call, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the written call, profits generally increase at a faster rate as time passes.

Alternatives before expiration

A bull call spread purchased as a unit for a net debit in one transaction can be sold as a unit in one transaction in the options marketplace for a credit, if it has value. This is generally the manner in which investors close out a spread before its options expire, in order to cut a loss or realize the profit.

Alternatives at expiration

If both options have value, investors will generally close out a spread in the marketplace as the options expire. This will be less expensive than incurring the commissions and transaction costs from a transfer of stock resulting from either an exercise of and/or an assignment on the calls. If only the purchased call is in-the-money as it expires, the investor can either sell it in the marketplace if it has value or exercise the call and purchase an equivalent number of shares. In either of these cases, the transaction(s) must occur before the close of the market on the options’ last trading day.


Bear Put Spread

Establishing a bear put spread involves the purchase of a put option on a particular underlying stock, while simultaneously writing a put option on the same underlying stock with the same expiration month, but with a lower strike price.

Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a “vertical spread”: a family of spreads involving options of the same stock, same expiration month, but different strike prices.

They can be created with either all calls or all puts, and be bullish or bearish. The bear put spread, as any spread, can be executed as a “package” in one single transaction, not as separate buy and sell transactions. For this bearish vertical spread, a bid and offer for the whole package can be requested through your brokerage firm from an exchange where the options are listed and traded.

The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively.

Market Opinion

Moderately bearish to bearish.

When to Use

Moderately Bearish: An investor often employs the bear put spread is moderately bearish market environments and wants to capitalize on a modest decrease in the price of the underlying stock. If the investor’s opinion is very bearish on a stock it will generally prove more profitable to make a simple put purchase.

Risk Reduction: An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long put alone or with the conviction of his bearish market opinion.

Benefit

The bear put spread can be considered a doubly hedged strategy. The price paid for the put with the higher strike price is partially offset by the premium received from writing the put with a lower strike price. Thus, the investor’s investment in the long put and the risk of losing the entire premium paid for it is reduced or hedged.

On the other hand, the long put with the higher strike price caps or hedges the financial risk of the written put with the lower strike price. If the investor is assigned an exercise notice on the written put and must purchase an equivalent number of underlying shares at its strike price, he can sell the purchased put with the higher strike price in the marketplace.

The premium received from the put’s sale can partially offset the cost of purchasing the shares from the assignment. The net cost to the investor will generally be a price less than current market prices. As a trade-off for the hedge it offers, this written put limits the potential maximum profit for the strategy.

Risk vs. Reward

Downside Maximum Profit: Limited Difference Between Strike Prices-Net Debit Paid

Maximum Loss: Limited

A bear put spread tends to be profitable if the underlying stock decreases in price. It can be established in one transaction, but always at a debit (net cash outflow). The put with the higher strike price will always be purchased at a price greater than the offsetting premium received from writing the put with the lower strike price.

Maximum loss for this spread will generally occur as the underlying stock price rises above the higher strike price. If both options expire out-of-the-money with no value, the entire net debit paid for the spread will be lost.

The maximum profit for this spread will generally occur as the underlying stock price declines below the lower strike price, and both options expire in-the-money. This will be the case no matter how low the underlying stock has declined in price. If the underlying stock is in between the strike prices when the puts expire, the purchased put will be in-the-money, and be worth its intrinsic value. The written put will be out-of-the-money, and have no value.

Break-Even Point (BEP)

BEP: Strike Price of Purchased Put – Net Debit Paid

Volatility

If Volatility Increases: Effect Varies

If Volatility Decreases: Effect Varies

The effect of an increase or decrease in either the volatility of the underlying stock may be noticed in the time value portion of the options’ premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration.

Time Decay

Passage of Time: Effect Varies

The effect of time decay on this strategy varies with the underlying stock’s price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal.

If the stock price is closer to the higher strike price of the purchased put, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the lower strike price of the written put, profits generally increase at a faster rate as time passes.

Alternatives before expiration

A bear put spread purchased as a unit for a net debit in one transaction can be sold as a unit in one transaction in the options marketplace for a credit, if it has value. This is generally the manner in which investors close out a spread before its options expire, in order to cut a loss or realize a profit.

Alternatives at expiration

If both options have value, investors will generally close out a spread in the marketplace as the options expire. This will be less expensive than incurring the commissions and transaction costs from a transfer of stock resulting from either an exercise of and/or an assignment on the puts.

If only the purchase put is in-the-money and has value as it expires, the investor can sell it in the marketplace before the close of the market on the option’s last trading day. On the other hand, the investor can exercise the put and either sell an equivalent number of shares that he owns or establish a short stock position.


My Final Thoughts

Using the Basic Option Strategies we have just reviewed, we will start creating Advanced Strategies. Most of the Advanced Strategies will be Combinations creating various types of Spreads.

  • Vertical Spread: All the Legs, (components) will have the same expiry, same or different strike prices.
  • Horizontal Spread: All the Legs (components) will have different expiry, same strike prices and we will create Ratios in our favour.
  • Diagonal Spread: All the Legs (components) will have different expiry, different strike prices and again we will create Ratios in our favour.

You will find that using your creativity you can create some of your own strategies. Also keep in mind that brokerages will allow you to trade Vertical Debit and Credit Spreads, Horizontal, and Diagonal Debit Spreads, however, when it comes to Credit Spreads you will be expected to cover the Cash Margin Requirement of the Spread in the event it is needed to cover your position.

Also, as far as Horizontal and Diagonal Credit Spreads, although, the limited risk is taken into account when we create these strategies because this risk is not clearly defined many brokerage firms will require that you maintain a large cash account to cover the ultimate possible potential loss.

Start getting familiar with Vertical Spreads Debit and Credit Strategies, slowly progress to Debit Horizontal and Diagonal Spreads. Last, as you build your success in trading and your cash account grows in value you can explore Credit Horizontal and Diagonal Spreads.

You may find these strategies we are about to explore somewhat confusing, however before trying any of these Advanced Strategies concentrate on building your confidence using the Basic Option Strategies first!

Sit back relax and enjoy the ride you are about to discover the amazing world of Options. Keep your mind open, anything is possible, use your imagination, and create your own strategies. Then, focus on the strategies you feel comfortable applying and study the rest, build your confidence, and practice the use of options, before you start applying them with real money.

-Martina

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