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Options are one of the most popular trading vehicles that can result in you making (or losing) money fast. There are many different ways in which one can trade options, ranging from simple strategies to the more complicated ones, the latter often with fanciful names associated with birds and insects (Iron condor, butterfly, anyone?)
The truth is that you do not need to know these fanciful and complex options strategies to make money. Very often, the simplest strategies work the best. As long as one comprehends the fundamentals associated with these basic options strategies, it is sufficient to generate a consistent stream of profit.
In this article, I will look to introduce 4 option trading strategies for beginners. Knowing these 4 basic options trading strategies will be sufficient for a beginner options trader to start making profits, both in a bullish and bearish environment.
Before I delve into these four beginner-friendly options strategies, let me briefly run through the very basics of options buying and selling
Additional Reading: 3 Safe Options Strategies better than stock buying
Basics of options
Buying options
In the world of options, you can select to be a buyer or seller. Most investors are only familiar with stock buying. They rarely sell stocks “short” (ie selling stocks that they do not own). However, when it comes to options, there are possibly even more traders who are selling options vs. buying options.
When you are an option buyer, you PAY a premium to “lock in” the stock price of an underlying stock. You, as the buyer now, have the RIGHT to purchase this stock at this “lock-in” price anytime during the validity of the contract (HORIZON).
Let’s use a quick example. Say you have a bullish outlook on a stock like AAPL, currently trading at $150/share. You will hence buy a call option of AAPL by paying a premium and locking in the price (strike price) at $150. Your option contract is valid for 1-year. This means that during this 1-year horizon, you have the right to buy at least 100 AAPL shares at the “lock-in” strike price of $150.
If after a year, AAPL trades at $200/share, your call option contract which gives you the RIGHT to purchase AAPL at a stock price of $200, will be a lot more valuable than when you initially purchased it.
As an option buyer, your maximum downside risk is capped at the premium that you pay while your maximum gain could potentially be very substantial.
Selling options
As I previously mentioned, there could be more traders who are selling options rather than buying them. Why is that so? This is the case because selling options are a good way to generate income on a consistent basis.
When you are an option seller, you now RECEIVE the premium from the buyer. This is money that you “pocket” from Day 1, but that does not mean you have earned it (more of that later). After receiving this premium, you now have the OBLIGATION to the buyer to buy from or sell to him shares at the agreed price (strike price) during the validity of the option contract (HORIZON)
Again, let us use a quick example to illustrate. Say you are now bearish on AAPL and do not think that its stock price will go higher than the current price of $150. You will hence sell a call option of AAPL at the strike price of $150. As a seller, you are entitled to receive a premium from the buyer.
However, in the event that AAPL’s rising stock price goes above $150, the buyer will now want to “exercise his right” to purchase 100 shares of AAPL at the lower “lock-in” stock price of $150 vs. the stock market price.
You as the seller now have the obligation to sell to the buyer 100 shares of AAPL. The higher the share price appreciates above $150, the more losses the options seller will incur (as a seller is now committed to selling at a lower price of $150 and buying back at a higher stock market price)
For the option seller, your maximum profit is limited to the premium you receive while your losses could be very significant. However, if you know how to execute options-selling trades efficiently, it is a good way to generate income month in, and month out.
With that basic introduction out of the way, let us take a look at 4 options strategies that you can easily engage in as a newbie options trader.
Strategy #1: Long Call (Buy Call)
The simplest of all strategies and sometimes the most profitable one as well where a single right trade could generate an ROI of 1000%, is to Buy a call option.
I have highlighted earlier that buying a call option is a bullish strategy. If a trader is bullish on a stock and believes its share price will appreciate significantly moving forward, it makes sense to pay a premium to “lock-in” a price such that when the stock price does indeed appreciates significantly, he/she can now enjoy the benefit of purchasing at the lower “lock-in” price.
The maximum downside is the premium paid while the upside could be many times the initial cost (premium) if the share price does indeed “fly to the moon”.
Example: Stock ABC is trading for $50/share and a call with a strike price of $50 and expiring in 3 months is trading at $2/share. 1 call options contract thus costs you $200 (since 1 option contract = 100 shares)
In this example, the maximum risk potential for you, the call option buyer, is $200. Regardless of what happened to the price of Stock ABC (stocks fall by 50% overnight), you have absolute certainty that your maximum risk exposure is limited to just $200.
Your breakeven price on expiration in 3 months-time is $50 (strike price) + $2 (premium paid) = $52/share. You will need the price to be above $52 on expiration for you to be profitable. If ABC’s price is at $50 (strike price) or below, the call option will expire worthless (out of the money) and you will lose your $200 premium.
At prices between $50 and $52, you will lose a portion of your $200 cost and for prices above $52, you will have recoup back your $200 premium cost and start making a profit. The higher the price of ABC on expiration, the greater will be your profit potential.
If the price of ABC is at $60 on expiration, your profit potential will be $60 – $52 (breakeven price) = $8/share or $800/contract. In this case, your ROI will be a hefty 400% ($800 profit / $200 cost)
When to use it:
A long call is a good choice when you are very bullish on the counter and you expect the stock to rise significantly within the duration of the options expiration. You pay a small premium which is also your maximum loss potential and if you are correct in your expectation of a price rise, your profit potential will be rather significant.
Do, however, note that your price needs to rise above your breakeven price (calculated as buy strike + premium paid) for you to be profitable on expiration.
Strategy #2: Covered Call
I have introduced the Long Call strategy, which is one of the most basic and beginner-friendly strategies for a new option trader to get started. However, being basic does not mean that it is not an effective strategy to make money. As I mentioned, sometimes the simplest strategy is often the most profitable.
A long call strategy does have the potential for you to generate a 10-bagger return (1000% ROI) since it has “unlimited” upside potential.
Now, we know that buying requires one to pay a premium while selling allows the trader to receive a premium.
How do we combine a bullish strategy (ie we are positive on the stock appreciating) while yet also generating income consistently along the way?
One simple way is to structure a covered call strategy. This is our second options trading strategy for beginners which a STOCK INVESTOR will be very interested in.
Why am I bringing a stock investor into the picture when this article is all about options traders?
This is because a covered call strategy involves the ownership of (at least) 100 shares of an underlying stock.
At this juncture, allow me to digress slightly. A key downside of options trading is that each options contract represents 100 shares of the underlying stock. If the underlying stock is a “high-price” one, then purchasing a single options contract on that underlying could still be a significant outlay.
Typically, a stock trader will argue that there is no “flexibility” when it comes to options contracts as the minimum exposure is 100 shares while stocks can be purchased for just 1 share (or even fractional trading).
Yes, that is correct, which is why it is difficult for a retail options trader to gain exposure to a high-priced stock like Amazon (no longer the case after its stock split) through options contracts.
However, what is good about owning at least 100 shares of the underlying stock is that you can generate income (your own passive stream of dividends) every single month (or weeks) through the covered call strategy. How do you accomplish that?
The covered call strategy is essentially a strategy that involves the ownership of 100 shares of stock combined with the selling of 1 call option
Covered Call = Long 100 Shares + Sell 1 Call Option
This is a strategy that an option trader has the flexibility to take if he owns at least 100 shares of the stock.
He/she remains bullish on the underlying, hence the stock ownership, and expects the price to appreciate over a longer horizon.
However, while waiting for his stock price to appreciate, the trader also wishes to be “paid while waiting”. This is where the selling of the call options comes into the picture.
As a seller, he receives a premium right from Day 1. As long as the price does not go beyond the strike price level at which he sold the call at, he gets to keep the full premium. If the seller does this efficiently, it is like creating his own “synthetic” stream of dividends that are being paid out every single month to him. The diagram below shows the payoff structure of a covered call strategy
Example: Say John bought 100 shares of stock ABC for $50/share. His initial cost outlay is $5,000 (100 shares * $50/share). While waiting for his stock to appreciate, he sold a call options contract with expiration in 1 month, at a strike price of $55/share, receiving a premium of $1/share or $100/contract
Scenario 1: ABC price ends at $55
This is the most ideal scenario where stock ABC ends at $55/share after 1 month (sell call expiration). The capital appreciation is $5 * 100 shares = $500. At the same time, the sell call option which John sold has expired worthless (when the price is at or lower than $55, the call contract expires out of the money) and he gets to keep the full premium that he sold.
Total profit = $500 (capital appreciation) + $100 (premium from sell call) = $600
John gets to continue owning his 100 shares of ABC and partake in further price upside while continuing to generate another round of profit by selling a new set of short-duration call options contracts.
Scenario 2: ABC price ends at $50
John does not make any money from his shares (zero capital appreciation). However, his call option which he sold expires worthless (out of the money) and as a seller, he gets to keep the full premium that he received from Day 1.
Total profit = $0 (capital appreciation) + $100 (premium from sell call) = $100
While most stock owners will not be making a profit when the price remains flat from their purchase cost, a covered call strategy will allow the trader to generate a profit from his sell call premium
Scenario 3: ABC price ends at $60
If ABC saw a strong appreciation in price, John might be forced to “relinquish” his stock ownership of ABC prematurely. If the price of ABC appreciates to $60, the call option which John sold is now In-the-money or ITM for short.
What this is means is that this option contract is now valuable from the buyer’s perspective. He can purchase ABC from YOU at $55 and flip it in the stock market immediately which is at $60/share. Hence, he has that incentive to exercise his RIGHT and purchase from John at $55.
John, who had sold the call option and received the premium of $100 earlier, now has the obligation to sell 100 shares of ABC at a strike price of $55 to the call option buyer, even though the current market price is at $60.
Total Profit = $500 (bought at $50, forced to sell at $55 * 100 shares) + $100 premium (from sell call) = $600. The profit potential is similar to Scenario 1.
However, unlike Scenario 1, in Scenario 3, John no longer has ownership of his 100 shares in ABC as he has been forced to sell it at $55/share.
Hence, the key downside risk, as I mentioned earlier, is the potential premature exit of one’s stock ownership. While John will still like to continue his 100 share ownership in ABC, he is no longer able to do so as a result of the call option he sold at the start which “forces” him to relinquish ownership of ABC for $55/share (still realizing capital appreciation though).
Of course, John could avoid selling off his 100 shares of ABC by rolling his sell call options contract. I have also written about the covered call options strategy which you can check out.
When to use it:
This is typically a strategy for beginners who start with 100 shares of an underlying stock. That can be converted into a covered call strategy to generate a stream of passive income every month through the action of selling call options on your existing stock.
I would typically structure this trade on dividend-paying counters, which incentivizes me to own shares in the counter and I could “juice up” that dividend potential through my synthetic dividend creation.
One stock that is ideal right now (as of late-Feb 2023) for the covered call strategy in my opinion is Verizon Communications (VZ). The company currently pays a dividend yield of close to 7% at its current price which is an attractive proposition for stock ownership. One can elect to execute the covered call strategy to further increase its yield potential.
Additional Reading: Philip Morris. How to Put its 6% Yield on Steroids
I will, however, need to be wary that structuring a covered call could potentially cap my upside potential if the share price appreciates beyond the strike prices on which I sold the call option. Hence, if I don’t expect the counter to see significant price gain in the near term but am still positive about its longer-term potential, this will be a good strategy to “get paid while you wait”.
A cheaper alternative to the covered call strategy to execute on is the poor man’s covered call strategy.
Strategy #3: Long Put (Buy Put)
I have introduced the Long Call (buying call options) strategy in strategy #1 and introduced selling call options as part of a strategy alongside owning 100 shares of the underlying stock to generate a stream of passive income in strategy #2.
In this strategy, an options beginner trader now can make money even if the stock market is to collapse, with shares witnessing massive price decline.
The great thing about options trading is its flexibility. You can make money when prices are going up and you can also easily make money when prices are coming down. This is unlike trading stock where it might be restrictive to go “short” on stocks.
More importantly, even if you are wrong in your expectation, and the stock trends significantly higher instead, your losses are capped in this strategy.
Hence, this 3rd Option trading strategy that beginners can easily execute is to Long Put, or Buy Put options.
This is similar to buying call options, but instead of being bullish on the counter, you are now taking a bearish stance.
As a buyer of the put option, you pay a premium as usual. This premium paid is now your maximum loss potential, even if you are wrong in your judgment and the stock price appreciates instead.
Your profit potential, on the other hand, starts increasing as the share price of the underlying gets lower, with the maximum profit potential reached when the share price hits $0.
As a Put Option buyer, you now have the RIGHT to SELL your stock to the counterparty at the agreed strike price during the options contracts’ validity. Compares this to a Call Option Buyer who has the RIGHT to BUY the stock from the counterparty.
Example: Now, assume that you believe stock ABC, which is currently trading at $50/share has more downside potential. You will like to profit from the weakness seen in its share price. You bought a put option, with a strike price of $50, paying a premium of $2/share. This options contract expires in 6 months.
During this entire 6-month period, you now have the RIGHT to sell ABC for $50/share. You want to do it only if the share price is substantially lower, say at $40/share. You now have the right to SELL at $50 and buy back from the market at $40 (Sell high, Buy low), thus profiting from the difference of $10.
However, do note that you have paid $2 in premium (breakeven price on expiration is $50 – $2 = $48/share), hence your exact profit potential in this scenario is $8/share or $800 for each put options contract you bought.
This translates to an ROI of 400%.
If the price of Stock ABC is to appreciate from $50 to $60 instead, meaning your initial expectation was wrong, you would have lost $1,000 if you had “shorted” 100 shares. When you bought this put option instead, your maximum loss is capped at the premium you paid, which amounts to $200.
When to use it
Just like a long call, a beginner can execute a long put if he/she is bearish on the counter and is witnessing increasing downside momentum on the stock. This is where it makes sense to buy a put option to profit from that downside momentum persisting or even accelerating. The more the price of the underlying drops, the more profitable your trade will become.
Even if you got the trade wrong and the price increases instead, you can sleep well at night, knowing perfectly that the maximum loss you will incur is the premium you paid for your put option.
Additional Reading: Hedging with options. How to Hedge using Put Options
Strategy #4: Short Put (Sell Put)
When you are a buyer of Put options, as I have detailed in strategy #3, you are taking a bearish stance. You pay a premium and if you are correct in your view (ie price decline), your profit potential can be substantial.
Now, on the flip side is being a seller of the put option or short put. This is a very popular strategy that is recommended by many option courses out there to generate income consistently. However, a beginner should be mindful of the risk involved when it comes to selling put options.
Unlike in buying where the downside risk is capped at the premium paid, selling options could result in substantial losses and this is where many new option traders get hit.
They are enticed by the reward of “getting a consistent stream of premiums every month” but when that one bad trade happens, it typically wipes out all the previous hard-earned profits that they have generated over multiple trades.
You see, when it comes to the short put strategy, you are taking a neutral to a bullish view of the underlying. You receive a premium by selling a put option. That is your maximum reward potential. However, when you are wrong and the underlying price collapses instead, your downside risk could be magnified, with the greatest risk occurring when the share price hits $0.
Example: Say you believe that Stock ABC, which is currently trading at $50/share, will witness a gradual appreciation over the coming weeks to $55/share. However, your conviction is low. You hence decide to sell a put option of stock ABC at a price of $50/share, receiving a premium of $2/share or $200 for an option contract. The contract lasts for 1 month.
As a put option seller, the $200 premium you received is your maximum profit and this is the profit that you will realize after 1 month when this put option contract that you have sold expire worthless (out of the money). As an option seller, you wish for the contract to expire worthless.
This means you pay NOTHING to close it off (ie Sell to open and receive $200 in premium and subsequently buy to close and pay $0). This happens when the share price of stock ABC is trading at a price of $50 or higher on expiration.
What happens when ABC closes below $50 on expiration, say at $45?
This is a scenario where the buyer of the Put option will have the incentive to “exercise” his/her right to sell the option to you at the higher price of $50 and you have the obligation to buy from him/her at the agreed price of $50/share. This is despite the current market price being at a much lower $45/share.
You now have to take ownership of 100 shares of ABC at a cost price of $50/share. Your unrealized loss is thus $500 ($50 cost – $45 market price)*100 shares.
When to use it
When it comes to Short Put or selling a put option, many option experts will claim that you should execute this strategy only on stocks you love and wish to own in the first place. You should also have enough capital to take ownership of 100 shares of the underlying when you are assigned to it. This is called “cash-secured put”, ie having sufficient capital to own 100 shares of the counter at the strike prices at which you sold the put at.
You expect the price to rise, by which the put option expires worthless and you get to keep the full premium. But if the price dips below your short put strike, you don’t mind taking ownership of a stock that you had the intention of buying in the first place (now also benefiting from the additional premium you received from selling the put option). This seems to be a win-win scenario.
However, there is a significant risk with such a strategy. What if the stock you love has significant downside risk (for example a hyper-growth stock). Your downside risk might be substantial if the price collapses.
Most beginner option sellers do not realize the risk exposure of the put option that they are selling, only enticed by the “juicy” premiums that they receive from the selling process until the share price collapses and they are forced to take ownership of hundreds of the underlying shares.
Additional Reading: The Wheel Strategy Options. Does This Options Strategy Make Sense?
This is hence a “riskier” strategy that beginner options traders should be aware of. When it comes to selling, the risk is never defined vs. option buying. While the probability of winning the trade is high for option selling, do note that one bad trade could potentially wipe out all the “hard-earned” winnings that you have generated over multiple previous trades.
My preferred strategy is to only select stocks that have limited downside risk and not stocks that I love when it comes to the put-selling process. I have written a detailed Put Selling Process in this article on how I would seek to select the right stocks to execute this put-selling strategy.
While options are normally associated with high risk, traders have several basic strategies that have limited risk. Hence, even risk-averse traders can use options to enhance their overall returns. However, it’s always important to understand the downside to any investment so that you know what you could lose and whether it’s worth the potential gain.
For those who find this options article informative, do share it with your friends who are interested to learn more about options. Do also consider signing up for the New Academy of Finance Newsletter to receive more of such articles on a timely basis.
Additional Reading: 3 Safe Options Strategies better than stock buying
Disclaimer: This article is not meant to be investment advice to trade options. Also, past performance is not representative of future performance. Please do your necessary due diligence, particularly when dealing with leveraged products such as options and executing on complex options strategies.
