Basic Strategies for Options - Print Friendly Version

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Basic Strategies for Options

Okay, now that we have gotten our feet wet with some of option basics – and even some of the more complicated stuff like the option Greeks -- it is time to tackle some simple option strategies. Don't fret, we promise, if the previous five sections didn't "bake your noodle" this section is going to be like a walk in the park. Plus, it should help you understand the versatility of options as an investment vehicle.

Before we get started we must note that for the purposes of clarity, commissions and other transaction costs, tax considerations and the costs involved in margin accounts have been omitted from our examples. All of these factors will affect a strategy's potential outcome so you are always well advised to check with your broker and tax advisor before entering into any of these strategies. Also, we are going to assume that all options are American-style and therefore can be exercised at any time before expiration.

Four Basic Strategies

Understanding options requires that investors get comfortable with one very simple concept, there are two sides of every market, bullish and bearish. We know that calls give the buyer the right, but not the obligation to buy a specified underlying security at a specified price for a fixed period of time. The call buyer believes the underlying security will rise in price, he is bullish. We also know that puts give the buyer the right, but not the obligation to sell a specified underlying security at a specified price for a fixed period of time. The put buyer believes the underlying security will fall in price, he is bearish. These actions are on opposite sides of the market.

Now let's look at the transaction from the option writer's (seller) point of view. When an investor sells a call option he assumes the obligation to deliver the underlying security at a specified price for a fixed period of time if requested by the holder of the option contract. The call writer is speculating that the underlying security will not rise in price and he will keep the premium, he is bearish. When an investor sells puts he assumes the obligation to buy the underlying security at a specified price for a fixed period of time if requested by the holder of the option contract. The put writer is speculating that the underlying stock will not fall in price and he will keep the premium, he is bullish. These two actions are on opposite sides of the market.

Bet you guessed where we are going with all of this. The logical conclusion is that buying calls and selling puts are each bullish strategies. By the same logic buying puts and selling calls are bearish strategies. These are the four basic option strategies.

You're probably ready to get into the strategies in greater detail but that will have to wait until the next lesson. Take a moment to think about how these strategies are intertwined.

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