Beginners guide to trading options
Trading options can be mind-boggling, but when used correctly, they offer many advantages.
Today, we’re going to share with you six different options strategies that allow traders to leverage their trades and reduce risk.
Options are contracts that give the holder the right, but not the obligation to buy or sell an asset at a predetermined price or before the contract expires.
To break this process down into simpler terms… buying options is similar to purchasing home or car insurance.
When you buy insurance, you’re protecting yourself against something awful, but you’re paying the agency a premium. When you sell insurance, you’re receiving a premium, but you’re liable to cover the cost when disaster strikes.
Options are essentially the same, except you’re insuring the specific price of an asset.
And, they’re easy to execute if you follow a few key points…
Buying a Call option
What is a Call Option and how do you buy one?
Buying a Call Option is a bullish trading technique traders use when the price of a stock is going to go up.
This strategy gives traders the right as the buyer, but not the obligation, to buy a stock at a specific Strike Price for that certain time period.
Here’s an example… I’m going to take a look at the S&P 500 ETF and specifically the SPY.
I’m going to focus in on the June 285 calls.
Since I’m buying a Call Option, I’m going to pay the asking price. In this case, it’s going to be $3.14.
Now, my max risk on the trade per one contract will be $3.14 multiplied by 100, because each time you buy one option contract it’s representing 100 shares of stock.
3.14 x 100 = $314.00.
Buying Call Options is popular among traders due to the amount of advantages…
For instance, one advantage of buying a Call Option is limited risk…
Let’s say the SPY goes back down to 270 next week, these options could only go to zero or my $314.00 can only go to zero.
Another advantage of buying a Call Option is that if the price of the stock goes up, the price of the Call Options also goes up in value.
For example, my breakeven on this trade will be the Strike Price that I’m picking, which is 285 plus the premium I paid.
Since I’m paying $3.14, my breakeven will be 285 plus 3.14, which equals to 288.14
Don’t forget… for every dollar amount that the SPY goes above that 288.14, my Call Options begin to make money.
For instance, let’s say that the SPY by June expiration is at 300, which means that my Call Options that I paid 3.14, will go to the value of $15.00.
But, how did I get there?
Well, if the stock of the SPY is at 300 and I have the 285 Call Options, then I must subtract the 285 from 300, which gives me $15.00.
Therefore, I can sell those options for a minimum of $15 or I can take stock of the SPY at 285, which is a $15 gain.
That’s a massive return and that’s the power of buying a Call Option.
Buying a Put Option
I personally like buying Put Options for two, valuable reasons… If I’m in a long position and I want to hedge my long or if I believe that a stock is going to go down.
Buying Put Options when you’re long is similar to buying insurance on your car or house.
If the stock goes lower, then you’re hedged and you could make money as the stock goes lower since Put Options give the owner the right, not obligation, to sell the stock at the strike that you chose or the premium that you paid during that specific time period.
When a trader buys a Put Option, they believe that the stock is going to go down. However, if a trader is long, they should buy the Put Option to hedge, or as insurance.
For example, let’s take a look at the SPY S&P 500 ETF June options that expire in 14 days.
I’m going to look at the 285 Puts and since I’m buying the June SPY 280 Puts, I’m paying 388.
Remember, the max loss when you’re buying a Put Option is the amount you paid or the premium.
They are 3.88 per one contract, which means that my max loss is 388 per contract.
In other words… 3.88 x 100 = $388.
Therefore, every dollar amount that the SPY goes below 285, and we take away that 388, so that gives us 281.12, we start to make money. That is our breakeven.
Now, let’s say that the SPY goes to 275 by June expiration.
These particular Puts are now starting to make money as the stock market goes down in value because they’re going up in value.
For example, let’s say the Put price moved to 270 by June expiration. My 3.88 went up to $15.00! (285 – 270 = 15).
That’s a fantastic return and it demonstrates exactly how powerful buying Put Options can be.
Bull Call Spread
A Bull Call Spread is a bullish options spread where traders buy a Call Option and then sell an upside Call Option. This strategy caps your risk, but also caps your potential gains.
For example, let’s take a look at the SPY, a very liquid, high volume S&P 500 ETF, which makes this extremely attractive to trade.
I’m going to look at buying the June 285 Call Options and I’m going to pay on the ask at 3.14.
Now, I want to turn that regular Call to a Bull Call Spread.
So, let’s say I think the SPY goes up by June expiration, but I don’t think it’s surpasses 290.
Therefore, I’m going to go to the bid on the June 290 calls and then turn around and sell them.
In other words, I’m going to buy those June 280 calls at 3.14 and I’m gonna sell the June 290 calls for $0.99.
This gives me a debit of 2.15, therefore my max risk or max lost on the trade is $215.00, or the debit I paid.
Now, if the SPY is above 290 at the June expiration, then my max gain is $285.
But, how did I figure that out?
I subtracted the width of the spread, which is $5.00, from the premium I paid or 2.15 for a max gain of 2.85 or $285.
The one downside of buying a Bull Call Spread is that you’re selling the upside Call Spread, which means your max gain is capped.
For example, if the June expiration traded at 300, we are capped at $5.00 (width) minus 215 (what we paid/premium), which leaves us with a max of 285.
Bear Put Spread
The Bear Put Spread is a bearish strategy traders use when they believe that the value of the stock is going to go lower, but not too low as you’re capping the downside risk.
For example, let’s look at the 285 Puts in the SPY at the June expiration. I’m going to buy these Puts.
Now, if I bought these Puts outright, I would pay 3.88 or $388.00.
Let’s say that I think the SPY will move lower, but not below 280.
Therefore, I’m going to sell these 280 Puts on the bid at 196.
So for this example, if I put my trade mid market and I get filled at 190 as a debit, so I am paying the debit or premium of $190.00 for the 288 Bear Put Spread.
The number one thing traders always need to know when trading a Bear Put Spread is their max loss.
Now, the only negative aspect of buying a Bear Put Spread is that your gains are capped at the dollar amount you’re paying for the spread, which in this case is 1.96 or $196.00. Remember, we always multiply options by 100 per one contract.
Now, my max gain on the trade will be at the SPY is at 280 or below by the June expiration, which is $310.00.
So, how do I find that max gain?
By subtracting 280 from 285, which leaves us with $5 or the width of the spread. Then I’m going to subtract the premium I paid (1.90) from the width of the spread. This means that we have a total of $3.10 for the max gain on the trade if the SPY is below the 280 Put Options that I sold by June expiration.
There’s one strategy that professional traders use in bullish market conditions… and it’s called a Call Fly.
Let’s get started…
Take a look at this example… Here, I’m going to say by June expiration that the SPY goes and stays like a magnet at 290.
Therefore, I can go to my trade tab and put on a Bull Call Spread.
Right now, the SPY is precisely at 285, so I’m going to buy those June 285 calls at 3.14.
Since I think that the SPY is going to go to 290, I’m going to sell double the amount of the 290 calls for $0.99.
Then, I’m going to buy the 295 Call Options.
Now that I have my Call Fly. I’m going to buy the 280 calls and sell double the amount of the 290 calls.
Then, I’m going to buy the 295 Calls to just limit my risk and margin purposes to avoid spending too much.
For this example, I’m going to try to get filled for a debit or the premium I paid at $1.40
Now, let’s analyze the trade…
Since we’re doing a Call Fly, it looks similar to an actual butterfly, where my max gain is the SPY penny at 290 at June expiration.
In this example, we can find the max gain by utilizing the Call Fly Spread and the wings or width of the spread ($5.00).
Therefore, I subtract the premium I’m paid (1.40) from the width ($5.00) and I’m left with a max gain of 3.60 or $360.
Now, my max loss on the trade is the debit or premium I paid, which is 1.40 or $140.00.
In other words, I am risking $140 to potentially make $360.
With a Call Fly Spread, I’m giving myself a precision pinpoint of where I think the SPY can trade.
So anywhere in between that range of 285 to 295, I start to make money on the Call Fly.
Call Fly Spreads are an attractive trading strategy because you only have to risk a little to receive massive amounts of profit in a short amount of time.
Bear Put Fly or Bear Butterfly
Traders use a Bear Put Fly or Bear Butterfly when they think the price of a stock is going to go down to a certain price point and stay there or what I like to call it… a pinpoint price target.
To explain this strategy, let’s jump straight into an example…
For instance, take a look at the SPY. I’m going to look at my chart and say that the SPY is just shy of 285, but I think the price is going to go lower by about $5.00 to 280.
Now, this could be any stock, but for this example we’re going to use the S&P 500 ETF.
Then I can go to my options chain under my trade tab and buy those 285 puts, which are marking at about $3.88.
Since I’m completing a Bear Put Fly, I’m going to sell double the amount of the 280 Put where I think the SPY is going to go. They’re about 196, and therefore I’m going to sell them for double the amount that I bought the 285.
To minimize risk, maximize my gains, and to avoid eating up a large amount of margin on the trade, I’m going to buy the 275 Puts on the ask here at $0.98.
This is where the wings of the Bear Put Fly or Bear Butterfly come into play and I’m making the wings $5.00 wide on the trade.
To take it one step further, I’m now going to pay a debit of $0.90 per contract.
Let’s analyze how this works…
The precision pinpoint is at 280 by June expiration. To calculate my max gain, I must subtract the premium I paid from the width of the spread.
For example, the width of my spread is $5.00 and I paid $0.90, so my max gain is $410.
5.00 – .90 = 4.10 or $410.
In other words, I’m risking $90 to potentially gain $410 on the trade if the SPY goes to 280 by expiration.
Additionally, my max loss is the debit that I paid, or $90.00.
Now let’s say that the S&P 500 goes to $300 by June expiration. I will lose my $90 per contract.
If SPY sells off below at 270, the max loss is still $90.00.
Anywhere in between the price point of 275 to 285, I start to make money in the Bear Put Butterfly.