Trading options can be riskier than laying a bet on a spin of the roulette wheel in Atlantic City, but it doesn't have to be. Savvy investors use options as a means of reducing their risk. You can use options trading strategies to limit your risk of loss or to lock in a price on a stock that you expect to take off. Some conservative option strategies even allow you to increase your income from your current stock position.
You can protect your current stock position from a dramatic loss by purchasing a "put" option against your stock. This strategy is referred to as a long put. A long put gives you the right, but not the obligation, to sell your stock at a set price for a specified period of time. You would typically buy a put with a strike price that represents the greatest loss that you are willing to take on your stock. If the stock price declines below that price, you can exercise your put option, allowing you to sell your stock at the higher strike price. If the price of your stock increases, your put option expires unexercised. You will lose the amount you paid for the premium, but you will keep your stock.
You can lock in the maximum price you are willing to pay for stock by purchasing a call option. This strategy is referred to as a long call. A long call gives you the right, but not the obligation, to purchase the underlying stock at a set price for a specified period of time. A long call strategy gives you time to observe a stock before you commit the full amount to make the stock purchase. If the stock declines significantly in price, you are under no obligation to buy it. You will lose the amount you paid for the option premium, but you will be protected from a potentially much larger loss. If the stock increases significantly, you can exercise your option and buy the stock at the lower strike price, earning an immediate profit.
You can make additional money from your existing stock portfolio, even if the stock price isn't moving much, by selling call options against your existing stock. This strategy is referred to as writing covered calls. You will receive a premium for agreeing to sell your stock at a set price for a specified period of time. If the stock does not increase more than the strike price, the option typically expires unexercised. You will keep both your stock and the premium. If the option is exercised, you will have to sell your stock at the strike price and you will get to keep the premium. If your stock decreases in price, your loss will be partially offset by the amount of the premium.
All advanced option strategies involve a combination of calls and puts. Many of these strategies, such as a bull call spread or a bear put spread, limit your potential loss to the price you paid for the premiums. Some strategies, such as writing naked call options, limit your potential gain to the amount of the premium you receive while exposing you to unlimited risk of loss. Options trading can be either a conservative or highly speculative investment strategy, but all options trading strategies involve some level of risk. Options are not appropriate for all investors.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.