9 Bullish Strategies for Trading Options

1. Long Call

Image and video hosting by TinyPic

Components
A long call is simply the purchase of one call option.


Risk / Reward
Maximum Loss: Limited to the premium paid up front for the option.
Maximum Gain: Unlimited as the market rallies.


Characteristics
When to use: When you are bullish on market direction and also bullish on market volatility.

A long call option is the simplest way to benefit if you believe that the market will make an upward move and is the most common choice among first time investors.

Being long a call option means that you will benefit if the stock/future rallies, however, you risk is limited on the downside if the market makes a correction.

From the above graph you can see that if the stock/future is below the strike price at expiration, your only loss will be the premium paid for the option. Even if the stock goes into liquidation, you will never lose more than the option premium that you paid initially at the trade date.

Not only will your losses be limited on the downside, you will still benefit infinitely if the market stages a strong rally. A long call has unlimited profit potential on the upside.

2. Short Put

Image and video hosting by TinyPic

Components
A short put is simply the sale of a put option.

Risk / Reward
Maximum Loss: Unlimited in a falling market.
Maximum Gain: Limited to the premium received for selling the put option.

Characteristics
When to use: When you are bullish on market direction and bearish on market volatility.

Like the Short Call Option, selling naked puts can be a very risky strategy as your losses are unlimited in a falling market.

Although selling puts carries the potential for unlimited losses on the downside they are a great way to position yourself to buy stock when it becomes "cheap". Selling a put option is another way of saying "I would buy this stock for [strike] price if it were to trade there by [expiration] date."

A short put locks in the purchase price of a stock at the strike price. Plus you will keep any premium received as a result of the trade.

For example, say AAPL is trading at $98.25. You want to buy this stock buy think it could come off a bit in the next couple of weeks. You say to yourself "if AAPL sells off to $90 in two weeks I will buy."

At the time of writing this the $90 November put option (Nov 21) is trading at $2.37. You sell the put option and receive $237 for the trade and have now locked in a purchase price of $90 if AAPL trades that low in the 10 or so days until expiration. Plus you get to keep the $237 no matter what.

3. Long Synthetic

Image and video hosting by TinyPic

Components
Buy one call option and sell one put option at the same strike price.

Risk / Reward
Maximum Loss: Unlimited.
Maximum Gain: Unlimited.

Characteristics
When to use: When you are bullish on market direction.

Long Synthetic behaves exactly the same as being long the underlying security. You can use long synthetic's when you want the same payoff characteristics as holding a stock or futures contract. It has the benefit of being much cheaper than buying stock outright.

4. Call Backspread

Note: A Backspread is also called a Ratio Spread.

Image and video hosting by TinyPic

Components
Short one ITM call option and long two OTM call options.

Risk / Reward
Maximum Loss: Limited to the difference between the two strikes plus the net premium (which should be a credit).
Maximum Gain: Unlimited on the upside and limited on the downside.

Characteristics
Similar to a Short Straddle except the loss on the downside is limited.

When to use: When you are bullish on volatility and bullish on market price. Note though, that you profit when prices fall, although the gains are greater if the market rallies.

A Backspread looks a lot like a Long Straddle except the payoff flattens out on the downside. The other key difference is that Backspreads are usually done at a credit. That is, the net difference for both legs means that you receive money into your account up front instead of paying (debit) for the spread.

Even though the payoff looks like a "long" type position, it is often referred to as a "short" strategy. Generally it is like this: if you receive money for the position up front it is called a "Short" position and when you pay for a position it is called being "Long".

5. Call Bull Spread

Image and video hosting by TinyPic

Components
Long one call option with a low strike price and short one call option with a higher strike price.

Risk / Reward
Maximum Loss: Limited to premium paid for the long option minus the premium received for the short option.
Maximum Gain: Limited to the difference between the two strike prices minus the net premium paid for the spread.
Characteristics

When to use: When you are mildly bullish on market price and/or volatility.

You can see from the above graph that a call bull spread can only be worth as much as the difference between the two strike prices. So, when putting on a bull spread remember that the wider the strikes the more you can make. But the downside to this is that you will end up paying more for the spread. So, the deeper in the money calls you buy relative to the call options that you sell means a greater maximum loss if the market sells off.

A call bull spread is a very cost effective way to take a position when you are bullish on market direction. The cost of the bought call option will be partially offset by the premium received by the sold call option. This does, however, limit your potential gain if the market does rally but also reduces the cost of entering into this position.

This type of strategy is suited to investors who want to go long on market direction and also have an upside target in mind. The sold call acts as a profit target for the position. So, if the trader sees a short term move in an underlying but doesn't see the market going past $X, then a bull spread is ideal. With a bull spread he can easily go long without the added expenditure of an outright long stock and can even reduce the cost by selling the additional call option.

6. Put Bull Spread

Image and video hosting by TinyPic

Components
Long one put option and short another put option with a higher strike price.

Risk / Reward
Maximum Loss: Limited to the difference between the two strike prices minus the net premium received for the position.
Maximum Gain: Limited to the net credit received for the spread. I.e. the premium receieved for the short option less the premium paid for the long option.

Characteristics
When to use: When you are bullish on market direction.

A Put Bull Spread has the same payoff as the Call Bull Spread except the contracts used are put options instead of call options. Even though bullish, a trader may decide to place a put spread instead of a call spread because the risk/reward profile may be more favorable. This may be if the ITM call options have a higher implied volatility than the OTM put options. In this case, a call spread would be more expensive to initiate and hence the trader might prefer the lower cost option of a put spread.

7. Covered Call

Image and video hosting by TinyPic

Components
Long the underlying asset and short call options.

Risk / Reward
Maximum Loss: Unlimited on the downside.
Maximum Gain: Limited to the premium received from the sold call option.

Characteristics
When to use: When you own the underlying stock (or futures contract) and wish to lock in profits.

This strategy is used by many investors who hold stock. It is also used by many large funds as a method of generating consistent income from the sold options.

The idea behind a Covered Call (also called Covered Write) is to hold stock over a long period of time and every month or so sell out-of-the-money call options.

Even though the payoff diagram shows an unlimited loss potential, you must remember that many investors implementing this type of strategy have bought the stock long ago and hence the call option's strike price may be a long way from the purchase price of the stock.

For example, say you bought IBM last year at $25 and today it is trading at $40. You might decide write a $45 call option. Even if the market sells off temporarily it will have a long way to go before you start seeing losses on the underlying. Meanwhile, the call option expires worthless and you pocket the premium received from the spread.

Protected Covered Call
A "protected" covered call involves buying a downside (out-of-the-money) put together with the covered call i.e.: Buy Stock, Sell Call Option and Buy Put Option.

The profile of a protected covered call looks like call spread and has the benefit of limiting your downside risk in the event of a large sell off in the underlying stock/future.

8. Protective Put

Image and video hosting by TinyPic

Components
Long the underlying asset and long put options.

Risk / Reward
Maximum Loss: Limited to the premium paid for the put option.
Maximum Gain: Unlimited as the market rallies.

Characteristics
When to use: When you are long on the stock and want to protect yourself against a market correction.

A Protective Put strategy has a very similar pay off profile to the Long Call. You maximum loss is limited to the premium paid for the option and you have an unlimited profit potential.

Protective Puts are ideal for investors whom are very risk averse, i.e. they hold stock and are concerned about a stock market correction. So, if the market does sell off rapidly, the value of the put options that the trader holds will increase while the value of the stock will decrease. If the combined position is hedged then the profits of the put options will offset the losses of the stock and all the investor will lose will be the premium paid.

However, if the market rises substantially past the exercise price of the put options, then the puts will expire worthless while the stock position increases. But, the loss of the put position is limited, while the profits gained from the increase in the stock position are unlimited. So, in this case the losses of the put option and the gains forming from the stock do not offset each other: the profits gained from the increase in the underlying out weight the loss sustained from the put option premium.

9. Collar

Image and video hosting by TinyPic

Components
Long underlying stock/future
Short OTM call option
Long OTM put option

Risk / Reward
Maximum Loss: Limited to the difference between the two strikes less the net premium paid or received less the loss on the stock leg.

Maximum Gain: Limited to the difference between the two strikes plus the net premium paid or received plus the gain on the stock leg.

If the net premium is a credit, i.e. you received money for the option legs, then your maximum gain is the difference between the strikes plus this amount (and then plus the profit from the stock leg). If the net premium was a payment then it is subtracted from the strike differential.

Characteristics
As you can see from the above payoff chart, a collar behaves just like a long call spread.

It is suited to investors who already own the stock and are looking to:
  • increase their return by writing call options
  • minimize their downside risk by buying put options
Covered calls are becoming very popular strategy for investors who already own stock. They sell out-of-the-money call options at a price that they are happy to sell the stock at in return for receiving some premium upfront. If the stock doesn't trade above this level, the investor keeps the premium.

The problem with covered calls is that they have unlimited downside risk.

The solution to this is to protect the downside by buying an out-of-the-money put.

This increases the cost as you will have to outlay more to purchase the put and hence lowers your overall return.


Related Posts Plugin for WordPress, Blogger...

3-column blogger templates(available in 4 different styles)