Stock and Call/Put options are combined to implement advanced trading strategies such as Covered Call, Married Put, Long Straddle and Spread.
In the “Call and Put Options” blog we reviewed how basic stock options work. In this blog, we will use these options to build more complex derivatives that cater to specific trading strategies.
Covered Call: The strategy here is to generate income while giving up some upside potential of the stock. The implementation involves buying (or holding) a stock and writing/selling a call option on the stock. The investor makes money by collecting a premium P. The investor is betting that the stock’s upside potential is limited to the Strike price (K) prior to option expiry. If the stock price (S) settles less than the Strike price (K) then the option will expire worthless. The investor is then able to repeat this process with no further investment as the underlying stock is already in possession. However, when the option is in-the-money (S>K), the investor has to relinquish the stock to the buyer of the option for the price K even though the stock is trading at a higher value than K.
Married Put: This is a principal protection strategy that involves buying the stock and a Put option with a Strike price equal to the stock price. If the stock price falls before the option expires, then the Put option will be in-the-money and would cover the stock loss for the investor. The investor would be able to sell the stock to the Put seller at the Strike price, or the original principal amount minus the premium paid for the Put. Thus, the Put acts as an insurance policy against a stock decline. If the stock goes up, then the Put will be out-of-the-money, but as the stock owner, the investor would fully participate in its upside.
Long Straddle: This strategy allows the investor to trade on the stock’s volatility by buying a Call and Put with the same expiration date and at a Strike price equal to the current stock price. Straddles are more expensive due to two premiums being involved. If the stock goes higher, then the Call option will be in-the-money and the Put out-of-the-money. The investor makes money by buying the stock at K and selling it higher at the current stock price (S2) in the open market. If the stock falls, then the Put option will be in-the-money and the Call out-of-the-money. The investor can buy the stock at a lower price (S1) and sell it to the Put seller for K, making a profit of K – S1. However, if the stock trades in the narrow range of +/- 2*P, then the Straddle option will expire worthless.
Spread: In this strategy, the investor is moderately bullish on the stock and intends to reduce the premium or the cost of setting up the strategy. The implementation involves buying a Call option at a lower Strike price of K1 and selling a Call option at a higher Strike price of K2, both with the same expiration. The premium collected on the second Call will subsidize the cost of the first Call option. The investor is betting that the stock has some upside potential from K1 but it is limited to K2 prior to the options expiring.
If the stock settles below K1, then both the options will expire as worthless. If the stock settles between the two Strike prices, then the first Call option will be in-the-money and the second one out-of-the-money. The investor profits from acquiring the stock at K1 and selling it higher at S in the open market. If the stock value increases beyond K2, then both options will be in-the-money and the investor still makes a profit, but it will be limited to the difference between the two Strike prices, as the investor is now obligated to sell the stock to the Call buyer for K2 even though the market price is higher.
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