If you’re familiar with options basics such as open interest, pricing, sentiment and expiration cycles, then it’s time to put your knowledge to work. In this article, we examine how to do that, presenting some basic options trading strategies and discussing how they can be used in bullish and bearish scenarios.

Figure 1. Bullish vs. Bearish Options Trading Strategies

Source: Schwab Center for Financial Research

Long calls

A long call trade is often the first option strategy investors try. It can be difficult to profit from long call trades, but understanding this strategy can be the first step toward more complex options trades. A long call option is a bullish strategy, insofar as you believe the share’s price will rise enough in the future to be worth buying a call with a specified strike price, but unlike with a long stock trade (purchasing the stock outright), you generally have to be right about more than just the direction of the stock to be profitable.

The price of an option is based on many components, including: (1) type of option (call or put), (2) the strike price of the option, (3) the amount of time until the option expires and (4) the anticipated level of volatility in the underlying stock, index or ETF. To profit on a long call trade, you will usually need to be right about the direction of the underlying stock’s price movement, the size of the move and the timing of the move.

Here are a few other things about call options to keep in mind:

1. Call options tend to move up or down along with the underlying instrument, though the moves are usually of a smaller magnitude.
2. The lower the strike price, the higher the value.
3. Option values are based in part on the number of days until expiration and generally lose a small amount of value with each day that passes. As a result, the closer the option gets to expiry, the lower its value tends to be.
4. Option values are also based in part on the anticipated level of volatility in the underlying instrument, so if volatility expectations rise or fall, options values adjust accordingly. In general, the lower the anticipated volatility, the lower the value of the option.

Before you decide to enter into any option strategy, it is important to do some simple calculations to find the maximum gain, the maximum loss and the breakeven point—the price the underlying stock or index must exceed at expiration to be profitable.

Here is the formula you would use on a long call trade, assuming the position is held until expiration:

• Long 1 XYZ Jan 50 Call @ $3
• Maximum gain = unlimited
• Maximum loss = $300 (3.00 option premium paid x 100 shares per contract)
• Breakeven point = 53 (50 strike price + 3.00 option premium)
   

Figure 2. Long Call Profit or Loss Visualization

Source: Schwab Center for Financial Research

As you can see in Figure 2, while the maximum potential loss on a long call trade is the price paid for the option, the potential profit is theoretically unlimited. Keep in mind that because the option has a limited lifespan, the move in the underlying stock needs to occur before expiration and be big enough to cover the cost of the option. It must also be sufficient to offset the erosion in time value and possibly changes in volatility. These factors work against the holder of a long option, resulting in a more difficult profit-or-loss scenario than one might think.

Short calls

Short calls, also known as uncovered or naked calls, are bearish trades, and I generally don’t recommend using them. They would be particularly inappropriate for inexperienced options traders or traders without substantial risk capital. Still, I think it’s helpful to illustrate how selling a short call creates a profit-or-loss scenario that is exactly the opposite of a long call. Here’s an example:

• Short 1 XYZ Jan 50 Call @ $3
• Maximum gain = $300 (3.00 option premium received x 100 shares per contract)
• Maximum loss = unlimited
• Breakeven point = 53 (50 strike price + 3.00 option premium)
   

Figure 3. Short (Uncovered) Call Profit or Loss Visualization

Source: Schwab Center for Financial Research

An uncovered or naked call is an extremely risky position to trade. While the profit (if the stock drops in price) is limited to the premium received at the time the option is sold, the risk is unlimited. To enter an uncovered call trade, you’ll need the highest option approval level available at Schwab (Level 3) and must have substantial funds to meet the higher margin requirements of this strategy.

Long puts

As with a long call trade, a long put trade is fairly straightforward. Again, these can be difficult to trade profitably, but they can serve as a foundation for more complex option strategies.

A long put option is a bearish strategy, like shorting a stock, insofar as you’re assuming a share’s price will fall enough in the future to be worth agreeing beforehand to sell at a certain price. Unlike a short stock position, however, you generally have to be right about more than just the direction of the stock to be profitable. As with long calls, you will usually need to be right about the direction, the magnitude and the timeframe of the stock price movement.

Here are a few other things about put options to keep in mind:

1. Put options tend to move in the opposite direction as the underlying instrument, whether up or down, though the moves are usually of a smaller magnitude.
2. The higher the strike price, the higher the value.
3. As with calls, put options also tend to lose a small amount of value with each day that passes on the way to expiration.
4. Put values are also based in part on expected volatility, and as a result, the lower the anticipated volatility, the lower the option value.

As with any options strategy, before you decide to enter a long put trade, be sure to find the maximum gain, maximum loss and breakeven points. The formula for these calculations on a long put trade is as follows:

• Long 1 XYZ Jan 50 Put @ $3
• Maximum gain = $4,700 (50 strike price – 3.00 option premium x 100 shares per contract)
• Maximum loss = $300 (3.00 option premium paid x 100 shares per contract)
• Breakeven point = 47 (50 strike price – 3.00 option premium)
   

Figure 4. Long Put Profit or Loss Visualization

Source: Schwab Center for Financial Research

As you can see in Figure 4, while the maximum potential loss on a long put trade is the price paid for the option, the profit potential as the stock drops in price is significant. Keep in mind that because the option has a limited lifespan, the move in the underlying security needs to happen before expiration and be big enough to cover the cost of the option. It also needs to be sufficient to offset the erosion in time value and possibly even changes in volatility. These characteristics of the trade make it more difficult than one might think to profit from the position.

Short puts

While short puts (also known as cash secured puts or naked puts) are not quite as risky as short calls, they are still not a strategy for inexperienced option traders or traders without substantial risk capital. Selling a put creates a profit-or-loss scenario that is exactly the opposite of long put. Here’s an example:

• Short 1 XYZ Jan 50 Put @ $3
• Maximum gain = $300 (3.00 option premium received x 100 shares per contract)
• Maximum loss = $4,700 (50 strike price – 3.00 option premium x 100 shares per contract)
• Breakeven = 47 (50 strike price – 3.00 option premium)
   

Figure 5. Short (Cash Secured or Naked) Put Profit or Loss Visualization

Source: Schwab Center for Financial Research

Note: Chart depicts strategy at expiration.

A short put trade can be an extremely risky position because while the profit (if the stock rises in price) is limited to the premium received at the time the option is sold, the downside risk increases the closer the stock gets to zero.

To enter a cash-secured short put trade, you’ll need the lowest option approval level available at Schwab (Level 0), and also sufficient cash available in your account to meet the potential assignment obligation. To enter a naked short put trade you’ll need not only the highest option approval level (Level 3), but you must also have substantial funds to meet the high margin requirements of this strategy.

Selecting your strike price

Traders who are new to options are usually quick to understand the risk/reward characteristics. But traders often have difficulty deciding what strike prices to use. Whether the strike price is in the money (ITM), at the money (ATM) or out of the money (OOTM) will affect the magnitude of the underlying move needed to reach profitability (or help you determine whether the trade can be profitable if the underlying stock remains unchanged). The tables below (Figures 6 and 7) illustrate how to properly structure a long or short option trade to match your level of bullishness or bearishness.

For example, if you are extremely bullish, you may want to consider out-of-the-money long calls or in-the-money short puts. Keep in mind, both will generally require a very large bullish move in the underlying stock or index in order to reach profitability. In contrast, if you are only slightly bullish, you may want to consider in-the-money long calls or out-of-the-money short puts, the latter of which can sometimes be profitable with no movement in the underlying stock.

Figure 6. Bullish Options Strategies

Source: Schwab Center for Financial Research

In the same manner, if you are extremely bearish you may want to consider out-of-the-money long puts or in-the-money short calls. Keep in mind, both will generally require a very large bearish move in the underlying stock or index to be profitable. In contrast, if you are only slightly bearish, you may want to consider in-the-money long puts, or out-of-the-money short calls, the latter of which can sometimes be profitable with no movement in the underlying stock.

Figure 7. Bearish Options Strategies

Source: Schwab Center for Financial Research

As with most option strategies, the greater the underlying move needed, the higher the profit potential—and the less likely it is that any profit will be made. In the case of out-of-the-money short puts and short calls, because profitability is possible with no movement in the underlying stock, the potential profit will likely be small. And the risk on these trades is extremely high, which is why I generally don’t recommend them. The use of credit spreads involves far less risk while generally providing only slightly less profit potential.

Another important concept to understand is that when you pair stocks and options, your sentiment on the underlying stock does not change (see Figure 8). You are simply using the option leg of the strategy to hedge your position or to help generate additional income.

Figure 8. Pairing Stocks and Options

Source: Schwab Center for Financial Research

In summary, you can take either a bullish or bearish position on an underlying instrument—a stock, an exchange-traded fund (ETF) or an index—using either calls or puts. What you use simply depends upon whether you buy or sell them first.