Iron condors and butterflies. Short and long straddles and strangles. Call and put ratio backspreads. Who said options are confusing?
If you let all the jargon overwhelm you, there is a good chance you will give up on options before you even get started.
There is no doubting that some strategies sound daunting. Like something from a board game, or perhaps even some type of military manoeuvre.
The biggest trap, however, is to bog yourself down learning about strategies that you are unlikely to ever use. Just as likely is that, by the time you are ready to use them, you will have forgotten what they are even about.
Despite their exotic names, options strategies use just two building blocks — call and/or put options. In isolation, or as part of a combination, these two option types form the basis of every option strategy.
Instead of worrying about complex strategies, option traders first need to get a handle on the basics.
Part of that is understanding call and put options. A call option gives the buyer the right (but not the obligation) to buy something, while a put option gives the buyer the right to sell something (again, not the obligation).
While it is important to understand the different types of options, there is something equally important that traders need to grasp.
It comes back not only to these basic definitions of call and put options, but to something that is inherent in any option strategy. That is, risks and obligations.
What are these risks and obligations?
All option strategies come with risks and obligations. Irrespective of how complicated the strategy is, though, there is something that remains unchanged.
That is, that the risks and obligations of any strategy are the sum total of each of the options that combine to make that strategy. In other words, the risks and obligations of each call and/or put option in the strategy.
If you keep this in mind, you can quickly pick apart even the most complicated strategy.
When writing an option — where the initial trade is a ‘sell’ — traders always need to be fully aware of their obligations. That is, if the buyer exercises their option, their obligations as the option writer.
For a call option writer, they must hand over the shares if the buyer exercises their call option. And for a put option, the writer must take delivery of the shares, if the buyer exercises their put option. Settlement takes place at the option strike price.
As discussed, the option buyer has the right, but not the obligation, to do something. That is, to buy the underlying shares if they exercise their call option. And, to offload their shares if they exercise their put option.
That is why the option buyer pays a premium to the option writer. They are paying for this right, that if they choose to exercise, the option writer must fulfil.
Knowing your risks
One of the attractions of buying options — whether a call or a put — is that the risk lies with the option writer who must fulfil their obligations.
As the option buyer, the most you can lose is the premium you pay. If you buy a call option, and the share price tanks, you will lose just a fraction of your funds compared to buying the shares outright.
In that regard, buying a call option might seem less risky than buying shares. But that’s not the case.
While buying a call option only costs a fraction of buying the underlying shares outright, all options have a finite life.
Because of that, if you buy an option, you are racing against time. The move you are trying to capture needs to happen before the option expires.
If that move doesn’t happen, you can kiss your premium good-bye. If you buy multiple options in a row, and they all expire worthless, it doesn’t take long for your losses to grow.
Mind you, you can always sell your option before it expires to recoup some of your funds back.
However, as time decay accelerates in the latter half of the option’s life, it doesn’t take long for the value of your option to fall.
Always another way
This is where options can be so versatile. Not only in reducing the costs of taking out a position, but in managing the obligations that come with different strategies.
For example, if you think a share price is going to rally, you could buy a call option. As I mentioned, though, you are racing against time.
So option traders can add another option leg to reduce their cost. In the case of buying a call option, they can also write an option with a higher strike price. In option jargon, it is a ‘bull call spread’.
By writing the higher strike price option, it puts a cap on your potential profits. But because you receive a premium for writing that (higher price) option, it reduces your overall cost. And that means it increases your chance of making money on the trade.
You are still paying money out. Your risk, though, is the (reduced) premium you pay.
With options, as I say, there is always another way. And that applies to the strategy we just looked at — the bull call spread.
If you think a share price is going to rally, another strategy is to write put options instead.
While your view of the market is the same as the bull call spread, this strategy comes with very different risks and obligations.
By writing a put option, you are agreeing to buy the shares if the buyer exercises the option — and will be required to pay the full amount. To protect yourself, you also buy a lower strike put option. This is a ‘bull put spread’.
Just like our other strategy, it means we are bullish on the trade. The difference being that we use put options instead of call options.
While buying the lower strike put option reduces the overall premium you receive, the most you can lose is the difference between the two strike prices.
But as I say, you are obligated to take delivery of the shares if the buyer exercises their option.
What this shows you is just how versatile options can be.
Again, though, you need to be aware of risks and obligations involved. These are things that you must always, always, understand.
All the best,
Matt Hibbard
Contributor