Generally, an Option Strategy involves the simultaneous purchase and/or sale of different option contracts, also known as an Option Combination. I say generally because there are such a wide variety of option strategies that use multiple legs as their structure, however, even a one legged Long Call Option can be viewed as an option strategy.
Under the Options101 link, you may have noticed that the option examples provided have only looked at taking one option trade at a time. That is, if a trader thought that Coca Cola's share price was going to increase over the next month a simple way to profit from this move while limiting his/her risk is to buy a call option. Of course, s/he could also sell a put option.
But what if s/he bought a call and a put option at the same strike price in the same expiry month? How could a trader profit from such a scenario? Let's take a look at this option combination;
In this example, imagine you bought (long) 1 $65 July call option and also bought 1 $65 July put option. With the underlying trading at $65, the call costs you $2.88 and the put costs $2.88 also.
Now, when you're the option buyer (or going long) you can't lose more than your initial investment. So, you've outlaid a total of $5.76, which is you're maximum loss if all else goes wrong.
But what happens if the market rallies? The put option becomes less valuable as the market trades higher because you bought an option that gives you the right to sell the asset - meaning for a long put you want the market to go down. You can look at a long put diagram here.
However, the call option becomes infinitely valuable as the market trades higher. So, after you break away from your break even point your position has unlimited profit potential.
The same situation occurs if the market sells off. The call becomes worthless as trades below $67.88 (strike of $65 minus what you paid for it - $2.88), however, the put option becomes increasingly profitable.
If the market trades down 10%, and at expiry, closes at $58.50, then your option position is worth $0.74. You lose the total value of the call, which cost $2.88, however, the put option has expired in the money and is worth $6.5. Subtract from this to total amount paid for the position, $5.76 and now the position is worth 0.74. This means that you will exercise your right and take possession of the underlying asset at the strike price.
This means that you will effectively be short the underlying shares at $65. With the current price in the market trading at $58.50, you can buy back the shares and make an instant $6.50 per share for a total net profit of $0.74 per share.
That might not sound like much, but consider what your return on investment is. You outlaid a total $5.76 and made $0.74 in a two month period. That's a 12.85% return in a two month period with a known maximum risk and unlimited profit potential.
This is just one example of an option combination. There are many different ways that you can combine option contracts together, and also with the underlying asset, to customize your risk/reward profile.
You've probably realized by now that buying and selling options requires more than just a view on the market direction of the underlying asset. You also need to understand and make a decision on what you think will happen to the underlying asset's volatility. Or more importantly, what will happen to the implied volatility of the options themselves.
If the market price of an option contract implies that it is 50% more expensive than the historical prices for the same characteristics, then you may decide against buying into this option and hence make a move to sell it instead.
But how can you tell if an options implied volatility is historically high?
Well, the only tool that I know of that does this well is the Volcone Analyzer. It analyzes any option contract and compares it against the historical averages, while providing a graphical representation of the price movements through time - know as the Volatility Cone. A great tool to use for price comparisons.
Anyway, for further ideas on option combinations, take a look at the list to the left and see what strategy is right for you.
Comments (72)
danielyee
December 22nd, 2011 at 7:08am
Peter
If I buy a call e.g price $50 if the market start at 9.30 then suddenly drop is this mean all my money gone?
Peter
December 21st, 2011 at 3:52pm
You should be able to see the last price - even if the market is closed.
danielyee
December 21st, 2011 at 4:38am
Thanks and when I click e.g AAPL per contract value N/A
Does this mean I need to wait until market open to see the price?
Peter
December 20th, 2011 at 5:05pm
You can take a look at the option prices on Yahoo.
danielyee
December 20th, 2011 at 5:15am
Peter
I'm a new guy here...can you teach me where I can see if I want to buy e.g AAPL option trading per contract how much? Thanks.
Peter
December 18th, 2011 at 3:52pm
Yes.
Jorge
December 16th, 2011 at 4:35pm
Peter,
What if I sell 5000K put on the day of expiration of the contract and the stock does not move significantly in value to exercise the contract for who ever bought it.
Do I get to keep the commission?
Peter
September 29th, 2011 at 12:15am
You won't be able to roll over at the same price - if you want to keep a position in the same strike price, you will have to sell (buy) out of the front month contract and buy (sell) into the back month at the current market prices.
Ankur
September 29th, 2011 at 12:00am
Thanks Peter. Further, if I need to rollover my position to next month, then do I need to pay some extra premium or can I rollover at the same price?
Thanks
Peter
September 28th, 2011 at 6:04pm
Yes, exactly. You would close your position for a profit without having to wait until expiration to exercise the option.
Ankur
September 28th, 2011 at 8:00am
Hi Peter,
Really good information on Options. I had one question - Suppose I buy a an option Call 5000 for Rs 30 whereas the index is at 4950. Within 2 hours, index moves to 4990 and option premium is Rs 35. Can I sell the contract now and earn Rs 5 per lot as profit though the index did not reach 5000?
Thanks
Peter
September 18th, 2011 at 11:37pm
Risk-free? Me too, please let me know when you find such strategies ;-)
aparna
September 18th, 2011 at 11:34pm
I want to learn risk-free option trading in Indian market. Suggest me some website for it.
NAGESH
September 4th, 2011 at 11:30am
First time I found more information about options. Thanks a lot.
Peter
August 3rd, 2011 at 5:55pm
Both futures and stocks have a delta of 1 so hedging with a future is much the same as hedging with a stock.
Raj baghel
August 3rd, 2011 at 1:08am
is there any help for hedging in future with respect to call/put.
Peter
August 1st, 2011 at 5:48pm
Please see the in-the-money page.
Arul
August 1st, 2011 at 7:02am
what is in the money call & put?
Peter
May 12th, 2011 at 11:05pm
Hi spinnerrobert, yes, you can exit an option position at any time prior to the expiraton date.
Peter
May 12th, 2011 at 11:04pm
Hi Azaragoza, you can check out my option pricing spreadsheet for the formula.
spinnerrobert
May 12th, 2011 at 8:29pm
My qestion is let say i own akam and buy option for either put or call. I want to sell it right after i purchase the contract let say within one hour. Is that allow?
azaragoza
May 5th, 2011 at 3:15pm
what is the formula you use to optain the PnL charts, do you have an example?
Peter
February 28th, 2011 at 3:05am
Hi Jai, it really depends on what market you're looking at and what your view is of this market i.e is it trending upwards, is there a lot of volatility etc?
That's what's great about options - the strategies vary according to lots of factors.
Jai
February 24th, 2011 at 11:14pm
hi
Would you tell which are the best available statergies in the option market now
S.Vivek
February 7th, 2011 at 4:48am
can you tell me short on options and how its works ?
UOG
December 13th, 2010 at 1:26pm
Hello, I think your blog is epic. Congrats.
Peter
December 7th, 2010 at 1:25am
You'd need to check with your if they can provide this service. I know that Interactive Brokers provide an API to plug external systems into that operates over the Internet.
DAJB
December 6th, 2010 at 3:38pm
Hi,
If one is using computational systems as an aid to decision making, then is there a source to receive streaming real time prices over the internet in a way which could be easily integrated into a system?
Thanks,
D
Peter
October 31st, 2010 at 3:53am
Hi Anon,
Premium is the price of the option as it is traded in the market. Commissions (aka brokerage) are what you pay to your broker for executing your trade.
1. You would lose the premium plus any commissions paid to the broker, so $32.95
2. Depends on where the stock is in relation to the strike price. If you were very confident that the stock will not be above the strike price by the expiration date, then you would sell the option back at whatever price you could get and the loss would be $32.95 less (price sold for + $2.95).
3. You will only lose the premium paid (plus commissions) i.e. $32.95.
Hope this helps. Let me know if anything is unclear.
Anonymous
October 29th, 2010 at 10:16pm
I am using Thinkorswim. I haven't seen about premium. So, I am wondering that what the differences between "premium" and "commission" are?
I bought long call GLD at 128 and expire Oct 2010, I got info from Thinkorswim; max profit = infinite, max loss = 30(not including possible dividend risk), cost of trade including commissions = 30+2.95 = 32.95.
My question are;
1. If the strike price expired Oct 31, 2010 is 125, how much would I loss (30 or 2.95 or 32.95)
2. Before the end of expiration, I thought that the market would go down. Which one should I pick between "sell it before expiration" or "do nothing in order to let it expired." How much does it cost of both of them?
3. If the strike price expired Oct 31,2010 is 130, what will happen if I do nothing and let it expired?
Thank you
Sam
Peter
October 21st, 2010 at 4:21am
Depends on the country and what your main form of income is I'd say, whether the trade is treated as capital gains or income.
syrus
October 21st, 2010 at 2:08am
What is the tax liablity of a option trading when option is exercised. whether it will be profitable after payment of commission to broker and tax. is there any safe net to safeguard profit
Peter
October 18th, 2010 at 5:15pm
Yes, you can surely exit an option position by trading out of it prior to the expiration date.
Kartik
October 18th, 2010 at 8:03am
This explaination talks about option in case of expiry but what in case of trade which takes place in between the expiry date.
Peter
September 17th, 2010 at 2:26am
Hi Meghna, just because there are no bids out there doesn't mean there aren't any buyers. You can just enter a sell order into the market and if the price is right a market maker will take it.
Meghna
September 17th, 2010 at 2:19am
Hi Peter, I know that i can reverse the position by selling in the same market. But in electronic trading generally bids are not available for deep ITM / OTM options, while in OTC market I can easily reverse the position by paying some what higher to the broker. Hence kindly clarify how to deel with such situation in e-trading like "Indian Nifty".
Peter
September 15th, 2010 at 6:39am
Yep, you can just reverse the option position by selling the same option contract in the option market.
Meghna
September 15th, 2010 at 5:25am
HI, Say if I am buying an in the money European option with an expiry of 4 months and If the option is deep ITM or OTM during at the end of 2nd month and if i want to crystallize my profits than is there any way out for it?
Peter
September 5th, 2010 at 5:15am
It's hard to beat Interactive Brokers on brokerage and platform functionality. Although I've heard that Think or Swim have a great platform also.
ramesh
September 5th, 2010 at 12:32am
Which firm has best trading tools and low commissions?
Peter
September 2nd, 2010 at 5:55pm
I use and can recommend Interactive Brokers. They are a US based company and you don't have to live in the US to open an account with them.
NaZZ
September 2nd, 2010 at 7:02am
I stay in Thailand(in Asia), how can I start to trade because I do not any account with any broker in USA. Can you suggest me broker's web site to open account and trade.
Peter
August 29th, 2010 at 5:07pm
Hi Sam, thanks for the feedback!
Yes, I think that simple naked long positions are still useful and obviously have the most bang for buck so to speak. It's just that option traders need to understand the factors that affect an option's value - specifically volatility.
Often you may purchase a call option and even though the stock does rally the call option won't gain any value - or could even lose value in the market. This is because the drop in implied volatility has played a larger role in the option's value than the move in the stock price.
This can be discouraging to new option traders. But this doesn't mean that naked call and put buying should be avoided...just needs to be understood.
Sam
August 29th, 2010 at 10:41am
hi Peter,
it's really nice website you have. Anyway, talking about options strategy , based on your experience, is it still useful using only simple long call or put ? because i heard that these are useless, mostly worthless.
Peter
August 29th, 2010 at 5:44am
Hi Rajesh, are you located in the US? If so, the following companies provide option courses and training;
Options University
Online Trading Academy
rajashekargoud
August 27th, 2010 at 12:11pm
i am interested option please suggest me good insitituion for traning and from where i should start option(instial investments)and for dealing in option we should have any experiance
Peter
August 26th, 2010 at 12:31am
Hi Raju, thanks for the feedback...if you have any other suggestions for the site, please let me know.
raju jee
August 25th, 2010 at 9:59pm
hi.. jst go thru ths site and m stant abut knowing option stategy. plz teach me more and CONGRAT 4 ur valuable meteriel.
Peter
August 18th, 2010 at 6:57pm
Hi Dale, HPQ is currently at 41.36 so your put options are ITM for the buyer, which means you're looking at being exercised and taking delivery of the stock at $45.
With expiration tomorrow your put has a delta of -1, which means you're effectively long the stock now.
(use Option-Price.com for Greeks)
What you do now depends on your view of HPQ. By selling a put, I would say that you must have been somewhat bullish in the first place to be prepared to hold the stock at $45...although HPQ has take a sharp dive lately, maybe your view has changed. If that's the case you could sell out of the puts tomorrow and cut your losses on this trade.
Or, if you want to continue holding the stock, then why not have a look at writing some September $43 calls? You will limit your gains if the stock gets there but will have the immediate gain of income from the premium received.
Dale Brooks
August 18th, 2010 at 6:00pm
I am short the hpq jan 12 45 put, what is a good stategy to limit my risk on the down side ? Should I go long the same put at the same strike ? Thank you Dale
Peter
August 14th, 2010 at 4:00pm
Hi Amit, there are two firms that provide this kind of training;
Options University
Online Trading Academy
Amit Sharma
August 14th, 2010 at 2:06pm
Want to learn Option Strategy with prctical Knowledge Contact : 9818759927, 9211663645
Peter
August 14th, 2010 at 6:28am
You could try Options University
shamsul idrisi
August 13th, 2010 at 12:27pm
i want to learn option trading please suggest me some good training center
Peter
August 6th, 2010 at 2:00am
Interesting...do you know of a good place to source the put/call ratio numbers?
Brad
August 6th, 2010 at 12:44am
I think that the best overbought oversold indicator and a reversal signal is when lets say a stock is in an up trend than for a couple of days in bound-range.
the signal comes with a sudden PUT/CALL ratio change with a significant volume
AUMKAR
August 3rd, 2010 at 1:21pm
What will be happen if the NIFTY STRAIT go 100+
anjanappa
July 30th, 2010 at 2:04am
call opt put optns strategies, i am very succsed in this field pl anybody try and earn get more money thank u
Peter
May 26th, 2010 at 12:57am
No, OTC can mean a transaction between two parties for any type of financial instrument - even stocks can be traded OTC.
Maria
May 25th, 2010 at 9:16am
When somebody talks about OTC Commodities: does this only mean Commodities options?
Peter
May 11th, 2010 at 6:34am
It's where you buy/sell the underlying to reduce your delta exposure.
piyul
May 7th, 2010 at 8:24am
what is hedging stratges
roshan
March 27th, 2010 at 8:18am
wat is option101
Peter
July 19th, 2009 at 8:18am
Hi Yogesh, any strategy that has unlimited updside profit potential e.g. Long Straddle, which allows for unlimited profit if the stock trades up or down.
yogesh
July 18th, 2009 at 5:11am
which strategies use for give the more profit plz reply the answer
priyal
May 9th, 2009 at 4:25am
for understanding option u have to read more books & be practical
Vinesh
May 6th, 2009 at 9:55pm
Hi, i am Indian Investor and trader. I have just this website few days back and i want to tell you this is best site on Options Trading and imparting knowledge on the subject. Congratulations...
Admin
December 8th, 2008 at 3:21am
Hi Lisa,
Yes, you sure can trade online.
I use http://www.interactivebrokers.com who have a great font end and pretty low brokerage. You could also try http://www.tradeking.com
lisa Ascolese
November 22nd, 2008 at 8:56am
Who would I call if I wanted to trade options. Is this something that I could do online?
chandi
November 12th, 2008 at 7:00am
I want to know what r the Riskless Strategies in Option Trading. That will give money in any market condition.
Admin
November 7th, 2008 at 7:03pm
Hi Prafulla,
Sorry, I don't understand your question. Could you be more specific please?
prafulla
November 3rd, 2008 at 11:39am
what r the proces for invest on it.
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