Intro: Option/Stock Strategy
An Introduction to Option and Stock Strategies
Uses of Options
Options can be used to decrease or increase risk.
A call option is a leveraged position in stock—so it can be used to take on a riskier position than simply buying the underlying stock.
However, options are also used in many cases to decrease risk.
In this interactive presentation, we’ll focus on using options and stock together in ways which reduce or limit risk.
Option and Stock Strategies
We’ll cover the following very common strategies:
- Covered Call
- Protective Put
The covered call strategy consists of buying a share of stock while selling a call option on that share. Generally the call’s strike price is above the present price of the stock.
Example: Buy 100 shares of TWTR for $40/share and sell a call option contract with a $45 strike price. Say we received a price of $1.50 per option.
The effect of the sale of the call option is to effectively lower the purchase price of the stock by $1.50 per share. Nothing is free however. In exchange we have given up any gain from the stock increasing over $45 per share.
The covered call is similar to buying a stock and setting a limit sell order.
For our example we can calculate the max gain, loss, and the stock price at which we break-even.
Max gain at option expiration: If the stock increases to $45, then we earn $5 on the stock, and we pay $0 on the option (keeping the entire $1.50 premium). So our max gain is: $5 + $1.50 = $6.50 per share, or $650 for the entire contract.
Max loss: This is easy—if the stock falls to $0 we will lose $40 - $1.50 = $38.50 per share. We of course kept the option premium.
Break-even: If the stock falls to $38.50, then we will lose $1.50 on the stock and gain $1.50 on the option to break even.
Note that the above ignores the time-value-of-money.
A second common strategy is the protective put. Here we buy a stock and limit our downside by also buying a put (generally with a strike below the present stock price).
If we buy a put with a $45 strike price, this means we are guaranteed to be able to sell the stock for $45 anytime before the expiration of the option.
In a protective put, we own the stock and also have a guaranteed price at which we can sell that stock. So it is similar to buying the stock and setting a stop loss order.
For example, say we bought 100 shares of AAPL for $100 per share and that we simultaneously bought 1 put option contract with a $90 strike price for a $2 premium.
Our maximum loss is $12 per share, which is a $10 loss on the stock plus the $2 put option premium.
We break even when AAPL trades at $102. This is a $2 gain on AAPL, and a $2 loss on the option.
Our maximum gain is unbounded.
In a collar you buy a share of stock, sell a call with a higher strike, and buy a put with a lower strike.
In essence, a collar is a protective put, where the cost of the put is partially financed through the sale of a call.
Say you bought 100 shares of CSCO stock for $30, sold a $35 call for $1, and bought a $25 put for $2.
The most you can lose is $6 (lose $5 on the stock and $2 on the put, but gain $1 on the call).
The most you can gain is $4 (gain $5 on the stock plus $1 on the call, but lose $2 on the put).
You break even when the CSCO trades for $29.
An Important Consideration
These strategies only work only until the option expires. If you want to continue the option strategy, you have to enter into new option trades.
Each time you enter into new trades you incur transaction costs, which must be considered when evaluating the effectiveness of the strategy.
Credits and Collaboration
Click the following links to see the code, line-by-line contributions to this presentation, and all the collaborators who have contributed to 5-Minute Finance via GitHub.
Learn more about how to contribute here.