In this post we cover some of the basic option strategies that option traders have to be familiar with.
Firstly, when you trade options, you can either buy or sell options. Well, that sounds obvious but it actually surprises a lot of people when they realise that you can sell an option that you don't even have. When you do that in your 'books' the quantity will be a negative number. E.g. you sell one put option then your broker platform will show that you have -1 put option.
As option traders, we primarily focus on collecting premiums, which means we normally sell options first and buy it back later. So our quantity will go down to negative number and when we close the deal, we bring the quantity back to 0.
Short position
When you have an option position with a negative quantity then it is called 'short' position.
Long position
When you have an option position with a positive quantity then it's called 'long' position.
When we talk about stock price movement directions then short means that we believe that the stock is going to go down. When we say we are 'long' on a stock then we believe that the price is going to go up.
So now that we clarified some basic terminologies let's take a look at some of the frequently used option trading strategies.
Naked Put
It means you sell one or more put options hoping that the stock is going to go up or at least stay above your strike price. It's probably the most common strategy as most of the times share prices go up instead of down.
Max profit: the amount of premium that you collected ($400 on the below graph)
Max loss: your strike price x 100 less the premium you collected ($12,000 - 400 = $11,600 on the below graph). Your max loss would literally mean that the company has gone bankrupt.
Naked call
It means you sell one or more call options hoping that the stock is going to go down or at least stay below your strike price. It's another popular strategy but your risk is infinite so you must use it carefully.
Max profit: the amount of premium that you collected ($400 on the below graph)
Max loss: infinite because there is no upper limit to how high a share price can go.
Straddle
It means you sell one or more call options and the same amount of put options with the same strike price hoping that the stock is going to stay where it is.
Max profit: the amount of premium that you collected ($800 on the below graph). You will only realise this if the share price stops exactly on the strike price, which is very unlikely to happen.
Max loss: infinite because there is no upper limit to how high a share price can go. But the good (or rather better) news is that if the share price goes downwards than your max loss is your strike price x 100 less the premium you collected ($12,000 - 800 = $11,200 on the below graph).
Strangle
It means you sell one or more call options and the same amount of put options with a lower strike price hoping that the stock is going to stay between the two strike prices.
Max profit: the amount of premium that you collected ($600 on the below graph).
Max loss: infinite because there is no upper limit to how high a share price can go. But the good (or rather better) news is that if the share price goes downwards than your max loss is your strike price x 100 less the premium you collected ($12,000 - 600 = $11,400 on the below graph).
Put Vertical
It means you sell one or more put options and buy the same amount of put options with a lower strike price hoping that the stock is going to stay above your short put strike.
Max profit: the amount of premium that you collected ($200 on the below graph).
Max loss: is based on the difference between your two strike prices x 100 less the premium you collected ($12,000 - 11,600 - 200 = $200 on the below graph).
Call Vertical
It means you sell one or more call options and buy the same amount of call options with a higher strike price hoping that the stock is going to stay below your short call strike.
Max profit: the amount of premium that you collected ($200 on the below graph).
Max loss: is based on the difference between your two strike prices x 100 less the premium you collected ($12,400 - 12,000 - 200 = $200 on the below graph).
Covered Call
It means you buy shares and sell one call option for each 100 share hoping that the share price will go up.
Max profit: is the amount of premium that you collected plus the increase of value of your shares. ($400 on the graph below as the shares were purchased for $118 and the call strike was at $120 so we had to sell the shares for $120, which generated $2 per share so it's 2 x 100 plus the $200 premium collected for the call option.)
Max loss: is the amount you spent on the shares less the premium you collected. ($11,800 - 200 = $11,600).
Let me know if you have any questions.