Stock Option Strategies

Options are flexible derivative securities that can enable an investor to successfully hedge against price movement, or speculate a move on stocks and commodities. Here are some of the most common option strategies;

Protective Put
If you were to purchase a stock, you could theoretically lose all of your investment if the price were to go to zero. But we know that a put option increases in value as the price of the underlying security decreases. Therefore one could consider a transaction where the stock is purchased along with put options. Whatever happens to the stock price, you are guaranteed a payoff equal to the put option's exercise price because the put gives you the right to sell the underlying security for a given price, even if its market value is less than the exercise price. Protective puts can therefore manage your downside risk and are often referred to as portfolio insurance. The downside to a protective put is the case where the stock would increase in value. Here your profits would be decreased by the cost of the put.

Covered Call
A covered call position involves buying a stock and simultaneously selling a call option on the stock. The position is covered as the potential future obligation to sell the stock can be met with the shares owned. This strategy is often used by long investors who wish to boost income by collecting premiums on these calls. It is especially effective when the exercise price on the call is matched with a specific selling price that has been decided by the investor. In a sense, it locks the profit but limits the potential upside if the stock shoots up above the exercise price.

Straddle
A straddle is established by buying both a call on a put on a stock, each with the same exercise price and the same expiration date. Straddles can be a useful strategy for investors who believe that a stock will move a lot in price, but they are not sure of the direction. The straddle position would do well regardless of the outcome because its value will be the highest when the stock makes an extreme move, in either direction. The worst case scenerio for a straddle option strategy is when the stock stays relatively flat in price. This would mean that both options would expire and the investor would lose the amount invested in them.

A strip is a variation of a straddle that uses two put and one call while a strap uses two calls and one put, but with the same exercise price and expiration date. They can allow the investor extra leverage for the down or up move.

Spreads
A spread is a combination of two or more call options or two or more put options one the same stock, but at differing exercise prices and expiration dates. Some options will be held long, while others will be written. A money spread involves the purchase of one option and the simultaneous sale of another with different exercise price. A time spread referes top the sale and purchase of options with differing expriation dates.

Collars
A collar is an option strategy that brackets the value of a portfolio between two price points. A collar would be appropriate if an investor wanted to maintain the value of his/her portfolio within a certain range. A combination of options can be used to maintain that level.