by Randy Frederick 09/03/08
Once you understand the basics of options -- including terminology, rights and obligations, open interest, pricing, sentiment and expiration cycles -- it's time to put that knowledge to work by examining some basic option strategies and how they can be used.
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For simplicity's sake, we'll use equities as the underlying instrument in this discussion, but keep in mind that the underlying instrument can also be an exchange-traded fund (ETF) or even an index.
Remember that you can take a bullish or bearish position using either long/short calls or long/short puts.
Long Calls
Perhaps the simplest option strategy to understand (though not necessarily the easiest with which to make a profit) may be the long call trade, which you can use if you believe the underlying stock will rise.
Buying a call gives you the right (but not the obligation) to buy the underlying stock at the strike price at any time up until the option expires.
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If the price of the underlying stock rises higher than the strike price, exercising the option allows you to "call" away the stock from the option seller for less than its market value.
A long call trade is often the first option strategy investors use when they decide to venture into trading options. Unfortunately, long calls can often be difficult to trade profitably.
A long call option is a bullish strategy, but unlike a long stock trade, you generally have to be right about more than just the direction of the underlying stock to be profitable. Remember, the price of an option is based on many components, including whether it's a put or call option, the strike price of the option and the amount of time until it expires.
To profit on a long call trade, you'll typically need to be right about the direction of the underlying stock price movement and the magnitude it moves in that direction, as well as how long it takes to make the move. Occasionally, you can be profitable if you're right on two of these three items, but direction alone is almost never enough.
Before you decide to enter any option position, it's important to do some simple calculations to find the maximum gain, maximum loss and break-even points.
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