Options Basics
Call Options
A call option gives the buyer the right (but not obligation) to buy shares of a stock at a specified price (strike price) before a specified date (expiration). Call buyers are bullish, expecting the stock price to rise.
Put Options
A put option gives the buyer the right (but not obligation) to sell shares of a stock at a specified price (strike price) before a specified date (expiration). Put buyers are bearish, expecting the stock price to fall.
Key Terms
Strike Price: The price at which the option can be exercised.
Expiration Date: The date when the option contract expires.
Premium: The price paid to purchase an option or received when selling an option.
In-the-Money (ITM): A call option with strike price below the current stock price, or a put option with strike price above the current stock price.
Out-of-the-Money (OTM): A call option with strike price above the current stock price, or a put option with strike price below the current stock price.
Understanding Time Decay (Theta)
Options are wasting assets that lose value as they approach expiration, a concept known as time decay or theta. This decay accelerates in the final weeks before expiration.
Buying Options (Long Positions):
Time decay works against you when buying options. Your option loses value each day if the underlying price doesn't move favorably enough to offset the decay.
Selling Options (Short Positions):
Time decay works in your favor when selling options. As an option seller, you profit from the erosion of the option's value over time if the price stays within your expected range.
Basic Strategies
Covered Call
A strategy where you own the underlying stock and sell call options against it to generate income.
Components
Profit Potential
Limited to the strike price of the call minus the purchase price of the stock plus the premium received.
Loss Potential
Limited to the purchase price of the stock minus the premium received.
Time Decay Effect
Benefits from time decay
Best Used In
Sideways or slightly bullish markets when you want to generate income from existing stock positions.
Example
You own 100 shares of XYZ at $50 per share. You sell a call option with a strike price of $55 and receive $2 premium. Maximum profit: $7 per share if stock rises above $55.
Long Call
Buying a call option gives you the right to purchase the stock at the strike price before expiration.
Components
Profit Potential
Unlimited as the stock price rises above the strike price plus premium paid.
Loss Potential
Limited to the premium paid for the option.
Time Decay Effect
Hurt by time decay
Best Used In
Strongly bullish markets when you expect significant upward movement in the stock price.
Example
You buy a call option on XYZ with a strike price of $50 for $3 premium. Break-even: $53. You profit if the stock price exceeds $53 before expiration.
Long Put
Buying a put option gives you the right to sell the stock at the strike price before expiration.
Components
Profit Potential
Maximum profit potential is the strike price minus the premium paid (if the stock goes to zero).
Loss Potential
Limited to the premium paid for the option.
Time Decay Effect
Hurt by time decay
Best Used In
Bearish markets when you expect significant downward movement in the stock price.
Example
You buy a put option on XYZ with a strike price of $50 for $3 premium. Break-even: $47. You profit if the stock price falls below $47 before expiration.
Cash-Secured Put
Selling a put option while holding enough cash to buy the stock if assigned. Often used to enter a stock position at a lower price.
Components
Profit Potential
Limited to the premium received from selling the put.
Loss Potential
Limited to the strike price minus the premium received (if the stock goes to zero).
Time Decay Effect
Benefits from time decay
Best Used In
Neutral to bullish markets when you want to enter a stock position at a lower price than the current market price.
Example
XYZ is trading at $50. You sell a $45 put for $2, receiving $200. If the stock stays above $45, you keep the $200. If it falls below $45, you buy the stock at $45 per share, with an effective entry price of $43 after the premium.
Directional Spread Strategies
Put Credit Spread
Selling a put option at a higher strike price and buying a put option at a lower strike price with the same expiration date.
Components
Profit Potential
Limited to the net premium received.
Loss Potential
Limited to the difference between strike prices minus the net premium received.
Time Decay Effect
Benefits from time decay
Best Used In
Moderately bullish or neutral markets when you want defined risk and expect the stock to remain above the short put strike.
Example
You sell a $45 put on XYZ for $2 and buy a $40 put for $1. Net premium: $1. Max profit: $100 per spread if XYZ stays above $45. Max loss: $400 per spread if XYZ falls below $40.
Call Credit Spread
Selling a call option at a lower strike price and buying a call option at a higher strike price with the same expiration date.
Components
Profit Potential
Limited to the net premium received.
Loss Potential
Limited to the difference between strike prices minus the net premium received.
Time Decay Effect
Benefits from time decay
Best Used In
Moderately bearish or neutral markets when you want defined risk and expect the stock to remain below the short call strike.
Example
You sell a $55 call on XYZ for $2 and buy a $60 call for $1. Net premium: $1. Max profit: $100 per spread if XYZ stays below $55. Max loss: $400 per spread if XYZ rises above $60.
Neutral and Range-Bound Strategies
Iron Condor
A combination of a bull put spread and a bear call spread with the same expiration date, creating a range where you profit if the stock stays between your short strikes.
Components
Profit Potential
Limited to the net premium received.
Loss Potential
Limited to the difference between either the call strikes or put strikes (whichever is greater) minus the net premium received.
Time Decay Effect
Benefits from time decay
Best Used In
Low volatility, sideways-trending markets when you expect the stock to remain within a specific price range.
Example
On XYZ trading at $50, you sell the $45 put for $1, buy the $40 put for $0.50, sell the $55 call for $1, and buy the $60 call for $0.50. Net premium: $1. Max profit: $100 per spread if XYZ stays between $45-$55.
Butterfly Spread
A three-leg options strategy that combines bull and bear spreads, using four options with three strike prices, designed to profit from low volatility.
Components
Profit Potential
Limited to the difference between adjacent strike prices minus the net premium paid.
Loss Potential
Limited to the net premium paid.
Time Decay Effect
Mixed effect from time decay
Best Used In
Low volatility markets when you expect the stock to be near a specific price at expiration.
Example
On XYZ trading at $50, you buy one $45 call for $6, sell two $50 calls for $3 each, and buy one $55 call for $1. Net cost: $1. Max profit: $4 per spread if XYZ is exactly $50 at expiration.
Collar Strategy
A protective strategy where you own the stock, buy a protective put, and sell a covered call. Limits both potential losses and gains.
Components
Profit Potential
Limited to the call strike price minus the stock purchase price, minus the net cost of the options.
Loss Potential
Limited to the stock purchase price minus the put strike price, plus the net cost of the options.
Time Decay Effect
Mixed effect from time decay
Best Used In
When you want to protect an existing stock position against significant downside while generating some income.
Example
You own XYZ at $50. You buy a $45 put for $1 and sell a $55 call for $1. The options have a net cost of $0. Your maximum gain is $5 per share if the stock rises above $55, and your maximum loss is $5 per share if it falls below $45.
Calendar Spread
Selling a near-term option and buying a longer-term option at the same strike price. Profits from time decay and volatility increase.
Components
Profit Potential
Variable, typically maximized when the stock price is at the strike price at the near-term expiration.
Loss Potential
Limited to the net premium paid for the spread.
Time Decay Effect
Benefits from time decay
Best Used In
Neutral markets when you expect minimal price movement in the near term but possible movement later.
Example
With XYZ at $50, you sell a $50 call expiring in 1 month for $2 and buy a $50 call expiring in 3 months for $4. Net cost: $2. If XYZ is near $50 when the short call expires, you profit from time decay.
Volatility Strategies
Long Straddle
Buying both a call and a put option with the same strike price and expiration date, profiting from significant price movement in either direction.
Components
Profit Potential
Unlimited in either direction as the stock moves away from the strike price.
Loss Potential
Limited to the total premium paid for both options.
Time Decay Effect
Hurt by time decay
Best Used In
High volatility markets or before major announcements when you expect a significant move but are uncertain of the direction.
Example
You buy a $50 call for $3 and a $50 put for $3 on XYZ stock trading at $50. Total cost: $6. Break-even points: $44 and $56. You profit if the stock moves beyond either point before expiration.
Long Strangle
Buying an out-of-the-money call and an out-of-the-money put with the same expiration date, profiting from significant price movement in either direction.
Components
Profit Potential
Unlimited in either direction as the stock moves beyond either strike price.
Loss Potential
Limited to the total premium paid for both options.
Time Decay Effect
Hurt by time decay
Best Used In
High volatility markets or before major announcements, when you expect a large move but are uncertain of direction. Lower cost than a straddle.
Example
You buy a $55 call for $1.50 and a $45 put for $1.50 on XYZ stock trading at $50. Total cost: $3. Break-even points: $42 and $58. You profit if the stock moves beyond either point before expiration.
Short Strangle
Selling an out-of-the-money call and an out-of-the-money put with the same expiration date, profiting when the stock price stays between the strike prices.
Components
Profit Potential
Limited to the total premium received for both options.
Loss Potential
Potentially unlimited on the upside (short call) and substantial on the downside (short put) if the stock moves significantly.
Time Decay Effect
Benefits from time decay
Best Used In
Low volatility markets when you expect the stock to remain within a range and implied volatility is high.
Example
With XYZ trading at $50, you sell a $55 call for $1.50 and a $45 put for $1.50. Total premium received: $3. Maximum profit is $300 per spread if XYZ stays between $45 and $55 at expiration.
Short Straddle
Selling both a call and a put option with the same strike price and expiration date, profiting when the stock price remains near the strike price.
Components
Profit Potential
Limited to the total premium received for both options.
Loss Potential
Potentially unlimited on the upside (short call) and substantial on the downside (short put) if the stock moves significantly in either direction.
Time Decay Effect
Benefits from time decay
Best Used In
Low volatility markets when you expect minimal price movement and implied volatility is high.
Example
With XYZ at $50, you sell a $50 call for $3 and a $50 put for $3. Total premium: $6. Maximum profit is $600 per straddle if XYZ is exactly $50 at expiration. Break-even points: $44 and $56.