Option Investing Strategies: 2 Proven Approaches for Risk Management & Profit

Option investing provides a way or investors to minimize their loss potential and maximize their gains. An option is a contract between a holder and a writer to perform some action by some predetermined expiration date, typically 9 months. A premium is the price the buyer pays for their right, and the holder receives for their obligation.

There are various option strategies that are available to an option investor. These involve the two types of option contracts; calls and puts. From the holder’s perspective, a call is a write to buy stock from the writer at a fixed price stated in the option contract. A put gives the holder the right to sell stock to the writer at the contractual price.

Writing Covered Calls

One of the basic option strategies that is used by investors is writing calls. Covered call writing is an income strategy used to maximize income in a stable market. The writer owns the underlying shares of the stock and sells a call. The premium received from the sale represents the income that the writer earns. If the stock price remains the relatively same during the contract period, it will not be exercised by the holder.

Covered call writing tends to be the easiest and safest stock strategies. The call is written with a contract price that is near the purchase price of the underlying stock. If the market stays stable, the investor profits. The premium represents the maximum profit that can be earned by the option writer.

If the market goes down, the investor stands to lose to the extent that the price of the stock falls below the original price minus the premium received. For example, if the option writer paid $50 for the stock and received $5 for the call, when the price falls below $45 a loss occurs.

Holding Puts against a Stock Position

A hedge strategy that protects an investor during a falling or declining market involved buying a put against a long stock position. The option holder pays a premium for the right to sell the stock at a contractual price. This strategy protects the investor against a fall in the price of the stock. An investor who bought 100 shares of ABC stock at $40 per share but sees a potential downward trend can purchase 1 ABC 40 put for a premium of $5 (note that the market sets the premium price for each call and put option traded). If the price of ABC falls to $25, the holder can exercise the put and require the writer to buy ABC at $40, even though the market is at $25. The investor would only be down $500 as oppose to $1,500 as a result.

Hedging a long stock position with a put allows the investor to limit their downside exposure to loss. The hedge minimizes the loss and acted as an insurance policy.

The market must rise at least the amount of the premium paid in order for the investor to break even. In the above example, the investor paid $40 a share for 100 shares of ABC and bought the put at $5 ($500). The price of ABC must rise to at least $45 in order to recoup the cost of the premium paid.