Stock options have a reputation for being risky and complex. While that reputation isn’t entirely undeserved, beginners can use several straightforward options strategies to generate an income, hedge their portfolio, or speculate. You can build up your skills with these strategies before moving on to more advanced techniques.
Let’s look at three options strategies that beginners can use to harness the power of options without getting in over their heads.
#1. Covered Calls
Are you looking to generate more income from your portfolio?
Covered calls involve selling a call option against a long stock position in exchange for a premium. If the stock remains below the option’s strike price, you keep the premium income and the stock. If the stock rises above the option’s strike price, you still keep the premium income, but you will have to sell the stock (at a profit) or buy back the option.
Some investors sell covered calls against stocks they already own to generate an income that goes above and beyond dividends. In other cases, they may use a covered call screener to find promising opportunities and simultaneously buy the stock and write the call option in what’s commonly known as a buy-write strategy. Either way, it’s a great starting point for new options traders given the low risk and easier wins.
Snider Advisors’ Covered Call Screener – Source: Snider Advisors
At Snider Advisors, we developed the Snider Investment Method to provide a clear set of rules for entering and managing covered call trades to generate monthly cash flow in retirement. Our free three-part training series goes over how to choose the right stocks, expiration dates, and strike prices, as well as how to manage trades that go awry.
#2. Protective Puts
Are you looking for ways to lock in profits or hedge against a decline?
Protective puts enable you to lock in profits or hedge against a decline by purchasing the right to sell at a specific price until a certain date. If the stock falls below the strike price, you can exercise the option and sell the stock at the strike price, protecting yourself from any further downside. But, of course, this put protection costs you money up front. Buying this protection month after month can become very costly.
The catch is that protective puts only work in the early stages of a decline when there’s little volatility. If you wait too long, the price of the put option will become prohibitively expensive. The good news is that you still retain all of the upside potential. If the stock price soars higher, you still have the upside minus the option premium cost.
Another benefit of protective puts is that you don’t have to sell the stock after the decline. For instance, if you purchase a protective put option with a $10.00 strike price and the stock falls to $5.00, you can Sell to Close the option and receive at least $5.00 per share in intrinsic value and avoid selling the stock. That way, you avoid triggering any capital gains or disrupting your portfolio.
#3. Buying Calls
Are you looking for a way to take a big risk, leverage, and speculate?
Call options provide an easy way to speculate on stock price appreciation without tying up a lot of capital. For example, you can purchase an out-of-the-money call option for a fraction of the cost of buying 100 shares of the underlying stock. But, of course, the downside is that you could lose your entire investment if you’re wrong.
Unfortunately, buying calls are among the most common trades for new options traders, and they usually result in losses. In fact, it’s one of the big reasons that options get such a bad reputation for risk. The key to buying call options is to ensure that you understand these risks and you’re comfortable taking them as part of a diversified strategy.
Long-term equity anticipation securities, or LEAPS, are a lower-risk way to speculate on long-term price movements. These options typically have a two-year expiration date, providing you with a lot of time to be correct. The critical benefit is that you can purchase the right to buy 100 shares for a lot cheaper than purchasing 100 shares outright.
What Are the Next Steps?
There are many other option strategies that you may want to consider as you become more familiar with the process. In particular, you should consider strategies with limited downside potential as a way to expand your knowledge without taking on an excessive amount of risk.
Some of the most common strategies include:
- Protective Collars involve buying an out-of-the-money put option while simultaneously writing an out-of-the-money call option for the same stock. By combining a covered call with a protective put, you can protect your underlying stock from downside at a lower cost.
- Long Straddles consist of a call option and a put option with the same strike price and expiration date. This is a popular strategy if you expect a large price move, but don’t know which direction.
- Long Strangles involve buying an out-of-the-money call option and a put option with the same expiration date and different strike prices. The put strike should be below the call strike. Again, the strategy provides unlimited upside with limited downside. Your maximum loss is limited to the total cost of the call and put.
While these strategies are more complex, they have limited downside potential, making them less risky than other option strategies. However, you should avoid strategies with an unlimited downside—such as writing naked calls—until you’re very comfortable with options. These riskier strategies can result in sudden and severe losses.
The Bottom Line
Stock options provide you with a lot of flexibility: You can use them to generate an extra income, hedge against declines, or speculate. While some strategies can become very complex, the strategies that we’ve covered above only require a Level 1 or Level 2 options trading agreement with your broker, making it accessible to almost anyone. We encourage beginners to start with low risk option strategies like covered calls rather than buying calls to begin.