5 Tips For Trading Stock Options

You're ready for the exciting world of stock options, but you need some strategies to check out. Thankfully, the Internet is full of advice from traders. Unfortunately, not all of that advice is sound. Some traders are merely mimicking what they've seen other traders do. 
Others are newbies themselves. Still others are offering advice while secretly trying to sell you their proprietary software. While trading in stock options is an advanced strategy, you don't have to over-complicate things. Find yourself a good broker using a site like BrokerStance. Then, start with some basic strategies. 

The Covered Call

A covered call is a basic options strategy. Also called a "buy-write strategy," you purchase the underlying assets outright. Then, you simultaneously write or sell an option on those same assets. So, for example, if you wanted to buy 1,000 shares of General Electric, you would also write the option on GE. The volume of assets (the number of shares) should be equal to the number of shares controlled by the option. 

So, continuing the example, if you had purchased 1,000 shares of GE, you would also want to make sure the option allowed you to sell 1,000 shares of GE. Investors often use this strategy when they have a short-term position and a neutral view of the stock they're buying. You would use this strategy to generate income from the call premium (from writing the option). You would also use this strategy to protect yourself from a potential decline in the underlying stock's asset value. 

Since investors always make money with this strategy, they're attracted to it. However, it is possible to under perform the underlying stock, making it a less profitable strategy than, say, investing directly in the stock and forgetting the option contract. 

The Married Pull

A married pull is where an investor buys or owns a particular stock, and then simultaneously buys a put option for an equivalent number of shares in that stock. Typically, this strategy is used when you believe the underlying stock will decline in value and you want to protect yourself from short-term losses. It basically creates a sort of insurance policy against losses by establishing a "floor" on losses. 

This is a more conservative strategy and depends on you being bearish on the underlying asset. You are taking a defensive stance in your portfolio. The goal isn't necessarily to make money but to avoid losses. 

A Protective Collar

A protective collar strategy is used when you've already made a lot of money and you want to preserve your gains. To pull this off, you need to purchase out-of-the-money put options on the underlying asset and write an out-of-the-money call option at the same time. The effect? Even if your shares decline in price, the put options protect you and you get to keep the gains you've earned. 

Like the married pull, this is a more defensive strategy. You've already done the hard work of figuring out which stocks to buy, and you've made money. You just want to keep from losing it if the stock turns sour quickly. It buys you some time to get out of the asset if execution is slow (i.e. if the stock is thinly traded) or if you think there's new news about the company that will cause an immediate, short-term, reversal on the price. 

A Long Straddle

The long straddle is used when you want the potential for unlimited gains but want to limit your losses to the cost of the options contracts. To implement this strategy, you must purchase a call and a put option with the same strike price. The option is on the same underlying asset. So, in effect, you are "straddling" both sides of the stock. You have the right to both buy and sell that underlying asset. This strategy works best when you think the underlying asset is volatile and will move, but you're not sure which way it will move. 

A Long Strangle

By adopting a long strangle (as opposed to a long straddle), you are essentially trying to do the same thing as with the straddle, but you're buying the options contracts at different strike prices and you're also buying them out-of-the-money (meaning that they're not immediately profitable when you buy them). 

The call option strike price is typically higher than the put option strike price. Use this strategy when you think the underlying stock will make a huge move, but you're unsure of which way it will move. Like the straddle, losses are limited to the cost of the contracts. The upside potential is unlimited. 

Jarryd Harden enjoys sharing his know how on trading stock options. His articles mainly appear on investment blogs.

Looking for Part-Time Income?

Economic downturns, furloughs and sequesters have a lot of people looking to supplement their income to offset their losses in recent years. Fortunately, there are a number of options to get some extra income on the side, including options such as covered calls. Before you run to make extra money though, know that the first steps in financial freedom is always budgeting (try this method?) and living within your means (like this guy?). Do you need the newest iPad? Can you give yourself a raise by simply spending smarter? 
After taking an honest look at your own finances, you may decide you really do need extra income. Perhaps you want to fund a hobby, or you are one of the few lucky ones with extra time on your hands, or even want to find a different investment opportunity. Covered calls are one opportunity you can exercise in order to pull in extra income with investments you already have or can acquire.
What are Covered Calls?

Covered calls are an option one can sell on investments they already own. The option is to purchase the underlying investment at a strike price before a certain date. The hope for the seller of the covered call, is that the option is purchased and never exercised, allowing them to sell the option repeatedly to generate a consistent flow of income. This will happen if the underlying investment value remains below the strike price. If the investment value exceeds the strike price, you will be forced to sell the investment at the lower strike price, but you will keep the amount you sold the option for.
What do I need to start?

In order to start selling covered calls, you need to have investments. Certain investments will be better than others based on your expectations of their future performance. As stated above, investments you expect to remain constant in value, or to decline (and which you don't otherwise want to sell), are best investments for covered calls. Of course, the if the entire market agrees with you that the investment will not increase in value then no one will purchase your option to begin with, so obviously, you need to have an investment whose future is at least somewhat uncertain at the time of the option sale. Barring insider trading (which is illegal), predicting the future can be difficult, but also can be worth the rewards if you are willing to take the risks.
What are the risks?

The risks of covered calls are the same as with any option and with any stock investment. With the option itself, you put at risk only the difference between the increase in value of the stock and the strike price – thereby limiting the gain you can make if the price of the stock does increase. However, owning the underlying investment also presents a risk that is not eliminated by using covered calls. By owning the stock, you are risking the entire value of that stock, as you are when you invest in anything. Because the options are 'covered', that is, you own the underlying stock at the time of the option sale, you are limiting your risk as opposed to when the option is 'naked' where you will have to purchase the underlying stock at market price in order to sell it to the option buyer at the strike price if they exercise the option.
How do I get started?
There is a lot of information about covered calls available on the internet and in investment books. One such source is Compound Stock Earnings. Always remember, however, that options are bets on the future performance of the stock market and are not a guaranteed source of income. If you do choose to invest in covered calls, be sure you are using funds you don't necessarily need to survive (or retire) on.