Once an investor decides to enter the options trading scene, they will need to exploit the various types of options trades to engender highest possible profits with the least downside risk. There are four kinds of options trades: Long Call, Long Put, Short Call and Short Put. By bringing the two standard stock trading strategies (Long and Short) into the mix, a number of options strategies can be employed. Things can get very complicated very quickly, leading to complex options trading strategies with colorful names like “Bull Spread”, “Bear Spread”, “Strangle” and “Butterfly”. The great majority of small investors who trade options will generally restrict themselves to variations on Call and Put options, however.
Call options can be Long or Short. In essence, when a trader purchases a Long Call they are expecting the price of their target stock to increase by a certain date. Instead of just buying the actual stock, they will purchase a Call Option that gives them the right (but not the obligation) to buy the stock before the option’s expiry date. Upon expiry, the investor will profit from the difference between the premium paid and the value of the stock above the exercise price. Why not just buy the actual stock and sell it when it increases in price? The answer is, a trader can purchase many more options than shares of stock with the same amount of money. Short Calls work in a similar fashion, only in this case the investor is expecting the stock price to fall. Both Long and Short Calls embody a significant amount of downside risk, however, if the stock price moves opposite to that which the investor expects. The way options traders minimize this risk, is to buy or sell Covered Calls that in effect get them out of the market before their losses become unsustainable.
Put Options can also be Long or Short. In a Long Put, investors who expect the price of a stock to drop can buy options to sell that stock at a set price. Once again, there is no obligation to actually sell the stock, but the investor retains the right to sell up until the option’s expiry date. The investor will make a profit if the stock price drops below the exercise price by any amount greater than the premium they have paid. A Long Put helps minimize the risk that the stock price will rise. Should that scenario play out, the put contract will expire with the investor only liable to pay the premium he already paid on the contract.
In a Short Put, the trader who believes a stock’s price will increase will purchase a Short Put contract to sell the stock at a set price, assuming an obligation to buy the stock at that price on the expiry date. Naturally, if the stock rises above the fixed price plus the premium, the trader makes a profit from the difference. In effect, they can buy the stock at a lower price than the stock’s actual price and profit by then selling the stock. Of course, should things not go as planned and the stock drops below the exercise price plus the premium, the trader will suffer a loss.