Question

If one is bullish on a stock, what option contract would you purchase? When is it in the money? When does it become profitable? If bearish, what option would you purchase? When is it in the money? What are the key variables that determine the value of an option?

Answer 1

Bullish Option Strategies

Bullish strategies are used when you forecast an increase in a security’s price. This security may be referred to as the underlying or simply the stock. The basic concept behind bullish options strategies is for these trades to result in a gain if the trader’s forecast of the underlying is correct. If your projections did not come to fruition in the prescribed time, the option trade may result in a loss.

Buying a Call Option

A call option provides you with the right to buy the underlying shares (usually 100 per contract) at a pre-negotiated price on or before a specific date. If the stock increases in price, the call option’s price may increase as well, allowing you to profit. If the call option’s price increases above the amount paid, you’ll realize a profit. However, it is possible for the call option to lose value and you would incur a loss. Too much time may have passed or there may have been a decline in the corresponding equity’s price. If this happens, you may lose a portion of or the entire amount of the call option’s value.

Buying a Protective Put

If an online stock trader owns or is long 100 shares of a stock, the trader may decide to protect this investment during times of market uncertainty or increased market volatility. If the online trader’s longer term outlook is bullish, one option trading strategy to consider would be to buy a put option online in order to hedge or protect the long stock position. The buyer of the put option obtains the right to sell the individual equity shares (usually 100 per contract) at a predetermined price on or before a certain date. This means if the stock declines in value, the put buyer has the right to sell the shares potentially for an amount higher than the current stock price. The put option acts like a home insurance policy. You hope you never need to use it, but it’s nice to know you have it. This comes at a price, known as the option premium. Even though the asset is now “insured” there is no limit to the upside profitability of the stock if the stock increases by more than the cost of the put option. If the stock stagnates or only increases slightly, the purchase of the put option may not have been necessary in hindsight. The trader may incur a loss on the put trade.

Bearish Option Strategies

If you foresee a decline in a stock’s value, you’ll likely employ a bearish options trading strategy that will take advantage of a decrease in the underlying asset’s price. This may cause the strategy to realize a gain. If your forecast is incorrect, the option strategy could net a trading loss.

The first bearish strategy most online traders learn is how to sell a stock short online. This is profitable if the stock declines in price lower than your sell short price. You would buy back the shares that you are short and close out the short stock position. If the stock increases in price, you will incur incremental losses as the stock rises in price. Because there is no limit on how high a stock may rise, short selling may result in unlimited losses.

Buying a Put Option

If you have the same market outlook as a short seller but wish to employ a trading strategy with lower and predefined risks, you can purchase a put option. Unlike the Protective Put strategy, you do not own the underlying stock.

As the buyer of a put option, you have the right to sell shares of the stock (usually 100 per contract) at a fixed price on or before the expiration of the put option contract. If the stock decreases, the put option may become more valuable as the stock trades lower and lower in price. This increase in the put option’s value allows you to sell the put option for more than you paid, netting a profit.

Trades don’t always turn out as planned and the same is true for buying put options. This bearish trading strategy may lose money if the put price declines in value. One reason this may occur is if the stock movement is opposite to your forecast and actually increases. Another reason could be that too much time has passed. However, your loss is limited to the cost paid for the put option.

Options trading strategies aren’t all black and white – there are numerous shades of gray when it comes to identifying a suitable approach. Different trading scenarios will require a different approach to investment.

Market neutral option trading strategies attempt to take advantage of a stock that is expected to be range bound or stagnant in price over a period of time. Although any price movement is possible, it’s unlikely that a stock will move severely in either direction during orderly trading conditions.

You may foresee increased volatility in a certain stock. That’s when your strategy should maximize exposure to increased implied volatility in options. Increases in implied volatility infer that the stock has a greater propensity to move either up or down. Use certain strategies to make a profit if the stock makes an extreme price move. If the stock stagnates or implied volatility decreases, you may incur a loss.

Ally Invest has a flexible and customizable options trading platform, designed to improve your experience. We’ll help you research the underlying stocks and provide access to invaluable market data and statistics, which play a fundamental role in deciding on a trading strategy.

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