Options enable investors to use many different strategies to achieve their desired financial goals.
There are three primary reasons to trade options: to protect or “hedge” a position, to generate income, or to speculate on the future price movement of an asset.
Options traders can purchase or sell different options contracts to tailor positions to their market expectations. Options strategies can benefit from directional moves or from stock prices staying within a defined range.
Strategies vary significantly from single-leg options to more complex multi-leg positions with long and short options.
Risk Defined Strategies
Risk defined strategies are positions where the maximum loss is defined at trade entry. Risk defined strategies can be used to create a maximum loss scenario and help investors manage downside exposure. Single-leg long options have a maximum loss limited to the cost when the position is opened.
For example, purchasing a long call or put option for $2.50 means the most that can be lost on the position is $250 per contract, no matter what happens with the underlying asset.
Multi-leg options can be used to define risk by simultaneously buying and selling long and short contracts. With multi-leg options strategies, profit potential may also be defined. With net debit multi-leg strategies, the loss is still limited to the original debit paid, and profit may be limited to the width of the spread minus the cost of the trade.
For example, a $5 wide debit spread that costs $2.00 has a max loss of $200 and a max gain of $300 per contract. Short multi-leg options collect a credit when the contract is opened. The credit received is the maximum amount that can be gained. The maximum loss in a risk defined strategy is the width of the spread minus the credit received.
Risk defined options strategies have lower margin requirements than unlimited risk strategies, reducing the capital needed to initiate the position.
Unlimited Risk Strategies
Unlimited risk strategies have an undefined or unlimited risk of loss at trade entry. Unlimited risk is a possibility with naked or uncovered options selling.
For example, when selling a naked call option, the option writer is required to sell shares at the strike price if assigned stock. Because stock can potentially go up indefinitely, the risk is not defined. Selling a call option with a $100 strike price for $2.00 has $200 of potential profit but unlimited maximum loss if the underlying stock rises significantly.
Unlike risk defined strategies, naked options require more margin to be held in the account and more capital to hold the position. The margin needed to hold an unlimited risk strategy may not be static. If volatility in the market rises, margin requirements may increase because the brokerage firm wants to ensure enough money is in the account to cover an assignment in the underlying asset.
Payoff diagrams illustrate where options strategies will make or lose money at expiration based on the underlying asset’s different price points. Profit and loss diagrams are visual aids that can be used with single-leg and multi-leg strategies. Payoff diagrams help to explain all potential profit and loss outcomes of a strategy including break-even points, maximum loss, and maximum gain.
The green portion of the payoff diagram line shows where the position is profitable at expiration relative to the underlying security’s price. The red portion of the payoff diagram line shows where the position is at a loss at expiration relative to the underlying security’s price.
The further above or below the payoff diagram line is from the x-axis, the greater the profit or loss at expiration. The point (or points) where the payoff diagram line crosses the x-axis is the break-even price at expiration.
Before expiration, the position’s profit or loss will differ from the payoff diagram because of extrinsic factors like time value and volatility.