If you were wondering how options trading works, then you are at the right place! When an options trader buys an options contract, they purchase the right – but not the obligation – to buy or sell a security at a predetermined price at a predetermined date. An options contract thus gives contract holders a degree of flexibility at the price of a premium, which is the amount of money a trader pays to secure the contract.

Options trading can be complex, and it may be difficult for traders to get the hang of trading when they start out. Below, we cover four simple options trading strategies, from how they work to how to set them up and when traders should use them.

Writing a covered call

The first of these strategies is the covered call. It is one of the simplest strategies in options trading, but it is equally effective when done right.

A call option is an option that allows a trader to purchase a security at a predetermined price point at a predetermined date. The main point of the strategy is to write covered calls. This means you sell an option to someone else, and you give them the right to purchase a security that you already own.

When the market price continues to rise, the holder of the options will generally abandon the contract and let it expire worthlessly. From this, you can take profit from the premium they paid on the option, while you still get to keep your securities.

How to set up a covered call – Options Trading

To set up a covered call as an options writer, you will need to own the security first. You will then sell a contract that stipulates the holder to buy the security at a certain price (strike price) in the future. Generally, the stock price should be below the strike price at the time of this transaction.

When to write a covered call

Writing covered calls works best when you feel neutral or bullish about security. It is about waiting for the security’s price to rise, but also have some protection against adverse price movements. Often, traders run this strategy when there has been bullish sentiment in the market, and they want to make more income from it.

When you write a covered call, you are also selling the option for someone else to buy your security. This means you should be prepared to part with your security if it comes to that.

Purchasing a protective put – Options Trading

Another simple options trading strategy is to purchase a protective put.

A put option is an option that allows traders to sell a security at a predetermined price point at a predetermined date. When you purchase a protective put, you purchase the right – but not the obligation – to sell security depending on how the market performs.

Traders buy protective puts because they feel the market is tending bullish, but they are uncertain. Protective puts work little like stop orders. What they want is for the security to rise, as they own it, and for the option to expire worthlessly. They are hoping that the gains they earn from the rising prices of the security will be more than the premium they pay to purchase the contract.

How to set up a protective put

Just like writing a covered call, you purchase a protective put when you already own the security you want to speculate on. You then buy a put option at a strike price below the current stock price.

When to purchase a protective put

Trader buys a protective put when they think the market may be bullish, but they are uncertain. In other words, they purchase this option to protect any potential profits against a sudden market downturn.

Running a collar

The third options trading strategy is to run a collar. This means buying a put option that gives you the right to sell a security at a predetermined price and then selling a call at another predetermined price. This is a strategy that can limit your downside instantly but at the expense of imposing a limit on your upside.

This strategy requires both selling and buying options. Some traders will try to sell the call with a high enough premium that pays for the premium on the put they buy. If a trader succeeds in doing this, they have effectively established a ‘zero-cost collar’, as the price of their premiums cancels each other out.

When the premium of the call they sell is greater than the premium of the put they buy, they establish a positive net credit. Let’s say, the opposite occurs, they establish a negative net credit. This shifts the scale slightly for how much they will need to make to earn to break even later.

How to set up a collar

To set up a collar, a trader should already own the security. They then buy a put option at one strike price, and they sell a call option at another strike price. While they do this, they make sure the current security price is between the first- and second-strike prices.

When to run a collar

Traders run a collar when they think the market may be bullish, but they are uncertain. They want to protect any potential profits against a sudden market downturn. They break even when the stock price is above the second strike price.

Selling a cash-secured put

The final options strategy is selling a cash-secured put. This means selling a put option without owning the security first. This obligates the trader to buy the same units of security they sell the put option on.

For example, if they sell 1 put contract and the contract buyer decides to exercise their option, the trader will need to purchase 1 contract’s worth of stocks (100 shares). To play it safe, especially if you are risk-averse. It is best to be sensible about the number of put options contracts you sell. Especially, compared to the number of units of security you usually buy or can afford to buy.

Therefore, this strategy is called a cash-secured put. It is because the trader will need to have enough cash on hand to be able to purchase the security. This is important if their options buyer decides to exercise their contract.

How to set up a cash-secured put

To set up a cash-secured put, a trader needs to write a put option and sell it at a strike price that is lower than the current stock price. The goal is to end up owning the security.

When to sell a cash-secured put

Traders sell a cash-secured put when they are slightly bearish in the short-term, but are bullish in the long term. As mentioned, they want to keep some cash on hand in case the buyer of the option decides to exercise their contract. They should also ensure that the strike price in their put option is lower than that of the stock price at the time of selling.

The bottom line

Above, you have just seen four simple options trading that can change the way you view and trade options. These strategies are suitable for any trader of any level. However, you should make sure you really understand the mechanism behind them. This is important so you can make the most of your trades. If you are worried about trading options, you should consider participating in the markets in a different way. This is because options contracts can be more complex than traditional trading. There is never a need for you to put yourself at unnecessary risk.

If you would like to learn more about online trading, then definitely check out “The Importance of Forex Trading and Where To Learn It“.