7.2 Options Strategies

Options can be combined with stock positions or other options to create strategies for hedging, income generation, or speculation. The Series 65 tests your understanding of basic strategies and their risk/reward profiles.

Protective Strategies

Protective Put (Married Put)

A protective put combines owning stock with buying a put option on the same stock. This strategy acts like insurance against a decline in the stock price.

Stock: Long (own shares)

Put Option: Long (buy put)

Purpose: Protect against downside while maintaining upside potential

Characteristics:

- Maximum loss: (Stock cost - Strike price) + Put premium

- Maximum gain: Unlimited (stock can rise indefinitely)

- Breakeven: Stock cost + Put premium

- Outlook: Bullish long-term but concerned about short-term decline

In Practice

An investor owns 100 shares of XYZ at $50 and is worried about a potential decline. She buys a $45 put for $2.

- Maximum loss: ($50 - $45) + $2 = $7 per share

- Breakeven: $50 + $2 = $52 (stock must rise to cover put cost)

- If stock drops to $30, she can still sell at $45 (the strike price)

The put acts as a "floor" on her losses - no matter how far the stock falls, she can exercise at $45.

Income Strategies

Covered Call

A covered call combines owning stock with selling (writing) a call option against it. The call is "covered" because the writer owns the shares to deliver if assigned.

Stock: Long (own shares)

Call Option: Short (sell call)

Purpose: Generate income from premium; reduce cost basis

Characteristics:

- Maximum gain: (Strike - Stock cost) + Premium received

- Maximum loss: Stock cost - Premium received (stock could go to $0)

- Breakeven: Stock cost - Premium received

- Outlook: Neutral to slightly bullish

Example Calculation

An investor owns 100 shares of ABC at $40 and writes a $45 call for $2.

- Maximum gain: ($45 - $40) + $2 = $7 per share (if stock called away at $45)

- Breakeven: $40 - $2 = $38 (premium lowers effective cost)

- Trade-off: If stock soars to $60, investor still sells at $45

On the Exam

Covered calls are popular exam topics. Remember:

- Premium received provides downside cushion

- Upside is capped at the strike price

- Stock may be "called away" if price exceeds strike

Break-Even Calculations

Calculating break-even points is heavily tested on the Series 65.

Long Call: Strike Price + Premium Paid

Long Put: Strike Price - Premium Paid

Short Call: Strike Price + Premium Received

Short Put: Strike Price - Premium Received

Covered Call: Stock Cost - Premium Received

Protective Put: Stock Cost + Premium Paid

Memory Technique

For long positions (buying options):

- Call: Add premium to strike (need stock to go UP past breakeven)

- Put: Subtract premium from strike (need stock to go DOWN past breakeven)

Spread Strategies

Spreads involve buying and selling options of the same type (both calls or both puts) with different strike prices or expirations.

Bull Call Spread

Construction: Buy lower strike call + Sell higher strike call

Outlook: Moderately bullish

Maximum Gain: Difference in strikes - Net premium paid

Maximum Loss: Net premium paid

Cost: Lower than buying call alone

Example: Buy $50 call for $5, sell $55 call for $2 (Net cost: $3)

- Max gain: ($55 - $50) - $3 = $2

- Max loss: $3 (net premium)

Bear Put Spread

Construction: Buy higher strike put + Sell lower strike put

Outlook: Moderately bearish

Maximum Gain: Difference in strikes - Net premium paid

Maximum Loss: Net premium paid

Volatility Strategies

Long Straddle

A straddle involves buying both a call AND a put with the same strike price and expiration.

Construction: Buy call + Buy put (same strike, same expiration)

Outlook: Expecting significant price movement (either direction)

Maximum Gain: Unlimited (upside); Strike - Premium (downside)

Maximum Loss: Total premiums paid (both options)

Breakevens: Strike + Total Premium; Strike - Total Premium

When to Use a Straddle

Straddles profit from volatility, regardless of direction:

- Before earnings announcements

- Before FDA drug approvals

- Before major economic events

Example: Buy $50 call for $3 and $50 put for $2 (Total cost: $5)

- Upper breakeven: $50 + $5 = $55

- Lower breakeven: $50 - $5 = $45

- Stock must move beyond $45 or $55 to profit

In Practice

An investor expects a biotech stock to move significantly after trial results but doesn't know which direction. A straddle lets them profit whether the news is very good (stock soars) or very bad (stock crashes) - as long as the move exceeds the combined premium cost.

Collar Strategy

A collar combines a covered call with a protective put, creating a defined range for gains and losses.

Construction: Own stock + Buy put (below current price) + Sell call (above current price)

Maximum Gain: Call strike - Stock cost + Net premium

Maximum Loss: Stock cost - Put strike + Net premium

Cost: Often "zero-cost" if premiums offset

Collars are popular for protecting concentrated stock positions while minimizing cash outlay.

Summary: Strategy Comparison

Protective Put: Outlook - Bullish (hedged); Max Gain - Unlimited; Max Loss - Limited; Used For - Insurance

Covered Call: Outlook - Neutral/slightly bullish; Max Gain - Limited; Max Loss - Substantial; Used For - Income

Bull Call Spread: Outlook - Moderately bullish; Max Gain - Limited; Max Loss - Limited; Used For - Lower-cost speculation

Bear Put Spread: Outlook - Moderately bearish; Max Gain - Limited; Max Loss - Limited; Used For - Lower-cost speculation

Long Straddle: Outlook - Volatile (either direction); Max Gain - Unlimited; Max Loss - Limited; Used For - Volatility plays

Collar: Outlook - Neutral; Max Gain - Limited; Max Loss - Limited; Used For - Protecting gains

Key Takeaways

- Protective put: Own stock + buy put = insurance against decline; unlimited upside

- Covered call: Own stock + sell call = income generation; capped upside

- Spreads: Buy one option, sell another = limited risk AND limited reward

- Straddle: Buy call + put = profit from large moves in either direction

- Collar: Protective put + covered call = defined gain/loss range

- Break-even calculations: Add premium to strike for long calls; subtract for long puts