Selling Options for Fun and Profit
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A Beginner’s Guide to Covered Options Strategies
When it comes to options trading, selling options can be a profitable strategy if managed properly.
For beginners, it’s crucial to understand not just the potential profits but also the risks involved. One effective way to manage these risks is by using a strategy that involves selling an option while simultaneously buying another option at a different strike price to limit potential losses.
This is often referred to as a “covered” or “spread” strategy. Here, we’ll explore two specific types of these strategies: the Bear Call Spread and the Bull Put Spread.
1. Bear Call Spread
This strategy is used when you have a bearish outlook on a stock — meaning you expect the stock price to decline. Here’s how you can set up a Bear Call Spread:
- Sell a Call Option: This is your primary position. You sell a call option at a certain strike price. This position is profitable if the stock price stays below the strike price of the call you sold.
- Buy a Call Option: To cover this position, you buy another call option with the same expiration date but at a strike price that is higher (usually 5 strikes above). This is your insurance in case the stock price rises unexpectedly.
Example: Suppose a stock is trading at $100. You could sell a call option with a strike price of $105 and buy a call option with a strike price of $110. If the stock price stays below $105, your sold call option will expire worthless, and you keep the premium received. However, if the stock price rises above $105, your losses on the sold call are offset by gains in the bought call, up to the $110 strike price.
2. Bull Put Spread
This strategy is suitable when you have a bullish outlook on a stock — meaning you expect the stock price to increase. Here’s how you can set up a Bull Put Spread:
- Sell a Put Option: This is your primary position. You sell a put option at a certain strike price. This position is profitable if the stock price stays above the strike price of the put you sold.
- Buy a Put Option: To cover this position, you buy another put option with the same expiration date but at a strike price that is lower (usually 5 strikes below). This limits your potential losses if the stock price falls.
Example: Suppose a stock is trading at $100. You could sell a put option with a strike price of $95 and buy a put option with a strike price of $90. If the stock price stays above $95, your sold put option will expire worthless, and you keep the premium received. However, if the stock price falls below $95, your losses on the sold put are offset by gains in the bought put, up to the $90 strike.
Benefits of Covered Options Strategies
- Limited Risk: By buying another option, you cap the potential losses if the market moves against your initial position.
- Premium Income: You receive upfront income from the option you sold, which can provide a steady income stream.
- Defined Outcome: These strategies provide clear scenarios for profit and loss, making it easier to manage your trades.
Considerations
- Cost: Buying an option to cover your position reduces potential profits since you need to pay a premium for the bought option.
- Market Movements: These strategies work best in markets with less volatility, as significant market swings can still lead to losses.
For beginners, it’s advisable to start with a thorough understanding of how options work and consider paper trading (simulated trading) to practice these strategies without financial risk. Always be aware of the expiration dates and strike prices involved in your trades to manage them effectively.
This article does not offer either financial or legal advice. The content is purely informational and educational in nature. Never invest more than you can afford to lose. Always consult with a CPA or financial advisor or planner before making any investment decisions.
