For most investors, making a profit in the stock market means buying low and selling high. Options traders, on the other hand, realize a profit can be made in any environment, even when the market doesn't trade up or down. Options contracts are flexible tools that make this possible, though some approaches are as risky and complex as they are versatile.
One way to profit from options in any market, as well as to employ even more sophisticated strategies, is by writing options. When a speculator writes an option contract, he receives a payment from an investor who purchases it. This payment is known as the premium, and the speculator keeps this payment even if the contract right is never exercised. As a result, profitable call options can be written for commodities the speculator believes will trade flat or downward and put options for commodities trading flat or upward. Writing contracts without an appropriate position in the underlying commodity entails a substantial risk, however.
The Straddle Strategy
Most stock and option investments involve the purchase of a single security that becomes profitable if the underlying commodity moves in one particular direction, up or down. Instead of hoping for a specific move, a straddle involves buying both a call and a put option at the same strike price and with the same expiration dates. This becomes profitable if the security moves in either direction, as long as it moves enough to cover the premium cost for both contracts. A straddle may also be written by a speculator if he believes the commodity will trade flat but at a theoretically unlimited risk.
The Strangle Strategy
At first glance, a strangle appears very much like its brother, the straddle. While both feature the purchase of a put and call option with the same expiration date, the contracts are instead purchased at different strike prices. This enables a speculator to enter the position at a lower cost, as one or both of the contracts may be purchased out of the money, meaning they are not worth exercising at the underlying commodity's current value. While this is a less expensive position to enter, the strangle also requires more movement in the commodity before it becomes profitable than the comparable straddle strategy. Like the straddle, a strangle may also be written by the speculator, though at similarly great risk.
One of the more difficult option strategies to understand is the collar. To create a collar, the speculator first must own the commodity directly. She then writes an out-of-the-money call option and receives a premium for having done so. With the premium, she purchases an out-of-the-money put option. Therefore, if the commodity moves down, her loss is limited due to the put option. If the commodity moves up, she still makes a small but limited profit on the upward movement. A reversed form may be created by a speculator who begins with a short position in a commodity; she profits if it moves lower and is protected against unfavorable upward movement.
Video of the Day
- Trading and Exchanges: Market Microstructure for Practitioners; Larry Harris
- Equity and Index Options Explained; W.A. Beagles
- Brand X Pictures/Brand X Pictures/Getty Images