6 Great Option Strategies For Beginners

Option rookies are often eager to begin trading – too eager. It’s important to get a solid foundation to be certain you understand how options work and how they can help you achieve your goals – before trading.

Here’s a list of my favorite methods. Note: this list contains strategies that are easy to learn and understand. Each is less risky than owning stock. Most involve limited risk. For investors not familiar with options lingo read our beginners options terms and intermediate options terms posts.

1. Covered call writing. Using stock you already own (or buy new shares), you sell someone else a call option that grants the buyer the right to buy your stock at a specified price. That limits profit potential. You collect a cash premium that is yours to keep, no matter what else happens. That cash reduces your cost. Thus, if the stock declines in price, you may incur a loss, but you are better off than if you simply owned the shares.

Example: Buy 100 shares of IBM
Sell one IBM Jan 110 call

2. Cash-secured naked put writing. Sell a put option on a stock you want to own, choosing a strike price that represents the price you are willing to pay for stock. You collect a cash premium in return for accepting an obligation to buy stock by paying the strike price. You may not buy the stock, but if you don’t, you keep the premium as a consolation prize. If you maintain enough cash in your brokerage account to buy the shares (if the put owner exercises the put), then you are considered to be ‘cash-secured.’

Example: Sell one AMZN Jul 50 put; maintain $5,000 in account

3. Collar. A collar is a covered call position, with the addition of a put. The put acts as an insurance policy and limit losses to a minimal (but adjustable) amount. Profits are also limited, but conservative investors find that it’s a good trade-off to limit profits in return for limited losses.

Example: Buy 100 shares of IBM
Sell one IBM Jan 110 call
Buy one IBM Jan 95 put

4. Credit spread. The purchase of one call option, and the sale of another. Or the purchase of one put option, and the sale of another. Both options have the same expiration. It’s called a credit spread because the investor collects cash for the trade. Thus, the higher priced option is sold, and a less expensive, further out of the money option is bought. This strategy has a market bias (call spread is bearish and put spread is bullish) with limited profits and limited losses.

Example: Buy 5 JNJ Jul 60 calls
Sell 5 JNJ Jul 55 calls

or Buy 5 SPY Apr 78 puts
Sell 5 SPY Apr 80 puts

5. Iron condor. A position that consists of one call credit spread and one put credit spread. Again, gains and losses are limited.

Example: Buy 2 SPX May 880 calls
Sell 2 SPX May 860 calls

and Buy 2 SPX May 740 puts
Sell 2 SPX May 760 puts

6. Diagonal (or double diagonal) spread. These are spreads in which the options have different strike prices and different expiration dates.

1. The option bought expires later than the option sold
2. The option bought is further out of the money than the option sold

Example: Buy 7 XOM Nov 80 calls
Sell 7 XOM Oct 75 calls This is a diagonal spread

Or Buy 7 XOM Nov 60 puts
Sell 7 XOM Oct 65 puts This is a diagonal spread

If you own both positions at the same time, it’s a double diagonal spread

Note that buying calls and/or puts is NOT on this list, despite the fact that the majority of rookies begin their option trading careers by adopting that strategy. True, it’s fun to buy an option and treat it as a mini-lottery ticket. But, that’s gambling. The likelihood of consistently making money when buying options is small, and I cannot recommend that strategy.

Mark Wolfinger is a 20 year CBOE options veteran and is the writer for the blog Options for Rookies Premium. He also is the author of the book, The Rookie’s Guide to Options.

Further Reading, Options:

View our Options Trading page.

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Comments

  1. bryan says

    Im a new options trader and I like using the debit spread strategy. I notice you have credit spread but not the debit. Any reason you dont recommend this strategy?

    thanks

  2. says

    Bryan,

    You have not yet learned to recognize that a credit spread is equivalent to a debit spread – and you can use either position to achieve exactly the same results.

    Example

    If you SELL the XYX Jul 45/50 PUT spread, that gives you exactly the same risk and reward potential as BUYING the
    XYX Jul 45/50 Jul CALL spread.

    Neither one is ‘better’ than the other, assuming the options are priced efficiently.

    So if you prefer to buy a call spread instead of selling a put spread, that’s fine. For the spreads to be equivalent however, it’s essential that the strike prices be the same.

    If you prefer buying a put spread, instead of selling a call spread, that’s also fine.

    Take a look at the reference below, but I don’t usually recommend that someone who is a VERY new trader get to this information yet. But, it is important and if you grasp the ideas behind equivalent positions, then you will have moved a LONG way towards becoming a successful trader. Why? Because this demonstrates that you understand options.

    http://blog.mdwoptions.com/options_for_rookies/2008/07/equivalent-posi.html

  3. says

    Let’s say you buy 100shares of stock, and you’ve put a stop-loss on it. Then you sell options on the stock, with a certain strike price. What happens if the stock price drops, hits the stop-loss price, you sell the stock at that stop-loss price, so you don’t even own the stock anymore. What happens to the option? Many thanks for your attention

  4. says

    Joseph,

    With 100 shares, you would sell only ONE option.

    If you sell the stock, most brokers will require that you buy the option, to close the position. In fact, those same brokers will not even allow you to sell the stock, unless you buy the option FIRST.

    Other brokers will allow you to remain naked short the call option, but that is considered to be risky by the option industry.

    Advice:

    1) Ask your broker: “If I sell my stock, must I repurchase the call(s) I wrote?”

    2) Ask if broker allows OTO orders. (One Triggers the Other). If they do, you can set the OTO to automatically buy the call option (unfortunately I doubt they will allow a limit order and force you to enter a market order) if and only if the stock is sold.

    Best regards,
    Mark

  5. says

    I notice you don’t have buying calls & puts in your post. It is generally agreed that >70% of options expire worthless. Therefore, I’d much rather write options such as covered call writing. However, if my view is that the stock price could drop significantly, I may buy a put for insurance.