Lesson 2: Basic Option Strategies

Four Basic Option Positions

Every option strategy is built from these four basic positions:

Long Call (Buy Call)

• Objective: Bullish – profit from price increase
• Max Risk: Premium paid
• Max Reward: Unlimited
• Breakeven: Strike price + premium paid

Long Put (Buy Put)

• Objective: Bearish – profit from price decrease
• Max Risk: Premium paid
• Max Reward: Strike price – premium (theoretical: stock to zero)
• Breakeven: Strike price – premium paid

Short Call (Sell/Write Call)

• Objective: Neutral/Bearish – profit from price staying flat or falling
• Max Risk: Unlimited
• Max Reward: Premium received
• Breakeven: Strike price + premium received

Short Put (Sell/Write Put)

• Objective: Neutral/Bullish – profit from price staying flat or rising
• Max Risk: Strike price – premium (theoretical: stock to zero)
• Max Reward: Premium received
• Breakeven: Strike price – premium received

Covered vs. Naked Options

Covered Positions (Lower Risk)

• Covered Call: Own stock + sell call option
• Covered Put: Short stock + sell put option
• Have the underlying asset to cover the obligation

Naked Positions (Higher Risk)

• Selling options without owning the underlying asset
• Requires higher margin and experience

Popular Basic Strategies

1. Covered Call

• When to Use: Own stock, expect little movement or slight rise
• Setup: Own 100 shares + Sell 1 call option
• Income: Premium received
• Trade-off: Limited upside, must sell shares if called away

Example:

• Own 100 shares XYZ at $50
• Sell 1 XYZ 55 call for $2 premium
• Maximum profit: $700 ($500 appreciation + $200 premium)
• Breakeven: $48 ($50 – $2 premium)

2. Protective Put

• When to Use: Own stock, want downside protection
• Setup: Own 100 shares + Buy 1 put option
• Insurance: Limits downside risk
• Cost: Premium paid reduces overall returns

Example:

• Own 100 shares XYZ at $50
• Buy 1 XYZ 45 put for $1 premium
• Maximum loss: $600 ($500 decline + $100 premium)
• Protected below $45

3. Cash-Secured Put

• When to Use: Want to buy stock at lower price, generate income
• Setup: Sell put + Keep cash to buy shares if assigned
• Alternative: Gets paid to place a limit order

Example:

• Want to buy XYZ at $45 (current price $50)
• Sell 1 XYZ 45 put for $1.50 premium
• If assigned: Buy at $43.50 effective price ($45 – $1.50)
• If not assigned: Keep $150 premium

4. Long Straddle

• When to Use: Expect big move, unsure of direction
• Setup: Buy 1 call + Buy 1 put (same strike, same expiration)
• Profit: Large move in either direction
• Loss: Premium paid if stock stays near strike

Risk/Reward Profiles

Understanding profit/loss diagrams is crucial:

Long Call Profit/Loss Diagram:
        Profit ↑
            |
            |      /
            |     /
            |    /
            |   /
            |  /
            | /
            |/
------------+------------------> Stock Price
           /|
          / |
         /  |
        /   |

Key Points for Each Strategy:

• Maximum profit
• Maximum loss
• Breakeven points
• When strategy makes/loses money

Practical Exercise

Choose a stock and design two basic option strategies:

1. A covered call strategy (specify strike, premium, profit/loss)
2. A protective put strategy (specify strike, premium, protection level)
   Calculate maximum profit, maximum loss, and breakeven for each.